SUMMARY - How Should Microfinance Institutions Finance Themselves?

By Portocarrero, Tarazona and Westley (2005) -- Executive Summary
http://www.iadb.org/sds/doc/int7DCD.PDF

Abstract

Portocarrero, et. al. present an analysis of four different sources of funds available to MFIs and suggest the most adequate funding strategies at different levels of development of the organization.

The main takeaways are:

• Deposits are becoming a solid source of funding for MFIs; with fixed-term deposits representing a larger share than current account deposits.
• MFIs should concentrate on fixed term deposits, which are easier to manage, provide stability and predictability and help avoid asset-liability mismatches.
• Deposits are a stable source of funding for developing and sustainable organizations and should represent an increasing share of liabilities as organizations develop.
• As organizations build a solid base of depositors they gain access to capital markets, initially by issuing bonds and later in the equities markets.

Summary

A study of 61 MFIs in 9 Latin American countries shows that the success of Latin American MFIs has brought some new forms of financing, which increasingly resemble those used by banks. Deposits from the public are now the main source of funding, while credit lines from national and international sources are losing relevance.

Deposits from the public represent close to 65% of total liabilities, while credit lines represent 27%, and bonds only 1.7%. Moreover, deposits/credit was 76% in 2003, showing the importance of deposits within microfinance operations. MFIs received 74% of their deposits as fixed-term deposits, with the other 26% being deposits on current accounts. Most of depositors are small savers that contribute with an insignificant share of total deposits. Intermediate and large savers have a significantly larger share and importance in the total volume.

MFI's can finance themselves in four ways; each method has advantages and disadvantages.

• Public Deposits Client heterogeneity demands the implementation of strategies for each group (e.g., service type, products, and growth targets). Advantages (compared to banks): attractive interest rates, personalized service, no commissions, no minimum requirements. Disadvantages: lack of a network, liquidity risks, mismatch of terms, interest rates or exchange rate, management and marketing challenges.
• Credit Lines In 2003, the public sector provided 47% of credit lines to MFIs; donors provided 21%, commercial banks 18%, and social investors 14%. Advantages: facilitate liquidity management, since they can be mobilized in relative short-term. Disadvantages: increased exchange rate risk and interest rate risk.
• Bonds. Only two MFIs in the sample issued bonds systematically: Mibanco (Peru) and Compartamos (Mexico). The main characteristics of their issuances are: terms between 18 months and 5 years; in local currency; hired an experienced structurer; First issuances had a guarantor, which facilitated the placement.
• Equity. None of the organizations in the sample had an IPO, but there are 3 scenarios under which new shareholders could join the MFI. 1) an NGO becoming a regulated organization sometimes asks international development agencies to join it as partners through a private offering; 2) organizations with mainly private shareholders ask an international development agency to join in; and 3) privatization of the MFI.

Financial and Operative Costs of Funds
The study shows that total average cost of current account deposits is 15% and the cost of those at fixed term is 12%. Operative costs are 2.4% and 11.4%, respectively. The difference is the interest rate, which on average is 3.6% for current account deposits and 9.8% on fixed-term deposits. This highlights that MFIs should prioritize fixed-term deposits, because they are less costly, easier to manage, provide more stability and predictability, and help reduce any mismatches between assets and liabilities.

Characteristics of Fixed-term Deposits Fixed-term deposits are an average of 20 times higher than the average balance on current accounts. Evidence shows (contrary to expected) that operating costs are higher than for current accounts, probably given that fixed-term depositors receive personalized attention from directors and managers, while current account holders, who do a higher number of transactions get the attention of lower-ranking staff.

There is no clear evidence that there are economies of scale in receiving deposits. When the authors only compare the two smallest vs. the two largest organizations, cost per account seems to fall, but the opposite is true when all other organizations are considered.

Micro-accounts of under US$100 represent approximately 75% of all accounts and its operating costs are above 200%. These accounts, thus, need to be subsidized by larger accounts or use one of the following strategies: subsidize the micro-saver (usually justified by the social mission of the institution); implement a more selective policy for micro-savers; increase minimum balances; pay interest rates only above a minimum balance; charge commissions or fees; or use technology or new products to reach a massive number of clients.

The best funding strategy for an MFI depends on the developmental level of the organization and the stability of the macroeconomic environment in which it operates:

• Scenario I: Developing MFI + Stable Environment Diversify the sources of credit lines; those organizations that can take deposits from the public should concentrate gradually on fixed-term deposits.
• Scenario II: Developing MFI + Unstable Environment Reduce the terms of loans, reduce any terms and currency mismatches, reduce leverage, and increase external sources of funds. Also, be more prudent in deposit-taking.
• Scenario III: Clearly Sustainable MFI + Unstable Environment Make deposits be the base source of funds, not going beyond 65-75% of total liabilities. Strengthen and diversify credit lines to minimize currency and term mismatches and to face any liquidity issues. Bond issuance is not recommended, but strengthen equity by reinvesting profits.
• Scenario IV: Clearly Sustainable MFI + Stable Environment Make deposits represent up to 90% of liabilities, in order to keep financial and operational costs down. Rely on small depositors rather than institutional depositors, in order to avoid the risk of big withdrawals. Diversify credit lines and bond issuances to avoid term mismatches and keep liquid reserves. Bonds should not represent more than 15% of liabilities to avoid excessive exposure to capital markets. Increase leverage to profit from the favorable environment. Equity can also be increased under this environment through IPOs or getting new partners.
• Scenario V: Strong MFI + Stable Environment This stage is reached after achieving significant participation in the financial markets, just like the Spanish 'Cajas', which issue and purchase obligations and different kinds of instruments according to their investment and funding needs.

Best practices per funding source: