The ability to successfully operate in the microfinance sector brings a bank two key benefits. It can boost the bank’s credentials as a socially responsible institution, with the bank providing small loans, unsupported with any form of collateral, to help lift people out of poverty in the developing world.
However, microfinance is more than just a means of generating positive publicity.
“Microfinance also presents the bank with a real commercial opportunity,” Vibhuti Sharma, managing director, financial institutions, at Standard Chartered tells GTR.
Microfinance has moved out of the outer edges of the financial world, and has come to be recognised as a socially responsible and profitable commercial opportunity.
Arguing in a piece for The Japan Times, Christopher Domitter, head of corporate affairs at Japan Standard Chartered Bank, says it is imperative that microfinance be more that just an exercise in corporate responsibility for banks. “To ensure the long-term viability of the industry, microfinance should be a sustainable business,” he says.
“The risk-return equation must add up in the same way it does for any other business the banks get involved in. Moreover, social returns have to be brought into the equation while calculating the returns on investment,” he adds.
From a banking perspective, microfinance borrowers have in fact been viewed as a low credit risk. Money is often lent to a small group of borrowers, with all members knowing when and to whom payments are made and collected. Often borrowers will act as co guarantors for each other. This, in theory, creates a collective sense of responsibility and high level of transparency, therefore reducing the likelihood that people will default on loans.
Microfinance initiatives can also increase access to financial services, with the theory being that bringing in more people or smaller companies into the financial sector will ultimately drive growth and new financing opportunities.
There is preliminary research being done with banks and think-tanks into how effective microfinance can be as a stepping stone for micro-enterprises to gain access to other financial services.
For instance, it could be argued that eventually such companies may move on from micro-loans, looking to use part of their business as a form of collateral to fund expansion. Receivable financing or forms of trade finance could then be introduced to help micro-businesses become small or mid-cap businesses.
The business of solving poverty
Standard Chartered has made a very public commitment to the microfinance industry, having pledged at the Clinton Global initiative in 2006 to channel US$500mn into the microfinance sector within a five-year period. In 2007, it delivered US$170mn of this commitment via various means.
Through working with microfinance institutions (MFIs), Standard Chartered has provided a variety of microfinancing based on different business models, including individual lending, the Grameen model, lending to self-help groups and micro-enterprise financing.
The bank also provides technical assistance to MFIs and is in the process of formalising a technical assistance programme. It also works with governments and regulators to look at means of strengthening regulatory frameworks.
Sharma adds: “The key focus for 2008 is to expand to new markets and increase our product offering to our MFI partners, and formalise a technical assistance programme for the microfinance.”
The bank’s fourth arm of its microfinance strategy involves its efforts to create an asset class from microfinance to better manage its risks, and encourage more investors into the sector. It is by disbursing microfinance assets to investors, that it can free up liquidity to meet these goals, and expand its business.
Managing the risks
In 2007 the bank set itself a goal to distribute US$125mn of microfinance assets to investors, and as of May this year it has so far disbursed US$45mn to the World Bank’s IFC, though it is keen to seek further investment potentially from other multilaterals and interested investors.
The credit-linked notes which the IFC has invested in have been issued by a special purpose vehicle (SPV) known as Microfinance Institutional Loans for Asia and Africa (MILAA).
The notes are linked to a portfolio of loans that the bank has made specifically to microfinance institutions in Sub-Saharan Africa and South Asia. This is unusual from other earlier securitisations of microfinance loans completed by other banks which often featured transactions in Latin America and Eastern Europe or Central Asia.
The facility is also unique in that all the underlying loans are in local currency versus a combination of hard and local currency as in previous deals. The underlying portfolio is also replenishable with multiple loan types, and the issuance platform will allow other qualified investors to participate in the future.
Standard Chartered’s Sharma further explains to GTR how the microfinance securitisation vehicle works.
“The SPV MILLA will enter into a credit default swap with Standard Chartered whereby the bank buys protection on a portfolio of MFI loans extended through its subsidiaries and branches.”
SPV’s obligations will be funded by issuing a single class of unrated credit-linked notes, proceeds of which will be placed on deposit with Standard Chartered. The deposit will be used by the issuer to pay any cash settlement amounts due to Standard Chartered under the credit default swap.
“Investors will receive a pro-rata share of income received by the issuer, less SPV expenses, that will include the swap premium and interest received under the deposit account. This will equate to a Libor plus yield. The portfolio risks will be equally borne by all investors, through the vertical slicing of the notes,” he adds.
