December 5: Cost Management

CGAP-MicroSave Virtual Savings Exchange
"Serving Small Depositors: Meeting Demand while Managing Costs"¹

Summary of Dec. 5, 2005 Virtual Discussion of Cost Management

Cost Management

There are two keys to viable savings mobilization: achieving volume and controlling costs. Some keys to accomplishing this follow.²

I. Achieving Adequate Volume

A standard branch involves high costs that can only be covered by attracting a large volume of deposits. Market penetration is a key to achieving volume. However, it is not easily achieved. It requires innovations for service delivery, a systematic approach to identifying potential depositors, a staff incentive system based on the value of deposits collected; extensive market research, good public relations, massive staff training and local demand studies (Dhakal, Nepal, Afghanistan). A large volume of deposits requires depositor trust, appropriate products, good marketing, and sound liquidity and asset liability management.

A. Trust

When it comes to deposits, banking is nothing more than generating trust.

A strong market presence, along with a strong physical presence, helps to build trust. Building at least medium-sized full-service branches that inspire people's trust is an investment in the future. If this is not possible, then an institution must inspire trust through the staff it employs. Particularly where a big percentage of the population has lost money in banks, trust comes from establishing relationships (employees-clients) or, at the institutional level, by building a proper branch network and through proper marketing (Moelders, Bosnia and Herzegovina). Many microfinance clients borrow from the MFI and save with banks because they do not consider the MFI to be a safe place for their savings. Public relations and brand-building activities are hugely important to establish the institution's credibility as a secure place to save (Cracknell and Wright).

Ensuring accountable and dynamic governance is also crucial (Dhakal, Nepal).

The transparency, honesty, and integrity of leadership, management, and staff are essential to retain the confidence of depositors and the value of their savings (Pirie). Professional staff who inspire trust are critical (Moelders, Bosnia and Herzegovina), and are even more important than the physical appearance (Staehle, Bangladesh; Larcombe, Mozambique). Building trust takes time (Bhattacharya, India).

B. Products

Creating savings products that genuinely meet the needs and preferences of the majority of actual and potential clients is a major factor in achieving adequate volume. Rather than assume a 'we know best' approach, institutions should decide product design, delivery and pricing based on reality. Institutions should undertake well-designed and sufficient market research frequently, using tools such as those developed by MicroSave (Pirie). Before introducing a saving product, an institution needs to know the cash flow pattern of the target market customer. For example, farmers mostly have seasonal income, which means they save seasonally in big amounts and withdraw gradually according to their life and business need (Zakaria, Indonesia).

Designing new products periodically in response to different market segments can help an institution maintain a competitive edge (Bhattacharya, India). In competitive environments the product must truly be special and different. If an MFI cannot define the unique selling proposition of its product, it is unlikely to be able to compete with the larger, more secure commercial banks offering similar services (Wright and Cracknell).

(Facilitator's note: Most of the contributions on products will be included in the Product Mix discussion summary.)

C. Promotion : Incentive Schemes

In Nepal, the MFIs that are the most successful with savings mobilization provide staff with clearly defined performance standards and incentive schemes. Incentives are based on the number of clients served, the volume of deposits, and the average savings balance per account (Dhakal, Nepal). "Internal transfer costs" can be used to encourage deposit mobilization. SafeSave charges branches significantly more for capital from the head office than the interest rate paid on client savings. Branches can also earn a premium rate of interest for supplying their own surplus capital to other branches (Staehle, Bangladesh).

However, staff incentive systems can also have negative effects. Linking incentive payments to deposit volume may not be good for clients because staff may pressure clients to deposit or not withdraw (Staehle, Bangladesh). Where there is a history of failures and distrust of financial institutions, an incentive system can be counterproductive because clients will not know whether the bank clerk is really convinced about the solidity of the institution or is trying to persuade the client for his personal benefit (Moelders, Bosnia and Herzegovina).

(Facilitator's note: Other comments on promotion will be included in the Promotion discussion summary.)

