Best Practices for Banks in Small Business Finance World Bank Workshop SME Financing – Reaching Scale Dar es Salaam, Tanzania June 26-27, 2007 Glenn Westley Inter-American Development Bank

2 Contents of the Presentation Intro to Microlending in Latin America Possible Microlending Structures 1.Internal unit 2.External organization: Service company 3.External organization: Lightly regulated subsidiary 4.External organization: Heavily regulated subsidiary Best Practices (besides choice of structure) Advantages and Disadvantages of the 4 Microlending Structures Final Comments

3 Latin American Microlending by Type of Institution: Outreach

4 Growth in Latin American Microlending (mid end 2005) Compounded Annual % Growth Rates

5 Loan Delinquency Rates by Type of Institution (%) Source: Marulanda and Otero (2005), The Profile of Microfinance in Latin America in 10 Years: Vision and Characteristics. 30-Day Portfolio at Risk

6 Why Banks Are Entering Microfinance in Latin America Increased competition in banks’ traditional markets (such as corporate and even SME and consumer lending) – 1990s reforms High profits in microlending (MIX Market, MicroRate, press, etc.) Large unserved market Ample proof that microlending works, even in bad economic times (e.g., in MIX Market data for the and recessions, loan delinquency and ROA largely hold up in LAC) Diversification (1000s of tiny loans; often low correlations with traditional bank business lines – very different types of clients, resilience in bad times) Burnishes the bank’s public image Possibly the existence of underutilized capacity (in branches, MIS, excess liquidity, etc.) The availability of donor assistance

7 4 Possible Microlending Structures 1. Internal unit: microlending done in house 2-4. External organizations: normally corporations with own board of directors, management, & staff all focused on microfinance; may be either fully or partially owned by the parent bank. There are examples of all 6 cases in LAC. 2. Heavily regulated subsidiary: for example, a financiera or banco de desarrollo that is directly regulated by the banking superintendency 3 and 4 are “auxiliary providers of financial services,” which many countries allow. They engage in 1 or more of the bank’s permitted operations. Common examples: leasing or factoring companies set up as bank subsidiaries. Many auxiliary providers have been created in LAC to do microlending. Little or no direct regulation: generally consolidated with parent. 3. Service Company: doesn’t own the microloan portfolio (the bank does). Bank pays service company a fee for loan origination and collection services. 4. Lightly regulated subsidiary: owns the microloan portfolio and therefore receives its income from the interest on this portfolio.

8 Best Practices (besides choice of best structure)  If you do microfinance, do it right!  Leaning on the bank  Special considerations for internal units:  Should have high bureaucratic rank  Should not be located in the bank’s corporate lending department  Should have specialized loan officers  Special consideration for external organizations - how to reduce startup delays  Special consideration for service companies - setting the service company fee to maximize bank profits  Get specialized technical assistance  Beyond champions: institutional commitment … antidotes to the revolving door syndrome (entry and exit) include…

9 There are many important pros and cons associated with each of the microlending structures, and so the choice of structure will often have a major impact on the success of the bank in this new venture Possible Microlending Structures, with Examples …. especially since the best structure for microlending depends on many individual bank and country characteristics. There is no single microlending structure that is best for all banks!

10 Advantages of an External Organization over an Internal Unit Advantages of an Internal Unit over an External Organization A1. Greater freedom to do microfinance rightB1. Greater integration into the bank reduces operating costs (perhaps by 1-10%) A2. Directors, managers and staff have higher- powered incentives to be efficient and profitable B2. By eliminating initial tasks, start-up costs and often start-up time are reduced A3/B3. Image and branding (can be pro or con) A4. Can incorporate outside shareholders, which can have several benefits: added capital, improved governance, and high-quality TA B4. Always avoids outside shareholders, which reduce bank profits and can create conflicts in governance A5. Can reduce the risks to the bank of the microlending operations B5. Funding advantages: a) unconstrained capital backing of the bank, b) greater availability and less uncertainty about the availability of loan portfolio funding, and c) lower funding cost than subsidiaries A6-A7. Can escape the wage scale of the bank and other pay-related problems B6. Avoids imposition of VAT on certain activities (which sometimes affects external organizations) A8. Subsidiary may have a more favorable treatment under a usury ceiling than an internal unit or even a service company B7. Avoids duplicate capital problem (most likely to negatively affect heavily regulated subsidiaries) 1) Internal Unit vs. External Organization

11 2) Service Company vs. Subsidiary Advantages of a Service Company over a Subsidiary (Heavily or Lightly Regulated) Advantages of a Subsidiary (Heavily or Lightly Regulated) over a Service Company B1.* Greater integration into the bank reduces operating costs A1.* Greater autonomy in certain limited spheres including, for heavily regulated subsidiaries that can mobilize deposits, the chance to offer more appropriate savings products B2.* By eliminating initial tasks, start-up costs and often start-up time are reduced – especially with respect to heavily regulated subsidiaries A5. Can reduce the risks to the bank of the microlending operations B5.* Funding advantages: a) greater availability and less uncertainty about the availability of loan portfolio funding and b) lower funding costs A8.* Subsidiary may have a more favorable treatment under a usury ceiling than an internal unit or even a service company B7.* Duplicate capital problem (most likely to negatively affect heavily regulated subsidiaries) A7.* May escape from union wage scales and agreements Note: An asterisk (*) indicates those factors where the effect is (or may be) different depending on whether the comparison is made to a heavily regulated subsidiary or a lightly regulated subsidiary.

12 Final Comments It’s been shown innumerable times that microfinance is a highly profitable market segment that’s greatly underserved However, banks continue to suffer from the revolving door syndrome To avoid this, banks need to employ best practices. One of the key best practices is to choose the best structure. How much operating freedom do I need? How much more freedom would an external organization offer? How much more expensive would it be? Although there is no universal answer to the question of best structure, it is clear (at least in most cases) that the best structure must be chosen based on more than the trade-off between Cost vs. Flexibility. There are many more factors to consider, and the balance of these pros and cons varies enormously from bank to bank. The best structure depends upon each bank’s particular situation, its objectives, and the legal and institutional environment in which it operates.