Fundamentals of Microfinance: Challenges or difficulties for prudent management of MFI's

Hi, everyone!

Nowadays I'm taking a course of  Fundamentals of Microfinance (MENA - AGFUND x UNITAR), and I'd like to share with all of you my compulsory report. 

They ask me: What are some of the challenges or difficulties inherent in the prudent management of growth for microfinance institutions?

Microfinance, like all business, are exposed to different risks, some of which could affect their ability to pay their liabilities, including 1) bankruptcy (caused by poor operational control, poor risk management, or external issues such as changes to the political or environmental context, or fluctuations in the financial markets). 2) fraud (as with all businesses involving large amounts of money); and 3) portfolio risk (if a large number of borrowers default as a result of a catastrophe, conflict, natural disasters or a profound recession like the one generated by COVID 19, the MFI may find itself unable to pay its debt obligations). (Churchill & Coster, 2001; MicroWorld, n.d.)

For instance, Kangovi & Sinha (2016) pointed out three growth strategies to boost Sri Lanka’s microfinance sector, which, for the purpose of this report, rest on four pivots (that I think are of general application to other contexts, from the perspective of this course): 

1) Demand (tap in the existing demand for microfinance and capture existing client base from smaller players). 

2) Innovation (design innovative products to meet lifecycle or business cycle needs for various client categories). 

3) Digitalization (utilize digital finance to enhance operational efficiency and improve profitability). 

4) Savings (tap into savings products to reduce the cost of funds as well as minimize currency fluctuation risks).

In order to cope with currency fluctuation risk, part of the deal when speaking of receiving this kind of funds is that the lender must be aware of the social destination of the funds (I mean if the lending is for a microfinance institution, the lender must offer the money thinking that a part of the money that he will receive in return will be "lost", or, even better, that the foreign exchange loss, in the event of lending the money already converted in national currency, could be considered for instance as a donation, which means that the lender can have a fiscal benefit, it is a way to make the offering equally attractive, for the borrower who doesn't want to assume the currency risk, and for the lender who can absorb in some way the "loss" of the operation, as a way of tax planning). 

Obviously, from the side of the microfinance institution, it's not precisely a wise move to look for borrowing in foreign exchange, because these institutions are financially weaker than standard financial institutions. As a hypothetical advisor of an MFI, I would strongly advise against this lending practices, because, apart from their disadvantages, in some way, it goes against the philosophy of microfinance (which is not to give away money to the poor, but it is, indeed, to give the poorer of the poor an opportunity to access credit and other financial services, but be aware that this market is inherently riskier than other financial users).

Typical recommendations to governments are to allocate a substantial budget and donate to these microfinance institutions, and also encourage other donor organizations to aid these institutions financially, coming up with rules and regulations to prevent default risk. On the side of the MFI, microfinance institutions must enhance their management capacity and bring the effort to reach the needy people in the most effective way as possible (Dahir, 2015).

In general, I think that the most important challenge in the microfinance sector is how to reinvent the customer experience, eliminating traditional difficulties when interacting with the financial institution, with intensive use of technologies in order to facilitate and deliver its services in a more efficient and convenient way. 

Obviously,  this new focus (being the Metrobank case its paradigmatic newest example) must be taken into account considering the philosophy and purposes of microfinance, looking for dignification of its target clients (the "poor", or the "poorest of the poor") with adequate market focus (especial lines of credits, savings accounts, credit cards, e-banking and other customized services), and intensive use of technology. 

Other recommendations for prudent management of MFI are: 

1) Intensify training of risk managers to manage and handle the risk successfully in a volatile environment, particularly in the areas of credit and reputation.

2) Be aware of situations like riots, wars, or communal problems, situations that significantly affect the operations of an MFI even threatening to put it to a complete halt. As an MFI provides financial services such as loans, to low-income clients, including micro-companies and the self-employed (all of them, who traditionally lack access to finance), you can think that these transactions typically are of smaller amounts and shorter tenure, the risk is relatively low (given the smaller size and shorter tenure of transactions), but a contingency like an accident can affect the borrower's ability to repay a loan (Gutiérrez & Mommens, 2011). 

As an unpredicted "act of God", COVID 19 is an extreme example of this. 

3) An MFI must keep its portfolio diversified to limit its loss on account of such external factors, e.g., transferring the risk of robberies or thefts through insurance, limiting cash-carrying by staff using police.

On the side of government, it is fundamental to define regulations and policies, not interfering in the commerce of the sector by offering loan waivers or bad policy interventions like interest rate caps (formal or informal), and improving connectivity at the village level enabling ATMs, digital banking and other payment devices (Ranu Kumar, 2018).