D. Effective Liquidity and Asset Liability Management

With savings, the only significant income arises from how depositors' funds are invested. Investing deposits in a well-run microfinance portfolio will undoubtedly yield the best returns, but is illiquid. The implications of investing too heavily in this area and having insufficient liquidity to meet demand for withdrawals are dire. Managing the balance sheet daily, ensuring that liquidity is well-managed and funds are optimally invested requires highly specialized skills. Few organizations are equipped to cope with these demands (Walden, Africa, The Philippines).

Another view: If the country that has no financial instruments (T-bills, bonds, etc.) in which to invest, and if the MFI lacks funds to finance its loan portfolio, it might make sense for the MFI to use as much as 90% of its savings to finance its loan portfolio. To be competitive with other banks offering similar savings products, the MFI must also offer an interest rate similar to theirs on its fixed or time deposits. Therefore, mobilizing deposits to invest in a commercial bank is not worth the trouble (Oyo, Cambodia).

A third view: Fixed deposits should be completely used for credit to borrowers. Otherwise, they lose value for the savers. If they are loaned out, members benefit (Galor).

Central Banks' reserve requirements have a huge impact on profitability. If MFIs are required to deposit 25% of depositors' funds as reserves, they are hugely hampered in their investment potential (Walden, Africa, The Philippines).

E. Delivery Mechanisms That Provide Easy Access

If potential savers perceive and trust that they will be able to access their savings easily, it can motivate them to make an initial deposit and to minimize their withdrawals (Pirie). For example, in India, 154,000 post offices and some 10,000 branches of nationalized banks have mobilized almost USD $440 billion. A key to achieving this volume of deposits is that distribution outlets are found every 3 kilometers and nearly 500,000 agents provide door-to-door services to customers. Customers, therefore, do not have go to the post offices or to the distribution channels (Bhattacharya, India). For branch-based service, it is vital to have enough tellers to keep queues to a minimum (Larcombe, Mozambique).

(Facilitator's note: Other comments on delivery channels will be included in the Delivery Options discussion summary.)

II. Managing Costs

Practitioners often do not pay attention to or know the costs involved in mobilizing savings (Dhakal, Nepal, and Walden). Activity Based Costing (ABC) is the most accurate way of achieving this information. However, an organization that is launching savings products for the first time must focus on training, procedures, systems and marketing; so initiating ABC at this time may not be realistic. Banks that serve different markets, have a complex product portfolio, and have complex delivery channels cannot easily assess the exact cost of each product for different markets (Manrique, Columbia).

A rougher option exists: Typically, about 85% of the total savings expenditures will be absorbed by staff costs (salaries and other associated costs), depreciation, security and insurance, travel/transportation, and premises costs. Of these, staff costs are always the largest element. Other costs comprise only a small percentage of the total expense, and these can be allocated according to the number of staff, the number of accounts, or evenly among products, for example, without distorting the overall position too greatly.

Therefore, if managers can grasp how staff time is being used, they will have already gained a good understanding of how to manage costs. By identifying key drivers, managers can better understand their business, more accurately allocate staff time, and ultimately manage cost and price products better (Walden, Africa, The Philippines). Key drivers might include the number of transactions processed, the volume of cash deposited and withdrawn, the number of accounts opened, or the number of loans drawn down.

A third option: When conducting an ABC exercise is not feasible, some MFIs instead rely on competition analysis, financial projections, and focus group discussions to validate the price of the savings products (Oyo, Cambodia).

A. Financial Costs (and Revenues)

1. Interest Rates

Small depositors care more about the ease of depositing and whether their money will be available after the maturity period than about interest returns. For example, they may be willing to receive no interest if they receive door-to-door deposit service. Several institutions in India and Bangladesh have found that interest rates do not have a great effect on the volume of savings mobilized (Bhattacharya, India). (Facilitator's note: This may depend on whether there is formal sector competition.) Term, large-balance customers may be interest-rate sensitive while small-balance customers may not (Papua New Guinea).

