by Songbae Lee, Sr. Investments Officer on March 14, 2017
I joined the Calvert Foundation investments team in 2012 to manage our microfinance portfolio. Given how long it took me to sort out all the different players, I thought I’d try to make it easier for other microfinance newcomers by writing a series of blogs on the industry and its component parts.
This blog series will attempt to answer some of the common questions about microfinance using examples from our portfolio, but it won’t include a lot of beneficiary stories. If you are more seasoned in microfinance, read our microfinance sector profile and Impact Report. For deeper information on the topics in this post check out the Microfinance Gateway.
What is a microfinance institution?
An estimated 2 billion people globally lack access to basic financial services, according to the World Bank. At a basic level, I would define a microfinance institution (MFI) as a financial institution that provides small loans to people who otherwise wouldn’t have access to credit. The definition of “small loans” depends on the geographic context. India defines microfinance as loans less than 1 lakh which is about $1,500 today while the US SBA defines microloans as loans less than $50,000. It’s important to remember that there is no globally defined amount. India and the US are the only countries that even have defined limits (as far as I know). In this blog, I’ll be focusing on international microfinance, i.e. outside the US.
Why do MFIs charge such high interest rates?
The small size of the loans is directly related to the high interest rates that MFIs tend to charge. You might expect MFIs to charge low interest rates because they serve poorer segments of the population, but in fact the opposite is true. To serve the base of the pyramid, you need to provide small loan amounts, and small loan amounts are much more expensive to provide operationally than large loan amounts. If an MFI wants to be self-sustainable–meaning not dependent on grants–they need to charge a high enough interest rate to cover their costs.
There is an ongoing debate over whether the goal of microfinance is poverty reduction or financial inclusion. Part of the debate stems from the lack of studies (PDF) that show microfinance as an effective poverty reduction tool. However, there is still general agreement that microfinance helps improve the lives of the clients it serves. While we may still be waiting for studies showing microfinance alleviates poverty, it is clear that microfinance is helping create institutions that are improving the lives of the people it serves. https://www.cgdev.org/publication/9781933286488-due-diligence-impertinent-inquiry-microfinance
Should all MFIs scale?
Another ongoing debate is around the commercialization of microfinance. Take for example Kompanion http://www.kompanion.kg/en/ in Kyrgyzstan and Fonkoze http://www.fonkoze.org/ in Haiti, both in our portfolio. Both MFIs operate in very poor, small countries. The combined GDP of both countries is less than ½ of Vermont, the smallest state in the US.
Kompanion has scaled using more commercially-oriented debt while Fonkoze still receives grants/donor funding. This is also reflected by the relationship each MFI has with its US non-profit shareholder. Kompanion may be a potential source of income for its founder, Mercy Corps, by paying future dividends. On the other hand, Fonkoze US aggregates donations that are used to support Fonkoze operations in Haiti. These differences are partially reflected in their respective balance sheet sizes of $80mm and $20mm, respectively.
We don’t believe one approach is better than the other. It is important to have both, because both reflect the diverse needs and experiences of MFIs around the world. There are many MFIs that are much larger or more commercial than Kompanion and many MFIs that are much smaller or socially-oriented than Fonkoze.
It’s clear that scaling up requires commercial capital. To attract that capital you need to be self-sufficient, and it is difficult to be self-sufficient in challenging operating environments or if you provide many non-income earning services to clients. While Kompanion and Fonkoze are at different points along the social/commercial spectrum, I consider both to be part of the investable MFI universe of around 500 MFIs globally. According to Responsability, there are an estimated 10,000 additional MFIs that probably don’t have the operations, structures or processes required to take and repay a commercial loan from an international investor.
An MFI scale model in Kyrgyzstan (with an interest rate example)
Kyrgyzstan is a small, landlocked, mountainous country in Central Asia. With a population of 5 million (estimated 1 million working in Russia), they gained their independence from the Soviet Union in 1991. I was there from 2009-2012 and in 2010 there was a revolution, their second since independence. This is a good example of the type of headline risk that scares off traditional investors. While political instability is never a good thing, the daily life for most of the population was not greatly affected. The resulting turmoil caused the largest commercial bank in the country to shut down because of its political connections but in the end no MFI defaulted on any of their international loan obligations.
