Sustainable Banking With The Poor.1998


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Microfinance Hand Book, Sustainable Banking With the Poor:: An Institutional and Financial Perspective, Joanna Ledgerwood, 1999 skype: andrew.williams.jr mobile +1-424-222-1997

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Sustainable Banking With The Poor.1998

  1. 1. Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized .' tA W X* Joanna I Ledgerwood with a',, SUSTAINABLE the BANKING POOR -w ' _ __E
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  3. 3. SUSTAINABLE the BANKING POOR with MICROFI NANCE HANDBOOK An Institutional FinancialPerspective and Joanna Ledgerwood THE WORLD BANK WASHINGTON, D.C.
  4. 4. Copyright ( 1999 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rightsreserved Manufactured in the United Statesof America First printing December 1998 The findings, interpretations, and conclusionsexpressedin this paper are entirely those of the author and should not be attributed in any manner to the World Bank, to its affiliatedorganiza- tions, or to members of its Board of ExecutiveDirectors of the countries they represent. The World Bank does not guaranteethe accuracyof the data included in this publication and accepts no responsibilityfor any consequenceof their use. The boundaries, colors,denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any terri- tory or the endorsementor acceptanceof such boundaries. The material in this publication is copyrighted. Requestsfor permissionto reproduceportions of it should be sent to the Office of the Publisher at the addressshown in the copyright notice above. The World Bank encouragesdissemination of its work and will normallygive permissionprompt- ly and, when the reproduction is for noncommercial purposes,without asking a fee.Permission to copy portions for classroomuse is granted through the Copyright ClearanceCenter, Inc., Suite 910, 222 Rosewood Drive, Danvers,Massachusetts01923, U.S.A. Joanna Ledgerwoodis consultant to the SustainableBanking with the Poor Project, World Bank, for Micro Finance International, Toronto, Canada. Libraryof Congress Cataloging-in-PublicationData Ledgerwood,Joanna. Microfinancehandbook: an institutional and financialperspective/JoannaLedgerwood. p. cm.-(Sustainable banking with the poor) Includes bibliographicalreferencesand index. ISBN 0-8213-4306-8 1. Microfinance.2. Financial institutions. I. Title. II. Series. HG178.2.L43 1998 98-21754 332.1-dc21 CIP
  5. 5. Contents Foreword xv Preface xvi Introduction 1 PARTI-ISSUES TO CONSIDERWHEN PROVIDINGMICROFINANCE 9 Chapter 1 Understandingthe Country Context 11 Suppliers of Financial Intermediation Services 12 Existing Microfinance Providers 14 What Role Do Donors Play in Microfinance? 16 Financial Sector Policies and Legal Enforcement 17 Interest Rate Policies 18 Government Mandates for Sectoral Credit Allocations 19 Legal Enforcement of Financial Contracts 19 Financial Sector Regulationand Supervision 20 When Should MFIs Be Subject to Regulation? 21 Considerations When Regulating MFIs 23 Country Approaches to Regulating MFls 25 Economic and Social Policy Environment 26 Economic and Political Stability 26 Poverty Levels 28 Investment in Infrastructure and Human Resource Development 28 Government View of the Microenterprise Sectot 29 Appendix 1. Risks in the Microfinance Industry 30 Sources and Further Readting 31 Chapter 2 The Target Market and Impact Analysis 33 Objectives of the Microfinance Institution 33 Direct and Indirect Targeting 34 The Importance of Adequate Cash Flow and the Capacity to ServiceDebt 35 v
  6. 6. vi CONTENTS Minimal Equity Requirement 36 Moral Hazard 36 Market Size 36 Identifyingthe Target Market 37 Characteristics the Population Group of 37 Types of Microenterprises 42 Impact Analysis 46 Kinds of Impacts 47 What Kinds of Impacts Have We Seen with Microfinance? 48 Impact Proxies 49 Client-Oriented Impact Analysis 49 When Should Impact Be Assessed? 52 Methods of Impact Assessment 53 Fundamental Characteristicsof QualitativeApproaches 53 Fundamental Characteristicsof Quantitative Approaches 54 Comparisonsof Quantitative and QualitativeApproaches 56 IntegratingMethodologies 56 The Choice of Unit of Analysis 56 Appendix 1. Quantitative Impact Assessment 58 Sourcesand Further Reading 59 Chapter3 Productsand Services 63 The SystemsFramework 64 MicrofinanceInstitutions-Minimalist or Integrated? 65 FinancialIntermediation 66 Credit 66 Savings 71 Insurance 74 Credit Cards and Smart Cards 74 Payment Services 75 SocialIntermediation 76 EnterpriseDevelopmentServices 78 SocialServices 81 Appendix 1. MicrofinanceApproaches 82 Appendix 2. Matching Enterprise DevelopmentServicesto Demand 86 Sourcesand Further Reading 90 Chapter4 The Institution 93 The Importance of Institutions 93 Attributesof a Good Institution 94 The Importance of Partner Institutions 94 Institutional Types 97 Formal FinancialInstitutions 97 SemiformalFinancial Institutions 101 Informal FinancialProviders 104
  7. 7. CONTENTS vii Institutional Growth and Transformation 106 ExpansionWithin an ExistingStructure 106 Creating an Apex Institution 106 Creating a Formal FinancialIntermediary 109 Governanceand Ownership 110 Accessing Capital Markets 113 Institutional Capacity Building 117 Appendix 1. MFI Operational Review 118 Appendix 2. Manual for Elaboration of a BusinessPlan 123 Sourcesand Further Reading 128 PART II-DESIGNING AND MONITORING FINANCiAL PRODUCTS AND SERVICES 131 Chapter 5 Designing Lending Products 133 Cash Patterns,Loan Terms, and Payment Frequency 133 Client Cash Patterns and Loan Amounts 133 How Does the Loan Term Affectthe Borrower'sAbility to Repay? 134 Frequencyof Loan Payments 136 Working Capital and FixedAssetLoans 136 Loan Collateral 137 CollateralSubstitutes 137 AlternativeForms of Collateral 138 Loan Pricing 138 CalculatingInterest Rates 140 How Do Fees or ServiceChargesAffect the Borrowerand the MFI? 142 Cross-Subsidization Loans of 143 CalculatingEffectiveRates 143 Estimating the EffectiveRate 144 Calculatingthe EffectiveInterest Rate with Compulsory Savingsor Other Loan Variables 146 Calculatingthe EffectiveInterest Rate with VaryingCash Flows 147 How Does the EffectiveCost for the BorrowerDiffer from the EffectiveYieldto the Lender? 148 Appendix 1. How Can an MFI Set a SustainableRate on Its Loans? 149 Appendix 2. Calculatingan EffectiveInterest Rate Using the Internal Rate of Return Method 150 Appendix 3. Calculatingthe EffectiveRate with VaryingCash Flows 152 Sourcesand Further Reading 153 Chapter 6 Designing Savings Products 155 Demand for SavingsServices 156 Is There an EnablingEnvironment? 157 LegalRequirementsfor Offering Voluntary SavingsServices 157 Deposit Insurance 158 Does the MFI Have the NecessaryInstitutional Capacity to MobilizeSavings? 160 Ownershipand Governance 160 OrganizationalStructure 160 Human Resources 161 Marketing 162 Infrastructure 163
  8. 8. viii CONTENTS Securityand Internal Controls 163 Management Information Systems 163 Risk Management and Treasury 163 Sequencing the Introduction of SavingsServices 164 Types of SavingsProductsfor Microentrepreneurs 164 Liquid Accounts 165 SemiliquidAccounts 165 Fixed-TermDeposits 166 Costs of MobilizingVoluntary Savings 166 Pricing SavingsProducts 167 Sources and Further Reading 168 Chapter 7 ManagementInformationSystems 169 An Overviewof IssuesRelated to Management Information Systems 170 Three Areas of Management Information Systems 171 Accounting Systems 171 Credit and SavingsMonitoring Systems 172 Client Impact Tracking Systems 178 Installinga Management Information System 178 Institutional Assessment 178 Configuration 178 SoftwareModifications 179 Testing 179 Data Transfer 179 Training 180 Parallel Operations 180 Ongoing Support and Maintenance 180 Appendix 1. Overviewof Commercial Management Information SystemSoftwarePackages 180 Appendix 2. Criteria for Evaluating Loan Tracking Software 183 Sourcesand Further Reading 183 PARTIII-MEASURING PERFORMANCEAND MANAGING VLABILITY 185 Chapter 8 AdjustingFinancialStatements 187 AccountingAdjustments 188 Accounting for Loan Losses 188 Accounting for Depreciation of FixedAssets 192 Accounting for AccruedInterest and AccruedInterest Expense 193 Adjusting for Subsidiesand Inflation 194 Accounting for Subsidies 195 Accounting for Inflation 197 RestatingFinancial Statementsin Constant CurrencyTerms 199 Appendix 1. SampleFinancial StatementsAdjustedfor Subsidies 200 Appendix 2. SampleFinancial StatementsAdjustedfor Inflation 202 Sources and Further Reading 204
