Research Insight Peru - Model Market for Microfinance

Research Insight Peru - Model Market for Microfinance Research Insight is a publication of responsability research. At irregular intervals, responsability research conducts and compiles analyses, studies, and comments on countries, themes, companies, and commodities in responsability s areas of investment. March 2012 2

The Role of Microfinance in Development By Christian Etzensperger, Senior Research Analyst After two decades of financial sector development in Peru, it is time to take stock. The Peruvian microfinance industry, centered on 40 regulated local banks, serves 3. million poor households at ever-decreasing costs. The sector has remained profitable while the level of interest rates has declined consistently. The rise of microfinance has been accompanied by a steady fall in official poverty rates as well as lower income inequality. The case of Peru underlines the argument that financial sector building is a necessary condition of economic development and suggests that microfinance plays a key role by offering opportunities to poor households. The open secret of Peruvian microfinance success, sound regulation and strict supervision, should spur imitation worldwide. As the advanced economies are going through a prolonged crisis, Peru is arguably the fastestgrowing economy in the Western hemisphere. Its poverty share is falling relentlessly. Consumer, financial, and labor markets are thriving. The democratic system works reasonably well. Twenty years ago, Peru was a broken country. Hyperinflation had wrecked the economy and pushed millions into poverty. Misguided government policies including zero cost credit programs heavily distorted markets, while terrorism ruled the countryside. Many factors led to this astonishingly positive development over the last two decades. The rise of microfinance was one of the stylized facts that accompanied the economic development of Peru. While the poverty incidence, which had risen to % by 2001, dropped to 30% in one decade, 1 microfinance gross loan portfolios grew fifteenfold (Figure 1) or by 31% annually. 2 Microfinance in Peru has roots going back to the 190s, but private-sector microfinance took off in the 1990s, boosted by a new policy framework of economic liberalization. The new framework built on the work of economist Hernando de Soto, laid out in his best-selling book The Other Path. 3 Its central message is that huge economic potential is locked away in informality. People need formal rights over their resources in order to control them. Moreover, in order to use the resources they control productively and to manage them effectively, people need access to finance. Figure 1: Microfinance growth in Peru [Billion USD] 9 8 7 6 4 3 2 1 0 2002 2003 Gross Loan Portfolio Deposits Number of Borrowers 2004 200 2006 2007 Consequently, microfinance was very much the fertilizer that allowed growth in Peru to spread from a few mines 4 out to the masses. While the share of the population living on less than USD 2 per day was reduced by half, the Gini coefficient, a measure of income inequality, has also declined steadily. The degree of freedom provided by a variety of financial services (microloans, deposit accounts, money transfers, and others) allowed for self-employment on a large scale. Microfinance was probably not a fundamental cause of economic growth, but surely a means of dispersing, transforming, and catalyzing 2008 2009 2011 4.0 3. 3.0 2. 2.0 1. 1.0 0. 0.0 [People in millions] 1 Peruvian Institute of Statistics and Information (INEI) 2 Gross loan portfolio growth of regulated microfinance institutions. Sources: Superintendencia de Banca, Seguros y AFP (SBS) and Consorcio de Organizaciones Privadas de Promoción al Desarrollo de la Pequeña y Microempresa (COPEME) 3 El otro Sendero, by Hernando de Soto, Enrique Ghersi, and Mario Ghibellini, first published in 1986, reeditions in 1989, 2002, 2006, and 4 Peru is a world-leading producer of gold (6th), silver (1st), copper (2nd), zinc (2nd), lead (4th), tin (3rd), molybdenum (4th), rhenium (4th), bismuth (3rd), and arsenic trioxide (4th) (source: USGS). However, the 41 large mines provide only 47,00 jobs (source: INEI). IMF Article IV Report 2011 2