To motivate larger and longer-term deposits without requiring them, interest should only be paid on accounts with balances over a certain amount; and a higher rate should be paid for deposits that are held for longer. In many cases, clients seem willing to accept no returns for accounts with balances below a certain minimum (Bienstman). Tiered interest (starting with 0%) rewards the larger savers without introducing a second product. Strategically calculated interest rate tiers may also help to persuade clients to save more. A tier placed at the anticipated break-even point is a natural choice (Walden).

The gross amount customers keep on deposit is probably influenced less by rates of return than by the absence or presence of alternative investment opportunities in the informal market for money. Therefore, a small premium on savings may not be a good blanket rule for new customers as the added cost can impede profitability. In SafeSave's case, an increase from 6% to 8% might not impress clients much, but it would reduce profits by about a third (Staehle, Bangladesh).

Member-owned institutions should pay fixed deposit savings a competitive rate of interest, one that is higher than the ones paid by the commercial banking system and at least at the level of local annual inflation (Galor). Interest rates should be close to that of competitors but can be a bit less if the institution can market a unique selling proposition (e.g., higher security or international shareholders). Paying a lower rate of interest will help avoid attracting clients who are only interested in earning the high interest and then leaving the bank immediately afterwards (Mueller, Eastern Europe).

Interest rates should be set competitively to give the highest possible rate of interest on savings and a low rate on loans such that the interest rate spread exactly covers the total operating costs of the institution (Galor). Many institutions calculate interest on the minimum monthly balance and capitalize it every 3 or 6 months. This is neither equitable nor transparent. A daily cleared balance is easier to understand for staff and clients alike. Institutions should not sell deposit products based on rate alone. Respect for the poor, brand, customer service, et cetera is all part of the proposition. The rate should be an output from costing services (with some consideration to competitor analysis). Institutions may be able to increase the rate if they can cut costs by tightening and stream-lining operations (Walden). The communications industry has successfully reached lower income clients by designing a variety of well-priced products (e.g., mobile phones with a variety of plans depending on the number of minutes and services offered.) MFIs should learn from this experience (Manrique, Columbia).

2. Fees

Fees (for withdrawals from ATM´s, debit cards, penalties, lost identification, and ledger fees) help support the high costs of mobilizing small amounts. In some cases, they do not generate profits. In other cases they do. In Colombia, fee income represents about 15% of total income for the financial sector and amounts to 90% of net profits. Customers and local authorities tend to be uncomfortable with them. The key is to set fees that are perceived by customers as fair, and to price different services in order to induce customers to move from higher cost to cheaper delivery channels (Manrique, Columbia). Ledger fees can make sense where clients are provided with doorstep service. They also can motivate savers to close dormant accounts (Staehle, Bangladesh).

3. In-kind Returns: Lotteries

Once an institution starts holding lotteries and promotions, there is a danger that these will become a standard feature in the market, not providing a competitive advantage but pushing up costs for all institutions (Cracknell and Wright, various countries). On the other hand, a small institution that cannot afford to hold lotteries by itself may be able to do so by collaborating with other small institutions locally (Zakaria, Indonesia).

B. Direct Administrative Costs

Attracting Larger Accounts:

One view: The key to covering the costs of a full-service branch is to attract bigger deposits in order to lower average costs. Keeping costs extremely low (low cost offices, limited hours, one or two employees) can only work in an uncompetitive market. People will choose what they regard as the safest place to put their deposits, which can be one of the big banks or even their mattress (Moelders, Bosnia and Herzegovina). Institutions must develop products that attract both small and large savings (Islam, various).

Another view: Attracting larger accounts is a reasonable strategy if the institution can handle the impact on liquidity management, and if staff is of the right profile to interact with both types of clients. If big depositors need fancy staff and offices, the strategy could lead to mission drift. SafeSave focuses on small deposit mobilization because it believes that the staff needs to be "like its clients," and the core client is a slum-dweller (Staehle, Bangladesh).

A third view: The biggest challenge in managing the costs of savings mobilization is finding the best balance between managing costs and managing risks. Larger accounts carry lower costs but higher risks; smaller accounts are higher cost but lower risk (Lab-oyan, the Philippines). When considering market segments, managers should not only consider the cost per transaction but also the stability of deposits. Although more costly administratively, the deposits of the poor may be more stable and therefore more can be used for on-lending and investment (Mary George, India).

