A Case for Microfinance Backed Securities

By Gautam Kalani

It is now widely accepted that the microfinance model is successful in significantly reducing rural poverty by improving access to the credit market. It fills the gaps left by the inefficiency of formal credit markets in developing countries. Microfinance has been effectively implemented in countries as far reaching as Bangladesh, Indonesia, Kenya and Bolivia. The secret of its success lies in its ability to significantly reduce the debilitating information and enforcement costs inherent in the credit markets of developing countries, through the process of endogenous group formation and social monitoring. The repayment rate for microfinance loans is as high as 97% in some places, spurred on by the pride of the impoverished borrowers and the system of social enforcement. This is far higher than the rate for commercial banks and government-operated social banks . Also, unlike formal credit, most microfinance loans require no collateral. Moreover, when compared to social banking expansions, microfinance is a cheaper way of increasing rural access to the credit market because, unlike social banking, it tackles the inefficiencies at the root of formal credit markets. Microfinance undoubtedly increases and equalizes access to the credit market, and is a cost-effective method of lowering rural poverty.

Microfinance, however, is not nearly as widespread as is desirable. This is because microfinance institutions (MFIs) are run primarily by non-profit NGOs, which do not have sufficient funds to expand into rural and remote areas. In vast and heavily populated countries like India, the penetration costs of expansion into the far-reaching, isolated corners are too high for NGOs to bear. Though microfinance is more cost-efficient, it is not as widespread as government-controlled social banking, due to high penetration and expansion costs.

To overcome imperfections in the credit market and reduce rural poverty cost-effectively, efforts must be made to expand microfinance. One of the largest obstacles to the growth of microfinance today is the lack of resources available to MFIs. A possible method to overcome this barrier and promote the spread of microfinance is to float an MFI on a public stock exchange. Listing an MFI on a stock exchange would give it access to more funds and resources, which it could use to increase lending and also to expand into untapped regions. Positive financial returns (which can be in the mid to high single digits ), combined with the social benefits, can draw investors to MFIs. An MFI like Grameen Bank would be a prime candidate for such a listing. Its model is well known and it has an exceptional track record . If a listing proves to be successful and the model profitable, this would also cause other MFIs to start up, further increasing the reach and spread of microfinance.

If it is viable to float an MFI on a stock exchange of an emerging market, then it should be done as soon as possible. Growth in emerging markets is high and stock markets are at all time peaks. The Indian and Chinese stock markets, in particular, have reached unimaginable heights. In India, liquidity is also widely available.

Another possibility is to create microfinance backed securities. Microfinance loans from many regions could be bundled together; these bundles could then be sliced up and the parts sold to investors as microfinance backed securities. Securitization is probably the quickest and simplest way for the microfinance industry to gain access to mainstream capital markets. Since microfinance generates positive returns, it would not be hard to find investors for these securities, as profits are combined with the lure of ‘social investing’. These securities diversify risk for investors since they are based on loans given in different regions. This makes these securities more desirable than commercial bank shares as they would “represent lower country risk than shares in banks. ”

Additionally, there is evidence that MFIs have a low correlation with broader macro-economic indicators - “microcredit borrowers are operating in the informal sector, and so they are less affected by shocks to the formal economy. ” The positive performance of microfinance in recent financial crises is evidence that microfinance growth is less dependent on macro conditions. For example, when Indonesia had its financial crisis in the 1990s, the microfinance sector suffered less than the formal sector . Also, it can be argued that the poor have different risk sensitivity from the rest of the economy – they are not usually directly involved in the boom and bust of, say, real estate. This suggests that microfinance securities would probably be less likely to fail to pay out in the face of downturns; that is, the systematic risk (beta, in financial jargon) would be lower for these securities. Thus, microfinance backed securities would also be an attractive option for investors and fund managers looking into portfolio diversification. In times like these, this can only be a good thing. Robert Annibale, global director of Citi Microfinance, echoed this sentiment when he said that the “microfinance field looked to be largely immune from global credit liquidity problems following the U.S. subprime mortgage crisis, and that in previous economic crises the very poorest had proved themselves surprisingly bankable. ”

In fact, microfinance backed securities already exist. In April 2006, Morgan Stanley arranged the BlueOrchard Loans for Development 2006-1 transaction (BOLD 1)—an almost USD100 million collateralized loan obligation (CLO) backed by unsecured senior loans to 21 MFIs in 13 developing countries in Latin America, Eastern Europe and Asia. The largest of its kind to date, and the first to be arranged by a major international investment bank, the BOLD 1 transaction showed that standard securitization techniques can be used to allow the mainstream capital markets to invest in the microfinance industry. This was followed in 2007 by BOLD 2, which is a USD110 million CLO. The different BOLD 2 notes received S&P ratings of AA and BBB. These ‘investment grade’ are further evidence of the viability of microfinance as an asset class. (Ha! You can’t mean this, surely… especially after what happened over the summer? – but don’t I justify this statement when I explain that microfinance isn’t affected that much by broader macro indicators and that its not susceptible to a crash like the subprime market saw? If you feel that isn’t enough, just delete the last sentence and add ‘investment grade’ before S&P ratings.)

