MEET THE BOSS: Discussions on Developing a Global Credit Ratings Framework for Microfinance Institutions: Interview with Damian von Stauffenberg, Founder and Chairman of MicroRate

Damian von Stauffenberg is the founder of MicroRate, a rating agency specializing in microfinance.  Mr. von Stauffenberg founded MicroRate in 1997 and served as its CEO until 2009.  Through its Latin American and African subsidiaries, MicroRate has conducted over 400 ratings of microfinance institutions in Latin America, Africa and Eastern Europe. 

Mr. von Stauffenberg previously worked for 25 years at the World Bank and its private sector affiliate, the International Finance Corporation (IFC).  He has been president of Seed Capital Development Fund (SCDF), chairman of the investment committee of ProFund, chairman of the executive committee of MicroVest and a member of the executive committee of the Latin American Challenge Investment Fund (LA-CIF).

MicroCapital: What services does MicroRate offer to investors considering entering the microfinance sector?

Damian von Stauffenberg:  It’s really a simple concept: transparency.  It is giving investors insight into what is going on inside a microfinance institution (MFI).  That in itself is indispensable to an investor.  When it comes to small investors or other people who cannot directly invest in an MFI, they have to deal with intermediaries.  That is by far the majority of investors out there.  Even these intermediary MIVs (microfinance investment vehicles) to some extent rely on ratings.  We can afford to spend a week at an MFI and really ‘kick the tires,’ which hardly anybody else can do.     

MC: MicroRate was founded in 1997. What was the drive behind the evolution of the company?

DvS: What really kicked that off was a presentation in 1996 by Bob Christen, who is now the head of microfinance at the Gates Foundation.  He presented his findings on a study that he had done on microfinance institutions.  The results showed me how little we really knew about MFIs.  I later came to my own conclusion that microfinance is such a powerful tool that donors would not be able to fund its growth for very long.  Only investors and capital markets are big enough to fund the future growth of microfinance.  Capital markets need transparency; otherwise, they cannot measure risk and determine price. 

MC: What is your approach to evaluating performance risk of MFIs? 

DvS: We feel that while default risk is an important consideration, it is not the main thing or first thing that funders will want to know about the microfinance sector.  MicroRate’s concept of the performance ratings tells you how good an MFI is at providing microcredit compared to its peers.  Even if we had originally wanted to do credit ratings, we could not because there is not a statistical base in existence.  You need statistics from hundreds of MFIs over many years before you can predict this with any kind of accuracy.

MC: Please walk me through how you evaluate an MFI’s performance risk in detail.

DvS: First you ask the company to send you statistics based on an established questionnaire, such as their financials and balance sheet.  Next, you would want to be able to see the kind of reporting information that the leadership team utilizes to manage the MFI.  You look at what kind of reports their management information systems produce.  That gets analyzed by our team before we visit the client.  Next we travel to visit the MFI.  The first rating of the MFI would typically take four to five days.  The field visit is the heart of our ratings process. 

Once at the MFI’s site, we first meet with the CEO and later with second-tier management.  At this point, we differ from conventional rating agencies in that we also talk to middle management and loan officers.  We spend much more time with the companies that we rate. Conventional raters typically spend one day with their client. We are there up to a week with two analysts. This allows us to meet with more of their employees at various branches.  Talking to middle management and loan officers is important since the loan officers are the ones that are ‘out in the trenches’ issuing the loans.  We randomly visit several branches of our choice. 

The first thing we look at is portfolio quality.  There are certain tests that we conduct that can give you some assurance that what an MFI says about their portfolios is real.  We don’t have enough time and enough manpower to do a statistically valid sampling of their entire portfolio.  However, you can still get a clear picture even if you sample a few dozen client files, which is what we do.  Then you look at: What do they analyze?  How are investment decisions made?  What are their decisions based on?  We then always make a point to sit in on a of couple credit committee meetings where these decisions are made and listen to their discussions and how they are conducted. 

Another factor that comes up in our ratings analysis is evaluating their governance process.  Basically: Who calls the shots?  How effectively are decisions being executed?  Is anyone giving direction and, if so, who is that person(s)?  Are they positioning themselves in their market, or are they drifting from their mission statement?  These are very important qualities that allow one to decide if these MFIs are effective or not.

You also need to look at the market environment and country in which the MFI operates.  Is there MFI legislation and supervision?  Is there a banking supervisor that takes a hand in microfinance?  How strong is the competition?  Are clients over-indebted in the region?  If so, what are the MFIs doing to protect themselves against that?  This is very important.

Another component that we look at is the MFI’s management information systems.  The process of buying and implementing a system and pushing it upstream may take a couple of years.  By that time, the MFI has already outgrown that system.  That happens fairly often to MFIs.  The question then becomes: Does the MFI have an adequate technology system in place that can tell management what they need to know? 

You also want to get a feel of how the MFI balances its developmental role versus financial success.  Quite often you will have consumer credit agencies posing as MFIs.  That is a pretty common phenomenon where sometimes you have an unholy alliance between funders and these so-called MFIs, which are really consumer lenders.  The funders have not had any incentive to look closely at these consumer credit agencies who pose as MFIs because it increases a funder’s potential market many folds.  Thus, the question of what truly is microcredit is in flux.  

We feel that microcredit is not only based on loan size, but it also has to enable the borrower to create wealth.  In turn, this wealth is used to repay the microcredit. 

