Final Rating. FAER S.A. Romania. March Previous rating: ---

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1 March 2008 FAER S.A. Romania Final Rating B First rating Previous rating: --- Validity: 1 year if no relevant changes in operations or within the operation context will happen. The final rating grade does not consider the political and economic context. FAER SA has been registered as a Microfinance Commercial Company in December It is owned by FAER Foundation which was created in 1992 by the Suisse International Cooperation and EPER/HEKS (the aid agency of the Swiss Protestant Churches). FAER SA has now applied to become a Non-Bank Financial Institution in compliance with the new Microfinance law which was approved in FAER SA provides rural small-holders mostly with long-term individual loans for working capital and fixed assets. More than 80% of its loan portfolio finances the agricultural sector. FAER SA operates in the provinces of Mures, Bistrita and Suceava, located in the Transylvania Region. Legal Form Joint Stock Company Inception year December 2005 Area of intervention Credit methodology Rural Individual Evolution of loan portfolio quality (EUR) Equity and liabilities - Eur 3,000,000 2,500,000 2,000,000 1,500,000 1,000, ,000 - Dec06 Jun07 Dec07 Equity Short term liabilities Long term liabilities Other liabilities 3,000,000 2,500,000 2,000,000 1,500,000 1,000, ,000 0 Dec06 Jun07 Dec07 5% 4% 3% 2% 1% 0% Gross outstand. portfolio PAR 30 Write-off ratio Restructured portfolio MicroFinanza Rating srl Corso Sempione, Milan Italy Tel: info@microfinanzarating.com CONTACTS FAER S.A. Str. Apelor, 5 Reghin - Romania Tei/Fax: , faer@clicknet.ro

2 FAER Romania March 2008 Strengths Expertise in long-term agricultural lending Market reputation in rural areas Good MIS Joint Stock Company status Opportunities Transformation into a Non-Bank Financial Institution (no legal limitations on loan amount and term and consumer lending) Membership in the European Microfinance Network Access to EU funds and subsidies after membership Final opinion FAER SA relies on a good on-line MIS, on an excellent agricultural loan product and on a strong reputation in the areas of operations. FAER s market positioning as an agricultural specialized microfinance institution brings about potential risks related to the assets concentration in the agricultural sector, lack of products diversification and vulnerable competitive advantages. Main important challenges refer to the high exposure to currency risk and to the currently very thin profitability margins. Furthermore, considering the increasing commercialization of its funding structure, the strengthening of the ALM management tools and procedures is also urgently required. MicroFinanza Rating 2

3 FAER Romania March 2008 FAER s Head Office FAER s branches Growth 120% 100% 80% 60% 40% 20% Active gross portfolio Total assets Active clients (number) Funding liabilities Personnel Equity 0% -20% Dec06 Jun07 Dec07 Other highlights The mother-ngo of FAER SA provides non-financial services (NFS), most of which are linked to the financial services (FS) provided by FAER SA. There exist important synergies which contribute to the successful implementation of the agricultural lending methodology. Nevertheless the relationships between FS and NFS and between the Foundation and the Company should be disclaimed in order to avoid potential conflicts of interest between subsidized NFS and FS provided at commercial interest rates. MicroFinanza Rating 3

4 FAER Romania March 2008 Benchmarking FAER s financial ratios (as of December 2007) that are reported below do not fully correspond to the ratios presented in the report, as they are calculated according to the MicroBanking Bullettin (MBB) methodology 1. The last column refers to OMRO s financial ratios according to the latest rating report carried out by MicroFinanza Rating. FAER s portfolio is quite small compared to all the peer groups that have been taken into consideration for the benchmarking analysis. On the other hand, the average loan balance per borrower / per capita GNI is the highest (91%), after OMRO-Romania. The portfolio quality is quite good (PAR30 worth 1.7%) and comparable to the peer groups of mediumsize MFIs of Eastern Europe and Central Asia (both Financial Self-Sufficient and non-fss) The profitability is negative (AROE worth -7.6%), due to a very low portfolio yield and a low productivity. The operating expense ratio (efficiency) is in line with most of the peer groups of the benchmark. The leverage (debt to equity) seems to be comparable with the other peer groups but FAER debt is partially borrowed by the same owner (FAER Foundation). 1 The MBB adjusts financial data in order to uniform them among MFIs. Adjustments are made for: a) inflation, b) subsidies, c) loan loss provisions (MBB, Annex I: Notes on Adjustments and Statistical Issues). MicroFinanza Rating 4

5 INDEX 1. External Environment and FAER s positioning...6 Institutional background... 6 Context... 6 Banking Sector... 7 Regulation and Supervision... 8 Microfinance Industry... 9 FAER market positioning Governance and operational structure...11 Ownership and Governance Organisation and structure Human Resources (HR) Internal Control and operational risk management Accounting policy and procedures Management Information System Lending operations...14 Financial products Procedures for loan issuing Assets structure and quality...16 Assets structure Portfolio structure Loan portfolio quality Financial structure and ALM...19 Liabilities and equity structure Assets and Liabilities Management Financial and operational results Strategic objectives and financial needs...22 Strategic objectives and evolution Financial needs Details of the risk factors...23 Annex 1 - Financial statements...25 Annex 2 The adjustments to the financial statements...27 Annex 3 - Financial ratios...28 Annex 4 - Definitions...30 Annex 5 - Guidelines of reporting and accounting...31 Annex 6 - Rating Scale...34

