Financing Microfinance for Poverty Reduction

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					       Financing Microfinance for Poverty

                        Paper presented at the Plenary Session
                            on 18 Febraury 2004 at Dhaka


                                                  Atiqur Rahman

                                Lead Strategist and Policy Coordinator
                        International Fund for Agricultural Development, Rome

        Asia Pacific region Microcredit Summit Meeting of
                     Councils (APRMS) 2004

                      Dhaka, Bangladesh, 16-19 February 2004


                                             Dr. Atiqur Rahman, Lead Strategist & Policy Coordinator,
                                                                                           IFAD, Italy

1.    Until the early/mid-1990s, microfinance was mostly understood as ‘the provision of
small loans to poor people’. It subsequently started to include a broader spectrum of
financial services, such as saving facilities, insurance and transfer payments for the poor.

2.    The Microcredit Summit of 1997 marked a historical event for global microfinance, with
its objective of spreading microfinance to 100 million of the world’s poorest families by 2005.
Moreover, on 15 December 1998, the United Nations General Assembly adopted Resolution
53/197, declaring the year 2005 as the International Year of Microcredit.

3.    Over the last six years, a large number of microfinance programmes have successfully
contributed to lifting people out of poverty in many countries of the world. Financial services
enable the poor to increase their incomes and diversify their sources of income, and to build
up and change their mix of assets. In addition to income-generating activities, the poor use
microcredit for better nutrition; improved health; access to schooling; for supporting public
infrastructure, such as improved housing, water and sanitation; or for the purchase of
animals and consumer durables. Access to microfinance enables poor people to reduce their
vulnerability in times of crisis. In particular, microfinance allows poor women to have a
greater number of choices and to have a voice in family and community matters. It also
enhances their self-esteem and self-confidence and opens up new opportunities for them.

4.    While encouraging progress has been made in meeting the goals of the Microcredit
Summit, many challenges still remain. Adapting the volume and nature of the resources
dedicated to microfinance globally in order to maximize their impact for promoting strong and
sustainable microfinance institutions with large-scale outreach, is just one such challenge
facing both donors and microfinance institutions (MFIs) in the future. The issue of financing
is indeed crucial to MFIs, regardless of whether they operate as commercial banks, finance
companies, credit unions or non-profit foundations. But, especially for the small-scale and
promising MFIs that operate as non-profit foundations and those that have transformed into
regulated financial institutions, the issue of financing is critical.


5.    By end-December 2001, 2 186 microcredit institutions reported to the Microcredit
Summit Campaign that they had reached a total of 54.9 million clients with loans. Of these,
26.8 million (21.2 million women) were among the poorest of the poor when they started with
the programme.

6.   During the last decade, much progress has been made with regard to rural
microfinance. In a number of countries, macroeconomic stability and deregulation have
created a conducive policy environment for MFIs, and new banking legislation has provided
a legal framework for initiating regulated MFIs on a commercial basis. In most countries,
however, major shortcomings still exist in rural finance – shortcomings that hamper outreach
and sustainability.


7.     In order to achieve the Microcredit Summit’s goal of reaching 100 million families with
microfinance by the year 2005 and thus increase access to microfinance services for poor
households, many of whom live in rural areas, major current constraints on financing
microfinance will need to be addressed. These include (i) lack of institutional capacity; (ii) an
unfavourable environment; (iii) lack of capital for small and emerging MFIs; and
(iv) inadequate financial infrastructure. All of these constraints are somehow closely
interrelated, and the way they affect MFIs will need to be assessed in the context of
institutions’ maturity, their ability to mobilize savings or to raise equity to sustain their growth
(see further development in Section IV).

8.    The perception by MFIs of their role beyond microfinance may also constitute a
constraint in terms of their funding. Some MFIs consider that their role goes beyond
providing access to financial services, and that it includes the provision of other services
seen as important in terms of their impact on clients’ lives (health, education) or in increasing
their economic opportunities (commercial activities such as seed distribution, animal feed,
milk processing, mobile phones, etc.). Since many such activities are funded by donors, at
least initially, this raises the issue of how to separate costs, incomes and accounting
between both types of activities with a view to assessing the sustainability of the
microfinance operations. Large MFIs involved in multisector activities have done this

Lack of Institutional Capacity

9.     Lack of institutional capacity is recognized as one of the major constraints on MFIs.
Institutional capacity is the driving force for the development and institutionalization of MFIs,
deriving from (a) strong governance; (b) qualified and efficient staff; (c) an effective and
reliable management information system (MIS) and internal control; and (d) good market
analysis and well-designed products and services that match the demand of the target
population. Strengthening MFIs’ institutional capacity will help diversify funding sources as
commercial banks and investors gradually substitute donors as resource providers. Many
MFIs, even though they might break even or reach financial sustainability, may still be
lacking one or several parameters of institutional capacity that could impede their ability to
reach commercial funding sources. In that respect, MFIs should not be considered as
different from any other company: lack of institutional capacity constitutes a hindrance to

