Commercialization of Microfinance

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1 8/16/ Commercialization of Microfinance Robert Lensink (RUG/WUR) Presentation for the UMM Conference in Frankfurt

2 Schedule 8/16/ Some preliminary remarks Recent trend: commercialization of microfinance Is microfinance interesting for private investors? Is commercialization good for the poor? Microfinance and the financial crisis Conclusions

3 Microfinance is great! Until few years ago: an euphoric attitude among policy makers and aid organisations about the potential promise of microfinance Millennium Development Goals of the UN 2005: Year of microcredit 2006: Muhammed Yunus wins nobel peace price

4 8/16/ Recently: extremely positive view is challenged Empirical testing of microfinance suggest that effects are relatively modest. But testing difficult Commercialization of microfinance Some even argue that microfinance is obstacle to sustainable development: microfinance results in financing of unproductive small enterprises at the expense of the more productive SME sector

5 Commercialization Last decade, commercialization of microfinance Commercial banks more involved in microfinance Traditional services MFIs expanded: From microcredit to microfinance (microinsurance; savings; micro pensions, use of cell phones and internet)

6 Commercialization Funding situation changed rapidly: 8/16/ Traditionally MFIs funded by public donors and aid organisations Now capital market funding becomes important (last 3 years $500 million). MFIs start to borrow in the international capital markets directly. They did this through debt funds (investment funds) set up by commercial banks Some MFIs even went public (compartamos in Mexico) Also institutional investors interested in microfinance There is even securitization of microfinance: issuance of securities directly backed by a pool of loans.

7 Commercialization MFIs focus more on financial sustainability/efficiency Move from group lending to individual lending Also more attention for regulation

8 Types of MFIs 1) Tier 1: top 150 largest MFIs, with strong financial track record 2) Tier 2: smaller, less known MFIs, near profitable (about 8% of MFIs) Tier 3: mainly NGOs approaching profitability (about 20%) Tier 4: start up MFIs, not profitable (70%) Bulk is in Tier 4, but in terms of outreach and asset value, tier 1 most important.

9 Important Questions 8/16/ Why is it interesting for private investors to invest in MF? 2 Is an increase in private investments in MF beneficial for the poor (is commercialization good?)

10 MF and international investors Why is MF interesting for international investors? 1) increased attention for social responsible entrepreneurship 2) The potential size of the microfinance market is very big 3) high returns on microfinance lending 4) low default rates on microfinance lending 5) microloans may be uncorrelated with returns from other asset classes, and may be uncorrelated with macroeconomic shocks. A microloan can therefore serve as a natural hedge for investment banks, pension funds, insurance companies, and international private investors in general. Before dealing with these issues in more detail, first some hurdles.

11 Hurdles 1) mainstream investors deal with regulated entities that work in a clearly defined legal environment MFI needs to be transformed from NGO with weak corporate governance into regulated banks 2) Macro policy and government regulations have to be adapted to accommodate commercial microlending: stable exchange rates; prudential regulation/ laws etc 3) If international capital markets are to be tapped on a larger scale, the MFI investors have to be able to hedge the foreign exchange risk that appear when they borrow/ lend in a foreign currency. However, MFIs are often in countries were there are no possibilities to reduce exchange rate risk (currencies not convertible) 4) lending on subsidized terms may lead to crowding out of commercial lending.

12 1) increased attention for social responsible entrepreneurship MF could be an interesting alternative for private investors who, for altruistic motives, want to contribute to the fight against poverty By directly targeting the poor, and therefore circumventing inefficient/corrupt government structures, microlending could be an efficient means of doing well. However: there is little empirical evidence for a huge poverty reducing effect of MF.

