SPECIAL FEATURE: Are Microfinance Institutions and Investors Removed from Business Reality?

This opinion piece was contributed by David MacDougall, a consultant based in the US city of New York.

Microfinance inspires optimism. Investors – especially private equity investors – anticipate handsome returns; aid agencies see strong social impact; and microfinance institution (MFI) managers are certain they can grow themselves out of every tight situation. While microfinance can play an important role in development, most MFIs nevertheless are relatively simple financial institutions that need to be grounded in sound market and business principles rather than pie-in-the-sky expectations. These “Business 101” principles, which may sound like common sense truisms, in my experience, have not trickled down to many MFIs. In over 10 years of examining the viability of MFI business models as an analyst and risk manager, I have seen decision makers fail again and again to do reality checks. What’s still urgently needed is sound market analysis and professional risk management.

Examples abound. In Bosnia, MFIs grew rapidly with enthusiasm for microfinance and an ample supply of capital from external investors and aid agencies. Yet, risk management techniques were weak, and the market went through a wrenching crisis that still continues to shrink the sector and cause additional MFIs to fail. The overheated market in Nicaragua led to the collapse of several MFIs, notably Banex, a microfinance lender that had historically posted remarkable growth. The crisis drove MFIs out of business and reduced others to mere shadows of their former selves.

Among other problems, these markets faced a fundamental risk of oversupply. This risk remains relevant around the world. Although microfinance remains scarce in some regions, in others oversupply and associated competition have led to over-indebtedness, weaker lending criteria and unsustainably low interest rates. Many academics and practitioners contend that analyzing over-indebtedness requires detailed market analysis. However, simpler measures can give good indications of potential over-indebtedness. I use a simple ratio of borrowers to families, in other words, estimating the percentage of families with loans from MFIs. For this ratio, I define a family as two adults plus the average number of children per family in that country. In the table below, the average number of children is in Column 3, and Column 7 shows the ratio of borrowers to families. The ratio varies from 2 percent in the Democratic Republic of the Congo to 71 percent in Peru. In other words 7 out of 10 families in Peru have loans from an MFI.

MacDougall Chart 2015

The above population data is from http://www.ciaworldfactbook.us, and borrower numbers are from http://mixmarket.org.

This ratio does not account for multiple borrowing by a family, which would reduce the level of penetration. However, I believe that significant multiple lending is itself an indication of market saturation. In addition, the figures here do not include other types of lenders. “Indicadores de Inclusión Financiera de los Sistemas Financiero, de Seguros y de Pensiones,” by the Peruvian regulator, Superintendencia de Banca y Seguros, states that about 70 percent of households have loans from all types of financial institutions, comparing well with the method I propose.

The ratio has important implications for both MFI investors and MFI managers.

• Unsustainable Growth Rates – It obviously becomes increasingly difficult to grow in countries with high saturation. Nevertheless, hope springs eternal. Despite the 71-percent ratio in Peru, the 2014 weighted-average projected growth among MFIs in Peru is 23 percent. In Cambodia, where the ratio is 49 percent, the weighted-average growth rate is 18 percent according to the country barometer reports at http://mixmarket.org. Such growth could easily contribute to over-indebtedness.

• Private Equity Expectations – Microfinance growth rates affect all market participants, but they are especially important for private equity investors. This market is highly competitive, and the high price investors pay (investment multiples) can only be justified by strong, sustained growth. Consequently, private equity funds often advocate, via board membership, for rapid growth. While there is little public information on microfinance private equity, what is available suggests that this strategy has sometimes had limited success and, in certain cases, led to financial distress.

• Management Issues – MFI managers and board members often ignore market realities. The fallout from the global financial crisis that peaked in 2008 pushed some MFIs into financial distress. Portfolios deteriorated, cash flow shrank and capital adequacy declined. To address this, many MFI boards ignored indications of market saturation and adopted aggressive growth plans that could only be achieved through looser underwriting criteria and lower interest rates. They often matched this with cost reductions, including eliminating pesky risk managers. Usually, this resulted in MFIs enjoying near-term growth only to find that the reduced lending rates and weaker underwriting standards led to longer-term losses. This strategy continues today with MFIs under stress.

Market crises in Bosnia, Nicaragua, the Indian state of Andhra Pradesh and Morocco testify to the need to carefully evaluate broader market and national dynamics. The disregard of simple business principles and lack of risk management know-how threatens to undermine the entire microfinance industry in many countries. Investors and philanthropic players should take notice and try to remedy this by requiring MFIs to conduct appropriate analysis and risk management.

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