MICROCAPITAL STORY: Examination of Fitch Rating Standards for Microfinance Institutions

The credit ratings assigned to corporations affect the cost of borrowing money in international capital markets. Microfinance institutions (MFIs) are no exception. As more and more MFIs look to raise money from capital markets, their credit ratings will become increasingly important in their ability to provide financial services at a low cost. Fitch Ratings is a premier international ratings agency, which has evaluated a number of MFIs around the world. This story will examine how Fitch approaches ratings of microfinance.

It is important to note that these credit ratings differ from the performance ratings issued by other agencies such as MicroRate, M-CRIL, PlaNet Rating, and Microfinanza. Performance ratings include a broader analysis of the company’s operations and not just the likelihood that they will default on credit obligations. To learn about the recent involvement of Standard & Poor’s in microfinance, please read this previous MicroCapital story.

The Fitch Ratings system consists of two main subsections: the individual rating, which measures the firms stand-alone ability to repay debts, and the support rating, which measures the potential support a firm could receive if it were in danger of defaulting on a credit obligation. In the Fitch Rating system, MFIs tend to receive low grades (D or below).

Individual Rating

One prominent reason for low ratings is the operating environment for MFIs, which exist almost exclusively in developing countries. Fitch Ratings established a sovereign credit ceiling for many countries, which sets a maximum rating for institutions operating within the country. This limit is established using factors such as political risk and governance issues within a country and developing countries often receive low grades. MFIs also run into problems in their operating environment because they are often subject to interest rate caps and other intrusive measures from the government. Such actions are developed to protect borrowers, but they also limit the ability of MFIs to collect income and repay debts. The vulnerability of many developing areas to natural disasters and a lack of available insurance options for MFIs also combine to weigh on credit ratings. The last major factor in operating environment is the level of competition. In some areas, commercial banks can “downscale” and compete with MFIs, driving down interest rates and hampering their ability to repay loans.

Risk Management is another important factor in individual ratings assessments. Within Risk management, credit risk, market risk, operational risk and reputation risk come into play. According to Fitch, credit risk is the “main risk facing MFIs” becomes their revenue depends on the repayment of loans to low-income borrowers. While microfinance loans are considered to have high asset-quality (meaning that recovery from loans is high), they still face considerable problems from a lack of diversification and fluctuations in local currency. A sudden devaluation of local currency versus borrowed currency would require the MFIs to use the interest rates from more loans to repay debts to other financial institutions. Also, by definition, a true MFI only interacts with a specific portion of the population, the poor, and has relatively few products, mostly credit. This means that their source of revenue is not highly diversified. Thus, if something were to happen to this population, the ability of the MFIs to repay debts would be severely compromised. Such occurrences would include, a political or cultural uprising; a shift in trade terms, which would promote or discourage certain types of industry, or any changes to the informal economy, where many borrowers are employed.

Operational risk derives from the unique lending procedures of MFIs, which rely heavily on the personal relationship between borrowers and loan officers. Considering this fact, risks associates with identifying good candidates for employment, properly motivating loan officers, retaining good loan officers with attractive benefits and being able to find enough talented employees become increasingly important.

The concept of “double bottom-line” goals also creates additional risks for microfinance institutions. Many funders of MFIs are socially motivated investors or international financial institutions with development related motives. Thus, if an MFI is seen as drifting away from the goal of helping the poor, donors might pull funding despite increased profitability. Possible sources of reputation damage include raising interest rates, over indebtedness and immoral loan recovery procedures. Fitch labels this type of risk as “reputational risk.”

Market risks, which stem from fluctuations in the economy in which MFIs operate, have relatively small effects over the institutions. Microfinance Institutions are usually fairly removed from the overall economy and do not hold stocks or other securities that are directly affected by movements in the economy. Market risk does come into play, however, when discussing the movements of interest rates and currencies, which affect the borrowing costs of MFIs.

The ability of an MFI, or any other company, to generate earnings has a direct effect on the availability of funds to repay debt. MFIs tend to generate high margins on loans because the interest rates paid by customers are high. Their stream of income is also spread across many individuals, limiting the total negative effect of default froma single borrower. While these factors help MFIs in this section of the rating criteria, the firms face problems in other areas. For example, revenue for MFIs comes almost exclusively from providing loans, creating a lack of diversification in income streams.

Other factors in the Individual Rating area are similar to those of other financial institutions. These include assets, management capabilities and corporate governance.

Support Rating

The Support Rating judges the willingness and ability of countries, international institutions or other sources to provide support if an MFI or bank is in danger of defaulting on credit obligations. Fitch sees the chances of countries supporting an MFI to be low because the institutions generally control very little money, implying that a failure would not have a meaningful impact on the overall economy. They do maintain, however, that it is possible that countries would step in to assist larger MFIs in an attempt to further the development goals of the institution.

This information was taken from a criteria report entitled “Microfinance Institutions – Factors in Risk Assessment,” which is available on the Fitch Ratings website. It can be found by searching for ‘microfinance’ on the company’s homepage. The document was made available on June 12, 2008. To learn more about Fitch’s analysis of the microfinance sector, please read this previous MicroCapital story.

By Greg Casey, Research Assistant

Additional Resources:

MicroCapital Story, February 18, 2008: IDB Makes Donation to Billion Dollar Standard & Poor’s

Fitch Ratings: “Microfinance Institutions — Factors in Risk Assessment” (available here)

MicroCapital Story, August 19, 2008: “‘The Microfinance Sector: Its Success Could be its Biggest Risk’, Fitch Ratings

Fitch Ratings: Home

Planet Rating: Homepage

MicroRate: Homepage

M-CRIL: Homepage

CRISIL: Homepage

Microfinanza: Homepage

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