The growth of microfinance institutions in Africa has been nothing short of spectacular. However, while some institutions such as Kenya’s Equity Bank have been hugely beneficial to the usually unbanked, others have fallen short of the mark and some have ruthlessly exploited the very people they claim to serve. What are microfinance institutions and how should they be governed? Moin Siddiqi provides the answers.
Micro finance is a rapidly growing dynamic sector that offers useful services, whilst posing some risks. Thus, supervisors in Africa need sophisticated systems to monitor and respond to changing risks, in order to protect depositor funds, while fostering critically needed financial inclusion. This niche market can develop into an effective funding channel for emerging small businesses. However, it needs a proper capital structure, good corporate governance and relevant data on both lenders and borrowers through participation in credit bureaus.
Microfinance – the provision of financial services in modest amounts to low-income groups and smaller, informal businesses – is widely being offered by a variety of the African financial institutions, including banks and non-banks, either as their principal business or part of a diversified portfolio. Although banks control deposit-taking activity in most African countries, other types of organisations (e.g. microfinance lenders and financial cooperatives) are tapping the retail deposit market as well. According to estimates, other deposit-taking institutions (ODTIs) hold about 5% of retail deposits in the developing world.
While these ODTIs typically mobilise deposits in small increments, compared to conventional banks, the proportion of citizens they serve is sizeable in some jurisdictions. In Rwanda, ODTIs hold 10% of aggregate deposits, but serve nearly two fifths of depositors and Zambian micro-credit providers have three times as many borrowers as commercial banks. In Bangladesh, micro-credit lenders hold some 7m outstanding loans compared to 4.4m in retail banks.
The types of permissible product lines include micro-credit, micro-savings, and micro-insurance, as well as payments and funds transfers. Empirical evidence suggests poor people actually lead quite active financial lives, reflected in significant borrowing and higher savings relative to their income.
Product design, clientele profile and heavily labour-intensive underwriting methodologies differ significantly from those of commercial banking. Thus, effective credit risk management requires markedly different tools and analysis – relative to the type, complexity and size of each transaction.
Below are included some of the noticeable elements of microfinance business lines and risks:
Micro-borrowers: These are usually entrepreneurs owning an informal family business or petty traders and are typically confined to a limited geographical area or social segment, such as women and the underemployed.
Loans are modest, short-term and unsecured, hence with more frequent repayments and higher interest charges than conventional bank loans. Many lenders demand soaring or excessive interest rates to offset the higher operational costs entailed in labour-incentive lending procedures.
Credit risk analysis: The loan officer, through visits to the borrower’s home and business, handles loan documentation. Borrowers often lack formal banking records, so the loan officer helps in drafting documentation using projected cash flows and net asset worth to determine principal and interest schedule, hence the total loan amount.
The borrower’s integrity and repayment capacity is also carefully assessed during regular field visits, but ‘credit bureau’ data are rarely available for such clientele. Credit scoring (where possible) is being used by some micro-lenders, which complements the more labour-intensive and time-consuming approaches to credit analysis.
Use of collateral: Micro-borrowers mainly lack the collateral (i.e. tangible financial assets) demanded by traditional banks and what they pledge is of negligible value to financial institutions, but are highly valued by low-income groups (e.g. household items). Where the lender holds some kind of collateral, it is for leverage to induce or pressure due repayments rather than to recoup losses.
Credit approval and monitoring: Since micro-lending remains a highly decentralised process, final loan approval by credit committees relies upon the expertise of field officers and sub-managers for accurate and timely data.
Controlling arrears: Stringent control of arrears is essential due to the short-term nature of micro-loans, lack of real collateral and higher payment frequency (e.g. weekly or bi-weekly). Due diligence – needed for prompt debt collections – is also undertaken by loan officers with solid knowledge of the customer’s personal circumstances and ability to service outstanding loans.
Progressively increasing lending: Customers lacking access to other funding are usually heavily reliant upon a few established credit lines from a respective lender. The latter uses incentives to reward those borrowers (making regular payments) with preferential access to future, larger loans (sometimes with favourable repayment schedules and lower interest rates), which, however, can increase the risk of ‘over-indebtedness’, especially where credit information systems are either absent or ineffective within the financial institutions.
Group lending: Some micro-lenders prefer a group lending strategy, where loans are given to small close-knit groups of people who ‘cross guarantee’ other members of the group. Accordingly, peer pressures underpin high repayment levels since default by one group member can adversely impact credit availability to others.
