THE MICROFINANCE CRISIS: THE DÉVELOPPEMENT INTERNATIONAL DESJARDINS POINT OF VIEW

THE MICROFINANCE CRISIS: THE DÉVELOPPEMENT INTERNATIONAL DESJARDINS POINT OF VIEW BACKGROUND Over the last ten years the microfinance sector has developed at a fast pace allowing poor communities in developing countries to obtain increasingly wider access to basic financial services. By December 31, 2009 there were 3,589 microfinance institutions (MFIs) throughout the world serving over 190 million clients, of which 128 million individuals were classified as among the poorest and who were largely excluded from traditional financial services. Among the poorest clients, 82 percent were women. 1 Microfinance, as a tool for fighting poverty, benefits from a great amount of goodwill. However, some events have tarnished this image, with microfinance making headlines for its negative impact. In one example, in response to a wave of suicides by overindebted borrowers, a political party in Andhra Pradesh, India, advised clients of microfinance institutions to no longer repay their loans since the interest rates were considered too high and collection methods, unscrupulous. The No Pago movement endorsed by Nicaraguan President Daniel Ortega supports thousands of borrowers who are refusing to pay off their loans and are demanding lower interest rates. The movement has expanded to Bolivia and even to Pakistan where activists and politicians have urged borrowers to stop paying their loan installments. Some MFIs have been bankrupted by these events. It is true that microfinance results on an individual scale are modest but they are real. And because they affect 200 million people, they have a multiplier effect making this one of the strongest programs in recent decades. Esther Duflo, MIT Economics Professor and promoter of an incremental small step approach to poverty alleviation Sometimes seen as a panacea able to improve the living conditions of the poorest, revelations during these crisis now show that some microfinance practices have gone off track. Commercialization of microfinance has been identified as one of the underlying reasons. Some MFIs, required to make payouts to shareholders and post financial results to increase the value of their commercial venture, have been accused of putting priority on profit to the detriment of their primary mission by promoting doubtful practices for collection and recruiting of clients. This situation is disturbing for Professor Mohammad Yunus, Nobel Prize winner and microcredit promoter, who, over the last few years, has denounced the listing of microfinance institutions on stock exchanges, which, in his opinion, sends the wrong message that profits can be generated from helping the poor. The debate was ignited when the Banco Compartamos was listed on the Mexican stock exchange in 2007 making shares in this institution subject to speculation in the marketplace. For the initial offering, demand for Compartamos shares was 13 times oversubscribed with the amount of the transaction topping US $450 million and a price-to-book value ratio of over 12. In light of the Compartamos situation and that of other MFIs, the Consultative Group to Assist the Poor (CGAP) took a different position from that of Mr. Yunus, stating there was no problem in having shares produce a profit on an investment in an MFI and that this could even be beneficial for the microfinance sector. 2 1 REED, Larry R., State of the Microcredit Summit Campaign Report 2011, Washington. 2011 2 Consultative Group to Assist the Poor(CGAP), IPO Represents a Critical Transition for Microfinance, http://www.cgap.org/p/site/c/template.rc/1.26.14251/ June 2011 Page 1 of 6

From the client's point of view, the excesses made many of them overindebted, due to an increase in consumer loans over lending for productive purposes, along with practices which encourage microfinance kiting. 3 Consumer credit is now under scrutiny. Such loans are used for health expenses, to improve small lodgings or for expenses related to education for children and obviously are useful purposes and may even be of crucial importance to the clients, but they do not generate income to repay the loans. While these types of loans are necessary, abuse is likely when lending procedures do not distinguish between the types of loans and the true ability to pay by the borrowers is not properly assessed. In addition, loan officers are remunerated in relation to the number of loans made and their loan collection results which can encourage microfinance kiting practices. By suggesting that families pay off an already contracted loan with a new loan, these loan officers can post a 100 percent collection rate and increase the number and volume of loans made. Along with such practices which lead to the overindebtedness of households, abusive loan collection methods can place excessive pressure on borrowers. THE POSITION TAKEN BY DID What have been perceived today as excesses are partly the result of the widespread popularity of microcredit which was highly touted as a tool in the fight against poverty. For DID, the real issue has always been to promote access to financial services for all men and women, including those in the poorest communities. The outcomes that are expected from such an approach are all the benefits which accrue from lifting the barriers on development for individuals, families and communities resulting from the lack of access to quality, diversified financial services that are secure. We can only imagine what it would be like without access to the full range of financial services that are currently available to us in our daily lives to understand what an essential service this is to ensure the smooth running of our economic activity. For DID, access to financial services for all is just as fundamental as access to education when all the negative effects and constraints on development caused by a low level of bank use in communities are taken into consideration. It is so important that the rate of bank use should, in fact, be included among the Millennium Goal performance indicators. Consequently, the excesses that have been identified and which are related to lending practices, should not serve to call into question the development outcomes for investments aimed at improving access to financial services for all types of communities. PROTECTION OF ASSETS Dedicated for over 40 years to improving access to financial services in poor communities, DID is extremely concerned with such misdeeds linked to microfinance, and aware of the difficult environment in which microfinance institutions must operate. X 3,500 In Sri Lanka, rice growers and their families now have coverage against the effects of bad weather thanks to the crop insurance plan instituted by DID and its partners. To date 3,500 crop insurance policies have been written. DID is cognizant that disreputable practices can occur at any microfinance institution. However, DID is convinced that focusing on control of financial institutions that are community-owned and involved in community development provides a formula that can mitigate specific risks. DID is convinced that its promotion of the cooperative formula helps limit the risk of excess associated with microfinance. The concepts of collective ownership and strong community involvement by the institutions DID supports along with local management serve to restrain the more aggressive practices in the microfinance sector. DID believes that by encouraging the creation of cooperative institutions whose members take part in governance, the interests of the members are better taken into account when MFIs make decisions. In the case of partner institutions that are not organized as cooperatives, DID has encouraged the development of engagement with clients conducting business with the institution, especially through the establishment of client share purchase plans. 3 In the consumer area, microfinance kiting refers to cash-strapped borrowers taking out sequential loans using each new loan to repay a prior loan. June 2011 Page 2 of 6

