Financial instruments in MF

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Financial instruments in MF

• When shown a good business opportunity, banks
• and we would add any investor
• will take it regardless of the client group
• as long as it fits their investment objectives.
• - Robert Peck Christen

Yin Yu Michelle Lai yin.lai.wh08_at_wharton.upenn.ed
u September 2006
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1 The context, philosophy and state of MF today
(fnce)

• Lending methodologies and other financial
  instruments in MF
• Types of institutions delivering MF services
• A specific analysis of the various types of
  savings/lending structures that exist in MF how
  different types of methodologies address
  collateral and risk
• Principles of effective MF
• Savings mobilization as a financial service to
  the poor

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1 The context, philosophy and state of MF today
(fnce) - altered

• A specific analysis of the various types of
  savings/lending structures that exist in the
  microfinance world how different methodologies
  result in different effective interest rates, eg
  loan term, accounting method (declining balance
  or flat-rate), up-front interest-fee, compulsory
  savings and group fund contributions, Loan
  pricing formula is explained.
• Other financial instruments demand-side and
  supply-side dichotomy (demand) savings,
  insurance, and others (supply) bank loans,
  guarantees, debt equity, remittances, and
  others. Philosophy, mechanism, pricing, and
  examples.

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My resources

• GFUSA growth guarantees (reading list)
• News articles on new products
• Securitization challenges
• MicroBanking Bulletin 11 special edition on
  financing (MBB11)
• MF Handbook Chp 3 (Products and services), 6
  (Designing savings products)
• Microinsurance the Next Revolution (J. Murdoch,
  NYU)
• Leveraging the impact of remittances (Accion
  insight)
• Bridging the finance gap (Aaccion insight)
• MFIs and foreign exchange risk (Accion insight)
• Econ of MF chp 1
• Others

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Outline / Overview

• Demand side
• Savings
• Micro-Insurance
• Remittance-related
• Credit/debit/smart cards

• Supply Side
• Regular bank loans
• Guarantees
• Debt
• Equity

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Demand-side instruments
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Savings

• Types Compulsory Voluntary
• Unregulated MFIs (many NGO MFIs) not allowed to
  take deposits
• Loan-deposit ratios vary widely

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Savings arguments for against

• ()
• Income smoothing effect
• Inculcate savings habit
• Motivate repayment (savings locked in)
• Collateral to loans (sustainability of MFI)
• Savings mobilization (on-lending) allows local
  financing avoid forex risk)

• (-)
• Savings mobilization/on-lending Credit risk (of
  MFI)
• Locked up capital
• Increase default rate if compulsory savings leave
  little left over
• More expensive than intl capital or subsidized
  funds (15 vs 6-9)

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Income, consumption smoothing

• Conclusion
• Savings, as well as credit, help consumers
  adjust intertemporal income and consumption to
  increase total utility (IC2gtIC1).
• Agricultural communities, and other communities
  dependent on seasonal earnings or unpredictable,
  require savings services.

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Income, consumption smoothing(alternative
illustration)
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Micro-Insurance

• Relatively new
• Philosophy
• The poor are especially vulnerable to unexpected
  adverse events like natural calamities and
  illness because of living conditions and lack of
  rainy-day savings.
• They would benefit from insurance
  income-smoothing
• MFIs are best-positioned to be the intermediaries
  because of their existing network and
  infrastructure
• Types health, life, agriculture (crop yields or
  weather)
• Model
• Insurance is offered by formal insurers,
  microfinance institutions (MFIs), health
  institutions, agricultural and health
  cooperatives, traditional societies (e.g funeral
  societies), etc.
• MFIs link with formal insurance companies and act
  as agents for the formal insurer, although the
  insurer retains all of the risk.

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Micro-Insurance

• Barriers
• Moral hazard (esp for agricultural insurance)
• Asymmetric information / adverse selection gtgt
  limited scope for risk pooling (see appendix)
• High transaction costs, limited scale economics
  (individual assessment for small amount)
• No historical health data mispricing
• High potential losses
• eg individual loss expensive illnesses like
  AIDS. Solution? Caps and exclusions (eg Uganda)
• eg widespread catastrophe tsunamis. Solution?
  Reinsurance agreements to diversify share risk.
  