  9. 9. CONTENTS ix Chapter 9 PerformanceIndicators 205 Portfolio Quality 206 Repayment Rates 206 Portfolio Quality Ratios 207 Loan LossRatios 211 Productivityand EfficiencyRatios 212 Productivity Ratios 212 EfficiencyRatios 213 FinancialViability 215 Financial Spread 216 Two Levelsof Self-Sufficiency 216 Subsidy Dependence Index 218 ProfitabilityRatios 220 Return on AssetsRatio 221 Return on BusinessRatio 222 Return on Equity Ratio 223 Leverage Capital Adequacy and 223 Leverage 224 Capital AdequacyStandards 224 Scaleand Depth of Outreach Indicators 225 PerformanceStandards and Variations 227 Appendix 1. SampleBalanceSheet 233 Appendix 2. SampleIncome Statement 234 Appendix 3. SamplePortfolio Report 235 Appendix 4. Adjusted SampleFinancial Statements(Combined) 236 Appendix 5. Analyzingan MFI's Return on Assets 238 Sourcesand Further Reading 241 Chapter 10 PerformanceManagement 243 DelinquencyManagement 243 The Effect of Delinquency on an MFI's Profitability 244 Controlling Delinquency 245 Reschedulingor RefinancingLoans 246 Productivityand EfficiencyManagement 248 Improving Staff Productivity 248 Managing Costs 251 Risk Management 254 Assetand LiabilityManagement 254 Operating Risk Management 258 Appendix 1. Gap Analysis 260 Sourcesand Further Reading 261 GLossARY 263 INDEX 271
  10. 10. x CONTENTS Boxes 1.1 Formal Sector Suppliers in Rural Mexico 14 1.2 Do Microfinance Clients Need Subsidized Interest Rates? 15 1.3 Credit Institutions as a Political Tool: Debt Foregiveness in India 15 1.4 Microfinance in Indonesia 16 1.5 Multilateral Development Banks' Strategies for Microfinance 18 1.6 The Consultative Group to Assist the Poorest 19 1.7 Usury Laws in West Africa 19 1.8 Alexandria Business Association: Legal Sanctions 20 1.9 Regulating MFIs: The Case of Finansol 22 1.10 Enhancing the Effectiveness of Oversight 23 1.11 Private Financial Funds in Bolivia 25 1.12 Nonbank Financial Institutions in Ghana 26 1.13 Microfinance in Areas of Political Unrest 27 1.14 The Albanian Development Fund 28 1.15 Tax Laws in Argentina 29 2.1 Targeted Credit Activities 34 2.2 U.S. Agency for International Development Findings on Female Borrowers 38 2.3 The Kenya Rural Enterprise Programme 40 2.4 The Influence of Ethnicity and Language in Microfinance 41 2.5 Islamic Banking 42 2.6 The Association for the Development of Microenterprises' Work with Existing Microenterprises 43 2.7 Foundation for Enterprise Finance and Development's Approach to Sector Development 46 2.8 The Impact of Finance on the Rural Economy of India 47 2.9 PRODEM's Impact and Market Analysis Project 50 3.1 Principles of Financially Viable Lending to Poor Entrepreneurs 67 3.2 Individual Loans at F1deration des Caisses d'Epargne et de Credit Agricole Mutuel, Benin 69 3.3 The Association for the Development of Microenterprises 69 3.4 Rotating Savings and Credit Associations 70 3.5 Repayment Instability in Burkina Faso 71 3.6 The Role of Groups in Financial Intermediation 72 3.7 Caisses Villageoises, Pays Dogon, Mali 73 3.8 Self-Employed Women's Association Insurance 75 3.9 The Association for the Development of Microenterprises' MasterCard 75 3.10 Swazi Business Growth Trust Smart Cards 76 3.11 Demand for Payment Services at the Federation des Caisses d'Epargne et de Credit Agricole Mutuel, Benin 76 3.12 Village Banks: An Example of a Parallel System 77 3.13 Social Intermediation in a Social Fund in Benin 78 3.14 Business Skills Training 79 3.15 Direct and Indirect Business Advisory Services 79 3.16 Cattle Dealers in Mali 79 3.17 Who Offers Social Services? 81 3.18 Freedom From Hunger-Providing Nutrition Training with Microfinance 81 A3. 1.1 Training for Replicators in West Africa 83 A3.2.1 Policy Dialogue in El Salvador 90
  11. 11. CONTENTS xi 4.1 Freedom From Hunger: Partnering with LocalInstitutions 96 4.2 Types of Financial Institutions 97 4.3 DevelopmentBanks 98 4.4 Tulay sa Pag-Unlad'sTransformation into a Private DevelopmentBank 99 4.5 The SavingsBank of Madagascar 99 4.6 Caja Social:A Colombian Commercial Bank Reachingthe Poor 100 4.7 Caja de Ahorro y Prestamo LosAndes 101 4.8 AccionComunitaria del Peru 101 4.9 The Rehabilitation of a Credit Union in Benin 102 4.10 CARE Guatemala:The Women's Village BankingProgram 104 4.11 The Use of Self-HelpGroups in Nepal 105 4.12 Using the Nongovernmental Organizationas a Strategic Step in Expansion 107 4.13 Catholic Relief Services:Using the Apex Model for Expansion 108 4.14 Transformation from a NongovernmentalOrganization to FinancieraCalpia 110 4.15 Catholic Relief Services'Guatemala DevelopmentBank 110 4.16 BancoADEMIOwnership Structure 112 4.17 Guarantee Scheme in Sri Lanka 114 4.18 Key Measuresfor Accessing Commercial Financing 114 4.19 Accessing Capital Marketsby Issuing FinancialPaper 115 4.20 ProFund-an Equity Investment Fund for Latin America 115 4.21 The Calvert Group-a ScreenedMutual Fund 116 4.22 DEVCAP-a Shared-ReturnFund 116 4.23 Credit Unions Retooled 118 A4.2.1 SuggestedBusinessPlan Format 125 A4.2.2 Estimating the Market: An Example from Ecuador 126 5.1 The Associationfor the Developmentof Microenterprises'CollateralRequirements 139 5.2 Cross-Subsidization Loans of 143 6.1 Deposit Collectorsin India 156 6.2 SavingsMobilizationat Bank Rakyat Indonesia 158 6.3 Deposit Insurancein India 159 6.4 Securityof Deposits in the Bank for Agricultureand AgriculturalCooperatives, Thailand 159 6.5 Ownership and Governanceat the Bank for Agriculture and AgriculturalCooperatives,Thailand 161 6.6 Using LocalHuman Resourcesin CaissesVillageoises d'Epargne et de Credit Autogerees,Mali 162 6.7 The Sequencingof Voluntary SavingsMobilization 164 6.8 Bank Rakyat Indonesia SavingsInstruments 165 6.9 The Choice of SavingsProducts in Pays Dogon, Mali 166 6.10 AdministrativeCosts for Banco Caja Social,Colombia 167 7.1 Determining the Information Needs of an MFI 170 7.2 MicrofinanceInstitutions with Developed"In-House" Systems 174 7.3 Improving Reporting Formats: Experienceof the Workers Bank of Jamaica 176 7.4 Management Information Systemsat the Associationfor the Development of Microenterprises,Dominican Republic 177 7.5 Frameworkfor a Management Information Systemat Freedom From Hunger 178 7.6 Running ParallelOperations in the Fed6rationdes Caissesd'Epargneet de Cr6dit AgricoleMutuel, Benin 180 8.1 The Impact of Failure to Write Off Bad Debt 191 8.2 Cash and AccrualAccounting for MicrofinanceInstitutions 194
  12. 12. xii CONTENTS 9.1 Repayment Rates Compared with Portfolio Quality Ratios 208 9.2 The Effect of Write-offPolicies 211 9.3 Computation of the SubsidyDependence Index 220 9.4 CARE Guatemala'sSubsidy Dependence Index 221 9.5 Outreach Indicators 226 9.6 Depth of Outreach Diamonds 228 9.7 CAMEL System,ACCION 229 9.8 Financial Ratio Analysisfor MicrofinanceInstitutions, SmallEnterprise and Promotion Network 230 9.9 PEARLSSystem,World Council of Credit Unions 231 9.10 Tracking Performancethrough Indicators, Consultative Group to Assist the Poorest 232 A9.5.1 Analyzinga FinancialInstitution's Return on Assets 238 10.1 Fifteen Steps to Take in a DelinquencyCrisis 246 10.2 Unusual Gains in Efficiencyat Women's World Banking, Cali, Colombia 248 10.3 Performance Incentivesat the Association the Developmentof Microenterprises, for Dominican Republic 250 10.4 PerformanceIncentive Schemesat Tulay Sa Pag-UnladInc., the Philippines 251 10.5 Credit Officer Reports at the Associationfor the Developmentof Microenterprises 252 10.6 Transfer Pricingat Bank Rakyat Indonesia and Grameen Bank in Bangladesh 253 10.7 Standardizationat Grameen Bank 254 10.8 Institution Vulnerabilityto Fraud 259 10.9 Fraud Control at Mennonite Economic DevelopmentAssociation 260 Figures 1 Relationship betweenLevelof Analysisand Technical Complexityin this Book 5 1.1 Understanding the Country Context 11 2.1 Client Characteristics 38 2.2 Types of Microenterprises 42 3.1 Minimalistand IntegratedApproachesto Microfinance 65 3.2 Group SocialIntermediation 78 A3.2.1 The Entrepreneur's Context 86 Tables 1.1 Providersof FinancialIntermediation Services 13 1.2 Private Institutions in MicroenterpriseDevelopment 17 2.1 EnterpriseSector Credit Characteristics 45 4.1 Key Characteristicsof a Strong MicrofinanceInstitution 95 4.2 What Is at Stake for MicrofinanceOwners? 112 A4.2.1 Financial Cost as a WeightedAverage 128 5.1 Examplesof Loan Uses 137 5.2 Declining BalanceMethod 140 5.3 Flat Method 141 5.4 EffectiveRate Estimate, Declining Balance 145 5.5 EffectiveRate Estimate, Flat Method 145 5.6 Change in Loan Fee and Loan Term Effect 146 5.7 VariablesSummary 147 A5.3.1 Internal Rate of Return with VaryingCash Flows (Grace Period) 152 A5.3.2 Internal Rate of Return with Varying Cash Flows (Lump Sum) 152 8.1 SamplePortfolio Report 188
