Credit, according to Professor Muhammad Yunus, is a fundamental human right. However, if not handled with care, the magnification effect inherent in leverage can make it dangerous. One need only look at the current economic spiral to see the result of the provision of credit gone dangerously awry. Credit must be deployed to microfinance borrowers judiciously in order to minimize the risk of non-repayment, as this would cause lenders, themselves levered, to suffer magnified losses. Vinay Nair, an Executive Director at J.P. Morgan currently on sabbatical, explains that it is imperative to avoid over-leverage to avoid losing control.
“Those who cannot remember the past are condemned to repeat it.” George Santayana, Poet and Philosopher
As the world descends deeper into economic crisis, economic historians have their work cut out for them, positing which current events do or do not resemble those of the past. The microfinance sector cannot wait for their results. The crisis may be ongoing, but the root causes are now past and must be clearly understood. Given how fresh in the mind they are, it makes Mr. Santayana’s maxim all the more important.
The nature of this crisis has resulted in deep introspection about everything, from the role of financial services to globalization to capitalism itself. Microfinance should be no exception. Such self-reflection is not a purely academic exercise; it has a clear purpose, requiring us to re-appraise underpinning assumptions. We must be confident of the path we take from here: do we confidently march onwards or should we backtrack and take a new route? Above all, complacency has no place; the purveyors of stock lines--We have survived previous crises and we will survive this one—must not be heeded.
Key practitioners in microfinance have already begun to question fundamental assumptions. At a recent conference in London, while presenting findings from his forthcoming book Portfolios of the Poori, Professor Jonathan Morduch outlined the financial accounts of the world’s poor. He questioned the widely held assumption that those who live on US$2-a-day have “simple” financial affairs. His results uncover the detailed complexities across the formal and informal financial transactions at the base of the pyramid.
Given such striking results, revealed by questioning conventional wisdom, what other underlying assumptions should the industry confront?To answer this question, it may help to recap the early stages of the crisis in the United States. Over the last decade, credit was made abundantly available to some of those at the bottom of their pyramid – that is, ‘sub-prime’ borrowers. The inability of these borrowers to sustainably repay their burdensome debts triggered (and catalyzed) widespread losses. Irrespective of whether banks lent too much or people borrowed too much, it is this excessive credit (and now, de-leveraging) that is at the very nub of the issue.
In microfinance today, much is made of the dangers of cowboy lenders, falsely dressed up as MFIs, charging excessive interest rates to borrowers. But, given credit has been abundant in recent years, we must now consider a more lurking danger: loans loosely granted to the borrower without due consideration to the risks.
Professor Yunus’ much-quoted tenet is, “Credit is a fundamental human right.” ii I agree, but with one major caveat: we must recognize the innate dangers (and opportunities) embedded within “credit.”
First, let us take a moment to define the jargon, to ensure that we understand the terms correctly. The provision of credit increases the amount of debt a household or company holds versus their assets or equity. Leverage can therefore be understood as the ratio between debt and equity/assets.
For an individual household, leverage is a comparison of debt to total assets— if a borrower takes out a loan, her debt rises, and her leverage increases. For a company, at its Operating Company (OpCo) level, the same happens as it takes on more debt or if equity falls. It is important to therefore realize that an MFI is impacted by leverage twofold, at the company and household levels. Given leverage is a ratio, it increases as the numerator increases or the denominator falls. So what would happen to the ratio in the event of losses? With losses or a fall in asset values, leverage makes it more difficult to repay debts. This can result in further losses, which in turn, makes it even it more difficult to repay these debts. This is the magnification effect of leverage, and it underlies the innate danger of the circle of leverage.
For households, such as those described by Professor Morduch, it is easy to see how loose credit, even if provided with good intentions, can suddenly be the cause of a dangerous and downward spiral.
There are a number of risks that are widely recognized that may cause the denominator to decrease. At the January 2009 CGAP/Aavishkaar Goodwell/Intellecap Risk Roundtable in Mumbai, whose preliminaries I contributed to on behalf of JP Morgan’s Social Sector Finance group, many were identified: over-indebtedness due to multiple borrowings, high cost of debt, credit risk, asset liability mismatch, etc. The debate typically focuses on which of these pose the greatest clear and present danger to repayment rates. In my opinion, it almost does not matter–it is the magnification effect of any of these, caused by leverage, which is the greatest threat to households repaying their debts.
It is important to also assess microfinance institution (MFI) or Operating Company (OpCo) leverage. The challenges of OpCo de-leveraging are currently felt around the world—one need not look far. America’s US$800bn economic stimulus provided by the government is in part giving companies the equity they need to stabilize and de-leverage. This environment should provide the microfinance sector with salutary lessons.
Using India as a case study, we find that many MFIs are moving from a thrift co-operative structure into an NBFC (Non-Banking Financial Company). This is due, in part, to thrifts operating under highly restrictive parameters set by the Reserve Bank of India (RBI), India’s Central Bank. Whilst restrictive to MFIs looking to expand and impact more people’s lives, it cannot be used as an excuse to try to “lever up” and increase size if the motivation is purely for economic interests.
