Microfinance Rating
Agencies:

An Industry on
the Rise

Risk rating is no longer an unfamiliar concept to microfinance. Investors, donors and regulators now take into account risk ratings when forming an opinion about a particular microfinance institution. Ratings are becoming acceptable “business cards” in microfinance, mirroring a widespread practice in developed capital and financial markets. As happens with commercial banks, microfinance institutions (MFIs) are commonly viewed through the analytical lenses of conventional and specialized rating agencies. Recent estimates indicate that each year at least 281 MFI ratings are conducted worldwide; about 144 of these take place in Latin America and the Caribbean.

In the last few years, the microfinance rating market has undergone important changes. Previously, ratings were nothing more than assessments fitted to serve donors’ needs. Now, private investors and regulators are prime users of microfinance ratings and have sparked renewed interest in the subindustry by traditional players in financial markets, including traditional credit rating agencies. As a result, questions such as the following are being raised: How large is the microfinance rating market? How extended is risk rating in microfinance? And, most important, do microfinance investors utilize microfinance risk ratings in their investment processes? The answers to these questions were central discussion topics of the second Workshop on Microfinance Ratings, entitled “Toward a Sustainable Market,” held in Santa Cruz, Bolivia, October 4–5, 2005. The workshop was sponsored by the Consultative Group to Assist the Poor (CGAP), the Inter-American Development Bank (IDB) and the European Commission (EC), and preceded the eighth Inter-American Forum on Microenterprise. Participants included representatives from 11 rating agencies and select international and domestic investors and donors.

What Is Risk Rating in Microfinance?

In financial and capital markets, credit risk rating has been around for a while, with Moody’s first recorded bond rating in the early 1900s. Since then the business of rating has evolved and diversified. Today, it includes a variety of products seeking to satisfy different users and needs, allowing investors to demand risk ratings to compare risk within a country as well as globally.

Microfinance ratings emerged in the late 1990s and have evolved on their own. Probably the first tool specifically designed to assess MFIs’ financial health and overall performance was the CAMEL (Capital adequacy, Asset quality, Management, Earnings and Liquidity) method of ACCION International. The original CAMEL was developed in 1978 by the U.S. Federal Reserve to evaluate the solvency of U.S. banks. In 1993, ACCION International adapted the CAMEL to microfinance. This diagnostic tool has been mostly used within the member institutions of the ACCION network.

In 1996 the idea of a diagnostic tool for external users (such as investors) by a fully specialized microfinance rating agency was realized. The pioneer agency was MicroRate, which offered a new rating product more commonly known as performance assessments or global risk assessments. These ratings seek to evaluate the overall capacity of MFIs to meet their goals.

Compared to traditional credit risk ratings, performance assessments put more weight on operational elements such as appropriateness of lending methodologies and governance issues and allow comparability mainly to other MFIs. This emphasis seems to reflect the fact that performance assessments were originally designed to satisfy the needs of donors. The table summarizes the characteristics of ratings currently offered to MFIs by conventional and specialized rating agencies in Latin America and the Caribbean.

The Microfinance Rating Market

Since its beginnings, use of microfinance ratings has grown steadily worldwide. Naturally, this growth has been more intense in those regions where microfinance itself is more developed. Latin America and the Caribbean (LAC) and Asia represent almost 90% of the total number of microfinance ratings undertaken worldwide since the late 1990s (see graph on right).

In Latin America and the Caribbean alone, 710 ratings have been undertaken since 1997, and already 275 MFIs have been rated at least once. Half of those MFIs are located in three of the countries with more mature microfinance markets (Peru, Bolivia and Colombia). Another factor influencing the number of ratings is regulation. In some countries (such as Ecuador), the microfinance market is dominated by formal MFIs that are required—by local regulations—to obtain a risk rating. Less mature microfinance markets, such as those in the Caribbean have the fewest ratings.

In 2005, 144 ratings were undertaken in LAC. Of this total, 99 were of MFIs that had already been rated at some earlier point. These numbers show that the microfinance rating industry is not only reaching an increasing number of new MFIs every year, but also that risk ratings are becoming an established practice among MFIs, confirming that the microfinance industry finds ratings useful.

Carmen Velasco, manager of Pro Mujer-Bolivia, shared with us Pro Mujer’s experience with ratings, and elaborated on why Pro Mujer finds risk ratings a credible instrument to certify institutional quality and accomplishments for regulators and social and for-profit investors. Pro Mujer, a non-regulated MFI, is not required by Bolivian regulatory authorities to obtain a rating. “However, as a nonregulated MFI, it is important to align with best practices from the regulated institutions in order to show that nonregulated MFIs may also be successful and trustworthy,” Velasco explains.