• Basis risk (when agri insurance is made based on
  weather and not crop yields)
• Solution? Eg Global Weather Risk Facility by
  Aquila, Inc (Kansas) underwriting of weather
  derivatives or weather parameter based insurance
  in emerging markets. Backed by International
  Finance Corporation (IFC)

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Micro-Insurance

• Examples
• Bangladesh
• Grameen Bank served 3.4 million clients in early
  2004
• Life insurance
• China depositsinsurance (see appendix)
• Credit-life insurance (see appendix)
• Health insurance
• Self-Employed Womens Association (SEWA) of
  Ahmedabad, India (with Life Insurance Corporation
  of India and United India Insurance Company)

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Remittance-related products

• If MFIs can offer better service at lower prices
  than other remittance service providers and
  develop financial products appropriate to this
  market, remittances can provide fee-based
  revenues, attract new clients and open
  opportunities to crosssell microfinance products
  to recipient families.
• Products
• Savings Direct Deposits, DD w/ debit card,
  programmed savings
• Credit product related to housing credit (eg as
  downpayment or as credit evaluation in applying
  for bank loan), loan guarantee (increase loan
  capacity) focus on asset building (both in
  host country and home)

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Credit/debit/smart cards

• Very new
• Factors
• Acceptance as mode of payment
• Advantage to MFI and client op, admin and tnx
  costs, ongoing line of credit
• Examples
• ADEMI MasterCard (ADEMI Banco Popular
  Dominicano)
• Swazi Business Growth Trust Smart Card

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Supply-side instruments
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Investors their concerns

• International development investors
• Social impact
• Sustainability
• Private investors
• Repayment ratio
• Return on investment (on debt or equity)
• Dividends (wrt equity)
• benchmarking and determining risks as
  reflected by ratings on MIXMarket and other
  indices (eg SP, Moodys)

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Bank funding

• Regular bank loans
• May be international or domestic

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Guarantees

• Guarantees have played an important role in the
  early stages of local capital market funding and
  could be an effective way to support MFIs that
  are exploring alternative financing options
  beyond bank loans.
• Philosophy
• Excess liquidity exists in the commercial banking
  sector these can be harnessed (as guarantees) to
  encourage the flow of capital to MF industry gtgt
  used to encourage banks to approve unsecured
  loans, esp in cases of asym info gtgt as payments
  are made, credit-worthiness is proved, and MFIs
  can borrow without guarantee gtgt guarantee funds
  are free for another guarantee CYCLE
• Reduces foreign exchange risk (when no default
  occurs) b/c loans are made in local currency
  guarantees (in US) need only be mobilized if
  default occurs
• Guarantors earn income on assets risk of loss
  reduced by loan loss reserve (about 5 of loan),
  which is provided by donors and other
  socially-motivated agencies

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Guarantees

• Mechanism
• Usually, the proportion of a loan that is
  guaranteed is adjusted down as the MFI proves its
  credit-worthiness and does not need as high a
  guarantee in order to make the same amount of
  loan
• Now, debt issuance (vs just bank loans) by the
  MFI is also guaranteed. This also improved the
  rating, making the financing cheaper. This is an
  importance source of longer-term financing,
  beyond the funds available from bank loans and
  deposits (savings).

Examples GFUSA USAID Development Credit
Authority Accions Latin American Bridge Fund
(1984) Accions Global Bridge Fund (2005
non-affiliates as well debt issuance by MFI)
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Profile of capital structure is varied
Investors in capital market offerings
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Debt-equity mix

• Major factors in funding diversification age,
  legal registration and size/scale
• Debt varies with age
• Regulated MFIs are more highly leveraged
• Unregulated NGO structures - face limitations on
  financing options, with no license for taking
  public deposits and no shareholder structure for
  attracting equity other than donations.
• Debt varies with scale
• Larger MFIs attract more external funding,
  including borrowing and deposits
• Other factors
• the openness of the local capital markets to
  microfinance,
• the presence of donors (equity),
• the financial services that it offers clients, or
  other factors

