Behind the Headlines: The Credit Crunch and Microfinance – One Potential Scenario: An interview with CGAP expert Kate McKee

December 15, 2008    

It’s in times of crisis that we see what microfinance is really made of. During past emergencies, microfinance has held fast. And even as the current global banking mess has gone from bad to worse, recent headlines have global and industry leaders asserting that microfinance can and should be able to withstand it (What MFIs Can Teach Wall Street; Clinton Says Avoid Wrong Crisis Lesson, Invest in Poor; More Sub-prime Loans, Now!; SKS Microfin Raises Funds at Low Costs Despite Credit Crunch; Microloan Borrowers Repay Debts as Others Default). Yet, other reports strike a more worried tone (MFIs Face Challenge of Global Meltdown; Cambodian MFIs Fear Cash Drought; Economic Crisis Threatens to Destabilize Developing Countries). Only time will really tell.

As the world watches and waits to see just how far this crisis will spread, we asked CGAP expert Kate McKee how the global banking meltdown might affect the nature of the microfinance industry.

What changes might we see in the microfinance industry as a result of the global credit crunch?
There are many reasons to believe now that, at least in some markets, one fall-out of the current global financial turmoil will be a fall in available liquidity to finance MFI growth and perhaps even operations at current levels. This makes me think that some concentration of the microfinance market, and perhaps even consolidation, seems inevitable. Is this a good thing? If the winners are the best providers – those with better products, customer service, and outreach to underserved markets – we might welcome this trend. But size is not always the same as quality, and I wonder if we need to worry that solid, smaller, and less well-known providers, serving important market segments, could lose out.

Liquidity worries could lead to responses by microfinance providers, investors, lenders, depositors, and policy makers that end up creating a scenario where, in many markets, the big get bigger and the rich get richer.

What would be the potential drivers of reduced liquidity for MFIs?
There are at least four drivers of reduced liquidity that might operate to varying degrees in different markets and for different retail providers as a result of the credit crunch.

1. Shrinking cross-border financing
   The first is a drop in cross-border financing. We are already seeing plans for ambitious new financing deals put on hold, like the US$350 million Deutsche Bank–Blue Orchard financing transaction that was slated to launch in late 2008. IPOs and bond issues have also been postponed, and many agree that even the “go-go” India microfinance bubble might be bursting, with price-to-earnings ratios back down from stratospheric levels. Fund managers specializing in microfinance are uncertain about short-term demand from their institutional and retail investors. We don’t know whether “charitable lending” (like Kiva.org, MicroPlace.com, and so on), which was certainly on a roll, will take the kind of hit that many are predicting for the overall charitable giving sector. And fears of a global recession and reduced tax revenues will cast a shadow on the ambitious microfinance investment plans of at least some development finance institutions (DFIs). In short, “refinancing risk” is the buzz among many observers these days.
2. Diminished domestic bank borrowings
   Some MFIs that followed accepted best practices and leveraged up through domestic bank borrowing are finding that those loans are under review. If they are renewed, the cost is likely to be higher and the term shorter, at least in markets experiencing the backwash from the global credit crunch. We don’t know with much precision where this pull-back phenomenon is occurring and on what magnitude; nor do we know whether it will be a relatively short-lived phenomenon or not. But MFI leaders, raters, and investors are voicing some worries, and it seems possible that at least some MFIs (and their SME brethren) will lose out to the bigger corporates in domestic bank financing for a while.
3. More withdrawals and fewer savings?
   It’s unclear how depositors in MFIs will behave in the face of the nasty stew of bad financial and economic forces emanating from the developed economies. With remittances down almost everywhere and inflation slowing but still substantially higher than a year ago in many countries, will low-income families in need of cash find themselves withdrawing more and saving less? Will some worry about the safety of their life savings and shift to alternatives (such as bigger banks or state savings banks that they might perceive to be safer in volatile times)? Will others, hearing about the stress and failure of even the biggest, richest international banks, decide to cash out or shift to in-kind savings, at least for a while? Alternatively, perhaps local depositories will win the confidence game and benefit from the “flight to quality” of poor people’s savings. While in the past, depository MFIs appear to have weathered various crises (like the Bolivian recession, the Asian and Latin American financial crises, and natural disasters) reasonably unscathed, the past may not be a perfect guide to the future in this crisis. Clearly, the answer will vary enormously from place to place and institution to institution. But at a minimum, recent isolated deposit runs at a few well-run, financially solid microfinance banks give us pause and remind us that deposit behavior can be as much about rumors and confidence as ratios and capital.
4. Increased loan demand
   A final (and somewhat counterintuitive) liquidity drain might actually be increased loan demand. This can be a function of both stress and opportunity. Inflation tends to boost average loan size, a more general phenomenon that we’ve been observing in many places for a while. Inflation and loss of remittance income can force families to borrow for consumption purposes. But we also need to remember that although growth is slowing, most economies in the places we work are still doing alright. And some microenterprises and informal sector activities actually benefit from inflation, economic downturns, and a shift in consumer buying to the goods and services they produce (since many families, not just poor ones, shift to basic goods and services in hard times). These factors could work together to actually increase loan demand for an MFI’s available liquidity.