Standard Chartered will maintain its role as the servicer of the loans, and the reference portfolio will replenish over a three-year period when pre or repayments occur. This means that although the IFC is the anchor investor in the deal, the transaction structure allows for other qualified investors to come on board in the future.
Appeal to investor
According to Sharma, the deal has a dual appeal to investors. “Microfinance investments provide a double bottom line return – financial and social returns.”
“Some investors have a focus on supporting the microfinance sector. Given the high social impact of microfinance investment, it appeals to the socially responsible investors.”
The investment vehicle also provides investors with a high degree of transparency. The investor is fully aware of the underlying assets, and as the transaction allows for replenishment, the investors will also be updated every quarter what the underlying loans are.
However despite the ethical and commercial appeal of this new asset class and the microfinance sector in general, there have also been some concerns raised about the rapid growth of the industry, poor management standards and governance, and the potential this all has to cause lending standards to decline.
In a survey published by the London-based think-tank the Centre for the Study of Financial Innovation in March, one of the main concerns among microfinance practitioners was the growing level of competition in the market, and the potentially negative impact this could have on the industry and its reputation.
Some of those questioned feared that a market flooded by global commercial banks could end up cutting off supplies of finance to the neediest, and encourage overdebtedness in the more creditworthy.
However, others questioned by the think tank saw rising competition as a good development as it would bring down loan costs as well as encourage innovation.
It was not just the presence of global banks that have started to worry practitioners, there was also concerns with a lack of adequate management within MFIs themselves, and poor governance with regulations and government interference hindering the development of the industry.
The likelihood of increased credit risk was also raised by the report. Not usually seen as a major threat to this industry, some practitioners have been worried that heightened competition will encourage banks to take greater risks by extending into unfamiliar markets. The report cites a comment made by a bank regulator from Central Africa who notes: “the high rate of non-performing loans to several MFIs” in her territory.
Standard Chartered’s Domitter also reflects on the various risks and pitfalls of microfinance. Writing for The Japan Times, he cites poor and varying regulatory frameworks, increasing political risks and lack of transparency among MFIs as potential obstacles for those venturing into this relatively nascent market.
He remarks that to date only a selection of MFIs follow internationally recognised standards, and that there is a huge need for education and training.
Yet, these problems should not, he argues, necessarily bar commercial banks from taking part in the market. Indeed, banks should apply the same risk mitigating strategies to their microfinance activities as they do to any other area of finance. Furthermore, there is also a role for the global players to provide some of the much-needed financial and management training.
Vulnerability to the credit squeeze
There were also concerns about the impact of wider economic trends, such as the global tightening of liquidity. Typically the localised nature of microfinance means it has avoided some of the major blows of macroeconomic events.
However, as microfinance becomes more mainstream, some respondents to the think-tank’s report see the sector becoming more vulnerable to these wider developments. Being more integrated into mainstream banking means the sector will be more open to ‘contagion’. Yet, others cited in the report still believe that any impact will only be short-term.
Standard Chartered’s Sharma reflects on the extent of the sector’s resilience, commenting: “The market will remain attractive simply because of the huge demand-supply gap. Uncertain times have an impact on every industry and sector, and so it will on the microfinance sector, but this does not mean that its viability or attractiveness will disappear.”
Microfinance: here to stay
Despite the fact that microfinance has become ‘mainstream’, there are still some that express persistent doubts over its effectiveness. Most generally agree with the argument that microfinance as a ‘bottom-up’ form of development financing can be a more effective method than a more traditional ‘top-down’ approach, but that still hasn’t convinced everyone. In an article published in the Financial Times last year, professor Aneel Karnani of the University of Michagan was quoted as saying: “If societies are serious about helping the poorest of the poor, they should stop investing in microfinance and start supporting large, labour-intensive industries.”
Talking to GTR, Sharma explains that a bottom-up or a top-down approach do not have to be mutually exclusive. “Standard Chartered has a large SME business in developing and emerging markets. However, it also supports MFIs and the loans to the individual micro-entrepreneur. The market is intelligent enough to take care of this.”
As of June 2008, Standard Chartered has provided finance or financial instruments of US$277mn since September 2006.
Presently the bank provides credit to 48 MFI partners across 13 markets with a portfolio outstanding of US$183mn.