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Leverage borrowings (bonds)

• Two types Internationl and local
• History
• BancoSol in Bolivia first tapped the
  international capital markets in 1996 with three
  separate bond issuances of US1 million each.
  These issues were 50 percent guaranteed by USAID
  and privately placed with Bolivian
  institutions.15
• Geneva-based BlueOrchard Finance and Developing
  World Markets issued the first U.S.
  dollar-denominated microfinance bonds
• To attract risk-averse institutional investors to
  its seven-year 40 million subordinated debt
  issue, the funds got a 30 million credit
  guarantee from the Overseas Private Investment
  Corp., a U.S. development agency.
• Collateralized debt obligations The senior
  notes, backed by the OPIC-guaranteed funds, yield
  55 basis points over Treasuries, while three
  junior tranches offer between 100 and 500 basis
  points over Treasuries. The riskiest equity piece
  is held by the sponsors.
• Proceeds from bond offering expected to help
  40,000 microentrepreneurs in Latin America, Asia,
  Africa, Eastern Europe.

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Leverage borrowings (bonds)

• Who invests in these issues?
• Pension funds
• Mutual funds
• Public entities
• Banks
• Insurance companies
• Private equity
• Public bond issuances have, however, been largely
  limited to Latin America and have yet to be used
  by regulated MFIs in other regions.
• Newest instrument direct securitization of loans
  to MF borrowers Bangladesh Rural Advancement
  Committee (BRAC)

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Leverage borrowings (bonds)
Example Local Bond Issues of 3 Leading MFIs
Conditions of Bond Financing
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Leverage mobilized savings

• See Savings section in demand-side instruments

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Equity financing

• The Council of Microenterprise Equity Funds, a
  private group founded in 2003
• These are now attracting private, socially
  responsible investors not just public
  development banks gtgt enormous potential for
  growth
• Characterized by illiquidity hence importance
  of dividends
• Risk The higher the equity as of portfolio,
  the higher the risk
• Other measures of risk include PAR, hedging
  policy (forex)

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Case XAC bank

• Please refer to attached handout (MBB p35-40)
• MIX Market and MicroBanking Bulletin
  participation five-diamond transparency grade
• 12 credit products, 6 deposit products, and a
  range of other services including funds
  transfers, foreign exchange and micro-leasing
• Achieved reach and economies of scale through
  mergers hedges foreign exchange risk and
  achieves longer-term stability through savings
  mobilization
• Market orientation and focus on transparency

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Case XAC bank
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Appendix / notes
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Risk-pooling

• Problems
• adverse selection, and
• cream skimming by other firms

• Conclusion
• average (pooled) rate cannot be charged for
  micro-insurance
• new pricing methods need to be examined (see
  Lesson IIB)

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Micro-Insurance Innovations

• China depositsinsurance
• Instead of receiving interest, the depositor
  receives insurance coverage
• Drawback in places where disposable income
  levels are very low, the principle amount (eg
  40) to generate the yearly premium (equivalent
  to the interest, eg 2) may not be available
• Credit-life insurance
• For a percentage of each loan (ie adding to
  borrowing rate), bank will pay off any debt
  outstanding at time of death, plus some for the
  family
• Drawback coverage only available to
  micro-borrowers
• Eg FINCA Uganda
• Additional 0.5 interest per month
• 630 payout at death by accidental cause
• AIG earns fat 30 profit

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Foreign VS Local funds

• MicroBanking Bulletin 11 (p39)
• Foreign eg institutional investors
• Local savings deposits
• Local is more costly (15, XACBank), Foreign is
  usually cheaper (6-9) even with forex risk
  premium
• Local is strategic (long-term) more stable
  source larger potential value service to poor
  limit forex risk

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Additional topics

• Leasing to aid microentrepreneurs
• Mortgage loans for homes
• Building, renovation or extension
• Mortgage loans for businesses
• Refer to Lesson IIB for more on the above