Contagion effects: The quality of individual loan portfolios can deteriorate rapidly given the unsecured nature of micro-loans, coupled with contagion effects, where borrowers who notice rising delinquency levels in the institution could stop debt servicing if they think the lender may be unable to advance future loans due to severe credit quality problems – i.e. rising bad debts.
Political influence: Microfinance business, in general, may be perceived as a socio-political tool in some developing countries, encouraging government officials and politicians to demand forgiveness of loans to poor people during times of hardship. This, in turn, can affect the repayment culture of such borrowers.
A coherent supervisory model
To advise member countries in devising a coherent strategy to regulate and supervise non-banks that mobilise retail deposits, the Basel Committee on Banking Supervision in late 2010 developed guidelines for applying ‘Core Principles for Effective Banking Supervision’ to microfinance activities conducted by ODTIs in their jurisdictions. The four overarching principles are:
*Allocating supervisory resources prudently, especially where ODTIs do not represent a major portion of the financial system, but comprise a larger number of small institutions;
*Developing specialised knowledge within the supervisory team to effectively evaluate inherent risks of micro-finance activities, notably micro-loans;
*Acknowledging that internal controls and managerial practices differ from conventional retail banking, but could suit the microfinance portfolio either in small and large institutions, specialised or not, in microfinance; and
*Achieving clarity in the regulations with respect to microfinance activities, particularly the definition of micro-credit and specifying which activities are permitted to different institutional types, while retaining some degree of flexibility for dealing with individual cases.
The Basel Committee noted: “Besides protecting depositor funds, official oversight may enhance access to financial services by increasing public confidence in microfinance providers, improving their operational standards and setting a level playing field for both banks and non-banks.”
Making microfinance safer
Most jurisdictions – including in the developing world – set clear legal/regulatory frameworks under which micro-credit institutions (MCIs) must operate so that business is conducted in a sound environment for the benefit of wider society. The procedures are quite similar to those applied in retail banking. But given the characteristics of microfinance, supervisors must possess in-depth knowledge of the differences between microfinance and commercial banking, since some techniques deployed to supervise latter’s activities are not appropriate for MCIs.
Supervisors set criteria for MCIs during the licensing process, which include background checks and professional experience of management; identity, suitability and financial strength of major shareholders; minimum initial capital for microfinance providers; assessment of the business plan; and legal, managerial, operational and ownership structures.
Also, ‘fit and proper’ rules apply whereby managers must prove absence of previous criminal convictions, financial expertise, as well as complying with initial capital standards for MCIs.
Most jurisdictions that supervise MCIs use a mix of ‘off-site’ surveillance and ‘on-site’ inspections by scrutinising statistical returns and balance sheets. But frequency of reporting is significantly lower for MCIs, compared with conventional banks. Nonetheless, supervisors have remedial powers to enforce administrative and criminal sanctions, including revocation of licences, as well as imposing heavy fines when MCIs engage in unsound activities or failing to observe prudential standards on accounting and disclosure and, at worst, fraud (e.g. phantom borrowers and misappropriation of funds). External auditors should also possess sufficient expertise in microfinance.
In well-regulated countries, MCIs are expected to establish ‘risk management’ systems to identify, assess, monitor and mitigate credit and operational risks. They are also required to have contingency plans to withstand liquidity squeeze.
On ‘liquidity risk’, MCIs are treated in the same level as retail banks. Although unsecured lending is allowed in most jurisdictions, micro-loans fall under general unsecured lending rules demanding higher provisions. In some countries, unsecured loans cannot exceed $6,250 to a single borrower, whilst in others, unsecured lending is confined to 30-50% of total capital of any lender.
Loan classification rules apply equally to conventional retail loans and micro-credit, although the latter is treated as a separate asset class in most countries. Some jurisdictions require even a minimum level of provisions for performing micro-loans as well. The Basel survey gave an example of an ‘unnamed’ African country, where regulations set ‘three’ risk levels for micro-loans according to days in arrears: 30-89 days; 90-179 days; and 180 or above. Provisions are established for each category at 25%; 50%; and 100%, respectively.
Rules on regulatory capital (according to Basel norms) in MCIs and ODTIs vary significantly among surveyed jurisdictions; however, they tend to be higher compared to retail banks. Kenya imposes a capital-to-total-deposit liabilities requirement on ODTIs of 8%.
In Brazil, cooperatives with total assets of below $2m are not compelled to allocate capital for market risk, but their capital asset requirement is increased by 200 basis points. Whereas in Pakistan, 1.5% of the ODTIs’ loan portfolio is reserved for covering market and operational risks.