37risk.net

Feature: Microfinance

It started out as a social experiment to extend credit to individuals and small businesses without access to traditional banking, but microfinance has become an

asset class in its own right – generating more liquidity and cheaper funds, as well as less-welcome attributes, such as talk of asset bubbles.

“Microfinance is almost a victim of its own success, because the pressure to lend money can undermine credit standards. Microfinance has a strong track record, but that may not be a good thing, as it may make people less wary than they should be,” says Washington, DC-based Brian Cox, chief executive of MFX Solutions, which provides hedging and advisory services to microfinance lenders.

The sector is clearly booming, with microfi-nance investment vehicles (MIVs) – independ-ent investment entities with more than 50% of their non-cash assets invested in microfinance – steadily growing in number and size. A total of 106 active MIVs were identified in 2013, with an estimated $9.9 billion in assets under management, up from around 102 MIVs with $6.8 billion under management in 2010, according to an annual survey carried out by Geneva-based emerging finance investment company Symbiotics.

Meanwhile, the number of microfinance institutions (MFIs) that funnel MIV money on to individuals and small businesses may not be enough. Out of the roughly 10,000 existing MFIs, only about 500 of them are suitable for private investment, according to a microfinance market outlook published in November 2013 by responsAbility Investments, a Zurich-based asset manager specialising in emerging econo-

mies. Of those, only 100 are considered to be tier-one MFIs, meaning they are profitable, regulated, have a developed client base and experienced management.

Further shrinking the available investment opportunities, a growing number of MFIs now get their funding through deposits, making them less reliant on MIVs – more than 60% of MFIs are projected to accept deposits by the end of this year, up from less than 50% at the end of 2008, according to responsAbility. The projected volume of MFI savings is expected to rise to more than $25 billion by the end of 2014, up from less than $10 billion at the end of 2008.

“It is a borrowers’ market,” says MFX’s Cox. “There is a lot of MIV money chasing fewer creditworthy MFIs than they would like, and there’s more and more competition from local markets, so there are a lot more options in local currency. It is definitely driving down the rate at which MIVs can lend.”

With more MIV lenders chasing limited target borrowers, fears of a credit bubble are being fuelled by the memory of microfinance repayment crises that have hit countries such as India, Morocco, Nicaragua and Pakistan in recent years. In 2010, the government of the Indian state of Andhra Pradesh, which had been a hotbed of microfinance in the country, took measures to impede the operations of MFIs after levels of indebtedness soared.

“The reputation of the sector took a hit for a while, but I think overall now the individual investor perception of microfinance and institutional investor perception of microfinance is trending upwards. My gut feeling is that private investment will continue to grow,” says

• Concerns are growing that an increasing number of microfinance investment vehicles (MIVs) are chasing a small number of creditworthy microfinance institutions (MFIs).

• The competition among MIVs is leading some to court riskier, less well-established MFIs, or to take on increasing levels of unhedged local currency exposures.

• Around a third of lending is now done in local currency, and the proportion of unhedged finance is growing.

• The use of independent credit ratings is patchy, although some say there is a preference among MIVs for internal ratings and due diligence to properly assess MFIs.

Need to know

Microfinance, major challenges

Investing in institutions that provide credit to small firms and individuals in poor countries is increasingly popular – so much so, that there are brewing fears of a breakdown in lending practices. Catherine Contiguglia reports

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38 Risk November 2014

Feature: Microfinance

Kate McKee, a senior adviser at the Consultative Group to Assist the Poor, which is based at the World Bank in Washington, DC.

But MIVs continue to compete fiercely for MFI business, prompting concerns that the ready availability of low-priced credit could incentivise MFIs to overlend to clients or move into new areas beyond their core expertise. Faced with intensifying competition, MIVs could also find themselves lending to less creditworthy MFIs, or taking on currency

exposure that is too expensive to hedge. “When the opportunities to lend to MFIs

become less abundant, a possible response of MIVs is to look at the tier-two and tier-three MFIs. The difficulty with reaching those is they are smaller, and inherently riskier,” says David Woods, managing director of Oikocredit, a co-operative investment firm based in Amers-foort, the Netherlands, which focuses partly on microfinance.

Sylvia Wisniwski, managing director for risk

management at Finance in Motion, an alternative asset manager focused on develop-ment finance, recalls one MFI that more than tripled the size of its loan portfolio within four years, from €12 million to €50 million. With easy access to cheap funding, the MFI became less discerning, expanding its focus to rural clients and consumer lending.

“Abundant funding supply and the continu-ous top-ups from international lenders, including MIVs, fuelled its excessive credit growth, loosening credit standards and over-indebtedness of the clients,” says Wisniwski.

So, what are MIVs doing about it? One popu-lar response is to focus on obtaining or generating credit ratings. Triple Jump, an Amsterdam-based fund manager, is implement-ing a new risk segmentation system for one of

Microfinance investment vehicles (MIVs) have histori-cally lent mostly in their own currencies, leaving the microfinance institutions (MFIs) to handle the risk. But the proportion of local currency lending has increased in recent years, reaching 31% of the direct debt in-vestments in 2013, according to emerging finance investment company Symbiotics. At the same time, the unhedged share of direct debt in local currencies in-creased from 2.5% in 2010 to 13.2% in 2013.