Kompanion is an MFI in Kyrgyzstan founded in 2004 when Mercy Corps consolidated five affiliated loan programs. By 2011, there were close to 400 MFIs in Kyrgyzstan with a combined loan portfolio of $450mm (average MFI loan portfolio of $1.1mm) serving 400,000 borrowers (average end borrower loan size of $1,100).
While originally founded with grant capital, today Kompanion completely funds itself through commercial sources: equity, debt, deposits, and retained earnings. With a loan portfolio of nearly $60mm they are the 3rd largest MFI in Kyrgyzstan after Bai Tushum and FINCA Kyrgyzstan, according to the MIX. Kompanion currently has about 100,000 borrowers for an average loan size of around $500. When I was an intern at Kompanion in 2009, their average loan size was $300 and their portfolio yield was around 60% (portfolio yield is calculated as interest income divided by loan portfolio and is used as a proxy for the average rate MFIs charge on the loans they make). One day I gave a talk to a group of Peace Corps volunteers and put together something like the following table to illustrate the effect of loan sizes on operational sustainability.
Row (2), interest income, represents portfolio yield in the % of total columns (B) and (D). Row (3), cost of capital, is how much it costs for an MFI to borrow the money it uses to on-lend. This is a variable cost, i.e. the more money the MFI borrows to on-lend, the more interest they will pay. The assumed rate includes things like hedging costs and provisions for expected losses. Row (4), operating expense, is mostly salaries and assumed to be fixed, i.e. it doesn’t automatically go up if you just increase the average loan size. Row (6), net income, is assumed to be zero, i.e. break-even.
This very simplistic example shows how if you do nothing else besides double the average loan size you can drop the rate you charge from 60% to 40% with no impact on your bottom line. That is because of the operating leverage you get from fixed costs of mostly salaries of loan officers. For example, a loan officer with 300 clients would go from representing $90,000 in loan portfolio ($300 average loan size x 300 clients) to representing $180,000 in loan portfolio ($600 average loan size x 300 clients).
Today, Kompanion’s portfolio yield is around 40% and each loan officer sees an average of around 260 clients, with an average loan size of about $500. What typically happens is that an MFI will be forced to lower its rate as competition increases. The impact of the lower rate is offset by increased efficiency from general economies of scale as well as larger loans sizes as repeat borrowers seek larger loans.
A direct service MFI model in Haiti
Fonkoze is another MFI in our portfolio. Fonkoze was founded in 1994 by Father Joseph Philippe, a Catholic priest. Fonkoze operates in Haiti, an extremely challenging environment, which is also why the services they provide are so important. Haiti is the poorest country in the Western hemisphere and also particularly vulnerable to natural disasters such as the earthquake in 2010 that killed over 100,000 people and more recently Hurricane Matthew in October 2016.
Fonkoze’s clients are a good illustration of what we mean when we talk about impact in the context of poverty alleviation. Their clients may still be poor after taking a loan but their lives have improved based on several indicators Fonkoze collects. After two years, the percent of clients living below $1/day drops only slightly from 53% to 51% but the percent food insecure drops more, from 72% to 63%, and their average savings increase from $13 to $30 .
We made a small investment in Fonkoze over 10 years ago to support their transformation to a regulated bank and are happy to continue supporting Fonkoze indirectly through other loans. Our current borrower Microcredit Enterprises has a loan to them and our borrower Oikocredit has invested equity.
Over to you
My goal in this post was to provide an intro to microfinance and discuss some of the common questions about microfinance institutions. Did I miss anything important? What would you add? I invite you to leave a comment below.
In my next post, I’ll give an overview of microfinance networks as owner/operators of MFIs.
This post was originally published on CalvertFoundation.org
Visit the Invest With Values - Resource Directory to access leading investor information, opportunities, organizations, events, groups and tools.