Lack of a Conducive Environment

10. In most developing countries, there are several constraints on the financing of MFIs. In
countries where a legal and regulatory framework for microfinance exists, savings
mobilization may be subject to MFIs being licensed and supervised by the Central Bank.
However, the Central Bank or supervisory body often lacks the necessary technical capacity
and resources to effectively supervise regulated MFIs. In the absence of an appropriate
regulatory framework, savings mobilization is often not allowed and MFI legal status is not
diversified (with no recognition of the plurality of approaches in microfinance). In addition,
prudential norms and ratios are not usually adapted as they often derive from those in force
in the banking sector (e.g. capital adequacy requirement). The microfinance sector also
frequently suffers from government interventions such as interest rate policy control that
distorts the market and undermines its sustainable development. Furthermore, the lack of a
policy for repatriating profits and limitations in foreign investments also discourages foreign
investors. Without proper regulations and supervision based on a legal framework that takes
account of the distinctiveness of microfinance, MFIs will not be able to attract financial
resources from the public or institutions and will continue to rely on donor funding.

Lack of Capital in Small and Emerging MFIs

11. The lack of capital to cover losses before MFIs become sustainable or to leverage
funding from lenders, such as banks or institutional investors, is a critical constraint on small
and emerging MFIs. According to Microcredit Summit Campaign reporting on
31 December 2001, 72% of MFIs reached less than 2 500 clients, and the combined rate of
the poorest clients of these institutions is only 3.1% (Rao, 2002). The capital base of these
small and emerging MFIs is often too limited to allow for continuous growth and for
accessing funding from the financial sector. Moreover, since most of them are not allowed to
mobilize savings, they rely on funding from financial institutions or donors. Risk-adverse
banks are reluctant to finance small and emerging MFIs insofar as their institutional capacity
is not yet fully developed and their financial needs exceed by far their indebtedness capacity,
calculated with a sound prudential ratio. Fortunately, donors have been important funders of
small and emerging MFIs. In addition, specific programmes in support of start-up MFIs have
been implemented over the past several years (such as MicroStart funded by the United
Nations Development Programme).

Inadequate Financial Infrastructure

12. In most developing countries, financial infrastructure such as MISs, accounting, and
auditing standards and systems are weak, inadequate and unsuited to the specific activities
of MFIs. Such a situation leads to lack of transparency in MFI financial reports, reduces their
sustainability, impedes fund-raising and slows down their integration into the banking/
financial sector. As mentioned earlier, while in most cases financial rules and regulations are
well adapted for banking, this is not the case for the microfinance sector, with the result that
funding of MFIs through commercial sources often poses problems. However, during recent
years, these issues have been addressed through, in particular, rating agencies and rating
systems that provide a standardized, reliable and clear view on MFIs’ financial reports and
activities, as well as through the Microfinance Information Exchange, a powerful instrument
through which MFIs can post standardized financial and performance information and
donors/investors can report on their investment strategies and activities.

13. Attracting commercial and institutional investors (both local and foreign) has also been
impeded by lack of experience in emerging markets; subsidized donor or government
funding to sustainable MFIs or social programmes targeting the same population; insufficient
social impact measurement; and the exchange rate risk associated with foreign investments.


14. As mentioned above, strengthening the institutional capacity of MFIs is often more
important than providing loan capital to expand their operations. But both actions often need
to be undertaken at one and the same time – albeit at different scales and by different
actors, depending on the phase of development reached by the MFI: start-up; growth; and
maturity and institutionalization.

Financing MFI Development: Role of Donors, MFI Clients/Members and Banks

15. During the start-up phase, MFIs need technical assistance (TA) to build up their
capacity (in particular members/clients and staff training), develop their organization, perfect
their products and services, and install tools, procedures and functions required for efficient
operations. TA financed through grant funds/subsidies provided by donors is of paramount
importance and a key factor of success in providing these young structures with the basic
knowledge they need to sustain their growth. MFIs also need subsidies to cover operational
losses, but it should be borne in mind that this should be only for a limited time. Such
subsidies should be based on financial projections that clearly identify the shortfalls between
operating costs and revenues from loan portfolio and other revenues during the start-up

phase until such time as the MFIs break even. At the same time, MFIs need sufficient
financial resources to implement and develop their lending activities. As previously
mentioned, too small a capital base becomes an obstacle to the long-term development of
an emerging MFI. Use of savings mobilized for onlending operations (if applicable) should be
avoided at this early stage of development in view of the limited experience and capacity of
start-up MFIs. Ultimately, MFI capital needs for strengthening their loan resources are
addressed by donors through grant funding, loans at low interest rates or quasi-equity
contributions (subordinated debt), and not by commercial banks, as the latter are risk-
adverse entities that generally avoid financing start-up MFIs. Financing through quasi-equity
does not give donors voting rights but might provide them with an observation/non-voting
seat in governance bodies (board or prudential committee). It also increases the amount of
funds that can be leveraged from banks or social investors, although donors should bear in
mind that the repayment of loan principal will alter the MFI onlending capacity and call for
new funding to avoid disruption in loan resources and portfolio size.