Many small demand deposits provide a more stable funding base for intermediation into loans than do larger term deposits. This sounds counter-intuitive, because term deposits are locked down for a fixed, predictable period while demand deposits can be withdrawn at any time. However, in most cases, the volatility of term deposits is actually larger than the variations in the daily total demand deposit balances. Term deposits are larger and fewer, therefore the impact of a withdrawal on the total balance is more noticeable. Bear in mind that with time deposits, there are typically no partial withdrawals; people either prolong the deposit or take all of the money out.

Term deposits are the hot money that's here today, gone tomorrow. As such, institutions should intermediate them into micro-loans much more cautiously than the stable, core portion of ordinary, on-demand savings balances (Bald).

Staffing: The largest administrative cost is staff salaries and benefits. A key to managing costs is to use staff with a minimum education level and with clearly-defined performance standards (Dhakal, Nepal). In Nepali Savings and Credit Cooperatives, board members manage deposits as volunteers until the SCC grows large enough to pay a staff salary (Simkhada, Nepal). Hiring appropriate staff who know the local culture and language but who need not have academic achievements can lower this cost. Using very basic transport and word-of-mouth advertising can also help keep costs down (Gobezie, Ethiopia).

Products: To keep overhead low, SafeSave offers just one product, a current savings account that is very flexible (Staehle, Bangladesh).

Delivery: Serving groups of savers in their community--or children in their classroom--can be a way to manage the costs of serving very small savers (Zakaria, Indonesia).

Cost of Security and Internal Controls: The cost of guards and security to move cash from the branches at the end of the day can be significant. Yet one of the main reasons clients save with a financial institution is its safety. The cost of security is a major impediment to extending services to rural areas (Larcombe, Mozambique). Digital passbooks, complete MIS, online banking, smart cards and handheld computers can improve security, but they also cost a lot (Adnan, Pakistan). One area not to cut costs is in internal controls (Staehle, Bangladesh).

Transportation: Using very basic transport and word-of-mouth advertising can also help keep costs down. (Gobezie, Ethiopia)

Delinquency: The cost both of maintaining an adequate allowance for loan losses and of un-received income from delinquent loans can be fatal if not properly controlled. Preserving the full income-generating capacity of the institution's primary asset, the loan portfolio, is crucial for everybody from loan officer to CEO (Pirie).

Currency: Transaction times (and therefore administrative costs) will be higher in countries with very small denominations. For example, in Ghana, a "cash-boy" is needed purely to assist in managing the vast mountains of notes transacted each day (Walden, Africa, The Philippines).

Dormancy: High rates of dormancy are found among all types of institutions. For example, one large institution found that 60% of its accounts were dormant. Dormancy is costly and can hide important trends within key segments such as growing client dissatisfaction. So it is important to measure and analyze it, close accounts, and clean house (Cracknell). A small monthly or quarterly "maintenance fee" or "ledger fee" could be used to deal with the dormancy problem. The dormant balance gradually returns to "nil," and the account can be closed. The added income might finance the lowering of other fees or fuel a higher interest rate (Walden).

C. Indirect Administrative Costs

Cost of branches: Infrastructure costs are horrendously high, and money for investment is difficult to come by (Larcombe, Mozambique). In particular, credit programs that seek to mobilize deposits often find that their offices are too far away from the clients. For branch-based systems, this often means expensive relocations (Cracknell).

Linkages to reduce costs: In many countries, savings banks or postal savings banks are the only financial institutions that reach extensively into rural and remote areas. Their branch infrastructure and institutional knowledge enable them to offer affordable savings products. Microfinance institutions should leverage this huge infrastructure instead of building small-scale institutions that could hardly achieve the same extent of outreach (Arévalo). Rather than offer services to clients directly, MFIs that seek to serve rural and small depositors should build relationships with established financial institutions such as postal banks, commercial banks or mobile phone service providers and negotiate for changes and services that benefit these markets. This can create great synergies (Lampe, South Africa). In this type of relationship, the MFI sensitizes its clients to use the postal saving system (El Ghormli, Morocco). Cooperation and linkages--such as an affiliation to a national or regional network, a partnership or joint venture, or membership in a deposit insurance firm--can reduce risk or perceived risk while maintaining cost savings (Lab-oyan, the Philippines).