Are we seeing any hard evidence of a liquidity crisis yet?
No, there isn’t much hard evidence of a widespread liquidity crisis in the microfinance world, but many market players and observers are anxious. (Or at least watchful – some fund managers are now insisting on weekly asset-liability management reports from the MFIs in their portfolios). IADB is expanding and extending the term of its Emergency Liquidity Fund, and fund managers and DFIs are considering creating one or more similar facilities for other parts of the world to provide quick-response mechanisms for solid MFIs experiencing difficulties on the deposit or borrowing front.

So, how could such a crisis contribute to a “rich getting richer/big getting bigger” or consolidation scenario in the microfinance industry?
There are a few possibilities, admittedly highly speculative, about how the global financial crisis, its fall-out, and public and private responses could lead to consolidation.

1. Tier I MFIs compete better for scarce liquidity
   First, in jittery financial markets, the Tier I’s (that is, the largest and best known MFIs that are the beneficiaries of most cross-border investment to date) are better positioned to cope with swings in their liabilities (such as deposits, international loans, and domestic borrowing) and attract the considerable undeployed assets still around in the microfinance investment vehicle (MIV) world (even if they might have to pay more for this cross-border financing). They could be attractive candidates for more patient equity investors willing to bet on the longer term microfinance value proposition. And the more “name brand” players might benefit more than their smaller competitors from local depositors in a “flight-to-quality” mood. Tier II and Tier III MFIs, the hungry “wanna-be’s” that were just starting to benefit from deeper microfinance investment markets, may find their dreams put on hold for a while.
2. Needs of Tier I providers met first
   Then, as investors work to create and expand emergency liquidity facilities in the face of global “deleveraging,” it is likely that certain Tier I MFIs and important microfinance markets will be at the top of the list for help if they need it. In our little corner of the financial market, these are our “too-big-to-fail” institutions.
3. Scaling back growth hurts smaller MFIs more
   While many MFIs, including the Tier I’s, will likely need to scale back ambitious growth plans until the markets are less uncertain, this may be easier for the big guys that already have enviable market shares in some of the more competitive microfinance markets. So, putting high-growth projections on hold for a while might also hurt those with well-established market shares less than those Tier II and Tier III institutions trying to establish a toehold.
4. Regulators: Less likely to take access-expanding measures
   Which brings us to policy and the likely responses from regulators to the current crisis. So far these responses favor the bigger, more established and better capitalized players. One predictable result of the jitters, anxieties, and rather mind-boggling policy responses being embraced in developed markets is to send regulators in poorer countries into “hunker down” mode. If the balance tilts toward safety preoccupations and away from access, it could be a good time to already have your license and an established relationship with your regulator, rather than being in the queue for a new license.

So how is it that the big might get bigger?
Alone or in combination, these forces could help the big get bigger in some microfinance markets, through processes of both concentration (greater market share) and consolidation (mergers and acquisitions). Tier I institutions might find opportunities to buy up good quality portfolios from liquidity-starved competitors. While mergers and acquisitions have been relatively rare in the microfinance industry, the current disruptions could create take-over targets, with the traditional barrier of manager resistance being overcome by investors willing to sell. Another factor could be nervous regulators, pushing consolidation of institutions under their supervision by boosting minimum capital requirements and promoting mergers.

Perhaps this scenario seems farfetched. Better informed observers than I will undoubtedly take issue with each scenario outlined here, and certainly with them occurring in combination in multiple markets.

But I find it unlikely that the structure of our industry will come out of this whirlwind time largely unchanged. At a minimum, we need to be mindful of the possible unintended consequences – less consumer choice, less competition, niche markets being less well-served – of focusing most of our energies on Tier I providers and not working explicitly on solutions for the solid but less well-known smaller players as well.