PROPOSAL OF A GLOBAL MICROFINANCE FINANCIAL AUTHORITY MECHANISM

CZECH AGRICULTURAL UNIVERSITY
INSTITUTE OF TROPICS AND SUBTROPICS
AGRICULTURAL SPECIALIZATION
SUSTAINABLE RURAL DEVELOPMENT IN TROPICS AND SUBTROPICS

List of abbreviations

FX Foreign Exchange
GMFA Global Microfinance Financing Authority
MFI Microfinance Institution
MII Microfinance Investment Intermediary
MIV Microfinance Investment Vehicle

Keywords: microfinance, funding, inefficiency, coordination, FX risk, guarantee, credit bureau

Abstract
It is expected that microfinance services at present affect more than 533 millions of people, including the families of the clients.[1] A third of the capital needs is satisfied with international funding. Despite the fact that almost two hundred million people depend on international capital sources, channelled through local MFIs and number of the sources is likely to double within the next ten years, transactions happen in an environment without coordination and lack central authority, which would prevent wastage of idle potentials of economies of scale. More so, the international funding is burdened with serious obstacles such as concentration of investment on few regions and institutions, FX risk endangering the local debtors and lack of information sharing between the sources, leading to duplicities and inefficiencies. The goal of this paper is to quantify the annual financial losses incurred due to lack of coordination and to propose the founding of Global Microfinance Financing Authority (GMFA), a which would face the aforementioned challenges through innovative instruments. According to estimates of this study, forming of the proposed body would prevent substantial annual losses, today absorbed by the clients, raising the cost of capital for the poor entrepreneurs.
1. Introduction
Funding through microfinance international vehicles (MIVs) provides the key link between local microfinance initiatives and international sources of capital. The total estimated investment by different funders is annually $13 billion USD (IAMFI), out of the total microfinance loans outstanding portfolio of over $44 billion USD.[2] This means that almost a third, 29% of the total of microfinance funding is channeled through international financing and continues to grow fast. The assets under management of MIVs rocketed from USD 1,1 billion in 2004 to 6,02 billion USD in 2008.[3] There is a number of limitations in local capital markets. Capital is usually expensive and loans are conditioned by short notice cancellations, increasing risks for MFIs which must build their portfolio on stable and durable funding foundations. Therefore MFIs have to look abroad for capital, balancing the mix of available financing sources. Too little and too few external funding sources can delay growth and inhibit poor clientele’s access to financial services, especially where local funding markets are underdeveloped or where young institutions cannot reach permission of the financial authority to accept deposits. Besides, international funding confers prestige and reduces susceptibility to local political risk. However, this type of funding is tied to severe problems difficult to surmount, such as FX risk, which transforms every unhedged loan into a potential threat for the debtor. Also, heavy investment concentration of the sector is a bareer for growth of small sized institutions. At last, lack of information sharing between the funders means the sector is not measured nor monitored and MFIs can and frequently do deceit funding sources. Given these facts, their reigns a striking absence of a globally acting authority, that would service individual financing initiatives in order to overcome the mentioned barreers, reap advantages of coordinated effort, increasing efficiency of the worldwide funding. As a result, the international market without a single coordinator is fragmented, inefficient and burdened with high transaction costs. This paper proposes creation of a Global Microfinance Financing Authority (GMFA) , formed by representatives of the sector, multilateral institutions and national states, in order to focus on synergy of three spheres of international financing, where aforementioned inefficiencies take place: foreign exchange risk coverage, foreign funding securities and information sharing between funders. These deficient and inefficient areas would be complemented with the following innovations: global foreign exchange risk fund, global guarantee fund and central registry of institutional debtors. The funds subjected to GMFA coordination do not require their own capital, instead they coordinate private resources currently available. Such multitasked endeavour could reap synergies due to its concentration of knowledge, strategic acting on planetary level, elimination of duplicities, lowering the transaction costs, leading to reduction of the cost of capital for the poor.