6 FAER Romania March 2008 Romania 1. External Environment and FAER s positioning Institutional background FAER (Foundation for the Agricultural Promotion of the Regional Development) 2 was created in 1992 as an Non-Governmental Organisation (NGO) by the Suisse International Cooperation (SIC) and EPER/HEKS (the aid agency of the Swiss Protestant Churches). FAER was established as a NGO implementing projects in the field of agricultural and rural development in favour of rural small-holders living in the provinces of Mures, Bistrita and Suceava, in the Transilvania Region. From the beginning of its operations until 2004, FAER received the support of SIC and EPER/HEKS through the provision of grants, soft loans, specialized technical assistance and training. The microcredit program with the current individual agricultural lending methodology started in 1999, following 2 years of unsuccessful experience gained with associative loans (to farmers associations). FAER SA completely spun off from the FAER Foundation 3 registering as a Microfinance Commercial Company 4 in December FAER SA has now applied to become a Non-Bank Financial Institution in compliance with the new Microfinance law approved in Context Over the last 5 years, after a long period of economic crises related to the collapse of the soviet system, Romania has experienced a very strong economic growth. Thanks to the macroeconomic policies, which the Government adopted starting from the year 2000, the main economic indicators improved significantly, and the country joined the European Union in January Sovereign risk 5 Foreign currency Short term Long term Domestic currency Long term Rating Outlook MOODY'S n.a. Baa3 Baa3 Stable S&P A-3 BBB- BBB Negative Fitch F3 BBB BBB+ Negative Disciplined fiscal and tight monetary policies as well as several structural reforms helped to improve the enterprise sector and placed public finances and the financial system on a much steady position. Romania s economy is marked by strong economic growth (GDP growth rate worth 7.9% in 2006 and estimated 6.0% in 2007). Forecasts for 2008 indicate a 6% growth, fuelled by a rapid increase of government spending (in view of the 2008 local and parliamentary elections) and a fast-growing level of wages. Real GDP growth is expected to slow to 5% in 2009 as fiscal and income policies are tightened following the elections 6. 2 In Rumanian: Fundatia pentru promovarea Agriculturii si a Economiei Regionale. 3 The FAER Foundation provides farmers with Business Development Services (technical information and training) and carries out social projects supporting rural schools and disadvantaged people. The Foundation, which employs just one permanent staff, relies on external consultants and providers. 4 The spin-off process started in June 2005 in compliance with the new Romanian Microfinance Commercial Companies Law, which was adopted by the Romanian Parliament in the same month (n.240/2005). 5 Scales used: MOODY'S: Long term - AAA, AA1, AA2, AA3, A1, A2, A3, Baa1, Baa2, Baa3 (Investment grade), Ba1, Ba2, Ba3, B1, B2, B3, Caa, Ca, C (Speculative grade); Short term - Prime-1, Prime-2, Prime-3 (Investment grade); Not Prime (Speculative grade); S&P: Long term - AAA, AA, A, BBB (Investment Grade); BB, B, CCC, CC (Speculative grade); SD (Selective Default); D (Default) - Rating from AA to CCC may be modified by a + or -; Short term - A-1(+), A- 2, A-3 (Investment Grade); B, C (Speculative Grade); SD (Selective Default); D (Default) Fitch: Long term - AAA, AA, A, BBB (Investment Grade); BB, B, CCC, CC, C (Speculative grade); DDD, DD, D (Default) - Rating from AA to CCC may be modified by a + or -; Short term: F1, F2, F3 (Investment grade); B, C (Speculative grade); D (Default). 6 Economist Intelligence Unit forecasts, Romania Report, April MicroFinanza Rating 6

7 FAER Romania March 2008 From 2002 to 2006, the inflation rate progressively diminished. Year-end inflation rate was 4.9% in 2006 but it increased to 6.6% in 2007 and inflationary pressures are expected to remain strong throughout 2008 (7.5%) and in 2009 (4.5%) 7. Large foreign-exchange inflows, encouraged by liberalisation of the capital account and a generally positive view of Romania s prospects, underpinned a rapid nominal appreciation of the domestic currency in The Leu appreciated sharply against both the euro and the US dollar until early July 2007, but depreciated by 19% against the euro between early July 2007 and end- January 2008, partly as a result of global financial market turmoil and partly owing to growing worries about Romania s macroeconomic fundamentals 8. The annual consolidated budget deficit could exceed 3% of GDP in 2008, despite the March budget revision, as forthcoming local and parliamentary elections see government spending rise steeply. Lax fiscal and wages policies will fuel domestic demand, but Leu depreciation should help to contain the current-account deficit at around 15% of GDP in Conflicts between the prime minister and the president, as well as between the ruling National Liberal Party (NLP) and the opposition Democratic Liberal Party (DLP), will underpin continued political discord. The minority government will remain under pressure to make policy concessions to the Social Democratic Party (SDP) on which it relies for a parliamentary majority with negative macroeconomic consequences. Finally, despite robust economic growth over the past five years, important challenges remain for Romania. Additional structural reforms are crucial for building a competitive market economy capable of withstanding the pressures of EU integration. Moreover, poverty persists in the country, with over 15 percent of the population living below the poverty line. Two-thirds of Romania's poor live in rural areas despite the country's substantial potential in agriculture, forestry, and fisheries. Following Romania s EU membership, large amounts of subsidies ( 8 billion) are expected to flow into the Romanian agricultural sector in the next years. The NBFIs could be engaged, starting from year 2010, into the subsidies delivery mechanism. Commercial banks are currently distributing the first subsidies into the rural areas already, taking the opportunity to displace NBFIs like FAER from their traditional market. Banking Sector Although Romania has made impressive progress in reforming its banking sector, the banking system s efficiency still lags that of developed market economies, highlighting the necessity to press forward with reforms, especially considering country s EU membership. In particular, the privatization of state-owned banks needs to be carried out in order to increase the 7 Ibid. 8 Ibid. MicroFinanza Rating 7