In 2002, Pro Mujer contracted a specialized microfinance rater to undertake its first rating exercise, and Pro Mujer obtained the highest rating. In 2004, the MFI received its second rating from the same rater with similar results. When asked about what results Pro Mujer had reaped from the rating exercises, Velasco says: “While the benefits of a credit rating in terms of additional financing from social investors may take some time to materialize, institutional assessment allows an MFI to gain more prestige in the eyes of ‘financial’ investors. Investors such as Blue Orchard, INCOFIN, OikoCredit and Global PartnerShip value the analysis from a well-known rating agency.”

In February 2006, Pro Mujer went one step further in increasing its trustworthiness, undertaking a rating with a specialized microfinance rater as well as a conventional rater who carried out their work simultaneously. The fact that these ratings occurred simultaneously will give the industry insights to better understand the differences and similarities offered by these two types of products.

The Relevance of Ratings

According to Velasco, the relevance of ratings for investors is one aspect that will determine the decision of MFIs to undertake a rating. This was one of the topics discussed in the Santa Cruz workshop. Representatives from international investment firms (Gil Crawford of MicroVest and Fernando Lucano of Cyrano Management) as well as domestic investors (Jorge Hinojosa of Caisa Bolivia) participated in a panel discussion on the importance investors give to microfinance ratings. The panelists described how these instruments affect their own investment processes and explored the future role for these ratings. The first point of consensus was on the meaning of a microfinance rating. For investors, a rating symbolizes the MFIs’ commitment to transparency. Crawford, for example, revealed that 80 percent of MicroVest’s portfolio is rated. However, Crawford added “it would be a mistake to conclude that ratings attract MicroVest to prospective MFIs. The proper conclusion is that MicroVest is interested in working with MFIs that value financial transparency.”

The panel confirmed information from a 2005 Rating Fund1 survey, which reported that investors save roughly 20% of their due-diligencetime by using rating reports. The survey also showed that investors value ratings differently: 29% of investors sampled consider ratings important, 47% somewhat important and 24% not important.

In the workshop, investors indicated their appreciation for the work of specialized microfinance raters, recognizing and valuing their intimate knowledge of microfinance operations. Nonetheless, investors said that specialized rating reports (or performance assessments) still suffer from an early design geared to satisfy donor requirements.

To be fully investor-friendly, investors explained, the comparability among ratings performed by different agencies must improve. Ideally, an investment officer should be able to compare between two potential investments even when analyzed by different raters. In traditional investment circles, a Moody’s rating can be easily translated to a Standard & Poor’s rating by using a simple table of equivalencies. Also, despite the progress in updating MFI ratings, these updates are still too infrequent. Investors have complained that a two-year-old rating report is of no use to support their investment operations.

The Challenges Today

Todd Farrington, manager of MicroRate for Latin America, explains the challenges faced today by specialized rating agencies: “While Moody’s has grown into a multimillion-dollar-ayear international company, MicroRate and those who followed, such as Planet Rating, Microfinanza or M-CRIL [Micro-Credit Ratings International], struggle to define their niche in a sector that is still part economic development and part financial intermediation. This is mainly because demand for specialized microfinance ratings, both from the capital market side and the regulatory side, is unclear at best: access to, and the price of funding for MFIs is not determined by a rating, nor do banking regulators uniformly require specialized ratings for MFIs in their systems. At least one of these elements of demand must be in place for specialized rating of microfinance institutions to flourish as a viable industry.”

The microfinance rating industry is certainly evolving. Recent developments include the spin-off processes undertaken by Planet Rating (from Planet Finance in France) and Microfinanza Rating SRL (from Microfinanza SRL in Italy).2 These efforts show a firm commitment to this line of business and reinforce earlier efforts put into developing rating methodologies for microfinance. Nonetheless, according to investors, there is still work to do in product design and comparability among microfinance rating products.

Despite growth in the market in the last decade, the reality is that the microfinance rating industry faces fierce competition in some of the most developed markets. This, together with a looming end to subsidies, means that rating products—and prices—probably will have to adapt to these new conditions. Also, traditional (conventional) raters, who are showing signs of interest in microfinance, may become important microfinance players in the future.

The end result, however, will most likely be a revamped and more sustainable microfinance rating sector, with more financial information available for regulators and investors and more MFIs on the road to accessing capital markets: Not a bad future.