Q&A with Glenn Westley

Glenn Westley, senior advisor for microenterprise at the Inter-American Development Bank, highlights the key messages of his paper "How Should Microfinance Institutions Best Fund Themselves?”.

1. What funding trends did your study uncover in Latin American MFIs?

In their start-up phase, many Latin American MFIs depended on grants and loans from donors and governments. Currently, however, deposits are by far the main source of MFI funding. This observation is based on the analysis of a database we have constructed covering 61 regulated MFIs.¹

Taken together, these 61 MFIs had US$ 1899 million in total liabilities at the end of 2003. These liabilities include:

• deposits of US$ 1243 millon, which represent 65 percent of total liabilities
• borrowed funds—from governments, donors, banks, social investors, and others—of US$ 517 million, which represent 27 percent of total liabilities
• bonds outstanding of US$ 33 million, which represent 1.7 percent of total liabilities

In addition, the net worth of the 61 MFIs is $376 million. This equals 20 percent of total liabilities, for a leverage ratio of 5:1.

The ratio of deposits to loans reached 76 percent by the end of 2003, so it’s fair to say that deposits are no longer the forgotten half of microfinance, at least not in Latin America. At the same time, borrowing has decreased in importance in the MFI funding structure. The issuance of bonds, while promising, continues to be little used. Although precise estimates are not available, issuing stock to add new shareholders is a mechanism rarely used by MFIs in Latin America. Instead, the capital base of the MFIs has been increased mostly by reinvestment of a large share of the sizable profits that the MFIs have generated.

In a nutshell, a closer examination of MFI depositors shows that:

1. MFIs have attracted a large number of depositors, thus expanding and diversifying their principal liability,
2. the vast majority of clients are small depositors, who provide only a small share of total deposits, and
3. both the intermediate and large size depositors provide substantial shares of total deposits.

2. What are the financial and operating costs of the different funding sources?

Detailed costing studies of 10 MFIs provide data on the financial and operating costs of borrowings, savings, bond and stock issuance. The 10 MFIs were selected to be broadly representative of the larger group of 61 MFIs. The 10 MFIs cover a wide range of sizes and funding mixes, factors that influence both the financial and operating costs of the different instruments.

The cost data show that capital is generally the most expensive funding source, while the cost ordering of the remaining sources varies according to the size of the MFI. For large MFIs, bonds tend to be the cheapest source of funding, following by deposits and borrowing, and then capital or shares. For small and medium-sized MFIs, borrowing tends to be cheapest, followed by deposits and capital. The degree to which borrowing is subsidized is found to have substantial impact on whether deposit-taking or borrowing is cheaper for the MFI. This is particularly the case for the large MFIs, given that these institutions typically have achieved significant scale economies in attracting deposits. Thus, the relative cost of funding sources may be affected by changes governments and donors make in their subsidy policies.

3. What are the main characteristics (in terms of costs) of deposit products offered by MFIs?

The MFIs examined here capture deposits mainly through savings accounts (SAs) and time deposits (TDs), in both local currency and dollars. In our sample of nine MFIs that offer both, the average total cost of savings accounts is 15 percent, versus 12.2 percent for time deposits. The operating costs for savings accounts are much higher than those for time deposits. The interest rates paid on the deposits constitutes the difference between total costs and operating costs.

Costs of savings & time deposits as percentage of deposits mobilized

	Operating cost	Interest cost	Total cost
Savings accounts	11.4%	3.6%	15%
Time deposits	2.4%	9.8%	12.2%

So the major cost component for time deposits is the interest rate paid, while for savings accounts it is operating costs.

The great operating cost advantage of TDs is mainly due to the larger balances maintained in these accounts, which are on average nearly 20 times the size of savings accounts (US$ 7,396 compared to US$ 399). Even though savings accounts were far more numerous, the 61 MFIs in the study obtained 74 percent of total deposits from time deposits, and only 26 percent from savings accounts.

However, MFIs’ monthly operating costs per account are higher for TDs than for SAs, by almost three times. It appears that this higher per-account cost for TDs is the result of the service that larger clients receive from branch managers and other relatively high-ranking personnel. Even though savings accounts generate more monthly transactions per account, they are largely attended to by tellers and other personnel with much lower salary levels. For this reason, the costs per account are much lower for SAs than TDs.

Still, given the lower total cost per dollar of mobilizing time deposits compared to savings accounts, MFIs should generally give priority to the former. TDs have other advantages as well: they are easier to manage and are more stable and predictable in the short- and medium-term (until the TDs mature). TDs may well permit a better matching between assets and liabilities during this same time period (but not necessarily in the longer term, after the current TDs mature).