8 FAER Romania March 2008 efficiency of financial intermediation. With foreign banks already dominant position expected to rise further and markets becoming increasingly saturated, fiercer competition among banks is expected to trigger a further wave of consolidation via mergers and acquisitions, which bodes well for further efficiency gains. Nevertheless, the future of Romania s banking sector cannot be viewed in isolation from the progress made in restructuring the enterprise sector. There are already indications that corporate restructuring is gathering momentum (e. g. energy sector), which in turn should have a positive impact on the banking sector s future development. The degree of financial intermediation remains low, despite an impressive revival of lending in recent years, as low-risk forms of investment (e. g. securities) have become increasingly unattractive for the banks. This shift in activities signals increasing confidence, both on the part of the population as well as the banks. In light of the credit boom in recent years and the economy s strong dynamic, the most important challenge for Romania s banking system is to deepen financial intermediation while maintaining the banking sector s soundness, particularly with regard to credit and foreign currency risk. Given Romania s accession to the EU in 2007, farreaching progress has been achieved in harmonizing Romania s banking legislation with international standards. Nevertheless, further alignment of legal regulations would appear to be on the agenda, not only with respect to EU standards, but also to Basel II. Regulation and Supervision After 10 years of legal vacuum and thanks to the lobbying activities of the World Bank, USAID and the Microfinance Coalition 9, the Romanian Parliament adopted in July 2005 a law (n.240/2005) regarding Micro Financing Commercial Companies (MFCCs). All MFCCs have to transform into a Joint Stock Commercial Company with a wider base of shareholders. The main provisions introduced by the law can be summarized as it follows: - MFCCs are not allowed to accept deposits or other repayable funds from the general public; - EUR 200,000 minimum capital requirement; - maximum loan size worth EUR 25,000 and maximum loan maturity of 60 months; - microfinance companies are not allowed to issue consumer loans; - provisions are deductible for microfinance companies; In January 2006 a second law regulating Non-Bank Financial Institutions (NBFIs) was issued, requiring MFIs to register under this form and to submit to the National Bank of Romania s supervisory authority. The National Bank has been designing specific prudential norms and monitoring activities for the microfinance sector, bringing MFIs supervision closer to the one applied to banks. According to the NBFIs law (2006), the main changes are the following ones: - EUR 200,000 minimum capital requirement; here, the National Bank of Romania is entitled to set differentiated levels of minimum share capital in terms of the type of activity of the non-bank financial institutions; - There are no limitations on the minimum or maximum loan size/loan maturity; - NBFIs may perform more lending activities than MFCCs. Such activities include consumer credits, mortgage credits, factoring, discount, financial leasing, pledging via pawnshops, etc. The overall legal framework has been supportive for the growth of the microfinance sector and the increase in the offer of different and new products; also, it has helped to improve consumer protection and transparency of operations by requiring to make available to the interested parties all the necessary information regarding offered terms and conditions. FAER, which is still registered as a MFCC, faces limitations with regard to the maximum loan amount and term and prohibition to issue consumer loans. The application to be registered 9 The Microfinance Coalition is one of the components of the Enterprise Development and Strengthening Program, financed by the United Stated Agency for International Development (USAID), designed to improve the legal and regulatory environment for microfinance institutions, creating the conditions for the growth of a healthy microfinance industry in Romania. MicroFinanza Rating 8

9 FAER Romania March 2008 as a NBFI has already been presented but the governmental authorization has not been received yet. Microfinance Industry Microfinance demand is very strong in Romania: a study of the EBRD estimates the aggregate demand over EUR 500m, leaving a large uncovered demand for microfinance providers. Potential microfinance borrowers are especially concentrated in Transylvania ( potential borrowers) and in Bucharest 10. Microfinance services, which well-suit the need of low income entrepreneurs, are considered to be crucial in stimulating the entrepreneurial culture in Romania. The sources of funds and support available are mainly international, with EBRD and the EU playing a primary role. The microfinance supply is mainly coming from Non Bank Financial Institutions (NBFIs) and banks. The interest shown by banks in the microfinance sector is currently limited, even if it is increasing; some overlaps with the NBFIs market are starting to appear (e.g. Sogebank is opening up info point-branches promoting its products in the rural areas). Besides traditional banks, it is worth mentioning ProCredit bank that is specialized in microfinance service delivery. Beside banks 11, there are currently 21 microfinance institutions, registered or in the process of registering under the NBFIs law 12. Overall, the microfinance sector is growing rapidly in Romania: the NBFIs operating in the field of microfinance (NBFIs MFIs) registered a total increase in their loan portfolio and in the number of active borrowers respectively worth 50% and 25% in Even if still limited, especially in rural areas, the level of competition is growing alongside with the growth of the sector. Indeed, rural areas of Romania are characterized by a very limited access to financial services, due to a lower credit culture, higher risk and higher delivery costs. Moreover, the lending technology that is applied to clients living in urban centres cannot easily be replicated in rural areas, requiring therefore specific adaptation. Individual lending is more commonly applied than group methodology. Among the main NBFIs/ MFIs it is worth mentioning OMRO, CAPA Finance, Express Finance, LAM PLC, FAER, RomCom and Integra ROM, with a consolidated portfolio of over EUR 40 M and about 12,000 active borrowers as of June There are three Credit Bureaus in Romania to date: one including 25 commercial banks (mainly retail banks) and two established by the National Bank of Romania (NBR). NBFIs are required to participate to a NBR Credit Bureau and to join a register of financial institutions 13. Regardless the provision contained into the new Law, which allows MFIs to join the banking Credit Bureau, the access to it and the overall exchange of information even informally - is basically inexistent. Concerns towards the risk of over-indebtedness are further amplified when considering the increasing competition coming from banks. A part the Microfinance Coalition, an entity funded by the World Bank and USAID and that has been built up only for legal lobbying, there is no formal MFI s Association. This in turn, causes negative consequences in terms of loss of opportunities to further develop: external training, access to technical assistance, and exchange of best practices and experiences. 10 OSI, Policy Monitor, Nr 7 May Many commercial banks are implementing SME lending programs mainly funded by EBRD. 12 The only exception is represented by the NGO CDE (Foundation). 13 Common register for MFIs with total assets<us$ 17.4M and loan portfolio<us$ 8.7M and a special register for larger MFIs. MicroFinanza Rating 9