GDP growth into broad prosperity and thus reducing poverty (Figure 2). Figure 2: Poverty reduction in Peru 6 The virtue of financial sectors Financial development is an indispensable condition for sustaining economic growth. Financial systems provide vital services: they evaluate, screen, and allocate capital, monitor the use of that capital, and facilitate transactions and risk management. If financial systems provide these services effectively, capital flows to the most promising firms, promoting and sustaining economic growth. 7 Any enterprise or household excluded from access to finance is severely impaired. This is a reality for 2. billion individuals in the world, 8 and 47% in Peru. 9 One should note that the distribution of the unbanked half of households is by no means even across the country, but heavily tilted to povertystricken areas, in particular in the countryside. People in such areas have been totally neglected by banks, on the premise that they lack the collateral or the wealth that would make them worthy banking clients. Consequently, banks would not provide financial access for poor households, excluding them from credit, savings accounts, insurance and transfer services. Furthermore, the capacity of small businesses to grow and the ability of households to save, manage risks, and smooth and diversify income and consumption, were all restricted. 6 INEI, Encuesta Nacional de Hogares Anual, 2001, 200, and 7 Ross Levine (2011) 8 2. billion according to CGAP (2009) and even slightly more according to the Financial Access Initiative in collaboration with McKinsey & Company (2009) 9 Microrate (2011) The innovation of microfinance Microfinance is the provision of financial services to low-income clients who traditionally lack access to financial services. The long-term goal is to build comprehensive financial sectors that provide a broad range of everyday financial products to all segments of society. 10 Microfinance requires a set of specialized tools to carry out the screening and monitoring of clients as well as to enforce repayment. Traditional banks require hard information such as audited statements, asset appraisals, tax receipts, and investment plans and use the threat of asset loss in cases of default. In contrast, a microfinance credit officer analyzes the cash flows generated by a household s (often numerous) micro-entrepreneurial activities. Close and frequent contact between both lender and borrower is key. Moreover, credit officers analyze the whole social and economic environment in which a micro-entrepreneur operates. Microfinance in Peru Microfinance has deep roots in Peru, as can be seen from the time line on page 4. Mohammed Yunus, a Bangladeshi entrepreneur and Nobel Prize winner often perceived as the inventor of modern microfinance, started microlending operations in the late 1970s with his Grameen bank, in operation since 1983. Developments in Peru were contemporary (Acción, an NGO, soon joined by IPC, a German consultancy) and subsequently evolved into a financial sector whose breadth and depth went far beyond that of the Bangladeshi market. In contrast to group lending with joint liability as practiced by Grameen Bank or Mexico s Compartamos Banco, Peru saw rapid advances in individual lending. Moreover, the Peruvians focused on savings as a key complement to borrowing, drawing on the German savings bank model. The resulting Cajas Municipales emerged at a time when the general wisdom of policy makers and development planners stated that poor people did not have significant savings capacity. Accompanied by savings, individual lending techniques prospered, and the predominance of group loans in Peru decreased sharply. 10 CGAP (2004): Key Principles of Microfinance 3