“We see more funds looking at partially hedged or unhedged strategies to manage their risk, because the cost of these derivatives tends to be very high. The increase in unhedged local currency lending is not in-herently a concern, but unhedged exposure to these currencies should be carefully managed, monitored and disclosed,” says Kate Marcus, Philadelphia-based direc-tor of private equity advisory at Chatham Financial, a risk management advisory firm. “There may be limited tools available to reduce the risk if necessary after an investment has been made, and during a crisis curren-cies may become more correlated than they have been in the past, limiting diversification benefits,” she adds.

As certain MFIs have gained market share and become more established, they are also becoming savvier about currency risk when negotiating with MIVs, says Luca Paonessa, head of portfolio manage-ment at Triple Jump. “The supply of funding is much greater than it was a couple of years ago. So I believe the good MFIs are starting to get additional negotiat-ing power, and they naturally tend to want to negoti-ate more pricing in local currency,” he says.

As the volume of microfinance lending has grown, new services focused on currency hedging for the sec-tor have appeared. The Currency Exchange Fund (TCX) was founded in 2007 to provide hedging products in currencies and maturities not covered by commercial banks, while MFX Solutions was founded in 2009. But some of the local currency funding is still too expen-

sive to hedge, while commercial banks may be reluc-tant to deal with smaller counterparties in any case.

“TCX is trying to make a price in a market-based ap-proach. We don’t want to distort markets, but contrib-ute to developing them. TCX doesn’t offer hedges when there is a commercial market alternative,” says Bert van Lier, chief investment officer at TCX in Amsterdam.

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“It is a borrowers’ market out there. There is a lot of MIV money chasing fewer creditworthy MFIs than they would like, and there’s more and more competition from local markets” Brian Cox, MFX Solutions

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Feature: Microfinance

the microcredit funds it manages, grouping holdings into four segments according to tenor and diversification. The structure is designed to help the fund reach smaller and less well-estab-lished MFIs.

“We decided if we had 100% of the fund invested in mature MFIs, we would never be able to deliver our return objectives to our investors because interest rates would be too low, and the yield on the portfolio would be too low. We have to constantly balance stability against risk,” says Luca Paonessa, head of portfolio management at Triple Jump.

A handful of independent credit rating companies, such as MicroRate, focus exclusively

on microfinance, but many MFIs don’t have independent external ratings.

“There are a number of rating agencies in microfinance, but they are having trouble – it seems less and less valuable to have a rating, and part of it is because there are so many MIVs that want to lend money to MFIs, they’ve stopped worrying about the ratings,” says Cox of MFX Solutions.

“From an investor’s perspective, institutional ratings are seen as a nice-to-have, but not strictly necessary. Though it does lead to questions around transparency – an MFI that hasn’t had a rating for some time might warrant a second look,” adds Daniel Rozas, an independent

microfinance consultant based in Brussels.The reluctance to use external agencies could

be the result of an increasing reliance on internal ratings rather than the rejection of ratings altogether. Fund managers argue that by conducting their own due diligence on MFIs, which often features on-site surveillance, they are better able to assess new investments on a case-by-case basis.

“There is price pressure, and it is important to have a clear view on pricing versus risk, which is why we have implemented a systematic internal rating process. The transparency we get from MFIs is extremely good; on a monthly basis we get a whole set of accounting data and balance sheet indicators of loan quality. So the covenants you set with an MFI become quite valid,” says Frédéric Berney, chief risk officer at Swiss microfinance investment manager BlueOrchard.

BlueOrchard’s internal rating methodology features two components: the first focuses on the financial strength and credit quality of MFIs; the second focuses on the social impact of the MFI’s activities. The ratings are based on monthly and quarterly financial reports, as well as various qualitative indicators derived from on-site due diligence. Other fund managers, such as Finance in Motion and Incofin, have similar models for ratings based on quantitative financial data and qualitative information, which combine financial ratios with social impact scores.

Credit growth in microfinance might not yet constitute a systemic threat, with the number of non-performing loans significantly less than in 2009, according to responsAbility. But as MIVs continue jostling to lend to MFIs, practitioners agree the industry is at a crossroads.

“Over time, the normal process is that some of the weaker MFIs will ultimately disappear, whereas other players will thrive and reach scale. Ultimately, this process leads to the creation of strong microfinance institutions that offer competitive financial services to a large clientele. But the transition phase might increase uncertainty across the board for investors, as identifying future winners is not a straightfor-ward task,” says Triple Jump’s Paonessa. R

1 Proportion of local currency lending that is unhedged

Latin America & Carribbean

Eastern Europe & Central Asia

East Asia & Pacific

South Asia

Middle East & North Africa

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2 MIV portfolio regional breakdown as percent of direct microfinance portfolio

$9.9bnMIVs’ assets under management in 2013, up from $6.8 billion in 2010

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Local currency lending

Unhedged local currency lending

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