In my opinion, giving microfinance access to mainstream capital markets is the key to its future growth. If MFIs can harness the power and efficiency of capital markets on a large scale to achieve its social goals, then microfinance would grow exponentially, leading to widespread poverty reduction. However, this is only feasible if MFIs, and microfinance ventures in general, are profitable. There has been much debate on this issue of profitability in relation to microfinance. Murdoch (1999) argues that although repayment rates associated with microfinance are high, there is little concrete evidence to suggest that microfinance is, in fact, a profitable venture. He claims that “(m)ost programs continue to be subsidized directly through grants and indirectly through soft terms on loans from donors. ”

This, however, cannot explain the successful survival of for-profit MFIs in recent years. Organizations like SKS Microfinance , which operates in India, and Bangladesh’s Grameen Bank, have notched up healthy profits in the past few years. SKS has already drawn millions of dollars from financial giants such as Citigroup, ABN Amro and HSBC – not as donations, but as investments. As of 2006, ICICI Bank, India’s largest private sector bank in terms of capital, had loaned more than USD10 million to SKS; these loans “have been low-risk and give ICICI a slightly higher return on capital than it gets from its corporate borrowers. ” Additionally, as the following graph shows, Grameen Bank has declared positive profits for every year since 1993; there has also been a rapid rise in profits in recent years which correspond to the exponential growth in microfinance. (BUT: Grameen is partly government owned <~6% by the Government of Bangladesh> AND it’s bonds were guaranteed by the government as well; so does using Grameen as an example invalidate your point that MFIs can operate/ survive on their own?? Yes, because now Grameen runs free of subsidies and donations – it is a self-sustaining organization. Also, the govt ownership is a very small percentage.) Thus, there is strong evidence that microfinance can be run as a profitable venture.

As the current debate on the profitability of microfinance rages on, there is a general consensus on one aspect – in order for the microfinance sector to sustain growth and better serve the poor, it needs to “diversify beyond small loans to saving and insurance schemes. ” Murdoch (1999), too, believes that the present microfinance model is by no means perfect – “The full promise of microfinance can only be realized by returning to the early commitments to experimentation, innovation, and evaluation. ” He claims that in order to attain financial sustainability, MFIs need to radically alter their management structures, and also expand into the provision of flexible savings plans to the poor. Thus, improvements to the microfinance model are essential for the continued growth of the sector.

As we enter an age in which the growth of the global economy is driven by strong emerging market growth, conditions are conducive to a large scale expansion of microfinance. Stable and positive growth prospects in large emerging markets like India and China are attracting large amounts of foreign investment into these countries – if microfinance does successfully access mainstream capital markets on a large scale, then a tiny fraction of this foreign investment will also undoubtedly reach the poor in the form of micro-loans. A tiny fraction of this massive foreign investment would be enough to alleviate millions from poverty. Additionally, the continued good economic performance of these developing countries in the face of global economic downturns like the sub-prime mortgage crisis implies greater immunity to MFIs operating in these countries from unfavorable macro conditions in the developed world.

Thus, the most efficient and cost effective way to broaden the spectrum for microfinance is through the financial market in the above mentioned ways. Competitive markets would then do their job in ensuring efficient allocation of resources. Spreading microfinance would be the cheapest way of increasing and equalizing access to the credit market, overcoming some of its barriers. This in turn would significantly lower rural poverty. It would truly be an extraordinary amalgamation and alignment of capital greed and social interests, bringing new meaning to the phrase, “Greed is good.”

Notes:
Endogenous group formation implies that borrowers form their own groups which are jointly liable for the loans. This process effectively improves the risk pool for MFIs and tackles the adverse selection problem of the mainstream credit market in a cost-effective manner
Financial Times article, “Microfinance: not as risky as you think,” published on May 25th, 2007.
http://www.ft.com/cms/s/2/848c27ee-0acd-11dc-8412-000b5df10621.html
Burgess and Pande (2004) claim that the social banking expansion in India (1977-90) was successful in reducing rural poverty; however, such expansions are extremely costly since they do not tackle inefficiencies at the root of formal credit markets in developing countries.
Financial Times article published on May 25th, 2007.
http://www.ft.com/cms/s/2/848c27ee-0acd-11dc-8412-000b5df10621.html
The official Grameen Bank website claims that, “As of January, 2008, it has 7.44 million borrowers, 97 percent of whom are women. With 2,488 branches, GB provides services in 80,949 villages, covering more than 96 percent of the total villages in Bangladesh.”
http://www.grameen-info.org/bank/index.html
Financial Times article mentioned in footnote 4.
Financial Times article mentioned in footnote 4.
Reuters article, “Citi sees microfinance growth even in downturn,” published on December 21st, 2007. http://www.reuters.com/article/email/idUSL2157748820071221?sp=true
Reuters article, “Citi sees microfinance growth even in downturn,” published on December 21st, 2007. http://www.reuters.com/article/email/idUSL2157748820071221?sp=true
Murdoch (1999) – The Microfinance Promise
For more information on SKS Microfinance and its profitability, refer to the Wall Street Journal article, “Entrepreneur Gets Big Banks to Back Very Small Loans”, published on May 15th, 2006.
Wall Street Journal article mentioned in footnote ?.
Data source: official Grameen Bank website.
http://www.grameen-info.org/
Reuters article mentioned in footnote 6.
Murdoch (1999) – The Microfinance Promise