The education of members and clients by DID partner finance institutions, another principle common to cooperatives, also helps mitigate risks related to consumer lending, microfinance kiting and overindebtedness. Education, training and information give members better understanding of credit, making them better able to assess their capacity for borrowing and comprehend the commitment made when a loan is contracted. EDUCATION Through its support for regulation by national governments of local microfinance and support for MFI supervision operations, DID has also demonstrated its own concern for maintaining X 4,000 honest and consistent lending practices by its partners. That is why DID backs strong external supervision of its partners in In Haiti, 90 percent of the children whose parents have taken out education loans complete their school year addition to suitable self-directed supervision methods. Access to in comparison with an average completion rate of 60 financial services is more than simply providing products or percent. Since this innovative product was introduced, developing methodologies. The services are delivered by nearly 4,000 loans for schooling have been granted to institutions which must raise their levels of professionalism and Haitian families. operate in compliance with the laws and regulations in effect. Therefore, it is just as important to focus on the availability of services as on capacity building for local institutions as well as on strengthening external supervision over these institutions. In our opinion, it is much more appropriate for governments dealing with specific excesses by MFIs to strengthen clean-up efforts in the sector, along with supervision mechanisms and regulatory oversight instead of setting a ceiling on interest rates or urging borrowers to stop paying back their loans which can create negative effects as bad as the excesses initially targeted for correction. DID contends that the recent events underscore the importance of making loans in relation to the economic value of the venture being financed and in relation to the borrower s ability to pay. Loans must be processed by loan officers who possess proper qualifications, which is why DID and its partners urge enhancing the professional practices of staff involved in managing lending. Analysis of the economic benefit of the projects planned by borrowers must be based on excellent knowledge of the income generating activities. The finance products must be carefully suited to the specifics of those activities. That is why DID has been working for several years to improve specialized financial services such as financing for small enterprises, agricultural finance and financing for small housing projects. Although all these services may be called financing, they differ greatly in terms of operations and adaptation to the needs and circumstances of the member clients. FOOD SECURITY X 5,400 In Burkina Faso, the financial centres for entrepreneurs set up in rural areas over the last two years have allowed 5,400 farmers to finance crop intensification and diversification. In a concern for equity and accessibility, DID adheres to the principle of transparency and advocates that interest rates posted by its partners be calculated using a decliningbalance method instead of the so-called flat rate method. However, when all actors in the same market post only straight line rates, the apparent rates posted under such practices put DID partners at a disadvantage. Efforts must be made to properly explain to each member client the meaning and the calculation methods used for the rates that are applied. June 2011 Page 3 of 6