2. Funding
2.1 GMFA Currency Fund
MFIs generally extend loans to their clients in the local currency. Therefore, international hard currency investments leave them with large foreign exchange exposure. In case of risk of local currency devaluation, the repayment of the unhedged hard currency debt becomes more expensive and detrimental to the capacity of the MFIs to repay foreign currency debt. Such incapacity increases peril of bankrupcies. While the lending in hard currency protects investors, it shifts the FX risk to MFIs, employing the hard currency debt to fund microcredit portfolios denominated in local currency. As the number of MFIs that rely on commercial sources of funding grows and volatility of local currencies in the past two years increased, taking its toll, the foreign exchange risk issue is becoming a concern for both investors and MFIs. The series of major MFI bankrupcies during 2010 in Mexico and in year before in Nicaragua has exposed weaknesses in the traditional investment model and made clear that borrowers of foreign currency must protect themselves from the risk of currency depreciations. While 76% of total fixed-income investments to MFIs made by international funds are denominated in Euros or dollars, the survey of CGAP indicates that 50 % of MFIs have nothing in place to protect them from foreign exchange risk. The survey further indicates that only 25 % of target MFIs are hedged against depreciation or devaluation risk, and 25 % are hedging only partially. [4]

Many existing funds provide hard currency loans, passing on the risk to the MFIs. Yet while there exist multiple options for hedging risk, only few MFIs have the ability to deploy them. Even if they do, the market solutions may not be available, as capital markets in developing countries often offer a limited range of financial instruments.[5] Domestic banks usually require too high transaction amounts or ask for costly liquidity deposits. Therefore, almost without exception, MFIs accept the risks of currency depreciation and takes risks without protection. Lack of solution to FX related uncertaneity not only creates risks for individual MFIs, but discriminates against whole regions. Because of the currency risks, the amount of international microfinance lending is channelled primarily to Eastern Europe and Latin America and only about 8% to Africa. If the MIVs were able to eliminate currency risk, over half of them (56%) would invest in Africa, as resulted in a survey organized by FX company MFX.[6] Solution to the foreign currency problem could thus open up many high risk markets which need microfinance. In order to eliminate the FX risk inherent to microfinance funding, the paper proposes a creation of global, local currency lending pool managed by GMFA, or GMFA CURRENCY FUND, which would face the FX risk problem through diversification, allowing MFIs to use a variety of debt instruments currently offered by private MIVs, while having the FX risk outsourced by GMFA. The fund assets would be diversified enough across countries and regions to balance the foreign exchange rate underperformances and gains, pooling loans denominated in different emerging market currencies, and off-setting the currency risks, thanks to low historical correlation observed among the currencies of developing countries.[7] The concept of mitigating risk through diversification is based on modern portfolio theory, proposing that grouping uncorrelated, diversified investments reduces the risk of an overall portfolio. Dodd and Spiegel (2005) applied this theory of diversification to FX risk. GMFA CURRENCY FUNDwould assume the FX risk by entering into forward contracts that allow an MIV to lock in a future exchange rate. In this way, the MIVs would be immune to future fluctuations in exchange rates, and GMFA would be able to manage the FX risk through diversification, while the MIVs could separate the FX risk from credit risk and issue local currency loans to MFIs without facing the risk of currency depreciation, focusing on their core business of managing the credit risk. The separation of risks would ultimately benefit MFIs, as loan margins would reflect only their credit risk. Such FX mitigation endeavours were proposed in the past by several researchers, however lacked additional instruments, such as guarantee cushion and link to system of information sharing between creditors, which are proposed in this paper and which are necessary in order to increase efficiency of the the mentioned instruments individually, but also their interaction as a whole. The GMFA GUARANTEE FUND, in more detail described later, would employ capital to create an "airbag" that would allow the portfolio to withstand short-term currency volatilities. The GMFA CREDIT BUREAU, outlined in 3. provides the necessary communication platform, needed for markets with unstable currencies due to strong correlation between FX risk and MIVs credit risk. Both the instruments mentioned are vital to MFIs in countries with weak legal, political and regulatory frameworks, leading to currency volatitilities. For estimation of the cost of lack of such FX protection system, we take as a benchmark a study of 23 countries with an active microfinance industry, stating that they experienced in at least three of five years an average annual devaluation of 8.8%.