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Microfinance business – Before and After Covid-19

Starting with definitions

Microfinance, development finance, inclusive finance, and impact finance are all terms used to refer to that branch of financial services, offered by financial institutions in emerging markets to a clientele with previously little or no access to financial services or credit history, and with generally informal and undocumented business activities.

Financial institutions operating in microfinance (also known as microfinance institutions, or MFIs) are generally double bottom-line organizations, which means they usually measure their performance in both financial and social performance indicators.

The most prominent financial product has been a micro loan, offered in individual or group lending methodologies. MFIs business philosophy is generally grounded in the belief that the most beneficial way to develop people’s economic welfare is through financing their small businesses. Financing private consumption has, until a decade ago, been considered as almost immoral - now it can be part of MFI product offering, but generally does not sit high in their business development goals.

The above is to differentiate MFIs from other consumer finance providers in these markets, broad-brush. Also known as “on-line lenders” due to their extensive use of web-based fintech, these consumer finance providers’ only aim is to finance short to medium term personal finance needs, starting from a daily liquidity shortfall (‘payday lenders’) to financing of a car, leasing, or even a mortgage.

The two groups of lenders are generally different in their risk appetite, operational set-up, corporate governance and in their funding.

This article will deal with the first group of institutions above, the microfinance institutions, or MFIs.


Topic of the day: Risk management environment of MFIs pre- and post- Covid-19

Life before Covid-19

Micro-lending is generally relationship based. At the center of the business model is the relationship between the Loan Officer and the micro-customer, whose funding needs are identified, capacity and willingness to repay is assessed, and repayment performance is permanently monitored and managed once a loan is disbursed.

Over time, as the internal control and risk management environment in MFIs evolved, such relationship between Loan Officer and the customer attracted more scrutiny and regulation, data collection became more structured and decision-making more risk based. Several tasks and duties in loan administration process were segregated to mitigate and reduce the operational risks. Many institutions invested in digitizing and automating their processes, from data collection to credit decision-making, which has improved efficiency and reduced operational risks.

Before analyzing what changed due to the Covid-19 crisis, it is worthwhile to emphasize one important distinction between MFI and mainstream banking credit risk management: method of financial information collection.

When deciding to take a credit exposure with a business customer, a bank relies on:

  1. More-or-less well-established accounting and financial management processes of the borrower, which result in rather reliable financial statements and projections, and
  2. Good collateral with a realizable fair value and generally free from legal risks.

In the case of a micro customer, the accounting processes, in the good cases, cover the bare minimum to comply with tax laws. Most commonly, they are inexistent. For assessing a customer’s creditworthiness, an MFI must generally rely on the financial and socio-economic data collected by their Loan Officer.

Good collateral is also not always available, either. Indeed, until a decade back, the MFI industry would pride itself in not doing “collateral-based lending” like traditional banks, but rather “cash flow – based lending”. Most of the time, there were good reasons for that. In many countries, MFI’s target customers had no assets to pledge as collateral.


So, what changed in the MFI business with the latest Covid-19 crisis?

A lot.

MFIs, and the banking sector in general, had to deal with a sudden drop of cash flows, which affected more significantly the small business owners, due to drastic lockdown measures. Before the Covid-19 crisis hit, even a 5% deterioration in portfolio-at-risk (PAR) indicators could, in many institutions, raise serious questions about their viability as a going concern. In our estimation, the Covid-19 crisis has affected anywhere between 15% to 40% of MFI portfolios in Eastern Europe and CIS. In Africa, that number can be higher. This is a hot topic as it determines the very ability of MFIs to weather this storm. As such, it deserves a dedicated analysis, so we will park it for a future article.

During 2020, in many countries the authorities introduced (and will most likely do so again in 2021) significant restrictions on office attendance and on MFI staff capability to have facetime with customers. Government regulations aside, there is also growing discomfort among staff to spend facetime with customers and visit their business premises.

In their office life (or any resemblance of that) for the last 10 months, people found comfort in using technology to communicate and collaborate. That has also had a spillover effect on relationships with customers. In the case of MFIs, there have been many good initiatives of improving customer acquisition through digital marketing and social media.