MC: Can you provide greater detail as to what a client or investor should look out for in terms of risk and reward when examining the operational structure of an MFI?

DvS:  First, you ask the question: Is that portfolio quality ‘dressed up’ and not what the MFI claims it to be?  That “dressing up” is fairly easy to do, but not that easy to spot from the outside.  The common way of doing it is when you see clients starting to run into trouble making their monthly payments.  An MFI calls in its client, tears up the loan agreement and reissues a new one for a larger amount with a longer repayment term.  That is not just specific to microfinance, but also a problem with banking in general, that you have a hidden bad portfolio.  Top management may not be particularly aware of it.  If management is not on top of things, then they will create the incentive for lower-level managers and officers to start ‘refinancing’ their portfolio and thereby hiding bad loans.

Secondly, one must ask: How solid is the MFI’s lending methodology?  How effective are they at spotting good clients?  That is the hard part.  What distinguishes a good MFI is the ability to identify those clients that can become productive and create wealth if you lend them the money.  That is the basic skill of an MFI that we look for.    

MC: What else is a challenge when rating MFIs, and what is the ratings reporting cycle at MicroRate?

DvS: One challenge is that you are forced to reach a judgment on a fairly large institution based on a very short visit.  So you have to extrapolate from what you see through the entire organization, and that is risky business.  It gets a bit easier than it sounds just by experience over time.  If you have previously analyzed dozens of MFIs, then you develop an instinct that tells you whether or not you will like the responses that an MFI provides.  So you may have to keep on ‘digging’.  You need to have that instinct; otherwise, you have to dig everywhere. 

With regards to a ratings reporting cycle, a year is roughly the life of a rating for us.  The rate at which MFIs have been growing this past decade is on average 40 percent per annum.  That means they double in size every two years.  Even a year is a long time for an MFI.  So I would be very careful of a rating that is older than a year.  But sometimes, very rarely, we do publish subsequent ratings earlier than a year later because of a specific event or because we have learned something new about the MFI.

MC: Is MicroRate starting to have a stronger commercial focus when rating MFIs – covering liquidity and debt covenants and providing further clarity as to how microfinance rating grades are comparable to mainstream rating grades?        

DvS: The ratings are going in that direction.  For the last two years we have been performing financial strength ratings (FSRs).  Whenever we do a performance rating, we also do an internal FSR.  That is much closer to a credit rating, but it still doesn’t try to predict the statistical likelihood of default.  It takes a more narrow view of how financially strong an institution is.  We have not yet published these findings because we needed to perform at least a hundred before we could roll them out and jump to certain conclusions.  We are now ready to roll them out and are using the Moody’s methodology for the definitions and class of ratings scale.

MC: A New York Times article in November 2009 covered how the Big Three credit rating agencies have received harsh criticism from lawmakers in Washington for their role in the housing market collapse with regards to the potential conflicts of interest that were embedded in their ratings model.  Banks and other issuers have paid rating agencies to appraise their securities, and this obviously has the potential to cause a conflict of interest.  What are your thoughts on this? 

DvS: In my opinion, the criticism from Washington is richly deserved.  We saw that when we first rated a microfinance CDO (collateralized debt obligation).  We looked at how other raters analyzed the CDO.  To our amazement, we saw that when they rated CDOs, they did not look at the underlying assets.  They looked at the structure, who was subordinated and under what conditions.  They also use very sophisticated Monte Carlo simulations, which hardly anyone understands.  However, the quality of the underlying assets must have something to do with the riskiness of the product, and that has been ignored by the traditional raters.  They did not look at the underlying assets.

MC: Outside of achieving a “double-bottom” line, how much different is it to rate an MFI versus a traditional financial institution? 

DvS: The difference is easy to spot, and it is in the lending technology.  The way that MFIs make loans is quite different from any other financial institution.  It’s the need for a more simplified cashflow model and to better understand the MFIs that one is analyzing without making a doctoral thesis of it.  Banks and other traditional lenders are not equipped to do that.  If you are not equipped to analyze that process, then your rating of an MFI has a glaring weakness.  If you look at MFIs through conventional lenses, they tend to look good.  The real risk is in an MFI’s portfolio because it is not typically backed by collateral.  So if your borrowers at the bottom of the pyramid stop paying, there is not much one can do to protect oneself.

MC: What is the current market demand for ratings and assessments from MFIs and investors? 

DvS: First off, development organizations do not rely on raters.  They have their own staff and are not cost-conscious.  They can afford to do their own due diligence.  The first generation of MIVs tended to perform their own due diligence and analyzed every MFI.  That is now turning out to be awfully expensive.  As competitive pressure builds among microfinance funds, I think these MIVs cannot keep up with the work.  That means that they will increasingly have to rely on something else, such as ratings.  At the moment, they are using the ratings as a supplement to their own analysis.  We are not yet at the point where you can leave risk assessment entirely to the raters.  It would be a cost-effective system, if that were the case, and advantageous to have the analysis done independently by objective people who have no ‘axes to grind’. 

If you look at the cost structure of an MIV, the costs are around 2-3 percent of assets.  That is very high for a fund.  They should be less than one percent.  You can’t have costs of less than one percent if you have to send a team to every MFI that you invest in throughout the world; quite apart from that, you may not have the country or sector expertise in that exotic country.  The trend is to rely more on ratings. 

By Zoran Stanisljevic

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