Sustainable Microfinance Key Issues in developing institutional capacity of Microfinance Institutions Micro-Credit Ratings International Ltd 104 Qutab Plaza, DLF City-1, Gurgaon INDIA Tel: , Fax: February 2002

The context Widespread, endemic poverty in South Asia A growing microfinance sector in India and Nepal Large, well known microfinance programmes in Bangladesh

The context…  Ad hoc appraisal systems using a mix of financial and development assessment tools to appraise the performance of microfinance institutions  Largely undertaken by individual consultants, academic institutions or, occasionally, western consultancy companies with mainly Latin American or African experience  Such evaluators have limited Asian experience, mainly in Indonesia/Bangladesh

The context… It became clear that a standardised tool was required in order to enable investors – mainly lenders and donors – to understand the risk profile and credit-worthiness of MFIs to estimate the appropriate volume of investments identify their strengths and weaknesses in order to determine their needs for institutional capacity building

Developing the tool EDA set out to develop a standardised tool for this purpose since it had a substantial research orientation considerable experience of monitoring studies been engaged in research on development appraisal methodologies substantive knowledge of microfinance a well-established reputation for quality, integrity and a knowledge of microfinance

Developing the tool… This was undertaken through An investment of 1.5 years at the most senior level Combining EDA’s experience and knowledge with international best practice methodologies and feedback Consultations with microfinance specialists in the region Rigorous field testing of instruments across different microfinance models and geographical regions within India Continuous and iterative process of testing and improvement

Why rating…? The methodology that emerged entailed the rating of MFIs Rating is about disclosure and accountability Rating provides a standard assessment comparable across organisations and over time It is undertaken by a team of professionals who specialise in the activity and work together to achieve a high degree of standardisation It is an internationally recognised service for investors – who were the primary target of the initiative

The Rating Instrument The working hypothesis is that The risk profile and creditworthiness of an MFI depends critically on its financial performance, but is also affected by its managerial capabilities and governance

The rating instrument… Governance issues  professional experience/involvement of board members  dominance of the leadership  strategy and organisational structure  degree of focus on microfinance  degree of concentration of operations

The rating instrument… Management/ resource indicators  quality of managerial and field staff  quality of accounts, MIS, tracking systems  financial control systems  strength and capability of clients  adequacy and use of infrastructure

The rating instrument… Financial performance  level and growth of savings of members  repayment rate (MFI-borrower and MFI-lender)  age statement of overdues and portfolio at risk  operating expense ratio, capital adequacy, financial sustainability

The rating instrument… Financial statements adjusted for  income recognition on loans on a cash basis  adequate loan loss provisioning  loan loss reserve  cost allocation - especially important in the case of multi-service NGOs/MFIs  sustainability calculations make the usual adjust- ments for inflation, cost of funds, all subsidies

Progress  A total of 106 ratings done so far – includes 88 MFIs in Asia and 18 rating updates  Seven ratings have been in Bangladesh, four in Nepal and one each in Cambodia and Kazakhstan; a capitalisation review of three MFIs in Myanmar was undertaken last year  Over the next few months M-CRIL will be rating MFIs in Indonesia, Pakistan, Sri Lanka and the Philippines

Grade distribution 86 MFI ratings

Promoting transparency Achievement 1 – helping to overcome information asymmetry Makes lenders/donors aware of issues affecting creditworthiness – emphasises for the sceptics amongst investors, MFIs enable provision of financial services to those the banks don’t reach – a substantive poverty focus a prudent approach to client savings responsibility in ensuring the repayment of loans from banks most importantly, many are at or near sustainability, therefore, good investments for either loans or equity

Promoting transparency… Key weaknesses found amongst many MFIs in India lack of a business orientation which limits sustainability – most MFIs in the region emerge from NGOs with a social agenda perceive microfinance as extension of social development not financial intermediation – affects orientation/systems many are leader dominated institutions with centralised decision making, which affects receptivity to ideas, limits response to market opportunities

Promoting transparency… Typical systemic weaknesses found in Indian MFIs incomplete understanding of client needs/product design poor loan tracking and follow up lack of incentives for staff accounting deficiencies failure to take account of income accruals rescheduling and refinancing of client loans (minor) cases of fraud undetected on account of poor MIS/internal audit processes

Promoting transparency… o Rating has enabled such issues to be highlighted and discussed between lenders/donors and MFIs o Some public transparency is also starting to happen as some MFIs now make their rating reports public – this puts pressure on others to do so o CGAP Fund imposes public disclosure of the rating report as a condition for its support

Establishing internal accountability Achievement 2: identifying strengths and weaknesses – prioritises capacity building needs – specific recommendations facilitate capacity building support financial/yield analysis and delinquency management loan tracking systems and MIS financial control – budgeting, cash planning & internal audit staff skill improvements through better recruitment and training better governance + focus on microfinance as specialised financial intermediation not social development

Strengthening links with investors Achievement 3: Detailing information on the risk profile of MFIs has facilitated substantive links with investors Lending of the order of $7 million by SIDBI to some 50 MFIs in India, others such as ICICI Bank and HDFC have also used M-CRIL ratings for this purpose Capitalisation of MFIs in India, Bangladesh, Myanmar by Hivos, DFID, SDC, UNDP – used in Bangladesh to facilitate a credit guarantee mechanism

Strengthening links with investors… Lending of the Dexia Micro-Fund in India, Cambodia of funds managed by Blue Orchard Finance – interested in further inputs vis-à-vis the Philippines and Indonesia Women’s World Banking also using the service to support its affiliates in Asia – Bank Dagang Bali to be rated soon

Enabling development of standards Achievement 4: In India – due to the resulting database – this has facilitated the process of developing industry standards related to performance and systems efficiency OER<25% portfolio qualityPAR 60 <10% sustainabilityOSS>90-100% accounting practicescash basis information systemseffective loan tracking staff recruitment and incentivesprofessionalisation

Conclusion M-CRIL’s experience is that institutional assessments based on accepted standards can be a very powerful tool in promoting institutional capacity building of MFIs – but to be effective, the service must be provided by a professional team  dedicated to microfinance, having the specialist knowledge and experience that goes with that dedication  committed to the long term development and growth of the microfinance sector.