In a meeting with a medium-sized Indian MFI in November 2008, the management outlined their expansion plans for becoming an NBFC and increasing leverage from 5:1 to 20:1, accumulating more debt in order to reach new borrowers. To give some context, at the start of 2008, commercial banks in the U.S. had leverage ratios of approximately 10-12 timesiii and investment banks of 20-25 timesv. The MFI’s motivation was purely to gain size and thereby attract increased enterprise valuations from potential investors. It was, in other words, a short-term numbers game bent on increasing the number of borrowers, with no concern for long-term scaling impact.
Leverage is a tool that can be used to effect very quick growth. However, this leads us back to the magnification effect. Should any of the multiple risks occur, we enter the dangerous cycle and our denominator—our assets and/or equity--shrinks very rapidly.
Further analysis from the Risk Roundtable in Mumbai supplies an eerie parallel to the early stages of the downfall of banks and investment banks. The risk survey leading up to the Roundtable found that most respondents, including MFIs, investors and lenders, felt that liquidity risk is the major risk, not risk of credit losses. In the United Kingdom, the crisis faced by Northern Rock in September 2007 required liquidity support facility from the Bank of England, following their problems in the markets. In other words, it was a crisis first born out of liquidity. But what we have seen, some 12-18 months later, is that liquidity risk is really only the first challenge for lenders. Realized credit losses in their loan portfolios have a much greater effect on the fundamental structure of the institution.
What this means, when we return to the root of this issue, is that the OpCo leverage dramatically amplifies the consequences of realized credit portfolio losses.iv
With a better understanding of the dangerous magnification effect of leverage, does this mean that growth of MFIs or microfinance itself must be systematically curtailed? Absolutely not. The provision of credit is not wrong; it just depends on what you do with it.
In fact, microfinance can provide the broader banking industry with some notable perspective. Indeed, as bankers return to Banking 101, they can learn from MFIs. Case in point: Grameen America’s recent report of a tremendous 99.5% repayment rate after its first year of business, which has received a considerable amount of coverage in the mainstream financial press, with the Bloomberg newswire running it as one of its top stories in January 2009. v
The key for MFIs is to understand fully the dual dangers of leverage at their OpCo and with their borrowers. Small mistakes and losses can spiral out of control.
The key is to sharply minimize losses in the first place. This may seem incredibly obvious; however, it has been systematically obviated around the world. If, for example, a better understanding of the purpose of the loan necessitates providing skills and training to the borrower, it must be done. This can only increase the likelihood of repayment. Loan officers must have better aligned incentivization and compensation, not only for saying “yes” but also for saying “no.” Furthermore, any moves away from the joint-liability group model to a large individual loan without complementary training is, from where I stand, dangerous mission drift.
Rather, to help more people and in a deeper way, the move must be to a more consumer-centric model from the existing product-centric model. Such visions are being pursued by innovative organizations around the world. One example of this is the Kshetriya Gramin Financial Services (KGFS) initiative in South India, where branches are located in villages (rather than villages periodically visited by MFI officers) offering a range of financial services to suit the needs of “clients,” who are not automatically assumed to be “borrowers.” It is not about just where the profits can be optimized (e.g. insurance, mobile telephony), but where impact can be scaled.
This transition will take time but it must happen. Of critical importance is how best to minimize risk and the degree of support to provide to the borrower. As the distinguished Vijay Mahajan, Founder of BASIX, writes: “[In] the familiar debate of ‘minimalist credit’ strategies versus the ‘integrated’ approach to microenterprise promotion…there is no one correct approach and the strategy for microenterprise promotion should be contingent on the requirements of the situation, based on a systematic analysis.”
The consequences of getting this wrong are great, knowing, as we do, that leverage will magnify the consequences.
The nature of the economic crisis has led to introspection across all aspects of society. Microfinance is no different. We have seen leading practitioners already begin to question fundamental assumptions. Additionally, CGAP and ACCION are in the process of doing important work in their “Beyond Codes” Steering Committee. Its purpose is to emphasize the importance of a fundamental principle: “Treat customers with dignity and respect.” One of the most critical parts of this is to “prevent over-indebtedness.”vii
It is true that credit is a fundamental human right. But there are dangers embedded within it. We have seen how the broader crisis has developed, starting with over-indebted borrowers, over-leveraged OpCos and liquidity risks moving to magnified credit losses. We are at a critical juncture in microfinance, but if we move quickly, we can heed Mr. Santayana’s words. The circle can turn vicious very rapidly, so it is imperative to redouble all efforts to ensure that the circle is, instead, virtuous.
Vinay Nair is an Executive Director at J.P.Morgan. He has been on sabbatical from the firm since August 2008, pursuing philanthropic, travel and research interests in the field of social enterprise, with a focus on microfinance.Vinay was born in India, brought up in Canada & Ireland and lives in London. He can be reached via email on vinay@nair.com
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