  13. 13. CONTENTS xiii 8.2 Sample Loan Loss Reserve Calculation, December 31, 1995 190 9.1 Sample Portfolio Report with Aging of Arrears 209 9.2 Sample Portfolio Report with Aging of Portfolio at Risk 209 9.3 Calculating Portfolio at Risk 210 9.4 Calculating Portfolio Quality Ratios 212 9.5 Calculating Productivity Ratios 213 9.6 Calculating Efficiency Ratios 215 9.7 Calculating Viability Ratios 219 9.8 Effect of Leverage on Return on Equity 224 A9.5.1 Breakdown of a Microfinance Institution's Profit Margin and Asset Utilization 239 A9.5.2 Analysis of ADEMI's Return on Assets 240 10.1 Cost of Delinquency, Example 1 244 10.2 Cost of Delinquency, Example 2 245 10.3 On-Time and Late or No Payments 247 10.4 Branch Cash Flow Forecasts 256
  14. 14. Foreword T he Sustainable Banking with the Poor Project (SBP)began severalyearsago as a rather unusual sive discussions with practitioners, policymakers, and donors. SBP also co-produced with the Consultative joint effort by a regional technical department, Group to Assist the Poorest the "MicrofinancePractical Asia Technical,and a central department, Agricultureand Guide," today a regular source of practical referencefor Natural Resources. Through the yearsand the institution- World Bank Group task team leaders and staff working al changes,the project has maintained the support of the on microfinanceoperations or project components that Asia Region and the Rural DevelopmentDepartment in involvethe provisionof financialservices the poor. to the Environmentally and Socially Sustainable This volume, Microfinance Handbook: An Developmentvice presidencyand the endorsementof the Institutional and Financial Perspective, represents in a Finance,PrivateSectorand InfrastructureNetwork. way a culmination of SBP work in pursuit of its princi- An applied research and dissemination project, SBP pal aim. A comprehensivesource for donors, policymak- aims at improving the ability of donors, governments, ers, and practitioners, the handbook first covers the and practitioners to design and implement policies and policy, legal, and regulatory issues relevant to microfi- programs to build sustainable financialinstitutions that nance development and subsequently treats rigorously effectivelyreach the poor. While its main audience has and in depth the key elements in the process of building been World Bank Group staff, the project has con- sustainable financial institutions with effectiveoutreach tributed significantly to the knowledge base in the to the poor. microfinanceand rural finance fieldsat large. The handbook focuseson the institutional and finan- More than 20 casestudiesof microfinanceinstitutions cial aspects of microfinance.Although impact analysisis have been published and disseminatedworldwide,many reviewedbriefly,a thorough discussionof poverty target- of them in two languages;a seminar seriesat the World ing and of the povertyalleviationeffectsof microfinanceis Bank has held more than 30 sessionson microfinanceand left to other studiesand publications. rural finance good practice and new developments;three We are confident that this handbook will contribute regional conferenceshave disseminatedSBP products in significantly to the improvement of policies and prac- Asiaand Africa,whilefosteringand benefitingfrom exten- tices in the microfinancefield. Nishimizu Ian Johnson Vice President Vice President South Asia Region Environmentallyand SociallySustainableDevelopment Jean-MichelSeverino MasoodAhmed Vice President Acting Vice President EastAsia and PacificRegion Finance, PrivateSector and Infrastructure xv
  15. 15. Preface T h Microfinance Handbook, one of the major products of the World Bank's Sustainable Group to Assist the Poorest. I am grateful to Mike Goldberg and Gregory Chen for their initial contribu- Banking with the Poor Project, gathers and pre- tions. Thomas Dichter wrote the sections on impact sents up-to-date knowledge directly or indirectly con- analysis and enterprise development services and provid- tributed by leading experts in the field of microfinance. ed comments on other chapters. Tony Sheldon wrote It is intended as a comprehensive source for donors, poli- the chapter on management information systems and cymakers, and practitioners, as it covers in depth matters provided comments on the first draft. Reinhardt pertaining to the regulatory and policy framework and Schmidt contributed substantially to the chapter on the essential components of institutional capaciry build- institutions. ing--product design, performance measuring and moni- I wish to thank especially Cecile Fruman for her ini- toting, and management of microfinance institutions. tial and ongoing contributions, comments, and support. The handbook was developed with contributions I also appreciate the support and flexibility of Carlos E. from other parts of the World Bank, including the Cuevas, which were vital in keeping the process going. Consultative Group to Assist the Poorest. It also benefit- Thanks are extended to Julia Paxton and Stephanie ed from the experience of a wide range of practitioners Charitonenko Church for their contributions as well as and donors from such organizations as ACCION to the many people who reviewed various chapters and International, Calmeadow, CARE, Women's World provided comments, including Jacob Yaron, Lynn Banking, the Smal Enterprise Education and Promotion Bennett, Mohini Malhotra, McDonald Benjamin, Network, the MicroFinance Network, the U.S. Agency Jeffrey Poyo, Jennifer Harold, Bikki Randhawa, Joyita for International Development, Deutsche Gesellschaft Mukherjee, Jennifer Isern, and Joakim Vincze. fuir Technische Zusammenarbeit, Caisse Fran~aise de I would also like to thank Laura Gomez for her con- D6veloppement, and the Inter-American Development tinued support in formatting the handbook and manag- Bank. ing its many iterations. Special thanks are due to the outside sponsors of the The book was edited, designed, and typeset by Coin- Sustainable Banking with the Poor Project-the Swiss munications DevelopmentInc. Agency for Development and Cooperation, the Royal Ministry of Foreign Affairs of Norway, and th Ford Foundation-for their patience, encouragement, and sup p o rt. T h he Sustainable Banking with the Poor Project team is I would like to thank the many individuals who con- led by Lynn Bennett and Jacob Yaron, task managers. tributed substantially to this handbook. A first draft was Carlos E. Cuevas is the technical manager and Cecile prepared by staff members at both the Sustainable Fruman is the associate mnanager. Laura Gomez is the Banking with the Poor Project and the Consultative administrative assistant. xvi
  16. 16. Introduction It has been estimated that there ate 500 million eco- nomically active poor people in the world operating Financial ser-vices generally include sa-vings and credit; however, some microfinance organizations also provide microenterprises and small businesses (Women's insurance a-nd payment services. In addition to financial World Banking 1995). Most of them do not have access intermediation, many MFIs provide social intermediation to adequate financial services. To meet this substantial services such as group formation, development of self- demand for financial services by low-income microentre- confidence, and training in financial literacy and manage- preneurs, microfinance practitioners and donors alike ment capabilities among members of a group. Thus the must adopt a long-term perspective. The purpose of this definition of microfinance often includes both financial handbook is to bring together in a single source guiding intermediation and social intermediation. Microfinance is principles and tools that will promote sustainable micro- not simply banking, it is a development tool. |I~~~~~~~~~~~~~~~~~~~~~~~~~~~~ S S | l S g | EI I | finance and create viable institutions. Microfinance activities usually involve: The goal of this book is to provide a comprehensive a Small loans, typically for working capital source for the design, implementation, evaluation, and u Informal appraisal of borrowers and investmients management of microfinance activities.1 * Collateral substitutes, such as group guarantees or The handbook takes a global perspective, drawing on compulsory savings lessons learned from the experiences of microfinance a Access to repeat and larger loans, based on repayment practitioners, donors, and others throughout the world. performance It offers readers relevant information that will help them * Streamlined loan disbursement and monitoring to make informed and effective decisions suited to their * Secure savings products. specific environment and objectives. Although some MFIs provide enterprise development services, such as skis tra-ining and marketing, and social services, such as literacy training and hiealth care, these Microfinance Defined are nor generally included in the definition of microfi- nance. (However, enterprise development services and Microfinance has evolved as an economic development social services are discussed briefly in chapter 3, as some approach intended to benefit low-income women and MFIs provide these services.) men. The term refers to the provision of financial services MFIs can be nongovernmental organizations to low-income clients, including the self-employed. (NGOs), savings and loan cooperatives, credit unions, 1. The term "microfinanceactivity" is used throughout to describethe operationsof a microfinanceinstitution, a mictofinancepro- jeer, ot a microfinancecomponent of a project. When tefetring to an organizationproviding microfinanceservices,whethet regulat- ed or untegulated, the term "mictofinanceinstitution' (MFI)is used.