Speaking about financial risk, we can find out that MFI does not enjoy the same rate of financial success when compared to commercial banks, and tend to have higher rates of interest and over-dependence on the banking system for funding. There is also a lack of awareness of financial services, due to illiteracy and other factors. Governments should play a more assertive role, and internet and communications technology appear to be crucial in terms of promoting access to services (Chetti, 2017). 

The financial viability of microfinance is one of the key issues because operating expenses are relatively high due to expensive credit risk management processes and relatively small loan portfolios. In this direction, there is a strong link between the MFI operating model and its financial performance. Cost efficiency decreases the more MFI expand their depth and/or breadth of outreach (reaching the most rural clients vs. urban clients? Operational efficiency is better when focusing on easier to reach clients, at a cost of social impact. Reducing the need for face-to-face visits could diminish the dilemma). 

On the other hand, cost-efficiency reduces the higher the credit risk of a loan portfolio, because the risk-return characteristics of microfinance lending are not in favor of high-risk portfolios (the required interest rates for these clients would be far beyond socially acceptable levels). Improvement of credit risk models could enhance the portfolio risk while lowering the cost of risk and operational cost of managing risk. Apart from that, lending more to existing borrowers is more efficient than lending to new customers, but it has a negative social impact as fewer people are reached when focusing on existing customers. Mobile banking allows MFI so both reach more customers and offer a wide range of financial services, such as payments and savings accounts, insurance, and microloans to expand the business with existing customers (Maas & de Bel, 2018).

Other examples of things that MFI must foresee: In spite of prudential oversight (a responsibility for risk managers), many microloans are used to fund consumption rather than income-generating initiatives (which is not the idea of microfinancing those borrowings do not generate new incomes, making the repayment of the initial loan difficult, and generating a vicious circle to further loans and further debts). A solution? to place greater restrictions of those eligible to take out loans (a credible business plan). Or how to be sure that those people who receive microloans use the money for the aim announced and not, for instance, to lend money to others, at a higher (even usury) rates of interest (Pearse, 2019).

Talking about the diversification of the portfolio, this topic is very important because history has shown that the passing from microcredit to microfinance (I mean, a variety of innovative financial products and services around standard microcredit loans) is the right way. The initial concept of microfinance as a poverty reduction tool via providing microcredits is certainly outdated. The poor households need access to the full range of financial services to generate incomes, build assets, smooth consumption, and manage risks. Even though, MFI needs to think about a systemic approach, build on a strong savings component (compulsory or voluntary), and a training component (livelihood asset management, financial education, environmental and inclusive entrepreneurship, etc.), schemes of collecting repayments monthly and even weekly, or policies of lending to individuals (men or women, taking notice of the importance of promoting gender inclusion, by access to services) while others to groups of clients. The choice of lending strategies has strong implications for the equilibrium between their financial & social performance and achievements (IESE, 2015).

There is indeed a strong relation between microfinancing and women's empowerment, entrepreneurship, and employment. And there still are difficulties for accessing women to such services, coping with social or cultural discrimination and restrictions (openly or implicit) towards women, as a consequence of gender-biased entrepreneurial societies (India, Pakistan, and several countries of Africa, for example). In this context, association schemes have made women more socially empowered, through micro-entrepreneurial activities, playing microfinance an important role in order to help the poor to become financially self-reliant (not only for struggling against poverty in rural environments but also for doing it so in urban contexts).

Microfinance (and especially, microcredit) for women entrepreneurship is one of the more critical issues, and, as I have noticed earlier, women struggle with special problems. Poverty, unemployment, low income, and societal discrimination have hindered them, restricting access to microfinance services for their entrepreneurial activity. Traditionally (and I must attest: for reasons external to their own abilities and potential), they tend to have lower business performance than their men counterparts, while their participation in the informal sector of the economy is higher than males (another reason to promote access to microfinance for women).

Apart from the importance of women's contribution to the economy, their activity has been considered as an "extra income" to family survival or a means to improve its living conditions, when microenterprises owned or managed by women must be considered as a way to meet primary needs and a more respectable way of living, even transferring "motherhood skills" to the job (a concept gender-constructed, that can be used to promote more acceptance to this increasing role). Their enterprises are small in size, having loose and informal structures, requiring very little start-up capital, and little or no formal education (even illiteracy), tending to groom in poor rural communities.

