Microfinance Q&A
Q. When did microfinance start up?
A. Microfinance started up during the 1970s mainly provided by charitable organisations
The concept of microfinance goes back to the 1970s. At that time it was Non Governmental Organisations (NGOs) that led the way in providing basic finance to low income and poor families. Poverty tends to be measured in income of $s per day. Real poverty is evaluated as less than $2 per day of income.
As the market grew during the 1980s and 90s commercial organisations began to move into microfinance supplementing and in some cases replacing NGOs as the only source of financial products. For the future it is believed that expansion particularly by commercial participants will continue, leaving NGOs to focus on their charitable operations or servicing dispersed rural markets that are not commercially viable.
Q. What does an MFI look like?
A. It varies
MFIs are highly variable in terms of size and quality and any fund manager must vet them in order to select those that are well run and know their market.
MFIs may be Non Governmental Organisations (NGOs), credit unions, cooperatives as well as commercial banks and finance companies. It was the NGOs who first identified the need for microfinance. They are generally non profit organisations but as the market has grown some are converting to more commercial structures and ‘for profit’ organisations.
A number of organisations have created rating systems for microfinance institutions. Microrate and the Microfinance Exchange have scoring systems which allow potential investors to understand how well managed, commercial and effective each microfinance institution is. Factors such as financial profile, operational performance, portfolio quality and governance, are considered. To get a rating, each business must submit itself to scrutiny; so only the largest and the best have so far been rated. More traditional financial ratings agencies are starting to look at the very largest players with a view to creating a more formal rating system.
The borrowers
Q. Who borrows from microfinance institutions?
A. The working poor
Microfinance clients are not a homogeneous group. There will be variations from country to country. Broadly speaking, microfinance is financial services for the working poor. The definition of working poor in some parts of sub-Saharan
Microfinance is for individuals who are excluded from formal financial services as they have no collateral to use to secure finance and would be considered unbankable and unprofitable using traditional financial services models.
Q. Why are default rates so low on microfinance loans?
A. A number of factors combine to reduce default rates
Firstly, borrowers tend to be women who have a better track record of loan repayment.
Secondly, microfinance borrowers know that they will need more capital in the future but few if any alternative sources of funds are available to them.
Fund managers do monitor loan repayments in order to spot potential risks within specific MFIs or countries.
Most MFIs have good local knowledge and use this to be selective in who they will lend to. Repayments are often collected in person at very short intervals like the old home service operations that provided financial services to the poor in the
Some loans are made on a group basis in which all members of the group share responsibility for paying back the loan. This again can help to minimise default rates.
A growing market
A. The market is difficult to size with estimates ranging from 30 million to 152 million users
A realistic estimate is that there is a core of around 30 – 50 million users of microfinance with many millions more accessing money through other finance projects (often government run) across the globe that might be described as very broadly as a form of microfinance.
There is a core of around 400 – 500 MFIs supplying this finance however a further 2,000 – 3,000 small institutions are also involved in serving fewer than 2,500 borrowers. In total as many as 10,000 MFIs may exist although it is apparent that many of these are very small.
The potential market is far larger however. Estimates developed by DWM place the total demand at $280 billion if financial services were provided to all the 1.5 billion working poor who could in theory benefit from microfinance. Supply of money is estimated by Developing World Markets to be approximately $25 billion at present.
Three factors are combining to make the microfinance market continue to grow
· Improvements in technology are making it less expensive to manage loan portfolios
· Increased financial regulation in developing nations is reducing the risk of running microfinance institutions
· Growing interest from capital markets in developed nations is causing money to flow to microfinance institutions. This in turn is acting to make those organisations better managed and more commercial.
A new asset class
Q. Are microfinance returns uncorrelated with developed stock markets?
A. They appear likely to be but the proof is not yet scientific
Developing World Markets, a
There appears to be no discernable correlation although it should be noted that this study focused on MFI performance and not returns from microfinance funds. What was shown (based on regression analysis) was how MFI performance was significantly less sensitive to movements in World and Emerging Market indexes than other more commercial banks.
Reasons for a lack of correlation are also unproven, however the authors of the study (Nicolas Kraus and Ingo Walter) speculate that
· Many of the businesses created and funded through microfinance are small and serve only a local market. As such they are far removed from global market trends
· Microfinance vetting of clients in based on onsite inspections rather than credit models and is therefore more robust
· Microfinance payment collections are more regular – weekly or bi-weekly rather than monthly giving early warning of problems
· Loans tend to be smaller amounts over a shorter term at higher interest rates making them less sensitive to market movements
· MFI shareholders are not solely focused on profit maximization as many are sponsored by non- profit organizations. This acts as a buffer against the effects of stock market turmoil
Without doubt microfinance carries significant risks for the investor. These risks should always be balanced against the fact that microfinance can deliver a huge social benefit and the microfinance model appears to be able to deliver steady returns albeit not at the spectacular levels promised by certain other sectors.
We believe the most significant issues to consider are:
· Foreign Exchange risk – Loans to microfinance institutions may be made in hard currencies (£,$,€) which are of course subject to movements in exchange rates in relation to the currency used by the investor. However loans made in local (exotic) currencies whilst providing the fund with a better return run the risk of local currency devaluations and politically motivated control.
· Political instability – In developing nations the political situation can often be unstable. We have witnessed major turmoil in
· Regulatory and legal infrastructure – Whilst generally the regulation of financial services is improving in developing nations it is far from being on the level we enjoy in more developed economies. Legal infrastructure and in particular legislation governing the ownership of property (so crucial in maintaining a viable financial services industry) is not always in place.
· Business infrastructure – Whilst many small businesses created through microfinance appear relatively unaffected by macro economic cycles the lack of a robust infrastructure in times of upheaval or natural disaster may impact a microfinance institution’s ability to keep trading. And recovery from these situations will take longer.
Of course these same risks might also be regarded as a list of reasons why it is so worthwhile investing in microfinance to help disadvantaged people build a better future.
Diversification is often adopted as an effective means of mitigating these risks. Funds will spread their investments across a wide range of countries, microfinance institutions and currencies to limit exposure to failure in any aspect of the market.
Q. What are the potential returns for the investor?
There are a number of different types of microfinance investment within the market. A recent paper produced for CGAP (Consultative Group to Assist the Poor) identified six main types of investment.
1. Registered mutual funds targeting mainly retail investors aiming to deliver near money market returns from primarily fixed income investment.
2. Commercial fixed-income investment funds targeting public and private institutional investors and seeking close to market returns
3. Structured finance vehicles offering a range of asset-backed securities with different risk and return profiles to microfinance investors
4. Blended value funds offering below-market returns to socially focussed investors using a mix of debt and equity to finance microfinance institutions
5. Holding companies of microfinance banks providing mainly equity finance and technical assistance to start-up microfinance banks
6. Private equity funds seeking market returns
The exact returns you get may be determined by your own motivation for investing. For example the Calvert Foundation offers a microfinance bond where you choose the level of return you receive between 0% - 3%. There are funds that offer a similarly philanthropic approach and provide returns of 3% - 4%. Other funds offer more commercial returns with ranging between 5% - 8% with some stretching the top end to possibly 10%. Higher levels are often driven by the proportion of a fund that invests in microfinance institution equity as opposed to capital to finance lending operations.
