Hailey College of Banking & Finance Lahore

Apr 28 - May 11, 2008

History: Microfinance evolved in the 1980s as a development approach that intended to benefit the (active) poor largely as response to the failure of targeted subsidised cheap credit programmes. In such programmes, benefits mainly went to those with connections and influence rather than the target beneficiaries; large loan losses accumulated, and frequent re-capitalisation were required to continue operating, suggesting the need for a new approach. The new approach considers microfinance as an integral part of the financial system, emphasises sustainable institutions operating on market principles to serve the poor (as opposed to subsidised loans to target populations), and recognises the importance of both credit and savings services. On the other hand, a pilot project led by professor Yunus in the late 1970s had demonstrated that the poor can be bankable and that high loan recovery rate can be achieved under non-collateral lending, leading to the establishment of the Grameen Bank (in 1983). Grameen Bank became a highly publicised success story. Governments, donors, NGOs, etc. found both the new approach to finance and MFI/Bs appealing. This led to efforts to establish Grameen-Bank-type institutions, resulting in the proliferation of MFI/Bs. Generally, MFI/Bs focus on the active poor, give emphasis to women, provide group-based lending, and use compulsory savings, joint liability and social sanctions.

Financial viability (also called financial self-sufficiency) refers to the ability to cover both direct costs (i.e. financing costs, loan loss provisions, operating expenses) and indirect costs (i.e. adjusted cost of capital) with operating revenue (i.e. revenue from credit and savings operations and investment)1[8]. Financial viability is essential for MFI/Bs to expand outreach and provide services on sustainable basis. An important determinant of financial viability is risk as it affects both the cost and the revenue side. The major types of risks deposit taking-lending institutions such as MFI/Bs face are credit risk, liquidity risk, reputational risk, operational risk, market risk, interest rate risk, and legal risk.

Regulatory Issues: Currently, MFI/Bs in Pakistan are subjected to restrictions on the size and term of their loans to Rs. 100,000. A single borrower limit is a standard regulatory measure to guard against imprudent behavior by lending financial institutions in general to ensure some degree of diversification in their loan portfolio. It is meant to limit excessive risk taking through excessive exposure to limited number of borrowers (asset portfolio concentration). Micro finance schemes also use small loan size (together with frequent regular compulsory meetings for savings and repayment) as means to induce the better-off to exclude themselves (i.e. encourage self-selection by non-target individuals), who, otherwise, may compete for funds with the poor, especially if the interest rate is low. In this regard the following specific restrictions have been imposed by the State Bank of Pakistan on certain transactions to be undertaken by an MFIB:

The MFB/MFI shall not:

(a) Allow any facility for speculative purposes;

(b) Allow financing facilities and other Microfinance Services to any of its sponsors, directors or employees including their spouses, parents, and children. The rule shall not apply on loans given to employees under staff loan policy of the MFB/MFI;

(c) Without the prior approval in writing of the State Bank, enter into leasing, renting and sale / purchase of any kind with its directors, officers, employees or persons who either individually or in concert with their family members, beneficially own 5% or more of the equity of the MFB/MFI;

(d) Hold, deal or trade in real estate except for use of MFB/MFI itself.

Further in order to protect its deposits from unseen risks the MFI/Bs are required to establish and maintain a Depositors" Protection Fund or scheme for the purpose of mitigating risk of its depositors, to which MFB/MFI shall credit not less than 5% of its annual profit after taxes.

GOVERNANCE : Governance, according to the World Bank (1994), refers to "the manner in which power is exercised in the management of a country's economic and social resources". Breakdown in corporate governance is an important element of operational risk. Such breakdown can cause losses to the institution through fraud or failure to perform in a timely manner or cause its interest to be compromised by its dealers, or its staff conducting business in an unethical or risky manner. Issues like whether MFI/Bs has appropriate governance structure including an effective independent board, whether board members and management have the appropriate mix of professional qualification and relevant experience, and face appropriate incentives are thus important. Taking account of the importance of Corporate Governance the Micro Finance Ordinance 2001 lays down the following provision for Management and Administration of MFI/Bs:

(1) The general superintendence and management of the affairs of a microfinance institution shall vest in its Board of Directors which shall manage its business and affairs in accordance with the principles of good governance.

(2) There shall be a chief executive officer who shall work full time and be responsible for the day-to-day administration of microfinance institution.

(3) The State Bank shall ensure that the persons serving on the Board of Directors and the chief executive officer of a microfinance institution are persons of integrity and have good financial reputation.

CONCLUSION: For the past three decades, micro-finance services in the region have developed greatly both in terms of size and quality. MFI/Bs are characterized by geographic concentration of their portfolio. For some, this is the result of limited financial capacity to diversify while, for the region-based MFI/Bs the problem is more than that. That they are regional institutions puts an inherent limit on their ability to diversify geographically both their loan portfolio and source of funds, hence are exposed to idiosyncratic risks (risks which can be diversified away). There is also high concentration in terms of their source of income (almost exclusively depending on interest income). These need to be resolved as they have negative implications on their financial viability, hence sustainability of their services. Currently, MFI/Bs exclusively focuses on short-term loans. The expressed preference on the part of MFI/Bs for short-term loans and the implication of providing longer term loans on their loanable fund needs and risk means that removal of the 1-year term regulatory limit by itself may not bring material change in this respect. Currently, borrowers "graduate" from the credit services of MFI/Bs prematurely (i.e. before their businesses can attract bank financing) while sustainability (and, arguably, poverty alleviation) requires continued access to finance. It also makes good business and economic sense for MFI/Bs to retain clients with proven record of good repayment by responding to their growing credit requirements until they become attractive to banks.