10 FAER Romania March 2008 FAER market positioning FAER provides rural micro-entrepreneurs and small-size farms with long-term loans for working capital and fixed assets. Its four branches operate in the provinces of Mures, Bistrita and Suceava, all located in the Transylvanian region. The most important competitors of FAER are CAPA Finance, OMRO and ProCredit. All of them are already either operating or entering the same regions covered by FAER, which is thus facing a growing and stronger competition especially in some rural areas like Mures and Bistrita. Competitors are getting increasingly aggressive also in terms of services and conditions offered and borrowers are benefiting from the supply of products differentiation and loan sizes that are bigger than those that FAER can currently provide. Nevertheless, as of now, FAER still maintains a very good positioning in rural areas and agricultural lending. Its main comparative advantages are related to the offered agricultural loan conditions (such as the flexible grace period) and methodology (which include FAER Foundation indirectly carrying out training activities to the farmers). A friendlier customer approach and a strong reputation built in the rural areas are the other important advantages. Main disadvantages of FAER are related to the smaller dimensions and branches network, lower access to funding, low portfolio diversification, and its current legal limitations regarding the maximum loan amount and term that it can provide. As for this last two constraints, by law FAER is not allowed to issue loans that are bigger than 25,000 and for a period exceeding 5 years. Main competitors are growing faster than FAER and they are expanding throughout the territory (including in the rural areas), also thanks to a greater and cheaper access to funding and to specialized technical assistance. As mentioned above, commercial banks started issuing SME loans and some of them show some interest in further downscaling their lending operations 14. FAER has recently contracted a microfinance market study which provides the management with useful and up-dated information regarding its competitors. Nevertheless, a regular monitoring of the market and competitors products and conditions is lacking. 14 Some examples are related to the state-owned CEC bank (which could be soon privatized and sold to Rabobank), the BRD Bank (Societe Generale), the Raiffeisen Bank, etc. While active in SME lending, it is not clear yet how much and how deep these commercial banks will enter the microfinance market. MicroFinanza Rating 10

11 FAER Romania April 2008 Chapter 2 2. Governance and operational structure Ownership and Governance Since December 2005 FAER SA is owned by FAER Foundation (99.977% 15 ), a Romanian not for profit organization that implements development projects locally and in favour of small and medium-size farmers. Before December 2005 the microcredit program was implemented directly by the Foundation. The spin-off process started in June 2005 in compliance with the new Romanian Microfinance Commercial Companies Law. However, in order to conclude the process of spin-off FAER SA s Board of Directors (BoD) still needs to be completely separated from FAER Foundation s Board. The two Boards share indeed the Chairman. FAER BoD has already planned to appoint a new Chairman, who should have specific knowledge and expertise in the field of banking and microfinance. Furthermore, written procedures on the principles and rules regulating the relationships (missions, fund-raising, staff sharing, synergies between activities) between the company and the foundation are missing too. On the one hand, FAER Foundation s training and farmerssupporting activities help FAER SA to increase its level of outreach and clients retention rate. Most beneficiaries of the Foundation s activities, in fact, are FAER SA s potential clientele and some of them are active clients. On the other hand, the Foundation annual budget rely exclusively on the Company, which pay an yearly on yearly interest rate (worth 4% for ) on the loan ( 1.25m) borrowed from the Foundation. FAER SA s BoD is composed of 5 members who meet once a month on a voluntary basis 17. The governance structure and functioning are adequate to the current dimensions and needs of the institution. The BoD members are quite acknowledged professionals in the agricultural sector (which is relevant for FAER mission and current operations) and some professional skills in the field of banking financial management occur. Nevertheless, specific competence in microfinance is still lacking, undermining the effective capacity of the BoD to provide a solid guidance and supervision of the management. The communication between the Chairman and the management seems to be fluent and constant. 15 FAER SA s management owns the remaining shares (0.023%). 16 It was 3% in 2007 and 2% in MicroFinanza Rating 11

12 FAER Romania April 2008 Chapter 2 Organisation and structure FAER is characterized by a centralized organization in terms of accounting and administrative function, while some decentralization has been set up in terms of credit approval authority. Branches are allowed to approve loans up to 5,000 (71% of the average disbursed loan). General Assembly Board of Directors Internal Auditor CEO Financial Manager Secretary REGHIN OFFICE Loan Officers IERNUT OFFICE Loan Officer Adm. Assistant MOLDOVENESC OFFICE Loan Officer Adm. Assistant BISTRITA OFFICE Loan Officer Human Resources (HR) As of December 2007, FAER personnel is composed of 9 people, 4 out of which are loan officers, showing a good staff allocation ratio (44%). Top management includes the CEO and the Financial Manager. The CEO, Mr. Personnel Dec06 Jun07 Dec07 Total Loan officers Other staff Ioan Vlasa, is also in charge of other relevant functions such as the credit management, the HR management and the fund-raising function. The latter strategic function will likely require additional efforts and specific skills. Even though the top management structure fits the current institutional needs, any future growth would require the appointment of an additional top management position. At the branch level, the manager position has not been fulfilled yet. The salary level offered at FAER is quite in line with comparable NBFIs and a bonus system for the staff working in the branches has also been introduced in Although staff turnover has been maintained under controlled (10% in 2006 and 11% in 2007) so far, the growing competition characterizing the microfinance industry and the banking sector should be accurately monitored in order to mitigate the risk of loosing high-skilled staff. The budget that has been allocated so far for the training of its staff is rather limited compared to the large training needs of the organization. Within the field staff in particular, the capacity to offer and sale the products in a more and more competitive market is insufficient. Neither staff assessment nor training needs assessment have been undertaken so far. The HR management function therefore, is improvable. 17 Each member benefits only a per-diem worth 30. MicroFinanza Rating 12