In such a context, I think that group lending is an effective way of improving access to credit for women if the associative effort needed for offering collective social collateral to microfinance institutions, don't convert itself in a way to ingrain cultural discrimination against women. I explain myself: if the social communal tissue is lead by women, and not by men, this texture satisfies effectively the goal of promoting women empowerment. 

Besides, there is another consideration: in the context of microfinance, I think that the concept of a collaborative economy is even more important than in other financial markets. So, if collective lending appears to be an alternative way to construct positive and sustainable ties in the community, much better.

Finally, we can observe intense efforts of MFI in order to cope with COVID 19 effects on the economy, which of course, tend to affect a lot deeper the informal sector as fragile clienteles during this crisis. We can say that far from other earlier crises (e.g., 2008 financial crisis, that put stress on capital markets and macroeconomy, affecting MSME in a different way, with a relatively small impact), COVID 19 hits the most vulnerable people directly in their health and economic situation; with unintended effects like volatility in local currency rates, falling oil prices and rising prices for basic needs such as food. Devastating effects on micro, small and medium enterprises are far to be fully acknowledged, but the truth is that many of the daily wage workers (formal and informal), micro and small entrepreneurs are right now facing serious problems, and they may hardly be able to repay their loans, as their incomes have dropped (Streppel, 2020). 

As of April 2020, ADA established a common pledge: "Key principles to protect microfinance institutions and their clients in the COVID 19 crisis", that exposes in a touching way, the magnitude of the problem.  At this moment, business continuity for MFI on the verge of the new global recession emerges at a big question to address. 

It's like globalization has been suddenly stopped like I just heard a few days ago. I don't know what to say (like I'm sure all of us), but the message is clear: the financial sector (including MFI and third parties who support them: donors, clients, and government) will play a critical, paramount role in coping this crisis. And life must go on, without losing faith.

See you all.

Camilo García Sarmiento

References:

(2015, December 9). Microfinance 3.0: Opportunities and challenges. IESE Business School. Retrieved from: https://blog.iese.edu/iese-and-africa/2015/12/09/microfinance-3-0-opportunities-and-challenges/

Maas, T. & de Bel, J. (2018, July 30). Overcoming the challenges of microfinance to reach more people. Holland Fintech. Retrieved from: https://hollandfintech.com/2018/07/overcoming-the-challenges-of-microfinance-to-reach-more-people/

Chetty, P. (2017, July 17). Challenges faced by the Indian microfinance industry. Project Guru. Retrieved from: https://www.projectguru.in/challenges-indian-microfinance-industry/

Kangovi, V., & Sinha, S. (2016, July 21). Three growth strategies to boost Sri Lanka’s microfinance sector. Retrieved from https://nextbillion.net/three-growth-strategies-to-boost-sri-lankas-microfinance-sector/

Dahir, A. (2015). The challenges facing microfinance institutions in poverty eradication: A case study in Mogadishu. International Journal of Humanities Social Sciences and Education. Vol. 2, 2, February 2015, pp. 56 – 62. Retrieved from: https://www.arcjournals.org/pdfs/ijhsse/v2-i2/5.pdf 

(n.d.) MicroWorld.org: Risk management. https://www.microworld.org/en/about-microworld/risk-management

Kumar, N. (2018). Problems & prospects of microfinance institutions – with special reference to Chandigarh. IOSR Journal of economics and finance. Vol. 9, 1, Ver. IV (Jan – Feb 2018), pp. 15 – 23. Retrieved from: http://www.iosrjournals.org/iosr-jef/papers/Vol9-Issue1/Version-4/C0901041523.pdf

Churchill. C. & Coster, D. (2001) Microfinance risk management handbook. CARE. Retrieved from: http://mfi-resources.org/images/microcred_2014/Risk_Management_Handbook_ch_1.pdf

Pearse, W. (2019, November 7). The challenges of microfinance. Inomics. Retrieved from: https://inomics.com/es/insight/the-challenges-of-microfinance-1384131

Gutiérrez, M. & Mommens, X. (2011) Climate change Latin America and the Caribbean. Risks for the microfinance sector and opportunities for adaptation. IDB - Sustainable Energy and Climate Change Initiative / Multilateral Investment Fund. Retrieved from: https://firstforsustainability.org/media/IDB%20Climate%20Change%20Risks%20for%20the%20MFIs%20in%20LAC.pdf

Streppel, F. (2020, April 9). The role of financial inclusion in addressing the impact of COVID 19. Triodos Investment Management. Retrieved from: https://www.triodos-im.com/articles/2020/the-role-of-financial-inclusion-in-addressing-the-impact-of-covid-19