Management: Decentralizing supervision to regions and keeping administration lean but professional is a key to controlling overhead costs (Bhattacharya, India).

Computerization: Computing is now very cheap--possibly cheaper than books and bookkeepers (Staehle, Bangladesh). Computerized banking information systems seem essential whenever financial institutions intermediate deposits. For example,

• Information must be timely and easily retrievable (Larcombe, Mozambique; Staehle, Bangladesh)
  
  
• Calculating interest would otherwise be extremely difficult (Larcombe, Mozambique)
  
  
• An MIS that provides information on the spread of account balances enables managers to a) create an interest rate structure that maximizes the incentive for clients to increase their savings and minimizes the overall cost to the institution; and b) determine whether a large volume of savings is held by a minority of clients who therefore should receive an extra investment in personal service (Pirie)

An exception to computerization would be areas without a reliable source of electricity (Staehle, Bangladesh).

How Much of the Deposits Can We Lend Out?

Joachim Bald on Assessing Core Deposits

How does an institution determine the percentage of deposits that are "core deposits" (the "bedrock of stable deposits") available for long-term funding purposes? Clearly, more is better. The MFI must observe any applicable prudential regulation, minimum reserve requirements, prescribed minimum holdings of liquid assets, et cetera. But once those rules are satisfied, the MFI should strive to utilize for intermediation the maximum of its stable deposit base.

The trick is to know how much of the deposit base an institution can count on in the long-term. How are core deposits determined? Unfortunately, there are no easy answers. However, here are some ideas on how to get started with analyzing deposit volumes:

• Accumulate lots of time series data on daily aggregate deposit balances.
  
  
• Break down the time series by product, especially if there could be different trends and influencing factors at work for different savings product types.
  
  
• Look for local minima in your balance function, which will provide a first indication of what the core deposit base is and what its growth trend might be.

A few years worth of data is the minimal input that can safely identify recurring seasonal swings that might correlate with agricultural production cycles, holidays or other annual consumption and income patterns among your depositors.

Since liquidity management is only really a challenge in times of adversity, the institution should trace the impact of past crisis events on the deposit supply. For example, what was the run-off behavior during a natural disaster? What happened during a name crisis "run" on another bank or MFI in the same market? Did that measurably spill over into the behavior of the institution's own depositors? Further, the institution you should try to correlate in the effect of the multi-year macro-economic cycle of boom and recession and of known regional economic events. And finally, it must take into consideration the possible supply effects of its own deposit pricing and promotion actions in conjunction with the pricing approach of local competitors. Obviously, it is not easy to identify causes and effects.

And the situation gets even more complex because deposit supply is only half the story in terms of assessing the liquidity impact of deposit operations. Institutions should analyze deposit behavior alongside loan demand. Quite likely, there will be seasonal off-sets or reinforcing correlations: borrowers might be beating down the doors for loans precisely when deposits tend to run-off for seasonal consumption uses.

This analysis will be hard to do without a multi-year steady-state track record that would allow isolation of the various effects. However, aggregate deposit balances are widely published, so institutions should analyze deposit time series on competitors' balance sheets and also draw on the system-wide deposit statistics published by central banks and microfinance apex institutions.

In short, analyzing aggregate deposit supply might be tedious, but it can add substantially to the bottom-line as the institution feels its way forward to placing more of its deposits into earning assets.

¹Facilitator, Madi Hirschland

²This framework comes from Dave Richardson. See "The Keys to Cost Recovery," by Richardson and Hirschland in Savings Services for the Poor: An Operational Guide (Kumarian Press: Bloomfield, CT) 2005.