13 FAER Romania April 2008 Chapter 2 Internal Control and operational risk management FAER s exposure to operational risk is not high because a) the on-line connection existing among branches, b) the centralized accounting, c) the use of bank accounts 18 for loan disbursements, and d) the bank services for loan repayments 19 mitigate the risk related to potential mistakes, frauds and assaults. As for Internal Auditing, FAER contracted the services of an external firm (previously in charge of the external audit). An annual plan exists but it focuses mostly on the accomplishment to the legal and fiscal relevant regulation and collaterals documentation as well as bookkeeping. Even though each branch is visited each quarter, the internal audit function does not seem to be tailored to the specific needs of a microfinance institution like FAER SA. For instance, no visits to the clients have been carried out so far; random cash checks at branch level are not conducted. The Internal Auditor reports to the management and the BoD on a quarterly basis. The formalization of written internal procedures should be enhanced. Only two manuals have been prepared so far: the MIS Manual and the Credit Manual; the latter one however is not updated (for instance, in terms of loan approval authority). Given the current operations, FAER still lacks of a complete HR Manual 20 and an Internal Control Manual as well. Accounting policy and procedures FAER S.A. financial statements for the last two fiscal years were audited by local companies and were found to present a true and fair view of the financial position of FAER S.A. Following the requirements of the National Bank of Romania, the financial statements do not fully comply with the International Accounting Standards (IAS). Some improvement in this direction have been remarked for Management Information System FAER invested in a new on-line MIS in The loan tracking module and the accounting module are integrated. All branches operate on-line. The central, unique data base is implemented on a dedicated data base server by using the free-of-charge version of the Microsoft SQL Server 2005, version SQL Express. Nevertheless its reporting capacity is still under-developed in terms of breakdown information per loan product/loan size/collateral type and in terms of summary management reports with relevant performance ratios. The implementing firm is currently in charge of the reporting capacity enhancement and MIS maintenance. Some new automatic reports will be ready at the end of the first semester of Back-ups and security processes are adequate to the current institutional size and operations. 18 FAER clients are required to open a bank account. 19 Approximately 10% of total loan repayments are accepted in cash directly by FAER, without any bank intermediation. 20 Job descriptions are however utilized. MicroFinanza Rating 13

14 FAER Romania March 2008 Chapter 3 3. Lending operations Financial products FAER S.A. provides only individual loans. The main target is represented by farmers. Free professionals and small enterprises operating in the rural areas of Mures, Bistrita and Suceava are also targeted by FAER SA. Its credit products finance mostly fixed assets and investments related to agricultural buildings, animal breeding, agricultural mechanization and non-agricultural investments. To a limited extent, operation loans for short term working capital is also provided. According to the Law for MFCCs, the maximum loan maturity is 60 months (12 months for operation loans) and the maximum amount is 25,000. The grace period is up to 9 months (11 months for the operation loans which finance mostly cash crops). Principal loan repayments and interest rate are paid on a monthly basis. The interest rate will suffer soon a slight increase after the BoD approval in March Additionally to the fees shown in the table, FAER SA s clients are required to open a bank account and they pay a 0.5% to the bank to withdraw the approved loan amount. Instead, no fees are charged for repayments. MicroFinanza Rating 14

15 FAER Romania March 2008 Chapter 3 As the main differences among existing products regard the specific destination of each loan, the supply of financial products is not much diversified compared to some other competitors. The introduction of consumer loans however will take place as soon as FAER obtains the governmental authorization to operate as a Non-Bank Financial Institution. The new product has already been designed according to the characteristics of the consumer loan products which are already provided by LAM (which shares with FAER common origins and donors). Procedures for loan issuing FAER s loan officers conduct regular assessments on clients and prepare loan application forms in accordance with best practices and including incomes and expenses of the business and the family. The evaluation of the applicants capacity of repayment is also accompanied by a monthly cash flow exercise along one representative year. In general, the loan disbursement period ranges from 4 days up to 10 days, depending on weather the applicant is an old or a first time client. Decisions for loans < 5,000 can be taken by the loan officer, while loans > 5,000 need to be approved by the Credit Committee, composed by the Loan Officer and the Financial Manager. The follow-up of delinquent loans seems to be adequate, based on close monitoring of late clients carried out by the loan officer. Old good clients do not receive any advantage or incentive regarding their access to loans. On the contrary, FAER is in the process to slightly increase its costs of lending services. In a competitive environment, such a measure could generate high clients drop-out. MicroFinanza Rating 15

16 FAER Romania March 2008 Chapter 4 Assets structure Along the year 2007, the net portfolio has represented on average about 90.4% of total assets, which is an adequate concentration of resources into the core business of the institution 21. Yearly on yearly average liquidity (cash and banks) is worth 8% in 2007 (it is 4.7% as of December 2007), slightly above a sound level for a non-deposit-taking microfinance institution. 4. Assets structure and quality Asset composition - December % Portfolio structure FAER s loan portfolio is 100% composed of individual loans. In 2007 the growth has been substantial (32% in local currency) in terms of gross outstanding portfolio. Along the same year on the contrary, the growth in terms of active borrowers has resulted much less important (7.6%) 22. About 80 % of the gross outstanding portfolio finance agricultural investments (buildings, mechanization, animal breeding and other agricultural investments) in the medium term (3 years on average). By including also the operation loans (financing the agricultural sector as well), the concentration in the agricultural sector is quite high (81.8% as of December 2007), thus generating the exposure of the institution to the co-variance risk. The trends shown by the loan portfolio breakdown by product indicate however a slight increase of the non-agricultural investments product during % Cash and Banks Net Fixed Assets Other Assets 0.5% 0.3% 4.7% Net Portfolio Accrued interest Even though the percentage of women on total clients has slightly increased from 4.6% to 11.2% during 2007, women clients share remain quite low. The average disbursed loan size on per capita GDP shows an upward trend and reaches 139% as of December The comparison with other MFIs operating in Romania should however take into consideration the longer average loan term 21 As of December 2007, FAER s net portfolio represents 92.6% of total assets, as shown in the graph. 22 Confirmed by the slight increase of the average disbursed loan from Eur 6,093 to Eur 7,054. MicroFinanza Rating 16