The Cajas Municipales were followed by the Cajas Rurales in the 1990s. The latter focused on the agricultural sector, filling a gap left by the closure of Banco Agrario, a government bank that failed in 1990. Specialized microfinance firms called Enterprises for Development of Small Businesses and Microenterprises (EDPYMEs) were also established in an effort to regulate the steadily increasing number of entities working in this area, thus adding to the growing diversity of the Peruvian microfinance landscape (Figure 3). Figure 3: Loan portfolio growth of Peruvian MFI s 11 [Billion USD] 6 4 3 2 1 0 2001 2002 EDPYMEs Cajas Rurales Cajas Municipales Financial Services Providers Banks 2003 2004 The evolution of MFIs 200 The leading MFI in Peru is Mibanco, an institution set up in 1998 as the first MFI fully equipped with a banking license. Mibanco did have a head start, as its mother group s (Grupo ACP) experience with microlending dates back to the 1970s. By 2003, Mibanco served 120,000 credit clients and 42,000 savings clients. As of 2011, it served 420,000 credit clients and 260,000 savings clients. 12 Mibanco s lead spurred efforts by its competitors, many of which started as humble MFIs and climbed up the formalization ladder to grow into fully fledged financial services providers. A further notable market event was the acquisition of Financiera Crear, an Arequipabased financial company, by Compartamos Banco, Mexico s leading MFI. This USD 63 million transnational equity transaction was yet another sign of healthy competition in the Peruvian microfinance market. It was preceded by a USD 9 million transaction, the 2009 acquisition of EDYFICAR, a financial company, by Banco de Crédito, Peru s largest commercial bank. Later on, Mibanco and EDYFICAR (then an EDPYME) were the first microfinance insti- 2006 2007 2008 2009 tutions (MFIs) to emit corporate bonds, in 2007 and 2008, respectively. In addition to those significant transactions, a large number of lesser moves by smaller market participants kept the Peruvian microfinance market in a state of continuous evolution. Due to the system of Peruvian regulation, which oversees six different regulatory types of MFIs, each with its rights and obligations, MFIs can move up the ranks and are indeed encouraged to do so. 13 The goal is a financial sector consisting of different forms of institutions, but with increasing numbers of institutions capable of providing a broad range of services, including deposit taking. Time line of microfinance in Peru 190s and 1960s First credit unions and saving and loans organizations set up by Priest Daniel McLellan (known as Father Dan the Money Man ) 1968 Acción International ventures into Peru, creates Groupo ACP (Acción Comunitaria del Perú) Early 1980s 1980s Gabriel Gallo Olmos and Claus-Peter Zeitinger s IPC start building municipal savings banks (CMAC) in Peru with the support of GTZ USAID and the IDB promote microfinance models featuring technical assistance and financing 1982 Acción International launches the microcredit program Progreso, the first selfsustaining microcredit program in Latin America Early 1990s COPEME starts tracking the credit history of microfinance clients 1992 Peru creates Rural Savings and Loans Banks (CRAC) to promote financial sector development in rural areas 1994 Creation of EDPYMEs incentivizes NGOs to seek formalization 1997 Private credit bureaus established in Peru 11 Superintendencia de Banca, Seguros y AFP (SBS) 12 Mibanco 2011 13 Such upward mobility was made easier by an amendment of Law 26702 in 2004. 4

1998 Grupo ACP creates Mibanco, a private microfinance bank 2009 Banco de Crédito acquires EDYFICAR, a large financial company founded as an NGO 12 years earlier, for USD 9 million 2011 Compartamos Banco (Mexico) takes over Financiera Crear Arequipa (Peru) for USD 63 million The Peruvian regulation The Peruvian microfinance regulation is based on the following pillars: Modular diversity of regulatory types and upward mobility between them Extensive supervision Nondiscrimination between domestic and foreign capital Nonintervention by the state, albeit with a few exceptions (Banco de la Nación, Banco Agropecuario) Freedom of capital allocation Freedom to determine prices (interest rates and commissions) Permission to take deposits for several regulatory forms (banks, financial services providers, CMAC, CRAC) These principles brought about one of the world s leading microfinance industries. Unfortunately, other countries have been excruciatingly slow in detecting and copying such success factors. In fact, government intervention, price controls, no upward mobility or an outright ban on deposit taking remain among the most significant obstacles to the goal of providing access to finance for the poor in many countries. Governments use taxpayers money to pursue their development agendas. This is welcome as long as public aid does not hinder or crowd out the emergence of private markets. Microfinance is one of the rare development success stories. It has extensively proven its ability to operate under market conditions; and at a more fundamental level, microfinance pays for itself by creating value in the development of new markets and market segments. In contrast, direct government involvement in financial intermediation, e.g., direct lending to poor people or to small businesses, has resulted time and again in failure, i.e. not achieving its stated goals. The Peruvian example is Banco Agrario, whose perennially loss-making subsidized lending scheme to farmers ended in insolvency. Another typical government intervention is to protect the poor by imposing interest rate caps. Such a measure may be politically appealing in the short run, but inevitably bears negative consequences in the long run. The difficulty is that by making it impossible to cover costs, interest rate ceilings undermine the ability of many MFIs to become sustainable, thus forcing many poor people to rely on much more expensive and limited informal alternatives. Conscious of such consequences, the Peruvian state has never attempted to manipulate interest rates and has so far restricted itself to very selective public intervention in microfinance. 14 One example would be the supply of public banking infrastructure to MFIs in rural areas where the MFIs could not yet afford to build such infrastructure themselves. Credit bureaus A further key element of the Peruvian microfinance market is its credit bureaus. The Peruvian regulator, SBS, operates a public credit bureau that collects information on regulated lenders. Banks and regulated MFIs are required to share their clients information on current, contingent, and total debt, as well as default records, on a monthly basis. 1 Since 1997, the bureau has also covered microfinance. At around the same time, private risk bureaus, namely Certicom and Equifax, began operations in Peru, the latter of which included non-regulated MFIs and is today s market leader. Peru now has some of the most complete and timely credit information coverage in the world. The result, a reduction in credit risk was brought about to a large extent by the market mechanism, once the state permitted it to work efficiently in a diligently regulated environment. 14 Law 26702, Article 7: The state shall not participate in the financial system, except for its investments in COFIDE as a second-floor bank, in the Banco de la Nación and in the Banco Agropecuario. 1 The Data Protection Law of Peru, enacted in August 2001, covers the private credit bureaus that collect and process credit information of both individuals and companies. The law specifies what type of information and records credit bureaus can legally collect. The law also states that individuals have the right to information and the right to modify or cancel their personal data.

