Role Reversal

This highlight is drawn from a recent paper published by MicroRate which analyzes the funding patterns and roles of International Financial Institutions (IFIs) in microfinance industry development. An online debate blog among experts examined this issue from March 28-30, 2007. Click here to read the debate summary, and click here to read the IFI perspective: Reversing the Coin.

Introduction

The rapid growth of foreign private lending to microfinance institutions (MFIs) in the last several years has led to a surprising reversal of roles between government-owned development institutions and private lenders. International Financial Institutions (IFIs) are concentrating their loans in the strongest MFIs, leaving private lenders to look for opportunities among smaller, riskier borrowers. Development institutions are “crowding” private lenders out of the best MFIs.

WHAT IS AN IFI? In this paper, IFI refers to an international financial institution that is a bilateral or multilateral development agency. This study limits its focus to development institutions that are more than 50% government-owned, and whose microfinance portfolio includes direct loans to retail microfinance institutions. Many IFIs also lend directly to governments, or to second tier funding channels, known as apex funds.

In the last three years, the volume of international private lending has exploded: in 2005 alone, outstanding loans doubled to nearly US$1 billion. IFIs publicly claim to take risks the private sector is unwilling to take. One would therefore have expected government-owned development institutions to shift their lending to more risky MFIs as soon as private lenders entered the field. The opposite is happening. Development agencies are today heavily concentrating their funding in the largest and most successful MFIs, exactly the target investment market of private investors.

MicroRate Findings

A private investor perspective… “IFIs should not fund the best MFIs. The argument that there is not enough private investment money to do that is absolutely wrong.” -Jean-Philippe de Schrevel, BlueOrchard

A MicroRate commissioned study of funding patterns confirmed that IFIs are not complementing private lenders, but crowding them out of the most attractive parts of the MFI market. IFIs nearly doubled (88% increase) their direct funding to top-rated MFIs in 2005. In the largest and most successful MFIs, IFIs are the dominant and growing foreign funding source. MIX data on over 160 MFIs confirm this trend. In some cases, private lenders wanted to provide funding to a MFI, but were unable to do so because they were unable to match terms offered by IFIs.

Trophy Lending: Why are development institutions concentrating on MFIs that can attract private lenders?

The answer has to do with the nature of IFIs. Their official mission is to go where the private sector does not yet dare to tread; to assume risks that private capital would find unacceptable. Often, IFIs have adhered to these principles. However, in recent years the risk-based division of labor between IFIs and private capital has broken down.

An IFI perspective… “MFIs are growing so fast, that private sources alone cannot meet their funding needs. They have to fall back on IFI funding…KfW presently makes 3-4 loans annually to Latin American MFIs for US$12-15 million. This volume (when compared to the total volume of MFI funding) shows that there is no crowding out.” -Quoted from KfW’s reply to MicroRate’s request for the IFIs position on crowding out. Translation by MicroRate.

Whether top decision-makers are aware of it or not, there are powerful incentives for IFIs to maximize their microfinance exposure, and to do so by concentrating on the largest and safest borrowers. Microfinance has acquired such a positive image, that a sizeable exposure in this sector has become a sign of an IFIs commitment to development. This is reinforced by the IFI’s need to disburse their microfinance budget each year. Since IFIs are not primarily profit-driven their success is often defined by the amounts that have been lent. If a budget has been allocated to microfinance, that budget must be spent – and spending it on a few large loans to top MFIs is far quicker, cheaper, and less risky than lending to, and nurturing immature institutions. Such “Trophy Loans” have in common that they are lender-driven: their chief purpose is to allow IFIs to book more microfinance transactions.

The practice of trophy lending is widespread. In terms of brazen disregard for whether borrowers actually need their loans AECI, the Spanish aid agency surely holds the lead; in terms of sheer volume, KfW the German Development Bank is in first place, but others among them the World Bank’s private sector affiliate IFC, BIO (Belgium), the European Investment Bank and the Central American Development Bank (CABEI) – to name just a few - have accumulated microfinance trophies as well.

The rapid emergence of a large number of private lenders is one of the most encouraging aspects of microfinance. If all of those among the poor who can use credit productively are to be reached, then vast amounts of private funding will be needed in the future. IFIs, large as they are, cannot come close to meeting these future funding needs of MFIs. Only private capital can provide that kind of money. By forcing private lenders out of the most lucrative segment of microfinance, IFIs are hampering the development of the very institutions on which the sector will depend in the long run.

“…IFIs, with their low-cost public money, should move away from the same regulated MFIs they have funded over the past several years and encourage them to develop their own links to domestic capital markets. This means focusing more on the next generation of strong institutions, offering seed capital and support for the development or transformation of this new crop of stars.” From CGAP’s “Access for All: Building Inclusive Financial Systems," p. 103.

What should be the role of IFIs and how can they best leverage their microfinance capital?

Their best role is to strengthen the overall capacity and transparency of the industry, and to act as a catalyst for private capital that would not otherwise invest in microfinance.

1) Make IFI funding transparent
2) Maximize commercial participation in innovative capital markets transactions
3) Seed the next generation of microfinance institutions
4) Help develop mechanisms to cover foreign exchange risk
5) Promote further private sector channels for microfinance, and finance industry infrastructure.

Conclusions

IFIs have naturally gravitated towards funding the largest and least risky microfinance institutions. Senior decision-makers, be they members of the Board of Directors or top managers, have been unable to prevent IFIs from opting for volume and low risk at the expense of development impact. This must change. What is happening in IFIs today has its roots in the governance of the microfinance operations of those institutions. An effective governance structure is necessary to compel public development institutions to counter this tendency and act as catalysts for - not substitutes to - private lending.

Reform of IFI lending behavior would be made easier if their microfinance operations were more open to public scrutiny with full and timely disclosure of the details of loans to MFIs. To dampen the appetite of IFIs for funding top tier MFIs, it would help if private lenders were able to monitor IFI lending. It is difficult for individual lenders to do this, but as a group, perhaps through the proposed Microfinance Investor Association, they could evaluate IFI loans as they are being approved and draw attention to those that displace private funding.

Microfinance is a dynamic industry where the pace of change seems to be accelerating daily. In this environment, IFIs urgently need to refocus on how to complement and attract the private sector instead of preempting it and competing with it as they are now often doing.