17 FAER Romania March 2008 Chapter 4 (and consequent higher loan amount) disbursed by FAER. FAER main target is indeed represented by low income farmers. FAER does not monitor the clients drop-out ratio. It has been noted that some old good clients recently moved to competitors because FAER cannot issue loans above 25,000. The reasons behind the drop-out of good clients should be carefully and systematically analyzed. Loan portfolio quality Portfolio quality is satisfactory. A remarkable improvement has been clearly achieved along the year Loan restructuring, although allowed and regulated by FAER, is not commonly practiced (0.2% as of dec-06 and 0.3% as of dec-07). The write-off ratio also has been kept under control (0% as of dec-07). The setting up of the new MIS and the fine-tuning of the lending procedures have notably contributed to these positive trends. PAR30 quarterly analysis shows clearly the positive trend from Mar- 06 up to Dec-07, while a slight increase (up to 2.4%) has been registered as of Mar-08. Although the risk coverage ratio (>30 days) as of dec-07 has increased on yearly basis (from 48.9% as of Dec-06 to 59.6%), it remains under the international best practices (100%). Nevertheless a portion of the PAR30 is backed by real collaterals which are systematically required for all loans bigger than 5, ,000,000 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 - mar-06 Jun06 Sep06 Portfolio quality Dec06 mar-07 Jun07 Sep07 Dec07 mar-08 FAER SA is currently managing FAER Foundation s loan portfolio, which is mostly (97% of the total) represented by loans in the Courts. As of dec-07 the Foundation loan portfolio is worth EUR 189,893 with 58 loans. In local currency it diminished by 21.5% in one year. This loan portfolio administration carried out by FAER does not represent any additional burdensome work for the FAER SA staff. 8% 7% 6% 5% 4% 3% 2% 1% 0% Outstanding portfolio PAR 30 (amount) PAR 30 (%) MicroFinanza Rating 17

18 FAER Romania March 2008 Chapter 4 The analysis of portfolio quality by branch shows a substantial equilibrium among the three main branches (Reghin, Iernut and C. Lung Moldovenesc), while the Bistrita branch was opened only at the end of The portfolio at risk distribution is also equilibrated, with the exception of the newest branch, whose PAR30 is worth 6% as of dec-07. The breakdown analysis by loan products highlights that the animal breeding product (27% of total portfolio) suffers from an higher value of the PAR30 and PAR1 ratios. The operations loan product s performance should also be checked. MicroFinanza Rating 18

19 FAER Romania March 2008 Chapter 5 As of December 2007, the debt to equity ratio is worth 2.9. This ratio would decrease to 0.5 if the loan from FAER Foundation (the owner of FAER SA) was alternatively put into the equity of FAER company. According to our opinion, the second value gives a more correct understanding of the institutional capacity to leverage its equity with external funds. An increase in the debt to equity ratio is however expected, as its planned growth will be almost exclusively financed by debt. 5. Financial structure and ALM 3,000,000 2,500,000 2,000,000 1,500,000 1,000, ,000 Long term liabilities Other liabilities Liabilities and equity structure The major current limitation which could hamper the growth in the first semester of 2008 is the shortage of funds. FAER is not allowed to collect public savings, so its funding liabilities are represented only by external Liabilities composition - December % 5% Short term loans Other short term liabilities 13% Long term loans borrowings. These are mostly (82%) long term liabilities, at yearly interest rates ranging from 0% to 8.5% in CHF (Swiss Franc) and from 0% to 4% in EUR, below the international commercial rates. 56% of total borrowings are represented by the loan borrowed from FAER Foundation whereas 35% by loans borrowed from Hekz-Dezza (Swiss cooperation). Most loans therefore stem from the network of the founder and the donor which financed FAER in its start-up stage. Thus FAER SA could face some difficulties, in terms of reporting capacity, once the access to new commercial borrowings starts. - Equity Equity and liabilities - Eur Dec06 Jun07 Dec07 Short term liabilities As of December 2007, total equity is worth EUR 675,375. The largest share (89%), represented by paid-in capital by FAER Foundation, is almost exclusively represented by accumulated donated equity since the origins of FAER Foundation. The retained earnings of previous years are worth only 2% while in 2007 FAER produced a net profit which represents 9% of total equity. The equity-related capitalization strategy is based essentially on the accumulation of positive net incomes. Equity - December % 2% 89% Paid-in capital Net income, previous years Net income, current year Assets and Liabilities Management The current ratio is high (3.1 as of December 2007). Even though the loan portfolio is mostly (66%) long term, the funding liabilities, as already mentioned, are mostly long-term. FAER is not exposed so far to any maturity mismatch risk. The expected increasing access to commercial MicroFinanza Rating 19

20 FAER Romania March 2008 Chapter 5 borrowings on the other hand will likely reduce the average borrowings term. FAER will be thus be forced to reduce the average loan portfolio term. The plan to introduce the short term consumer loans would permit the institution to match the expected reduction of the liabilities average term. While 60% of total assets are denominated in EUR and almost 40% in local currency, liabilities are denominated in EUR, local currency and the Swiss currency (CHF). The net position in EUR is positive and worth 46.8% of total equity and the CHF net position is negative and worth 90.5% of total equity 23. Therefore, FAER is highly vulnerable to the currency risk. Given the long average loan term in the asset side (3 years), an appreciation of CHF (against the local currency and EUR) for instance could provoke large exchange rate losses 24. The option to choose between EUR or RON denominated loans is moreover left to the clients. No hedging measures have been undertaken so far. On the other hand, FAER does not present exposure to the interest rate risk, because the interest rate associated with the funding liabilities is fixed, while the active interest rate could be changed by FAER during the loan period (long average loan term). The liquidity management tools used by the institution are improvable in terms of projected cashflows statements. Considering the increasing commercialization of the funding liabilities structure of FAER, the strengthening of the ALM management and monitoring tools and procedures is required. 23 The total net position (4 currencies) is equivalent to 181% on total equity and 46% on total assets. 24 FAER suffered important losses from exchange rate during the first quarter of MicroFinanza Rating 20