DID promotes sound microfinance practices as reflected in the microfinance client protection principles outlined in the Smart Campaign 4. A highly concerted effort has been made to encourage all members of the Proxfin international association composed of 20 DID partners to endorse the campaign. DID is of the opinion that certain microcredit practices, such as solidarity guarantees and incremental approaches, have contributed to the current difficult situation, especially by promoting automatic increase of the importance of the loan while lowering application examination standards. Such methods should be limited to very specific target groups and operated using clear guidelines. Far from limiting itself to microcredit, DID works in collaboration with its partners to set up a wide range of financial products and services that are accessible to the disadvantaged and designed for them. These services include mobilization of savings deposits which helps lower the costs of funds made available to clients and increases the room for maneuver by MFIs in setting loan terms and conditions as well as having them participate in creation of community-based wealth within targeted communities. When providing coaching services to partners, DID also takes a sound, methodical, and time-based approach. These collaborative effects set up over long periods of time provide for better understanding of partner practices and the constraints they are facing as well as for better in-depth supervision based on shared values. This approach is not always acknowledged at its proper value by donor agencies which are not focused on deeper partnerships but instead on maintaining a relationship of dependency. Best practices however are transmitted through an educational approach and cannot be imposed from the outside. These information and education efforts require bonds of trust and the time needed to pass on the practices and integrate them into the operations run by partners as they increasingly take control over their own progress. At the same time, partner MFI self-sufficiency means that DID cannot be held responsible for possible wrongful practices at these MFIs unless such practices were specifically recommended by DID. INTERCONNECTIONS In Vietnam 10,000 inter-coop transactions every month are now being conducted between different People's Credit Fund financial cooperatives by members. Making a trip from one coop to another is no longer necessary when transferring funds to another location. GROWTH X 10,000 X 200,000 In Africa, each loan made to a small business creates an average of 1.4 jobs. 5 The 7 financial centers for entrepreneurs set up with support from DID in various African countries provide more than 200,000 loans and are growing fast. Under the current circumstances, DID has little faith that credit bureaus can be effective in controlling the excesses seen in the microfinance sector. Such measures remain symbolic and are often ineffective in a highly competitive climate in which institutions have inadequate management information systems, borrower identification controls can often be extremely complicated due to lack of a reliable national identification system and MFIs are not able to pay the costs related to using a credit bureau which would only be passed on to borrowers during the lending process. Strengthening MFI governance and consequently the strategic role fulfilled by boards of directors is in our opinion a better strategy for preventing such excesses. 4 The Smart Campaign (www.smartcampaign.org) is a global campaign committed to embedding client protection practices into the institutional culture and operations of the microfinance industry. 5 Based on the Social Return on Investment (SROI) calculator developed by the Calvert Foundation (www2.calvertfoundation.org/impact/calculate/index.cgi) June 2011 Page 4 of 6

Concerning risk management, DID contends that MFI collection practices must be thorough. As a rule of thumb, interest rates at MFIs must reflect the costs related to community finance services. In order to reach low income clienteles, MFIs make loans for small amounts that are more costly to monitor and manage in relation to the amount of the loan. The rate of interest must therefore be higher for these MFIs to cover the cost of managing the loans and keep the institution viable. To avoid excessive increases in interest rates, these MFIs must ensure a suitable collection rate and remain watchful over upstream and downstream lending operations. DID is also aware that when MFI members and clients are facing difficult circumstances, the same applies to their institutions. MFIs often operate under difficult circumstances that can be economic or regulatory - especially in terms of their legal recourse before the courts. While not excusing certain doubtful OWNERSHIP X 375,000 In Haiti, members are proud of their financial cooperatives. The financial cooperatives associated with the Le Levier Federation serve over 375,000 Haitian families and have helped them deal with the aftermath of the 2010 earthquake. practices, this does offer a partial explanation for differences that have been observed with the developed world. The disparity seen in practices with developed countries is even more obvious when analyzing the interest rates charged by MFIs. Because the operating conditions are so extremely different, especially concerning the cost of funds, nominal comparisons are unsatisfactory. The interest rates must cover the both costs and risks while allowing for expansion (capitalization). However, considerable efforts must be maintained to increase efficiency and reduce the costs of distribution in order to lower the fees on products and services. Access to capital is a strategic challenge for microfinance institutions. The fact that an increasing number of investors are looking at this sector is a very positive development. However, focusing solely on profitability can lead to excesses - although it is not the only reason. DID has been working for over 15 years with investors in the microfinance sector and is looking to work with those who share its vision of development. Efforts must be made to understand this sector better so that the capital that is available has a positive impact on access to financial services. Lastly, DID issues a warning against the disinformation that has been spread during the debate over microfinance, as was the case for the Andhra Pradesh crisis in which MFIs were accused of causing difficulties for which they were only partially responsible since many borrowers had gone to informal lenders for their loans. In fact, a study financed by the Government of India six months before the crisis broke, revealed that most overindebted households in Andhra Pradesh had taken out loans, not from MFIs (11 percent), but instead from informal lenders (82 percent). IMPACT X 8,800,000 and + Today, DID partner institutions, working together within the Proxfin association, are helping 8.8 million families with their financial progress and could increase outreach by at least 10 percent a year for many years to come. June 2011 Page 5 of 6

CONCLUSION For DID, active in the area of development for 40 years, and specializing in promoting and improving access to financial services, it is essential to maintain a realistic outlook on development in this sector and not lose sight of the ultimate goal. Sustainable increases in access to financial services in developing or emerging countries will rely on numerous levers for development and must go hand-in-hand with expansion of the financial sector in the targeted countries. Microfinance, or inclusive finance, is one part of finance and must therefore make use of best practices while eliminating practices that exclude communities to participate on the economic and social progress of their countries. In fact, implementing best practices and maintaining a constant concern to increase the number of individuals using the formal financial system is what motivates DID and its partners. June 2011 Page 6 of 6