  17. 17. 2 NtICROFINANCE HANDBOOK government banks, commercial banks, or nonbank At the same time, local NGOs began to look for a financial institutions. Microfinance clients are typically more long-term approach than the unsustainableincome- self-employed,low-income entrepreneurs in both urban generation approaches to community development. In and rural areas. Clients are often traders, street vendors, Asia Dr. Mohammed Yunus of Bangladeshled the way small farmers, service providers (hairdressers, rickshaw with a pilot group lending scheme for landless people. drivers), and artisans and small producers, such as black- This later became the Grameen Bank, which now serves smiths and seamstresses.Usually their activitiesprovide more than 2.4 million clients (94 percent of them a stable source of income (often from more than one women) and is a model for many countries. In Latin activity).Although they are poor, they are generallynot AmericaACCION International supported the develop- consideredto be the "poorest of the poor." ment of solidaritygroup lending to urban vendors, and Moneylenders,pawnbrokers,and rotating savingsand Fundaci6n Carvajal developed a successful credit and credit associations are informal microfinance providers training systemfor individualmicroentrepreneurs. and important sources of financial intermediation but Changes were also occurring in the formal financial they are not discussedin detail in this handbook. Rather, sector. Bank Rakyat Indonesia, a state-owned, rural the focus is on more formal MFIs. bank, moved away from providing subsidized credit and took an institutional approach that operated on market Background principles. In particular, Bank Rakyat Indonesia devel- oped a transparent set of incentives for its borrowers Microfinance arose in the 1980s as a response to (smallfarmers) and staff, rewarding on-time loan repay- doubts and research findings about state delivery of ment and relying on voluntary savingsmobilization as a subsidized credit to poor farmers. In the 1970s govern- source of funds. ment agencies were the predominant method of pro- Since the 1980s the field of microfinancehas grown viding productive credit to those with no previous substantially. Donors actively support and encourage access to credit facilities-people who had been forced microfinanceactivities, focusing on MFIs that are com- to pay usurious interest rates or were subject to rent- mitted to achieving substantial outreach and financial seeking behavior. Governments and international sustainability.Today the focus is on providing financial donors assumed that the poor required cheap credit servicesonly, whereasthe 1970s and much of the 1980s and saw this as a way of promoting agricultural pro- were characterizedby an integratedpackageof credit and duction by small landholders. In addition to providing training-which required subsidies. Most recently, subsidized agricultural credit, donors set up credit microfinanceNGOs (including PRODEM/BancoSol in unions inspired by the Raiffeisen model developed in Bolivia, K-REP in Kenya, and ADEMI/BancoADEMI Germany in 1864. The focus of these cooperative in the Dominican Republic) have begun transforming financial institutions was mostly on savings mobiliza- into formal financialinstitutions that recognizethe need tion in rural areas in an attempt to "teach poor farmers to provide savingsservicesto their clients and to access how to save." market funding sources, rather than rely on donor funds. Beginning in the mid-1980s, the subsidized,targeted This recognition of the need to achieve financialsustain- credit model supported by many donors was the object ability has led to the current "financial systems" of steady criticism, because most programs accumulated approach to microfinance.This approach is characterized large loan lossesand required frequent recapitalizationto by the followingbeliefs: continue operating. It became more and more evident X Subsidizedcredit undermines development. that market-basedsolutions were required. This led to a X Poor people can pay interest rates high enough to new approach that considered microfinanceas an inte- cover transaction costs and the consequencesof the gral part of the overallfinancialsystem.Emphasisshifted imperfect information markets in which lenders from the rapid disbursementof subsidizedloans to target operate. populations toward the building up of local, sustainable X The goal of sustainability (cost recoveryand eventu- institutions to servethe poor. allyprofit) is the key not only to institutional perma-
  18. 18. INTRODUCTION 3 nence in lending, but also to making the lending * Sources of funds to finance loan portfoliosdiffered by institution more focusedand efficient. type of institution. NGOs relied heavily on donor e Because loan sizes to poor people are small, MFIs funding or concessional funds for the majorityof their must achieve sufficient scale if they are to become lending. Banks,savingsbanks, and credit unions fund- sustainable. ed their loan portfolios with client and member e Measurable enterprise growth, as well as impacts on depositsand commercialloans. poverty, cannot be demonstrated easilyor accurately; e NGOs offered the smallest loan sizes and relatively outreachand repaymentratescan be proxiesfor impact. more social services than banks, savings banks, or One of the main assumptions in the above view is credit unions. that many poor people actively want productive credit * Credit unions and banks are leaders in serving large and that they can absorb and use it. But as the field of numbers of clientswith small depositaccounts. microfinance has evolved, research has increasingly The study also found that basic accounting capacities found that in many situations poor people want secure and reporting varied widelyamong institutions, in many savingsfacilitiesand consumption loans just as much as cases revealing an inability to report plausible cost and productive credit and in some cases instead of produc- arrears data. This shortcoming, notably among NGOs, tive credit. MFIs are beginning to respond to these highlightsthe need to place greateremphasison financial demands by providing voluntary savings services and monitoring and reporting using standardizedpractices (a other types of loans. primary purpose of this handbook). Overall, the findings suggest that favorablemacroeconomicconditions, man- aged growth, deposit mobilization, and cost control, in Sizeof the Microfinance Industry combination, are among the key factors that contribute to the successand sustainability of many microfinance During 1995 and 1996 the Sustainable Banking with institutions. the Poor Project compiled a worldwide inventory of MFIs. The list included nearly 1,000 institutions that provided microfinance services, reached at least 1,000 Whyis Microfinance Growing? clients, and had operated for a minimum of three years. From this inventory, more than 200 institutions Microfinanceis growing for severalreasons: responded to a two-page questionnaire covering basic 1. Thepromise of reachingthepoor. Microfinance activi- institutional characteristics. ties can support income generation for enterprises According to the survey results, by September 1995 operated by low-incomehouseholds. about US$7 billion in outstanding loans had been pro- 2. Thepromise offinancial sustainability.Microfinance vided to more than 13 million individuals and groups. activities can help to build financiallyself-sufficient, In addition, more than US$19 billion had been mobi- subsidy-free,often locallymanagedinstitutions. lized in 45 million activedepositaccounts. 3. The potential to build on traditionalsystems.Micro- The generalconclusionsof the inventory were: finance activitiessometimesmimic traditional systems • Commercial and savings banks were responsible for (such as rotating savingsand credit associations). They the largest share of the outstanding loan balance and provide the same servicesin similar ways, but with deposit balance. greater flexibility, at a more affordable price to • Credit unions represented 11 percent of the total microenterprises on a more sustainablebasis.This and number of loans in the sample and 13 percent of the can make microfinance servicesvery attractive to a outstanding loan balance. largenumber of low-incomeclients. • NGOs made up more than half of the sample, but 4. The contributionof microfinance strengthening to and they accounted for only 9 percent of the total num- expanding existingformal financial systems.Micro- ber of outstanding loans and 4 percent of the out- finance activities can strengthen existing formal standing loan balance. financial institutions, such as savingsand loan coop-