[8] We consider 75% of the international debt funding being in hard currency, reaching volume of 8.71 billions of USD (IAMFI). We further assume that 50% of the hard currency debt stays unhedged, as based on CGAP study mentioned previously, accruing to 4,355 millions of USD per year. We draw the conclusion that annual cost of lack of centralized hedging reaches 287 millions of USD per year.
GMFAFX SAVINGS: 287,430,000 USD = (8,710,000,000 USD * 0.75/2) * 0.088
2.2. GMFA Guarantee Fund Flow of international investment capital to MFIs is highly unbalanced. Investment concentration is extreme and acts as a bareer for efficient allocation of development capital, leaving an important part of the landscape of microfinance needs unsatisfied. Currently, 73% of investment funding goes to institutions in Eastern Europe/Central Asia and Latin America. 82% of funding has been channelled only to licensed and regulated MFIs. In 2007, 10 MFIs received 60% of MIV investment.[9] In its 2009 report, Fitch Ratings estimates that 100 largest MFIs represent 80% of sector assets.[10] Many MFIs are unable to raise enough funds from international donors because they are too small, too young or are based in a politically unimportant country.[11] Until the MFIs create credit history they can hardly mobilize funding on market conditions, despite achieving excellent ratios, without sponsors or soft conditioned capital. Microfinance funding thus resembles a club of privileged institutions, where entry seems almost impossible without characteristics that are difficult to acquire. This important issue which hinders development may be partially solved by loan guarantees. Loan guarantees are a form of insurance that covers a lender against default on its loan to an MFI. If the MFI defaults, the guarantor pays the creditor the guaranteed loan portion. The funder, backed by a guarantee, can opt to finance promising MFIs that would be otherwise uneligible. Estimated at 0.9 % of total investment flow, reaching volume of 0.74 of billions of USD, MIVs are showing increasing interest in guarantees connecting MFIs to domestic funding sources.[12] Most of the loan guarantees are provided to small, nondeposit-taking, profitable, growing rapidly MFIs, as 92% percent of the MFIs had assets below US$25 million in the year of the transaction and only 8 % of these smaller MFIs took deposits.[13] However, the CGAP studies reveal that the real cost of a guarantee-backed bank loan can be more expensive for MFIs than other funding sources, on average 5.3 % higher than the MFIs’ average cost of funding liabilities.[14] Guarantees do not, consistently lead to subsequent direct lending by domestic banks without additional collateral as the banks despite guarantees, require “real” collaterals such as land, cash, securities,or letters of credit. Guarantees add value as the MFI can ask for a loan that it could not have otherwise, however to most MFIs guarantees are not an attractive funding complement, as they are not designed well enough, are expensive and technically complicated. A multi-functional Guarantee Fund operated by GMFA may tackle this problem by creating a pool of guarantee liabilities, which would on the one hand provide guarantees to local funders, while supporting younger institutions less eligible to traditional international sources, as a by product mitigating part of the FX risk of the sector. The fund would also provide guarantees to international funding sources, securing GMFA Currency Fund, focused on FX risk mitigation to the international transactions. The advantage of a central, globally acting pool of guarantees may reap similar benefits as GMFA Currency Fund: the credit risks, higher in regions where higher number of guarantees is executed due to loan defaults, can be off-set by less risky performance elsewhere, providing a base for permeation of capital to regions unpopular for funders, and leverage scarce socially-motivated financing. We quantify the guarantees potential by calculating the additional cost of 5.3% of the yearly flow of guarantee capital that MFIs today pay to intermediaries of the 1% portion of total investment flows and arrive to 6.9 millions of USD of savings potential.
GMFA GUARANTEE IMPACT : 6,890,000 USD = (13,000,000,000 USD *0.01)*0.053

