How Latin American Microfinance Institutions Should Change Their Funding Strategies

Last week, I had the opportunity to interview a financial executive who has worked in microfinance in Latin America over the last decade. The insights are of great value.

From your perspective, how would you describe what has been happening in Latin American microfinance over the last three to five years?

Microfinance Institutions (MFIs) in Latin America have been growing at a rapid pace. The growth has been fueled in part by cheap and readily accessible funding, with much of this coming from foreign microfinance investment vehicles (MIVs). I’m concerned that this model of funding is fragile.

What makes funding from foreign MIVs fragile?

There is the obvious foreign exchange risk if the MIV is lending in dollars into a non-dollarized economy. When a foreign MIV lends dollars to an MFI in Honduras, any devaluation of the Lempira against the dollar becomes a cost for the MFI. The more volatile the currency, the riskier the exchange. Some efforts are being made to minimize that risk or even eliminate it. Some MIV loans are made in local currency, but since the ultimate source of the funds is a non-local hard currency (dollars or euros), then the local currency hedging is going to add to the cost of the funding.

More worrying is that much of this MIV lending is medium term (2-4 years) and it can come and go with little warning. Particularly in Central America with many MFIs  funding 100% of their loan portfolio with debt, much of it foreign debt, and a high proportion of that debt needing to be refinanced each year, the MFI has few realistic alternatives should the foreign lending community, for whatever reason, decide that local issues in that the country (or at the MFI) make it unwise for the MIV to continue to roll over their loans.

So what kind of local issues are we talking about?

Any number of things: political strife, natural disaster, loss of key employees. The real issue is when the obstacles are systemic. Take Nicaragua for example. A combination of a poor economy, political/regulatory interference, and weak coffee and cattle prices has created the perfect storm for microfinance institutions. Even the best managed MFIs would have a hard time dealing with byzantine regulatory demands, high default rates, and angry clients. As a result, the whole industry is suffering from high PAR and bad debt. If they are not astutely managed (and few are), then you get an industry-wide problem.

Any other trouble spots out there?

Each of the countries has its own unique challenges, ranging from political change in Honduras to natural disasters (flooding) in Peru, but Nicaragua is certainly the most strongly affected as a result of conditions there and the high level of microfinance penetration in the country.

Is there any loyalty from the MIVs toward the MFIs? Any willingness to ride out the storm?

It’s too soon to say with any certainty.  Even completely commercial lenders will have a certain loyalty to their clients, if for no other reason than to preserve relationships for the future and to preserve reputation.  The more socially oriented lenders have indicated a willingness to take more risks, and to be more supportive in troubled times, but at the end of the day even the socially oriented lenders often also have their own investors to whom they must account for any possible losses.  A more conservative lending position by these lenders could put MFIs in a difficult position.  If lenders choose not to renew their loans and the MFI is stuck trying to repay the money the MFI will likely be compelled to shrink its portfolio in order to free up cash.  This inability to offer new loans to existing MFI borrowers can easily become a vicious circle as the MFI may experience still higher default rates when borrowers determine that no new loans are forthcoming.

So what alternatives do the MFIs have?

MFI’s need to think in a more nuanced way about their capital structure, and balance foreign borrowings with local sources. They need to change the nature of their relationships with the investment vehicles by pushing for longer terms on their borrowings–a minimum of five years. They also need to become less reliant on foreign debt as a source of funding. The two most obvious, though not easy solutions are for MFIs to deepen the equity base–the amount of funding coming from the recycling of profits back into the MFI. There is no cheaper source of funding than running a profitable MFI. Second, MFIs need to figure out how to access savings deposits–to become more like a classic savings and loan institution.  Doing so directly imposes a high regulatory burden which may not be desirable, but there may also be ways to access savings through becoming banking agents or the like.

Savings is something we’ve discussed at length on SeaMo. Are there any glimmers of hope out there that savings will begin to grow like microcredit has over the last decade?

I’m not optimistic that savings can scale as fast as microcredit has, but there does seem to be some momentum toward savings. The Bill and Melinda Gates Foundation is aggressively funding certain strategies, MFIs recognize its value, and the more socially-oriented MIVs are at least considering ways to encourage MFIs to incorporate savings account into their client offerings.