The diverse and wide dissemination of information about clients, high liquidity levels in the market, and open access to funding sources have generated increasing numbers of shared clients (clients of two or more institutions) and the approval of higher loan amounts. This naturally entails risks. However, thanks to credit bureaus, these risks are visible and appear well understood. It is preferable to have known unknowns, i.e., risks well defined on the basis of information provided by specialized, professional, and neutral agencies, rather than the unknown unknowns of a murkier environment, prevalent in many developing economies. Outcomes Today, the micro-enterprise and small-business segment is of paramount importance to Peru s economic development, representing almost half of the GDP and three-quarters of the economically active population of 14 million people. The micro segment of the Peruvian financial sector serves 3. million active borrowers plus their household members. Both microcredit and microdeposits have grown at a rate of 30% annually over the last decade. 16 The microfinance market is characterized by a wide range of institutional formats, which have all found a solid client base (Figure 4). Figure 4: Number of borrowers by regulatory type, in thousands 17 Part of the social benefit of financial sector development can be captured by the decline in creditsupply prices over time. The market mechanism has led to steadily lower prices of financial products. Interest rates charged to clients (shown by proxy via MFI loan portfolio yields) have declined over the last decade (Figure ). 16 SBS, COPEME 17 SBS, Planetrating 2011 234 200 187 Banca Multiple 402 271 Mibanco 979 1082 Financial Services Providers CMAC CRAC EDPYME NGO Figure : Portfolio yield over time 18 4% 40% 3% 30% 2% 20% Meanwhile, profit margins consistently remained positive, even during the worst period of the financial crisis. 19 Given the growth potential of the Peruvian economy and its fast-expanding domestic demand (shown in Figure 6), the Peruvian financial sector is set to evolve much further. Figure 6: Growth projections for Peru 20 [Thousand USD] 40 3 30 2 20 1 10 2003 - Risks 2004 200 2006 Portfolio yield (regulated) Portfolio yield (broad market) A market cannot grow fifteenfold without facing substantial risk. But the level of risk depends on how it is identified, monitored, and managed. Peru opted for transparency early on, enabling market actors to react to changing market signals. Thanks to the presence of constantly updated indicators in a clearly defined framework of rules, the strong expansion in Peruvian microfinance did not come at the price of extensive MFI failure or widespread overindebtedness. Despite fast growth and often ferocious competition, the supervisor, SBS, has seldom had to intervene in the market. 18 SBS, MIX market 19 The lowest quarterly return on assets was 1.6% in the second quarter of 2009. Source: SBS, COPEME 20 Economist Intelligence Unit 2011 2007 Private consumption per head GDP per head (PPP) Population 2020 2008 2030 2009 40 3 30 2 20 1 10 0 [People in millions] 6