But these advantages must be set against their greater financial cost and depositors’ sensitivity to the interest rates paid. In view of the high financial costs of time deposits, it is important to set their interest rates carefully: high enough to attract the needed funds, but otherwise at the lowest possible rates. Many MFIs still do not give this task the priority it deserves despite paying out substantial sums in time deposit interest.

4. One of the findings of your study is that microsavings generate very high operating costs at MFIs of all sizes. What are the possible strategies that MFIs could adopt to provide microsavings in a streamlined, cost-effective manner?

Microsavings were defined as savings accounts with balances of less than US$100. While they accounted for about 75 percent of the total number of savings accounts in the study, these small accounts provided only 2.5 - 3 percent of total savings deposits. However, they generated between 30 and 60 percent of total account transactions, depending on the size of the MFI. As a result, annual operating costs exceed 200 percent of deposits in microsavings accounts.

To deal with the costs of microsavings, MFIs have at least the following three options:

• Subsidize small savers. This option is the most commonly used by Latin American microfinance institutions. MFIs justify subsidies for small savers by pointing out that serving these savers is part of the MFI’s social mission, and that even small deposits offer economies of scope and other significant benefits. However, MFIs hardly ever estimate the cost of this subsidy or explore the possibilities for rationalizing it. It is possible that in the medium term growing competitive pressures in the microfinance marketplace will lead to a change in this orientation and adoption of one or both of the following options.
  
  
• Massify the microdepositor client base, in order to reach a critical mass that can be served more economically through technological and organizational innovations (including ATMs), as well as by offering a range of financial products to small savers—to both facilitate transactions and fully recover the costs generated. Both Prodem and Banco Sol in Bolivia are following this strategy and have found, for example, that ATMs have greatly reduced the cost of mobilizing deposits. At the same time, customer service and satisfaction have improved and significant additional savings have been captured.
  
  
• Adopt a more selective policy toward serving microdepositors, through a series of measures. These measures may include establishing higher minimum deposit sizes, paying interest on account balances only above a certain level, charging commissions for each transaction, and imposing monthly account fees.

While deposits have displaced borrowing as the main source of liabilities for MFIs in Latin America, deposits and borrowing are generally complementary sources of funding. Because of the longer terms of much of the borrowed funds, they help solve problems of term mismatch and facilitate medium-term financial planning. Only in situations of excess liquidity are deposits and borrowing substitutes instead of complements.

Even at small MFIs, the fact that borrowing can be done at lower cost than deposit mobilization should not lead these institutions to prioritize borrowing and de-emphasize deposit mobilization. That is because in choosing between these two funding sources, it is important to consider a number of other factors besides cost:

• The amount an MFI can borrow from each lender is typically restricted by loan limits these lenders place on the amount of credit they are willing to extend to any single borrower, including to MFIs.
  
  
• A significant amount of borrowing concentrates funding risks and may make the MFI overly reliant on governments and donors, which are the main sources of borrowed funds for the microfinance industry. As a result, liquidity management and the ability to do medium-term planning would typically be adversely impacted.
  
  
• Deposits greatly diversify an MFI’s funding sources and thus offer much greater stability to its overall liabilities. MFIs no longer depend so heavily on the sometimes unpredictable decisions of governments and donors, and so the management of MFIs becomes much more autonomous.
  
  
• Increasing the volume of deposits mobilized can help reduce their average operating costs since it is possible to spread fixed costs over a greater volume of funds and generate economies of scale.
  
  
• Finally, attracting deposits has other significant advantages, including: (i) knowing the clientele better by examining their deposit history, thereby reducing the cost of analyzing loan applications, (ii) achieving greater integration into the local and regional economies, which helps to build loyalty among the MFI’s clients, (iii) supporting greater prudence in MFI governance and management since MFI executives are held accountable by local depositors who continually monitor the MFI’s performance, and (iv) facilitating the development and/or cross-selling of other financial products—such as loans, money transfers, debit and credit cards and microinsurance—thus generating revenues that may be used to offset the operating costs of deposits, while also providing the client with better service.

These are the reasons that the MFIs in our study are in fact shifting towards deposits as a major funding source, despite the higher cost. And really, the relationship between borrowing and deposits is more one of complementarity than of substitution. In the medium term, the most important source of funding should be deposits, supplemented by borrowing in order to lengthen the average maturity of the MFI’s liabilities and reduce average funding costs. As the industry matures, these two sources could be supplemented by access to bond markets.

¹These 61 MFIs are located in nine Latin American countries with major microfinance markets: Bolivia, Colombia, Ecuador, El Salvador, Honduras, Mexico, Nicaragua, Paraguay and Peru.