  19. 19. 4 MICROFINANCE HANDBOOK eratives, credit union networks, commercial banks, c Others develop neither the financialmanagementsys- and even state-run financial institutions, by expand- tems nor the skillsrequiredto run a successful operation. ing their markets for both savings and credit-and, a Replication of successfulmodels has at times proved potentially, their profitability. difficult, due to differencesin social contexts and lack 5. The growing number of successstories. There is an of local adaptation. increasing number of well-documented, innovative Ultimately, most of the dilemmas and problems success stories in settings as diverse as rural encounteredin microfinance have to do with how clearthe Bangladesh,urban Bolivia,and rural Mali. This is in organizationis about its principalgoals.Does an MFI pro- stark contrast to the records of state-run specialized vide microfinanceto lightenthe heavyburdens of poverty? financial institutions, which have received large Or to encourage economic growth? Or to help poor amounts of funding over the past few decades but women develop confidenceand becomeempoweredwith- have failed in terms of both financial sustainability in their families?And so on. In a sense,goals are a matter and outreach to the poor. of choice;and in development, organizationcan choose an 6. The availability of betterfinancial productsas a result one or many goals-provided its constituents,governance of experimentationand innovation. The innovations structure,and funding areall in linewith those goals. that have shown the most promise are solving the problem of lack of collateral by using group-based and character-basedapproaches; solving problems of About ThisBook repayment discipline through high frequency of repayment collection, the use of social and peer This handbook was written for microfinancepractition- pressure, and the promise of higher repeat loans; ers, donors, and the wider readership of academics,con- solving problems of transaction costs by moving sultants, and others interested in microfinance design, some of these costs down to the group level and by implementation, evaluation,and management. It offersa increasing outreach; designing staff incentives to one-stop guide that coversmost topics in enough detail achieve greater outreach and high loan repayment; that most readerswill not need to refer to other sources. and providing savingsservicesthat meet the needs of At first glance it might seem that practitioners and small savers. donors have very different needs and objectivesand thus could not possiblybenefit equally from one book. The objectivesof many donors who support microfi- WhatArethe Risks Microfinance? of nance activitiesare to reduce poverty and empower spe- cific segments of the population (for example, women, Sound microfinanceactivitiesbasedon best practicesplay indigenous peoples).Their primary concerns traditional- a decisiverole in providing the poor with accessto finan- ly have been the amount of funds they are able to dis- cial services through sustainable institutions. However, burse and the timely receipt of requested (and, it is there havebeen many more failuresthan successes: hoped, successful) performance indicators. Donors are * Some MFIs target a segment of the population that rarely concerned with understanding the details of has no accessto businessopportunities becauseof lack microfinance. Rather, it is often enough for them to of markets, inputs, and demand. Productive credit is believethat microfinancesimply works. of no use to such people without other inputs. Practitioners need to know how actually to operate a * Many MFIs never reach either the minimal scale or microfinance institution. Their objectives are to meet the efficiencynecessaryto covercosts. the needs of their clients and to continue to operate in * Many MFIs face nonsupportivepolicyframeworksand the long term. daunting physical,social,and economicchallenges. Given the purpose of this handbook, it seems to be * Some MFIs fail to manage their funds adequately directed more toward practitioners than toward donors. enough to meet future cash needs and, as a result, However, donors are beginning to realize that MFI they confront a liquidity problem. capacityis a more binding constraint than the availability
  20. 20. INTRODUCTION 5 of funds, making it essential for donors and practitioners technical. Part II, "Designing and Monitoring Financial to operate from the same perspective if they are to meet Products and Services," narrows its focus to the provi- effectively the substantial need for financial services. In sion of financial intermediation, taking a more technical fact, if we look briefly at the evolution of microfinance, it approach and moving progressively toward more specific is apparent that both donors and practitioners need to (or micro) issues. Part III, "Measuring Performance and understand how microfinance institutions operate. Managing Viability," is the most technical part of the When microfinance first emerged as a development tool, handbook, focusing primarily on assessing the financial both donors and practitioners focused on the cumulative viability of MFIs. (These relationships are shown in fig- amount of loans disbursed, with no concern for how well the ure 1.) loans suited borrower needs and little concern about whether Part I addresses the broader considerations of microfi- or not loans were repaid. Donors were rewarded for disburs- nance activities, including the supply of and demand for ing funds, and practitioners were rewarded for on-lending financial services, the products and services that an MFI those finds to as many people (preferably women) as possi- might offer, and the institutions and institutional issues ble. Neither was particularly accountable for the long-term involved. Part I is the least technical part of the hand- sustainabiity of the microfinance institution or for the long- book; it requires no formal background in microfinance term effect on borrowers or beneficiaries. or financial theory. Its perspective is more macro than Now that the field of microfinance is more mature, it is that of parts II and III, which provide more detailed becoming clear that effective, efficient, and sustainable "how-to" discussions and are specifically focused on the institutions are needed to provide financial services well provision of financial services only. Part I will be of most suited to the demands of low-income clients. Both donors interest to donors and those considering providing micro- and practitioners are beginning to be held accountable for finance. Practitioners may also benefit from part I if they results. The focus is no longer solely on quantity-on the are considering redefining their market, changing their amount disbursed-but on the quality of operations. This institutional structure, offering additional services, or view is based on the notion that borrowers will buy micro- implementing different service delivery methods. finance products if they value the service; that is, if the Part II, which addresses more specific issues in the product is right for them. Borrowers are now being treated design of financial services (both lending and savings as clients rather than beneficiaries.Thus if they are to be effective and truly meet their development objectives donors must supr donors~~~~~~~~~~~~~~. ''doing it right." support MFIs that mus MFIstaar"digtrgh"T are 'To igure Compleity Book ofAnalysis 1. Relationship Level Technical between inthis and do so, they need to understandhow to both recognizeand evaluate a good microfinance provider. As it turns out, both donors and practitioners are real- Macro ly on the same side-their joint goal is to make available Part I * * * r appropriate services to low-income clients. Therefore, it * ~~~~~~~~~~~~~~~~~Issues to When Consider ProvidingsMitrofinonte falls to donors and practitioners themselves to define best practices and to advocate policies that will encourage growth, consistency, and accountability in the field. The Part11 intent of this handbook is to provide a basis of com Designing Monitoring and FinanCial and Products Services understanding among all stakeholders. Part III Orgnizadon theBook of Organization the Book of Measuring and Performance Managing Viability The handbook has three parts. Part I, "Issues in Micro- Micro finance Provision," takes a macroeconomc perspective Low High toward general microfinance issues and is primarily non- Technkil complexity