21 FAER Romania March 2008 Chapter 6 6. Financial and operational results Profitability and sustainability have not been achieved yet. The trend analysis 90% shows some improvements, especially in the 80% profitability ratios. As of dec-07 ROE is 70% worth 10.1% and ROA 2.5%. The 60% adjustments, especially those ones related 50% to the subsidized cost of funds (see annex 40% 2), substantially reduce the adjusted ratios 30% of profitability which assume negative 20% values: AROE worth -15.4% and AROA - 10% 3.1%. 0% The great impact of adjustment is also visible in terms of sustainability ratios. While OSS is worth 130.8%, FSS is only 82.4%. The trend is clearly positive for the OSS, not for FSS (due to different adjustment values along the periods under analysis). Profitability and sustainability Dec06 Jun07 Dec07 The portfolio yield has increased sharply from 2006 to 2007 and will likely follow an upward trend along the next year, because FAER has also decided to increase the nominal interest rate to be charged on loans. On the one hand, the efficiency is quite good and the operational expense ratio has been successfully maintained low (8.3% in 2007), mainly thanks to individual long-term lending methodology. LOs productivity and staff productivity (measured in terms of number of active borrowers), on the other hand, are not satisfactory and leaves room for improvements and gains from economies of scale. The financial expense ratio has been maintained quite low because most of the loans borrowed by FAER SA are soft loans. This ratio will increase soon because of the growing leverage and the increasing access to commercial borrowing 25. The margin for FAER is very limited and under pressure. Considering that the provision expense ratio has been maintained at very low levels, especially in 2007 (-0.6%), FAER is facing an important challenge regarding its sustainability and profitability. Other than the increase of the portfolio yield, a more aggressive growth strategy is hence needed to gain economies of scale. 20% 10% 0% -10% -20% -30% -40% -50% FSS ROE AROE AROA 25 Hekz-Dezza is gradually substituting all its loans to AFER SA by jumping from a subsidized 4% up to 8.5% in CHF on yearly basis. MicroFinanza Rating 21

22 FAER Romania March 2008 Annex 1 7. Strategic objectives and financial needs Strategic objectives and evolution FAER has commissioned the elaboration of its first Business Plan (BP) to a recognized external consultancy firm (LFS). A first draft of the BP is expected to be available by May As a consequence, the following projections are based on data and information provided by the management staff of FAER before the finalisation of the BP s document. FAER SA plans to increase the gross outstanding portfolio up to RON 13,500,000 by dec-09 with a yearly on yearly growth rate of around 21% by the end of 2008 and 25% by the end of Also, by the end of 2009, FAER foresees to reach around 750 active clients (+15% in 2008, +20% in ,000,000 16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 Financial projections of FAER (in RON) Gross outstanding portfolio Total assets External debt Equity A new branch will be opened in the city of Medias (Sibiu county) in Four more LOs will be recruited by the end of 2009 for the new branch and to reinforce the Bistrita branch, which has been opened at the end of The main strategy to face the growing competition mainly relies on the strengthening of FAER Sa positioning in the agricultural lending market and the cross-selling of additional products (consumer and housing loans) in the rural areas, where competition, coming from Microfinance Institutions like Procredit, OMRO, and some down-scaling commercial banks, is not too strong yet. FAER is also assessing and deciding on the proper measures to adopt in order to get advantage from the large incoming subsidies ( EU Structural Funds) for the Romanian agricultural sector. Starting from 2010, FAER would have indeed the opportunity to accede additional EU recapitalisation funding. During this period ( ) FAER s strategic objectives include also investing in training of its personnel and exchanging experiences with other MFIs working in the region. Last but not least, FAER is exploring the opportunity to merge with LAM, an MFI working in different areas of Transylvania, whose origins, mission, size, type of products, and clients are similar to those of FAER. LAM and FAER have the same Management Information System too. Any systematic feasibility study has not been carried out so far. Financial needs Since the start-up of its operations, FAER has mainly relied on subsidized funding coming from HEKS-DEZZA ( ) and FAER Foundation. FAER s financial needs for 2008 are worth about 600,000. A loan agreement worth 600,000 is under negotiation with CoopEst from Belgium. Some additional negotiations have then been undertaken with GLS Bank for the end of 2008 and the European Fund for South-East Europe (EFSE) for MicroFinanza Rating 22

23 FAER Romania March 2008 Annex 1 8. Details of the risk factors According to our analysis, the main risk factors of FAER are the following ones: MicroFinanza Rating 23

24 FAER Romania March 2008 Annex 1 MicroFinanza Rating 24

25 FAER Romania March 2008 Annex 1 Annex 1 - Financial statements MicroFinanza Rating 25

26 FAER Romania March 2008 Annex 1 MicroFinanza Rating 26

27 FAER Romania March 2008 Annex 2 Annex 2 The adjustments to the financial statements The financial statements in Annex 1 are the result of standard reclassification. They are based on the audited financial statements, except for the period Jul06-Jun07. Financial statements have been then adjusted to allow a comparison with other institutions which use a different logic of presentation of the information and to evaluate the level of sustainability of the institution at market conditions and prices. The main adjustments normally are: adjustment for the accrued interest on delinquent loans > 90 days elimination of subsidies (donations in kind 26 and soft loans 27 ) provisions are calculated with a standard formula 28 adjustments for inflation adjustments for write-offs The most important adjustment, especially in the last period, is represented by the subsidized cost of fund. The inflation erosion of FAER own capital is also important. The loan loss reserve has also been adjusted. Small adjustments have been also calculated because FAER accrues interests on loans that are late more than 90 days. Lastly, FAER received an in-kind subsidy related to an external TA consultancy for business planning Donations in kind are valorized and added to operational expenses. 27 In the income statement it is registered the value of the difference between financial costs of the institutions and financial cost evaluated at the market rate. In particular, in the case of loans in local currency, it is considered 75% of the average lending rate in the national market (IFS Line 60P). In the case of loans denominated in foreign currencies (US$ and Euro), it is considered the average value of LIBOR 1 year plus 3%. 28 Provisions are calculated according to the following formula: Portfolio: 1-30 days 10% Restructured loans 0-30 days 50% days 30% > 1 day 100% days 50% >90 days 100% 29 It represents only the portion for 2007 of the total subsidy. MicroFinanza Rating 27