However, in microfinance, like in many businesses, customer acquisition is only the first step. It is the credit analysis which is a key value-adding process, spelling the difference between a good and a bad credit decision. Of course, customers can now be interviewed remotely rather than face-to-face, and a good Loan Officer will know what information to obtain from the customer and how to ensure that information is reliable. But compiling a customer’s financial statements, at the end of the day, in microfinance is about testing the assumptions behind the headline numbers. That kind of job, when done properly, involves forensics, in addition to the analytical capabilities. It means a Loan Officer will need to inspect business premises and validate the assumptions behind numbers.

Now, imagine if you suddenly remove the forensics from the loan analysis process. All an MFI is left with is customer representations about their financial situation, with little or no accounting evidence. Some business assumptions can be corroborated by external sources[1], but the quality of assessment on key financial headlines, such as, for example, revenue, will suffer.

What does this mean for MFIs? Not only are they having an issue with their existing credit exposures, but the quality of their new loans is now worse than before, due to increased operational risk. And we did not factor the increased credit risk into the equation. Credit risk is now higher because of the increased uncertainty in customers’ future cash flows.


How do MFIs move forward after the Covid-19 crisis? Is their business model sustainable at all?

In the past, there were some “quick fixes” in the toolbox, when a country-specific crises would hit. Institutions would constrain their credit disbursements (or, in more extreme cases, stop them altogether) and switch their operations into crisis management mode. That meant that their main job was to manage the performance of the existing loan portfolios, until the crisis, internally generated or due to external factors, would subside. Those crisis times, in the right institutional context, were also times when significant performance improvement projects were implemented, thus boosting the long-term competitiveness of those institutions.

Going down the credit portfolio attrition spiral is, however, not always a cheap exercise. In the less successful (but not uncommon) examples, serious equity positions were wiped out of MFI balance sheets, creditors took significant losses and even financial institutions disappeared after the crises.

This Covid-19 crisis is, however, multifaceted, systematic, and international like never seen before in recent history. It affects a significant portion of portfolios, in many institutions, in many countries and it challenges radically the MFIs business model. Central Bank regulations, with their interventions, might have made the financial statements of many MFIs appear less worrisome than they should be, in regulatory terms. Loan loss provisions and capital requirement regulations have been significantly relaxed, which visually make those MFIs look like viable businesses. But this sort of regulatory intervention is generally about hitting the can down the road. They don’t (and they can’t) provide remedy for the non-performance of borrowers whose business failed, nor do they address the challenges of the microfinance business explained above.

Moving ahead, for those MFIs surviving this crisis, would require a rethink of their business model and processes. It is only prudential to assume the current situation as the new normal, and build automation, internal control and risk management processes around that new normal. For doing that, it requires management expertise and an innovation culture within the organization.

In the past, when perceiving the credit risk to be too high, an MFI would reduce the amount of exposure to a given customer. Anecdotal evidence suggests that customers would generally receive half the amount of a loan they had requested. Today’s industry landscape is more competitive. Those players which now disburse half the amount requested by customers, even if they still manage to do business, are giving up on important business opportunities. The crucial question is a rather conceptual one: what does a lender do when facing more unknowns? Simply take less exposures, or try to reduce the uncertainty?

We believe that reducing uncertainty, by improving the flow of customer information and by making smarter use of such information, is a better strategy to competitive advantage.

[1] For example, if the customer purchased a van or a machinery, it can be corroborated by other sources e.g. public register of property, or bank account movements.


Our next article in the Covid-19 series

For the next topic to continue our conversation, we will look into the funding challenges and trends based on this new environment affected by the COVID-19 outbreak. Specifically, shareholders and leadership of MFIs, during these volatile times, are being faced with several dilemmas and tradeoffs, such as:

  1. What sources of funding are more reliable and accessible (e.g. deposits, institutional borrowings, debt securities)?
  2. Which currency should be selected for funding purposes?
  3. How to build adequate liquidity and manage funding costs?

Follow our page to read the next article - to be published during April - where these relevant topics will be further explored and discussed.


Treasury challenges for financial institutions in microfinance - Before and After Covid-19

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