  21. 21. 6 MICROFINANCE HANDBOOK products) and the development of management informa- ACCION PublicationsDepartment tion systems,will be of most interest to practitionerswho 733 15th Street NW, Suite 700 are developing,modifying,or refining their financialprod- Washington D.C. 20005 ucts or systems,and donors or consultantswho are evalu- Phone: 1 202 393 5113, Fax 1 202 393 5115 ating microfinanceorganizationsand the appropriateness Web: of the products and servicesthat they provide. Part II E-mail: incorporatessome basicfinancialtheory and, accordingly, readers should have a basic understanding of financial CalmeadowResourceCenter management.Readersshould also be familiarwith using a 365 Bay Street,Suite 600 financialcalculator,computerspreadsheet, both.or Toronto, Canada M5H 2V1 Part III providestools for evaluatingthe financialhealth Phone: 1 416 362 9670, Fax: 1 416 362 0769 of an MFI and a means of managing operational issues. Web: The materialfocusesprimarilyon financialintermediation (that is, credit and savingsservices,based on the assump- tion that the main activityof an MFI is the provisionof CGAP Secretariat financial services).Social intermediation and enterprise Room G4-115, The World Bank developmentservices not addresseddirectly.However, are 1818 H Street NW basicfinancialtheory that is relevantto the financialman- Washington D.C. 20433 agement of MFIs delivering these servicesis provided as Phone: 1 202 473 9594, Fax: 1 202 522 3744 well.The materialalso underscoresthe importanceof the Web: interrelationshipbetween servingclientswell and moving E-rnail: towards institutional and financial self-sufficiency. These two goalsserveeach other; neitheris sufficient its own. on Micro Finance Network As the most technical section of the handbook, part 733 15th Street NW, Suite 700 III will be of particular interest to practitioners and con- Washington D.C. 20005 sultants. Donors will also benefit from part III if they Phone: 1 202 347 2953, Fax 1 202 347 2959 want to understand how MFIs should be adjusting their Web: financial statements and calculatingperformance indica- E-mail: tors. While the technical information is fairly basic, some understanding of financial statements and finan- PACT Publications cial analysisis required. 777 United Nations Plaza The overall purpose of part III is to improve the New York, NY 10017 level of financial understanding and management in Phone: 1 212 697 6222, Fax: 1 212 692 9748 MFI operations. As donors come to understand both Web: the complexityof microfinance and that it can be deliv- ered in a financiallysustainable manner, knowledge of the more technical aspects of microfinance will become PartI-Issues in Microfinance Provision increasinglyimportant to them in deciding whether to support institutions and programs. Chapter 1-The Country Context provides a framework Each chapter is designed to be used alone or in con- for analyzingcontextual factors. It focuseson issuesthat junction with other chapters, depending on the specific affect the supply of microfinance, including the finan- needs of the reader. A list of sources and additional cial sector, financial sector policies and legal enforce- reading material is provided at the end of each chapter. ment, financial sector regulation and supervision, and Many of the publications listed at the end of each economic and social policies. chapter can be accessedthrough the followingorganiza- Chapter 2-The Target Market and Impact Analysis tions, either by mail or through their Web sites: looks at the demand for financial services among low-
  22. 22. INTRODUCTION 7 incomepopulations presentswaysof identifying and a the financialstatementsand adjustmentsthat restate target market based on client characteristicsand the financialresultsto reflectmore accurately financial the typesof enterprises operate.It alsodiscusses they impact positionof an MFI. analysisand how the desiredimpact affectsan MFI's Chapter 9-Performance Indicatorsdetailshow to mea- choiceof targetmarket. sureand evaluate financial the performance the MFI, of Chapter 3-Products Services and considers various the focusing ratioanalysis determinehowsuccessful on to is services low-income that entrepreneursmight demand, the institution'sperformance whichareas couldbe and includingfinancial socialintermediation, and enterprise improved. addition,it provides In variousoutreachindi- development, socialservices. overview well- and An of catorsthat can be monitored. known microfinanceapproachesis presented in the Chapter10-Performance Management presentsways appendix. in whichto improvethe financial resource and manage- Chapter 4-The Institutiondiscusses varioustypes the ment of microfinanceinstitutions. It discussesdelin- of institutionsthat can effectively provideand manage quencymanagement, staff productivity incentives, and the provision of microfinanceactivities.It addresses and risk management, including assetand liabilityman- issuessuch as legalstructures,governance, institu- and agement. tionalcapacity, alsoprovides and information access- on ing capitalmarketsfor funding. A Necessary Caveat PartI-Designing Monitoring and FinancialProducts and Services Microfinance recently has becomethe favorite interven- tion for developmentinstitutions, due to its unique Chapter 5-Designing Lending Productsprovidesinforma- potentialforpovertyreductionandfinancial sustainabil- tion on how to designor modifylendingproductsfor ity. However, contraryto whatsomemayclaim,micro- microentrepreneurs both to meet their needs and to finance not a panacea poverty is for alleviation. fact,a In ensurefinancialsustainability the MFI. of poorlydesignedmicrofinance activitycan makethings Chapter 6-Designing Savings Productsprovidesinfor- worseby disrupting informalmarketsthat havereliably mation on the legal requirementsto providesavings, providedfinancial services poor households to over the typesof savingsproducts, operational and considerations pastcoupleof centuries, albeitat a highcost. for providingsavings,includingpricing.This chapter There are many situationsin whichmicrofinance is focuses the provision voluntarysavings; doesnot on of it neither the most importantnor the mostfeasible activi- addressforced or compulsorysavingsoften associated ty for a donor or other agency to support. with lendingproducts. Infrastructure,health, education,and other socialser- Chapter7-Management Information Systems(MIS) vices are critical to balancedeconomicdevelopment; presents an overview of effective MIS, including and eachin its ownwaycontributes a betterenviron- to accountingsystems, loan-tracking systems,and client- ment for microfinanceactivitiesin the future. Care impacttrackingsystems. alsoprovides briefdiscus- shouldbe takento ensurethat the provisionof microfi- It a sion on the processof installing MIS and a summary nance is truly demand driven, rather than simply a an evaluation existing of software packages. meansto satisfy donors'agendas. Part IlI-Measuring Perfonnance Managing and Viability Sources Further and Reading Chapter8-AdjustingFinancial Statements presentsthe Gonzalez-Vega, Claudio, Douglas Graham.1995. and H. adjustments financial to statements are requiredto that "State-Owned AgriculturalDevelopment Banks: Lessons accountfor loan losses,depreciation,accruedinterest, andOpportunities Microfinance." for Occasional Paper inflation, and subsidies. Adjustments are presented in 2245. Ohio State University, Departmentof Agricultural two groups: standard entries that should be included in Economics,Columbus, Ohio.