13 2) potential size of the microfinance market There are currently up to 3 billion people without access to proper financial services! There are also an estimated 500 million microentrepreneurs worldwide Thus, there is a largely untapped source of microcredits for international investment banks that can be pooled together and sold to investors all around the world

14 3) high returns on microfinance lending Microlending probably gives higher returns than traditional lending Typically, a poor farmer or entrepreneur in developing world generates much higher returns on his assets than corresponding business in developed world Thus, as is argued by some, many poor can afford to pay much higher lending rates

15 3) high returns on microfinance lending Some empirical evidence indeed suggests that interest rates can be much higher for lending to the poor There is evidence that moneylenders in developing countries ask daily interest rates of 20% (which is more than 5000% a year!!!)

16 4) Low default rates on microfinance lending literature suggests that default rates are indeed low, below 5% Low default rates are caused by innovative MFI lending techniques (group lending etc) However: there is evidence that default figures are deflated Moreover, MFIs are heavily subsidized In addition, credit quality of average borrowers could fall if client base is widened.

17 8/16/ ) MF attractive in terms of portfolio diversification? Some argue that risk adjusted returns of MFI exhibit low correlations with other assets/market risks. Why? 1) Mostly non-public ownership structure reduces sensitivity to market signals and dependency on capital markets 2) Lower international exposure of MFIs and their clients 3) Borrowers from the informal sector are less sensitive to market movements Investing in MFI could offer diversification benefits to investors seeking to reduce portfolio volatility.

18 8/16/ ) MF attractive in terms of portfolio diversification. International diversification and microfinance? Galema, Lensink and Spierdijk investigate whether adding microfinance funds to a benchmark portfolio is beneficial to investors Our study looks and risk and returns! This is different from other studies in the field. Other stuides look at: 1) are MFIs resilient to domestic macro-economic shocks (Ahlin and Lin and Gonzalez) 2) correlation between MFI returns and international and domestic performance measures (Krauss and Walter)

19 International diversification and microfinance Method: mean variance spanning tests 8/16/ Assumption: investment decisions are only made on the basis of the mean-variance properties of assets. Spanning test enables to test whether adding microfinance to a benchmark portfolio allows investors to reach a mean-variance efficient portfolio with a higher mean and a lower variance.

20 International diversification and microfinance Data: annual data on MFIs for period From MixMarket 8/16/ We focus on accounting earnings: return on equity (ROE) and return on assets (ROA) To mimic institutional investor s broad investment portfolio, we use global equity and bond indices (Morgan Stanley Capital International and JP Morgan Global Broad) We apply spanning tests to all MFIs and to MFIs from different regions and to different types of MFIs

21 International diversification and microfinance Results: 1) Spanning more often rejected for bond benchmarks than for stock benchmarks: micorfinance investment seems to be particularly valuable as addition to the bond share of a globally diversified portfolio 2) spanning NEVER rejected for Africa: high oper. costs, subject to interest ceilings, high inflation 8/16/ ) Spanning almost always rejected for Latin America 4) Spanning always rejected for microfinance banks; almost never rejected for cooperatives, NGOs, NBFIs

22 8/16/ Why is investing in microfinance attractive to the poor? more funds available, hence a better outreach: studies show that roughly percent of populations in most LDCs lack access to formal banking services! more loans with longer maturities more diversified funding sources

23 8/16/ Commercialization (and increased supply of private funds) versus outreach 1) since lending to the poor may be very costly, outreach and financial sustainability may be conflicting 2) Unit transaction costs are higher for smaller loans. For this reason, achieving financial sustainability reduces outreach 3) Mission drift: focusing on wealthier clients Hermes, Lensink and Meesters suggest that a tradeoff exists between outreach and efficiency of MFIs.

24 Overall conclusions 8/16/ ) Microfinance is still seen as a good thing, but the extremely positive view is challenged Evaluations Commercialization 2) Investing in MFIs may be interesting for private investors in terms of portfolio diversification 3) However, in general there is a tradeoff between outreach and financial results of MFIs

25 Overall conclusions 8/16/ Should MFIs return to their traditional focus? Less commercialization? More focus on the poor? Return to group lending? Or do we need a further segmentation of the market, with two types of MFIs (more commercialized versus not-for profits)?

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