Dec 27, 2007

Tough Enough: Microfinance Defies Recession

Amid political and financial crises in Ecuador, a commercial bank in Quito shifts its focus dramatically, no longer directing the bulk of its loans to mid-size or large firms but instead to microenterprises. The result? It survives—and emerges as Ecuador’s most profitable bank.

By  Benjamin Kahn and Tor Jansson

In the Philippines, recession prompts vendors at a public market outside Manila to stop borrowing from traditional banks with rigid lending rules and procedures. The vendors shift to local lenders who specialize in flexible, multifaceted relationships with microentrepreneurs. The traditional banks post losses because of the recession, while the microfinance-oriented institutions stay profitable, expand operations and even win market share from the banks.

Indonesia’s currency takes a harrowing nosedive. Its economy contracts; loan delinquencies run rampant throughout its imploding commercial banking sector. Many banks shut down, while others teeter on the verge of bankruptcy. Not, however, a small People’s Credit Bank in Central Java that offers thousands of tiny loans to low-end microenterprises. It keeps delinquencies near the previous year’s low level and even increases its profitability.

The fact that microfinance institutions—lenders that cater to the microenterprise market—can be profitable is no longer news. But as recession and financial crisis hit Southeast Asia and Latin America in the late ’90s, prominent microfinance institutions showed that their business strategy can also be a powerful tool for surviving and growing in hard times.

Is Microfinance Recession-Proof?

As Indonesia’s rupiah fell from Rp 2,400 per dollar in June 1997 to Rp 15,100 per dollar in June 1998—the largest single fall in currency value for any country since World War II—much of Southeast Asia suffered declining investor and consumer confidence.

The swell of the Asian financial crisis reached the shores of Latin America in 1998 and 1999. While large countries like Argentina, Brazil and Mexico grabbed the headlines, other countries felt the pain as well, including the Andean countries of Bolivia, Colombia, Ecuador and Peru. In these countries, other factors added to the effects of the Asian crisis: civil war in Colombia; the “el Niño” phenomenon in Peru and Ecuador; and the crackdown on coca production in Bolivia.

The economic slowdowns quickly showed up in the financial statements of commercial banks: loan portfolio growth stagnated, profitability fell, and loan delinquencies began to rise. Before long, the countries’ banking regulators were working overtime to deal with the growing number of failing banks.

Microfinance institutions—or MFIs—were not immune to the economic malaise in Asia and Latin America. But a review of some basic performance indicators suggests that the industry leaders held up as well as—or better than—their more established counterparts in the commercial banking sector.

MFIs vs. Commercial Banks in Colombia, Bolivia and Peru

Commercial bank Banco Sol and the private financial funds Caja Los Andes and FIE are the leading microfinance institutions in Bolivia. Their counterparts in Colombia are five affiliates of Women’s World Banking and the finance company Finamerica; in Peru, they are the municipal savings banks of Arequipa, Trujillo, Sullana, Ica and Tacna.

In terms of growth, these MFIs have outperformed their countries’ commercial banks every year since 1997 (see graphs).

After tough times in 1998 and 1999, portfolio growth for microfinance institutions picked up markedly in 2000, reaching 47.9 percent in Peru and 26.8 percent in Colombia, perhaps indicating that the worst was over for MFIs in those countries. At the same time, commercial banks languished with anemic growth rates, though their growth also improved slightly in 2000. Although MFIs in Bolivia outperformed the country’s commercial banking sector as a whole every year, the trend has been toward slower growth rates. This trend is due in part to Bolivia’s economic slowdown but also to the fact that Bolivian MFIs are reaching greater maturity and market penetration.

Amid the economic slowdown, commercial banks saw their profits plunge. While Bolivian and Peruvian banks managed to hang on to break-even returns, Colombian banks experienced a virtual free fall. Commercial bankers, to the extent they knew about the MFIs, must have looked at them with no small amount of envy. While MFI profits were affected by the tough economic climate, they managed to maintain healthy levels thoughout the period. MFIs also largely outperformed commercial banks in terms of portfolio quality during the crisis. In Colombia, for example, loan delinquency rates stayed at low levels near 3 percent for MFIs throughout 1997–2000 but rose to double digits for commercial banks. In Bolivia, MFIs outperformed commercial banks in every year except 1999, when a well-organized “borrowers’ revolt” took off.

MFIs vs. Commercial Banks in Indonesia and the Philippines

In Indonesia, the epicenter of Asia’s financial crisis, the currency collapsed and the economy shrank 13 percent in 1998, impoverishing much of the middle class. But the country’s network of People’s Credit Banks (BPRs)—2,200 institutions serving the low end of the microfinance market with loans averaging US$77—held their collective loan portfolio more or less steady throughout the crisis. The microfinance division of Bank Rakyat Indonesia (BRI), the largest microfinance operator in the world, with 2.6 million borrowers and 12 million savers, did not escape the financial mayhem but seems to have recovered quickly. Measured in real terms, its loan portfolio shrank 32.2 percent in 1998 but bounced back with a whopping 66 percent growth rate in 1999. The performance was impressive when compared with the financial sector as a whole, where total loans outstanding, measured in real terms, shrank 9.9 percent in 1998 and 42 percent more in 1999, not recovering until 2000, and even then with only 24 percent growth.