  23. 23. 8 MICROFINANCE HANDBOOK Mutua, Kimanthi, Pittayapol Nataradol, and Maria Otero. Institutions." Sustainable Banking with the Poor, World 1996. "The View from the Field: Perspectives from Bank, Washington, D.C. Managers of Microfinance Institutions." In Lynn Bennett Women's World Banking Global Policy Forum. 1995. and Carlos Cuevas, eds., Journal of International "The Missing Links: Financial Systems That Work for Development8(2): 195-210. the Majority." Women's World Banking (April). New Paxton, Julia. 1996. "A Worldwide Inventory of Microfinance York.
  24. 24. Part I- Issues to Consider When Providing Microfinance
  25. 25. CHAPTER ONE Understanding the Country Context T he overallpoliticaland economicenvironmentof a country affects how microfinance is provided. e What forms of financial sector regulation exist, and are MFIs subject to these regulations? Government economic and social polices, as well * What economic and social policies affect the provi- as the development level of the financial sector, influence sion of financial services and the ability of microen- microfinance organizations in the delivery of financiat ser- trepreneurs to operate? vices to the poor. Understanding these factors and their As can be seen in figure 1.1, contextual factors affect effect on microfinance is called assessing the country con- how suppliers of financial intermediation reach their text. This process asks the following questions: clients. e Who are the suppliers of financial services? What This chapter uses a macroeconomic approach to place products and services do they supply? What role do microfinance in the overall context of a country and so governments and donors play in providing financial make clear how important macro-level policy and regula- services to the poor? tion are for developing microfinance providers and a How do existing financial sector policies affect the microenterprises. Practitioners and donors need to exam- provision of financial services, including interest rate ine the financial system to locate needs and opportunities policies, government mandates for sectoral credit allo- for providing microfinance services. Analyzing the country cation, and legal enforcement policies? context reveals whether changes in policy or in the legal Figure Understanding Country 1.1 the Context Contextual factors l_ _ 1. Financial policies sector and Clients Suppliersof legal environment iWomen financial intermediation I Interest restrictions rate tIMicroentrepreneurs I Government mandates lal l - Formal institutions sector ! l.inancial contract enforcement SaLandessandsmalholders rs .Semi-formalsector * Resettled persons institutions 2. Financial regulation sector and * Indigenous persons I*nformal sector supervision | Low-income in persons ___j __institutions ________i 3. Economic social and policy remote subsistence or areas | EconomiE stability j *Poverty levels policies -Government 11
  26. 26. 12 MICROFINANCE HANDBOOK frameworkare needed to allow more efficientmarkets to providersthat can be found in each group. The dividing emerge. lines are not absolute, and regulatorystructuresvary. For example, credit unions may fall in the formal sector in one country and in the semiformalsectorin another. Suppliersof FinancialIntermediation Services Formalfinancialinstitutionsare chartered by the gov- ernment and are subject to banking regulations and The first step in understanding the context in which a supervision. They include public and private banks, microfinance provider operates is to determine who insurance firms, and finance companies. When these makes up the financialsystem. institutions servesmallerbusinessesor farmers (as is often "The financial system(or financialsector, or finan- the case with public sector financial institutions), there is cial infrastructure)includes all savingsand financ- potential for them to move into the microfinancesector. ing opportunitiesand the financialinstitutions that Within the formal sector, private institutions generally providesavingsand financingopportunities,as well focus on urban areas, whereas many public institutions as the valid norms and modesof behaviorrelated to provide services in both urban and rural areas. Loans these institutions and their operations. Financial from private sector institutions are often large individual marketsare the markets-supply, demand, and the amounts and are usually allocated to large, established, coordination thereof-for the servicesprovided by private, and government-owned enterprises in modern the financialinstitutions to the nonfinancialsectors industrial sectors. Private formal sector institutions typi- of the economy."(Krahnenand Schmidt 1994, 3) cally mobilize the greatest amount of deposits from the To analyze a country's financialsystem, it is necessary general public. Public sector rural institutions often pro- to look at both the demand for and the supply of finan- vide agriculturalloans as a means of developing the rural cial services.This section focuseson the supplyof finan- sector. Funding sources include government-distributed cial services;demandwill be examinedin chapter 2. and foreign capital, with savings and deposits as sec- Understanding a country's financial system allows ondary sources. Processing of transactions entails microfinanceprovidersto identify areas in which services detailed paperwork and bureaucratic procedures that or products for certain client groups are inadequate or result in high transaction costs, reinforcing the bias nonexistent. It can also identifyinstitutional gaps and the toward relativelylarge loans. Box 1.1 describes the oper- potential for partnerships between different types of ations and problems of rural financial institutions in institutions to reach the poor cost effectively. Mexico. Intermediaries that provide financial services range Semiformalinstitutionsare not regulated by banking from highly formal institutions to informal moneylen- authorities but are usually licensed and supervised by ders. Understanding the size, growth, number, gover- other government agencies. Examples are credit unions nance, and supervision of these institutions is an and cooperative banks, which are often supervisedby a important part of assessing how the financial system bureau in charge of cooperatives.(NGOs are sometimes works. Financial intermediation varies with the services considered part of the semiformal sector, because they and products provided and depends to some extent on are often legally registered entities that are subject to the type of institution providing the services. Not all some form of supervision or reporting requirements.) markets have access to the same services and products. These financial institutions, which vary greatly in size, Determining which financial servicesare currently being typically serve midrange clients associated by a profes- provided to the differing markets is important in identi- sion or geographic location and emphasize deposit fyingunservedor underservedclients. mobilization. Financial systems can generally be divided into the Semiformalinstitutions provide products and services formal,semiformal,and informal sectors.The distinction that fall somewherebetween those offeredby formal sec- between formal and informal is based primarily on tor and informal sector institutions. The design of their whether there is a legal infrastructure that provides loan and savings products often borrows characteristics recourse to lenders and protection to depositors. Table from both sectors. In many countries semiformal insti- 1.1 outlines the wide range of public and private tutions often receive donor or government support
  27. 27. UNDERSTANDING THE COUNTRY CONTEXT 13 through technical assistance or subsidies for their sanctions within a family, a village, or a religious com- operations. munity substitute for legal enforcement. Credit terms Informal financial intermediaries operate outside are typically adapted to the client's situation. The total the structure of government regulation and supervi- amount lent, as well as the number and the frequencyof sion. They include local moneylenders, pawnbrokers, installments, is fitted to the borrower's expected cash self-help groups, and NGOs, as well as the savings of flow. Little if any paperwork is involved in applying for family members who contribute to the microenter- a loan (Krahnen and Schmidt 1994, 32). prise. Often they do not comply with common book- Depending on historical factors and the country's keeping standards and are not reflected in official level of economic development, variouscombinationsof statistics on the depth and breadth of the national these suppliers are present in the financial sectors of financial sector. Knowing where and how these finan- developing countries. Research increasinglyshows that cial sources operate helps determine what services are the financial sector is complex and that there are sub- in demand. stantial flows of funds between subsectors. Identifying These institutions concentrate on the informal the suppliers of financial servicesin a given country or sector-on loans and depositsfor small firms and house- region leads to a greater understanding of the financial holds. Often loans are granted without formal collateral system and also revealsgaps for a microfinanceprovider on the basis of familiarity with the borrower. Social to address. Table Providers Finandal 1.1 of Intermediation Services Formalsector Semiformalsector informal sector Centralbank Savings creditcooperatives and Savings associations Banks Multipurpose cooperatives Combinedsavings credit and Commercial banks associations-rotating savings and Merchantbanks Creditunions creditassociations and Savingsbanks variants Ruralbanks Banques populaires Postalsavings banks Informalfinancial firms Laborbanks Cooperative quasi-banks Indigenousbankers Cooperativebanks Financecompanies Employee savings funds Investmentcompanies Development banks State-owned Village banks Nonregistered self-help groups Private Development projects Individual moneylenders Other nonbankinstitutions Commercial Financecompanies Registered self-help groupsand savings clubs Noncommercial Term-lendinginstitutions (friends, neighbors, relatives) Nongovernmental organizations (NGOs) Buildingsocieties creditunions and Tradersand shopkeepers Contractual savings institutions NGOs Pensionfunds Insurancecompanies Markets Stocks Bonds Source: andAgriculture Food Organization 5. 1995,