28 FAER Romania March 2008 Annex 3 Annex 3 - Financial ratios MicroFinanza Rating 28

29 FAER Romania March 2008 Annex 3 MicroFinanza Rating 29

30 FAER Romania March 2008 Annex 4 Annex 4 - Definitions Profitability Description of the ratio Return on equity (ROE) Adjusted return on equity (AROE) Return on assets (ROA) Adjusted return on assets (AROA) Operational self-sufficiency (OSS) Financial self-sufficiency (FSS) Profit margin Formula Net income before donations / Average equity Adjusted net income before donations / Average equity Net income before donations / Average assets Adjusted net income before donations / Average assets (Financial revenue + Other operating revenue) / (Financial expenses + Loan loss provision expenses + Operating expenses). (Adjusted financial revenue + Other operating revenue) / (Adjusted financial expenses + Adjusted loan loss provision expenses + Adjusted operating expenses) Net operating income / operating revenue Portfolio quality Portfolio at Risk (PAR30) Provision expense ratio Loan loss reserve ratio Risk coverage ratio (>30 days) Write-off ratio Portfolio at Risk > 30/ Average gross portfolio Loan loss provision expenses / Average gross portfolio Accumulated reserve / Gross portfolio Accumulated reserve / Portfolio at risk >30 days Write-off of loans / Average gross portfolio Efficiency and productivity Financial management Staff allocation ratio Loan officer productivity Borrowers Loan officer productivity Amount Staff productivity Borrowers Staff productivity Amount Operating expenses ratio Cost per borrower Administrative expenses ratio Personnel expenses ratio Portfolio yield Funding expense ratio Cost of funds ratio Current ratio Debt/Equity ratio Capital adequacy ratio Loan officers / Total staff Number of active borrowers / Number of loan officer Gross portfolio / Number of loan officer Number of active borrowers/ Number of staff Gross portfolio / Number of staff Operating expenses / Average gross portfolio Operating expenses / Number of borrowers Administrative expenses / Average gross portfolio Personnel expenses / Average gross portfolio Interest income from portfolio / Average gross or net portfolio Interests and fee expenses on funding liability / Average gross portfolio Interest expenses on funding liability / Period average funding liability Short term assets / Short term liability Total liability / Equity Total equity / Total assets Outreach Average disbursed loan size Amount issued in the period / Number of issued loans Average disbursed loan size on per-capita GDP Average disbursed loan size / Per-capita GDP Other definitions: Funding liability: Liability that finance the loan portfolio and the cash investments necessary to manage the loan portfolio Operating expenses: Personnel expenses + Administrative expenses Recovery from write-off ratio: Income from write-off (payments received from loan already written-off) / Average gross portfolio Restructuring of delinquent loans: includes rescheduling loans (extending the term of the loan or relaxing the schedule of required payments) and refinancing loans (paying off a problem loan by issuing a new loan). Drop-out ratio: calculated as follows: (number of active clients at the beginning of the period + number of new (first time) clients entering during the period clients written off during the period number of active clients at the end of the period) / (number of active clients at the beginning of the period). MicroFinanza Rating 30

31 FAER Romania March 2008 Annex 4 Annex 5 - Guidelines of reporting and accounting Financial statements FAER does not provide non-financial services, so its financial statements reflect exclusively the results of its financial activities. The Fiscal Year runs from January 1 to December 31. Loan loss provision and write-offs FAER sets the loan loss reserve on monthly basis, according to the National Bank s rules. FAER calculates the cost of provision according to fixed percentages calculated on ageing categories of the portfolio at risk (outstanding balance of past due loans). In the case of past-due loans without mortgage, the portfolio at risk > 30 days has to be provisioned by 100%. In case of mortgage, the ageing parameters are differentiated and the provision expenses is calculated as outstanding portfolio at risk minus mortgage value. The cost of the provision is recorded into the income statement and is cumulated into the loan loss reserve in the balance sheet. FAER writes-off bad loans when they are late > 365 days. Accrued interests FAER accrues interests on late loans up to 365 days. Ratios of portfolio quality FAER reports data on portfolio at risk and arrears in the correct way. The standard portfolio quality ratio used is PAR 30. Restructured loans FAER reschedules loans in very special cases (accidents, illness, calamities, and so on). FAER charges 3% fee on the rescheduled amount. FAER does not refinance loans. Rescheduled loans are not tracked separately in the MIS and no special loan loss provisioning is made. Insider loans FAER allows the disbursement of loans to the staff and BoD members, at the same conditions of clients. As of December 2007, the outstanding portfolio related to insider loans is 0. Donations and in-kind subsidies Donations for loan capital, fixed assets and operating expenses are registered in income statement. From November 2007 to May 2008, FAER has been receiving an in-kind subsidy in terms of specialized technical assistance for business planning. MicroFinanza Rating 31

32 FAER Romania March 2008 Annex 4 Details of funding liability MicroFinanza Rating 32

33 FAER Romania March 2008 Annex 4 Other accounting policy FAER is adopting the declining balance interest rates on an accrual basis. Fixed assets are depreciated using the straight-line system, with the estimated useful life of each class of asset as a basis. FAER does not consider the effect of the inflation in the financial statements. Exchange rate variations and assets and liability denominated in foreign currency The re-evaluation of the assets and liabilities denominated in different currencies is calculated according to the end-of-month exchange rate. Any difference is posted as income or cost in the Income Statement. MicroFinanza Rating 33

34 FAER Romania March 2008 Annex 4 Annex 6 - Rating Scale MicroFinanza Rating 34