Meanwhile, MFIs in the Philippines seem to have suffered only a brief (three- to six-month) pause in their growth. By 1998, their loan portfolios were rapidly expanding again, even while the country’s economy contracted 0.54 percent and total loans outstanding in the financial sector as a whole decreased by 4.4 percent.

The microfinance division of BRI reported return on assets holding steady at 4 percent to 6 percent throughout the Indonesian crisis—a truly impressive performance. BRI’s loan delinquency was far lower in its microfinance division than in its corporate or consumer divisions. The picture from BRI is corroborated by a case study of three members of the BPR network of small Indonesian banks that serve the low end of the microfinance market. Loan delinquency increased from an average of 16 percent to 25 percent between 1997 and 1998—not a positive development, but not nearly as bad as the 60 percent loan delinquency among commercial banks. One mid-1998 survey, conducted by the Asian and Pacific Development Center, of 16 leading MFIs in the Philippines, Indonesia, Malaysia and Thailand noted only modest increases in their default rates.

How MFIs Do Well in Hard Times

The above-average performances of the leading MFIs compared with those of commercial banks during economic crises transcends the circumstances of any one MFI, any specific crisis or even any single country or region—but why? Do poor people have better repayment ethics than big businesses? Do the lending and collection methods used by MFIs hold up better when times get rough? What makes some MFIs tough enough to survive and perform during hard times? Some clues can be found in the experiences of MFIs from Ecuador, Bolivia, the Philippines and Indonesia.

Avoiding Economic Collapse in Ecuador

Ecuador’s Banco Solidario was only two years old in 1998 when the country’s economy began to spin out of control. The Ecuadoran economy was hit hard by extreme weather, a costly border war with Peru, sluggish world prices for its oil exports and a political crisis that saw the government go through three heads of state in rapid succession. Economic growth essentially ground to a halt in 1998, and the economy contracted 7.3 percent in 1999.

In the midst of all this, Banco Solidario increased its lending to micro and small entrepreneurs a whopping fivefold, from about $4 million in 1998 to some $20 million in 2000. The proportion of its loans allocated to micro and small entrepreneurs went from 10 percent in 1998 to 60 percent in 2000, and it became Ecuador’s most profitable bank in early 2000. It was ranked as one of the country’s five best banks last year.

Four key factors in Banco Solidario’s success are cited by Alex Silva, CEO of ProFund International, a major shareholder in the bank. First, Banco Solidario turned hefty profits by betting against the Ecuadoran sucre and trading in government bonds, which were sharply discounted during the crisis. Second, Banco Solidario’s international investors, including ProFund, worked together to help it through the crisis with additional short-term financing, giving the bank much-needed liquidity and helping shore up its credibility in local capital markets. Third, Banco Solidario participated in a government-subsidized housing program that required low-income tenants to maintain savings accounts, thus providing the bank with yet more short-term liquidity. Fourth, the bank discovered that lending to microenterprises had its advantages, reinforcing, in Silva’s words, “the institution’s conviction not only that smaller clients are more resilient and withstand crisis better, but also that their payment ethics are better than those of larger clients.”

Bolivian Borrowers Revolt, MFIs Survive

The events that came to be called the Bolivian Borrowers’ Revolt of 1999 took place after the country’s worsening economic slowdown led many microenterprises to borrow from consumer finance companies, accumulating more debt on top of that which they had already secured from MFIs. As Bolivian consumer finance companies faced an increasingly saturated market in 1998, they began to move into microfinance, extending credit to microentrepreneurs. Since they did not have the know-how to analyze a client’s ability to pay, they simply relied on the fact that a microentrepreneur had already secured credit from an MFI as proof of creditworthiness. With the onset of recession, the already indebted microentrepreneurs began accepting consumer loans to compensate for declining sales.

As the recession continued, thousands defaulted on their consumer debt—but they continued making loan repayments to the MFIs, notes MicroRate Director Damian von Stauffenberg. The swelling number of over-indebted borrowers gave rise to the creation of two borrower associations that tapped into the growing desperation of these people. Both associations worked on the same principle: For a fixed membership fee of Bs 50 (roughly US$8.50), they promised debt relief through borrower revolts. Their appeal was powerful, and their membership swelled to huge numbers.

However, though MFIs were deeply concerned at the time, it is clear in hindsight that the borrower revolts were directed not so much at the MFIs as at the consumer finance companies, with their aggressive lending tactics and collection methods. According to von Stauffenberg, the three largest MFIs—BancoSol, Caja Los Andes and FIE, with roughly 140,000 clients among them—reported fewer than 500 cases of arrears directly related to the borrower revolts, while consumer lending was virtually wiped out. Although MFIs have not been insulated from the country’s economic woes, many microentrepreneurs nevertheless discriminated among their creditors, placing a higher value on keeping ongoing relationships and credit histories with the MFIs.