Figure 7: Portfolio development (PAR30) 21 8% 7% 6% % 4% Bolivia Colombia 3% Ecuador 2% Peru 1% 0% 2004 200 2006 2007 2008 2009 2011 Nevertheless, the share of nonperforming loans has been at a persistently higher level than in other major Latin American microfinance markets (Figure 7). In the absence of fundamental reasons for permanently higher levels, the cause often cited is that of higher levels of transparency in the Peruvian market. Even if that sounds plausible, these higher levels of nonperforming loans certainly keep the regulator on its toes. In for instance, SBS implemented additional capital requirements for financial institutions: 22 A countercyclical capital requirement is activated or deactivated according to a dynamic provisioning activation rule, based on GDP growth. The requirement takes into account default probabilities during a recession period and expected losses by type of loan. A capital requirement for concentration risks associated with individual exposures as well as sectoral and regional exposures. A capital requirement for interest rate risks on balance sheet level applies to banks dedicated to consumer lending and financial companies. Even so, as a country that holds high levels of international reserves (currently USD 47 billion or 30% of the GDP), whose public finances are sound (surplus of >1% of the GDP in 2011), and that holds little debt (20% of the GDP), Peru appears resilient to economic shocks and its microfinance industry well shielded. 21 MIX market 22 IMF Article IV Report 2011 7

Conclusion Peru has come a long way in terms of financial sector development. A dynamic market of diverse players, serving millions of households in the lowerincome segment at low prices, is an impressive result. This is an early assessment, though, as even this success story depicts a country that is only roughly halfway to the access for all goal. This must be put into perspective, however, by the many developing economies still lagging far behind Peru, the model market in terms of financial sector development. Few governments have learned from the reforms that Peru introduced in the early 1990s. Policy makers have shown frustratingly little interest in how to effectively regulate and supervise microfinance, despite the fact that poor households value access to finance more than any other income segment and are more vulnerable to a malfunctioning system. The fact that 97% of microcredits across the world are repaid 23 while tax collection in developing economies is usually dismal should not have escaped policy makers attention. Indeed, the benefits of better connecting large parts of society to markets and the key role of soundly regulated finance in achieving this goal are too compelling to ignore. The Peruvian sector itself still has as much as halfway to go in order to reach out to the many remaining households and small enterprises still without proper access to financial services, particularly in the countryside. Financial depth continues to be low in Peru when compared to advanced economies, with private credit volume representing only 29% of GDP. 24 Housing finance for the poorer segments of society, the financing of fixed assets (as opposed to short-term working capital) in enterprises, and rural finance are all poorly developed. Moreover, blessed as it is with rich biodiversity, Peru boasts a promising agricultural sector, but financing to farmers, particularly smallholders, remains severely constrained. 2 Further potential for social investors lies in health care and schooling, given that medical services are precariously insufficient, 26 and that 20% of the rural population is illiterate. This leaves plenty of room for investment activities that yield important economic as well as social returns. responsability in Peru With almost 10% of the worldwide investment volume, Peru has been the largest country exposure in responsability s investment portfolio for many years. Investments in debt and equity amount to USD 90 million. In 2011, responsability opened a branch office in Lima to act as the hub for its Latin American investment volume of USD 360 million. Acknowledgments Valuable input to this report came from: Jorge Arias, ASOMIF William Ferrer, FEDECMAC Jacinta Hamann, Consultant Jorge Meza Marín and Jesús Del Prado, COPEME Felipe Portocarrero, IFC Luis Felipe Derteano Marie and Julia Sobrevilla, Grupo ACP Carolina Trivelli, Minister of Development and Social Inclusion of the Republic of Peru 23 Data from responsability, MIX market, and a broad range of official sources 24 IMF Financial Access Survey 2011 2 Felipe Portocarrero 2011 26 18% of children in rural Peru suffer from chronic malnutrition, according to the IMF Article IV Report 2011. 8

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