  28. 28. 14 MICROFINANCE HANDBOOK Box Formal Suppliers Mexico 1.1 Sector inRural IN 1994 AND 1995 A WORLD BANKTEAMCONDUCTED AN As a consequenceof the inefficiencyof rural financial mar- economic and sector study in Mexico to examine the effi- kets, the funds did not flow to the best uses, hindering rural ciency and fairnessof rural financial markets.The team con- development in Mexico. ducted case studies of 96 nonbank lenders,plus a household The study convinced the government of Mexico to ask surveyof 800 rural entrepreneursand a reviewof the regula- the World Bank team to propose measuresthat would help tory framework for the unionesde credito(credit unions) and develop rural financial markets. The first measure proposed the sociedades ahorro prestamo(savingsand loan compa- de y was to expand the distribution network, introduce adequate nies). All forms of formal and informalsavingsand loan ser- financialproducts and technologies,and carry out organiza- viceswere analyzed. tional reforms, including the introduction of incentives and The study provided strong evidenceabout the poor per- internal controls. The second was to improve environmental formance of rural financial markets in Mexico. These mar- conditions by developingbetter policiesand regulationson a kets proved to be shallow (only 45 percent of rural broad range of issues,such as secured transactions and the entrepreneurs receiveda credit transaction during 1992-94), regulation of intermediaries(mostly nonbanks) and of relat- segmented, noncompetitive, inefficient, and inequitable ed markets such as insurance. (showing strong biases against disadvantaged individuals). A pilot operation was designed to set up a network of The consequencewasa weak supplyof credit.The main rea- bank branches in localitiesof fewer than 20,000 inhabitants sons for this situation were underdeveloped institutional in which no formal financial intermediarywas present. The infrastructure (two-thirdsof the municipalitieshave no bank first step was to convince commercial banks that there is a offices),inappropriate banking technologies for small mar- business opportunity in rural financialmarkets.The message kets, and attenuated property rights. Past government inter- was that profitability is possible if five conditions are met. vention characterized by debt forgiveness and subsidized First, banks must have a good understanding of their market interest rates had contributed to the bad image of rural and offer simple financial products, such as deposits with finance. Few bankers from the private sector truly believed short maturities and small minimum balances, as well as there was a business opportunity in this field. On the short-term credit lines. Second, they must keep their fixed demand side, 75 percent of the households interviewed had costs low, with minimum investments and two to four never requested a loan from the formal financial sector. employees.Third, they must lend on the basis of a client's Rural entrepreneurs felt this would be too risky, given the character and reputation. Fourth, they must develop con- excessiveamount of collateral required and the noninstitu- ducive incentive schemes, encouraging profit sharing and tional techniques used to enforcecontracts. Many entrepre- efficiencywages. Finally,their internal control mechanisms neurs admitted that they were afraid of formal institutions must be credible, and there must be a crediblethreat of dis- and that they were unwilling to pay high transaction costs. missalfor nonperformingstaff. Source: Chaves Sanchez and 1997. Existing Microfinance Providers demand, oversupplying, saturating or distorting the market). Microfinance providers are found in both the public and the private sectors. To identify market gaps when THE EFFECT GOVERNMENT OF PROGRAMS PRIVATE ON PRO- providing or considering providing financial services to VIDERS. Depending on their approach, government-run microentrepreneurs, it is important to determine who microfinance programs can either contribute to or be detri- the existing providers are and how well the needs of mental to successful microfinance activities. Governments the market are being met. Donors can determine who that operate subsidized, inefficient microfinance programs is active in microfinance and who might require sup- through health, social services, or other nonfinancial state- port or funding. In areas where there is no microfi- run ministries or departments (or through a state-run bank- nance activity, practitioners can determine who their ing system) negatively influence the provision of sustainable competitors are and the effects they have on the mar- microfinance services (see box 1.2). Governments often ketplace (such as developing awareness, increasing have little or no experience with implementing microfi-
  29. 29. UNDERSTANDING THE COUNTRY CONTEXT 15 Box Do 1.2 Microfinance Need Clients Subsidized Box Credit 1.3 InstitutionsPolitical Debt asa Tool: Interest Rates? Forgiveness inIndia MICROFINANCE CLIENTS TEND TO BORROW THE SAME RuRAL FINANCIAL INSTITUTIONSTHAT AREASSOCIATED WITH amount even if the interest rate increases,indicatingthat, governments often become the target of politicians.The within a certain range, they are not interest rate sensitive. influential clienteleof these institutionsmakesthem particu- In fact, people are often willing to pay higher rates for larlyattractive politicaltargets.India's government-appointed better service. Continuedand reliable accessto credit and Agricultural CreditReviewCommitteereportedin 1989: savingsservices what is most needed. is During the election years,and even at other times, Subsidizedlendingprograms provide a limited volume there is considerable propaganda from political of cheap loans. When these are scarce and desirable,the platforms for postponement of loan recovery or loans tend to be allocated predominantly to a local elite pressure on the credit institutions to grant exten- with the influence to obtain them, bypassing those who sions to avoid or delay the enforcementprocess of need smaller loans (which can usually be obtained com- recovery.In the course of our field visits, it was merciallyonly from informal lenders at far higher interest often reported that politicalfactorswere responsible rates). In addition, there is substantial evidence from for widespread defaults on the ostensible plea of developing countries worldwide that subsidized rural crop failuresin variousregions. credit programs resultin high arrears,generate lossesboth The "willful"defaulters are, in general,socially for the financial institutions administering the programs and politicallyimportantpeoplewhoseexampleoth- and for the government or donor agencies, and depress ers arelikelyto follow;and in the presentdemocratic institutional savingsand, consequently,the development set-up,the credit agencies'bureaucracy reluctant to is of profitable,viable rural financialinstitutions. touch the influentialrural elitewho wield much for- Microfinanceinstitutions that receivesubsidizedfund- mal and informalinfluenceand considerablepower. ing are less likely to effectivelymanage their financial per- Farmers'agitation in many parts of the country can formance, since they have little or no incentive to become take a virulentform, and bannersareput up in many sustainable.Subsidizedinterest rates create excessdemand villagesdeclaring that no bank officershould enter that may result in a form of rationing through private the villagefor loan recoverypurposes.This dampens transactionsbetweenclients and credit officers. the enthusiasmof eventhe conscientious membersof . Source Robinson 1994. the bank staff working in rural areas in recovery efforts.The general climate,therefore,is becoming increasingly hostileto recoveries. nance programs and no incentive to maintain long-term Source: Yaron, Benjamin, Piprek1997,102. and sustainability. Also, government microfinance programs are often perceived as social welfare, as opposed to economic development efforts. Some government programs grow too private sector microfinance organizations and that govern- large, without the necessary institutional base, and fail to ments should not lend funds directly to the poor. Others coordinate efforts with local NGOs or self-help groups. argue that the government should provide financial ser- Governments that forgive existing debts of the poor vices to microentrepreneurs but must do so on a commer- to state banks can have a tremendous effect on private cial basis to provide continued access to microfinance and sector MFIs, whose borrowers may mistakenly under- to avoid distorting the financial markets. Some advan- stand that their loans need not be repaid either. In gen- tages of government involvement include the capacity to eral, both donors and practitioners should determine the disseminate the program widely and obtain political sup- consequences of existing or past credit subsidies or debt port, the ability to address broader policy and regulatory forgiveness (see box 1.3). concerns, and the capacity to obtain a significant amount Much discussion surrounds the involvement of gov- of funds (Stearns and Otero 1990). A good example of a ernment in the provision of microfinance. Some people successfully run government operation is the Bank Rakyat argue that the government's role is to create an enabling Indonesia, a profitable state bank in Indonesia that serves environment for the success of both microenterprises and low-income clients (box 1.4).