Philippine Traders Prefer Microcredit

In the Santa Rosa public market outside Manila, family-run businesses are the main suppliers of credit to street vendors and other microentrepreneurs. They compete for clients and organize savings and business insurance associations alongside their credit operations. Offering flexible terms and multilayered, ongoing business relationships with borrowers, these lenders have outperformed the local banks and helped the Santa Rosa public market flourish despite the past years’ difficult economic climate.

The Santa Rosa lenders know their clients well, which turned out to be a critical advantage when the Asian financial crisis hit the Philippines in mid-1997. Being closer to the borrower than traditional banks are, the Santa Rosa lenders were in a better position to understand how their clients were affected by the recession. In fact, from mid-1997 to mid-2000, as consumers moved “down-market” from beef and pork to less expensive foods like fish and vegetables, the number of Santa Rosa market vendors selling fish and vegetables rose 15 percent and their average profits rose 40 percent.

More upscale vendors did not fare as well during the recession. But even they found the Santa Rosa lenders more flexible than the banks, willing to accept late payments without financial penalty and, sometimes, willing to refinance debt altogether. Repayments were scheduled daily or weekly. In many cases, clients proved their creditworthiness for new loans by developing parallel relationships with lenders, wherein collective savings accounts were managed by the lenders, or actual goods were bought from the lenders on credit, to be sold the same day in the market. Such multilayered relationships gave the lenders more personalized data on which to base their lending decisions during hard times. Multilayered relationships also meant multilayered incentives for borrowers to keep up repayments.

Customer Loyalty in Indonesia

At the height of the Indonesian crisis, BPR Karto in Central Java, one of the 2,200 People’s Credit Banks in Indonesia, was able to control loan delinquencies and increase profitability, even as other Indonesian financial institutions failed. BPR Karto’s analysis of local market conditions found that the local agricultural sector was actually benefiting from the economic difficulties. The bank expanded its loan portfolio in the agricultural sector, and cut back lending to other sectors. Meanwhile, its strong community ties helped make it successful at mobilizing savings. This proved critical when interest rates in Indonesia began to shoot upward, making it very expensive for MFIs to raise funds through interbank loans. BPR Karto was able to keep its financial costs down because its strong deposit base remained a stable source of inexpensive loanable funds.

The bank’s strong relations with Christian leaders in the community also helped it retain the loyalty and trust of its savers—to such a degree that, when desperate commercial banks began offering extremely high interest rates to attract term deposits, BPR Karto was able to keep almost all of its depositors with only a slight rise in the rates it offered. As a result, savings still represented 73 percent of BPR Karto’s liabilities in June 1998, down only moderately from 88 percent in June 1997. Thanks to stricter lending criteria for microenterprises operating outside the agricultural sector and to its borrowers’ allegiance to the MFI as an institution firmly embedded in their community, BPR Karto’s delinquency rate barely rose, from 9 percent in 1997 to 12 percent in 1998, while the commercial banking sector in Indonesia saw an estimated 60 percent of its outstanding loans go into delinquency in 1998.

What Makes an MFI Tough Enough?

Taken together, the cases above suggest conclusions about what makes some MFIs perform relatively well during recessions. The presence of financially strong shareholders was critical for Ecuador’s Banco Solidario. Ample savings mobilization helped cushion Banco Solidario, as well as the People’s Credit Bank in Indonesia and the Philippine public market lenders. The strong repayment ethics of microentrepreneurs and other low-income borrowers and the microlenders’ close ties to and knowledge of their borrowers and local markets played a role in all the cases. In testimonials, surveys and reports from tiny, landlocked Bolivia to the Indonesian archipelago, home to the fourth-largest population in the world, the same conclusions pop up time and again. MFIs tough enough to defy recession concentrate on these key ingredients.Microfinance is not a foolproof strategy for lenders beleaguered by the effects of recession. The fate of an MFI, like that of any firm, will hinge on countless factors both internal and external, some predictable and some not. But all else being equal, there is little doubt that MFIs will benefit from close ties with their local communities, from knowing their borrowers well, from having an ownership structure that includes shareholders with a strong interest in their well-being, from conforming to local financial regulations and from making good use of local savings.

Porfolio Growth

Return on Assets

Key Ingredients in a Tough MFI

?Close ties to and knowledge of borrowers and local markets, including experience with microfinance.

?Strong repayment ethics of microentrepreneurs and other low-income borrowers, stemming in large part from the particularly high value they place on keeping good standing and good credit history.

?Effective savings mobilization, which is possible only after an MFI “formalizes,” submitting itself to regulation by financial authorities.

?Strong ownership structure, with financial resources to help an MFI with access to funds when needed, and with sufficient equity investment to have an interest in monitoring the MFI’s management and performance.

?Down-market consumption trends, which occur during recessions and may benefit some microentrepreneurs.

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