3. GMFA Credit Bureau
Information sharing between funders is based on scattered, non-systematic initiatives producing few reliable numbers and long term coordinated strategy. Little is known about availability of capital, let alone whether it is structured in the most useful way.[15] Even if several worthy private initiatives exist, no central agency combines aggregation of numbers on international funding and dealing with debtors in post-default situation, working beyond private focus and driven by international mandate in the interest of the system as whole. Various factors are causes of this situation, including the challenging collection of data from decentralized operations, weak tracking systems, vague accountability, tabuization of bankrupcy related topics or business secrets inhibing lack of international collaboration. No international black list, nor reliable data on MFI bankruptcies and loan defaults is disponible, as information is concealed in order not to create negative marketing fame for both sources and MFI managers. While successful MFIs receive a lot of attention, there is no public analysis of failed experiences. Bankrupcies are hypocritically treated as a non-existing, shun away from the spot light. Yet central aggregation and analysis of data on both the quantity and the quality of capital funding is a key component in assessment of the real effectiveness of microfinance in order to avoid duplicities and inefficient dealings with debtors. Lack of central responsibility is more flagrant in case of dealings with major MFIs with deteriorated repayment capacity, which use newer debts to cover older liabilities. Bad manners proliferate, as there exists no international organism able to identify and stop such deceitful practices. International investment funds, in many cases having no local branch offices, thus keep pouring fresh resources into already insolvent MFIs, without knowing about debt restructurings going on behind their back with another MIVs. On example of Mexico, the period of 2008 and 2009 saw bankrupcies of three major traditional MFIs, with a wide variety of MIVs as creditors, MIVs between them. Had the international funders informed each other on regular basis, created united front using collective legal strategy against debtors who refused to accept responsability for defaults instead of confronting them on individual basis, and had they jointly administered the pledged portfolio, millions of dollars and the institutions could have been saved. Losses amounted to tens od millions of dollars, yet still no academic one has studied the cases, nor is public information available. When MFIs fail, the pursue of liquidations, even in the presence of strong portfolios, is often deemed too costly for investors to attempt, given the weak local enforcement systems. Even if these are not even the primary obstacle to carrying out successful liquidations, investors usually throw in the towel and walk away empty-handed. [16] Yet microfinance is not immune from business cycles and lack of studies of the downfalls of MFIs will have a high cost for the sector in the future. Therefore, international 2nd floor microfinance credit bureau, combined with central register of MIVs operations, managed by GMFA, is indispensable, more so, as more MFI bankrupcies are expected in the years to come, due to lower margins and increased competition. Credit bureau will not prevent delinquency, but is critical to improve credit risk management, overindebtedness and multiple borrowing.The task of GMFA Credit Bureau is to lead an evidence of the MIVs transactions, administration of a credit bureau of the institutional debtors, but also taking over the role of a restructuring manager, post-default portfolio sales arranger and systematizing legal advisor. It is obvious that the risk of funding is higher with small MFIs and in countries with high currency volatility: in this respect, the synergies with GMFA Currency and Guarantee Funds are plain. The default rate on MIV loans to MFIs has been historically low, about 2% in terms of number of loans and 0.2% in terms of volume. The default rate is however not likely to remain as low as it is now, as commercialization will most likely expose the challenges of weaker MFIs, investors may also begin to branch out from the small segment of top MFIs to which they are currently focused, leading to increased investment in higher risk MFIs with more attractive returns. Increased competition among MFIs may lead to microborrower overindebtedness as MFIs push more loans onto their customers, potentially causing portfolio deterioration.[17] If we assume, that annual default rate may be reduced to two thirds through GMCB Credit Bureau initiative, due to communication between creditors and prevention of bad investment described above, we conclude that default costs may be reduced by 17.4 million of USD per year.
GMFA CREDIT BUREAU IMPACT : 17,400,000 USD =(0.2*2/3)*13,000,000,000
4. Conclusion
Lack of coordination of the international microfinance funding affects the progress of microfinance and fight against poverty on planetary level. Creation of Global Microfinance Finance Authority, providing MIVs with Currency Fund, Guarantee Fund and MFI Credit Bureau, working in synergy, may leverage the efficiency of the microfinance sector and use idle potentials of economies of scale, with immediate annual savings of est. 311 millions of dollars. If we convert the savings into reduction of interest rates provided the MIVs retain their present profitability, we arrive to 2.4% diminuition potential of cost of capital for the poor microentrepreneurs.

Fig. 5 Mechanism of GMFA
Source: Author

GMFA TOTAL COST REDUCTION IMPACT: 2.4 p.a. % = (311,000,000 / 13,000,000,000)*100

The cheaper and the greater the supply of investment capital for microfinance, the greater the number of poor who can be potentially served for the benefit of their communities, as it is them who bear the implicite costs of inefficiency of the sector of today. In present international microfinance investment arena, consisting of scattered and uncollaborating capital sources, the necessary appearance of a unified system of communication and complementary security instruments, will lead to use of economies of scales, creation of knowledge and ultimately have as an impact protection of both investors as well as the poor clientele.
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