16. During the growth phase, MFIs extend their outreach, widen their geographical
coverage and increase the volume of their operations. Grants/subsidies are to be used to
finance new investments (such as equipment and premises for new offices, non-material
investments (such as training, research and development, and TA) or vital but costly
functions such as inspections or international audits). Since MFIs are not able to cover their
full operating costs with the income generated by their portfolio, subsidies to cover the
above-mentioned costs are still fully justified. Loan capital requirements are considerable
during this period of growth, and may be obtained in different ways. If an MFI is savings-
driven, savings and deposits will provide an internal source of funds, even if refinancing is
necessary to expand credit operations. An MFI based primarily on credit will seek external
resources that can be provided by donors in the form of credit lines and/or by commercial

17. The provision of a credit line (often at a concessionary rate) by a donor raises several
issues that need careful assessment: (i) What will be the impact on the MFI’s savings
mobilization strategy, if applicable, as a low rate of interest on refinancing loans/credit lines
may undermine its saving mobilization strategy? MFIs may choose the easiest and cheapest
source of funds instead of implementing a staff-consuming and costly savings mobilization
policy. (ii) How to maintain a high portfolio quality when a rapid injection of external capital
may overload the MFI’s absorptive capacity and lead to deteriorating portfolio quality?
(iii) How to combine access to external capital with the need to develop a long-term strategy
for mobilizing alternative resources to replace donors’ credit lines in order to avoid any
disruption in loan portfolio funding. In most cases, donors may provide loan capital until the
savings mobilized have reached a sufficient level to substitute for the line, if applicable; or
the MFI has reached a level of financial sustainability that enables it to access loan capital
from banks on a commercial basis.

18. In the event an MFI meets minimum performance standards, such as client outreach,
portfolio quality, strong and democratized governance and operational self-sufficiency, a
credit line could be transformed into institutional capital/equity. This would have the
immediate effect of increasing the indebtedness capacity of the MFI thanks to the leverage
effect on a larger capital base. This equity should be subscribed in the name of local
stakeholders (clients, staff and members) as a means of strengthening local ownership. In
the case of a donor such as IFAD, when a subsidiary loan agreement is signed between the
government and the MFI for providing loan capital, a promising exit strategy would be to
convert this loan capital into new equity to be subscribed in the name of local stakeholders,
based on agreed performance standards. This would help strengthen the financial basis of
the MFI while keeping the government away from the MFI management and decision

19. During the growth phase, loan resources may be also accessed from commercial
banks at market rates. However, in most cases, a guarantee provided by a donor or a
specialized entity such as a guarantee fund may be a pre-condition requested by the bank
prior to lending to an MFI. Overall donor experience with guarantee funds has been quite
negative, especially in the case of donor-funded or government-managed guarantee funds.
Some experiences have, however, been successful. ACCION International’s Bridge Fund
has given its affiliates commercial loans that they would not otherwise have been able to
access. The Bridge Fund issues letters of guarantee with commercial banks, which in return
onlend to the affiliates at market rates. After some time, these affiliates begin to borrow from
commercial banks without the use of the guarantee scheme. In parallel to this facility,
ACCION International has financed a considerable amount of TA to its affiliates for capacity-
building and institutional strengthening, and, through TA, successfully combined the
leveraging of its loan resources (necessary to help its affiliates achieve rapid growth and
sustainability) with investments in institutional strengthening and capacity building.

20. At the institutionalization phase, TA is needed for upgrading procedures; fine-tuning
services and products; adopting the most appropriate legal status; reviewing internal
organization; and preparing for the MFI’s conversion into a licensed institution. The cost of
TA should be borne by the MFI since it has reached financial sustainability. Conversion into
a licensed institution may require broadening and strengthening its equity base by bringing in
new investors/shareholders who would have a vested interest in bringing in their own
expertise. In principle, conversion into a licensed institution enables the MFI to leverage up
to 12 times its equity on local or international financial markets or to mobilize savings in the
same proportion. At this stage of development, which is characterized by financial
sustainability and strong institutional capacity, support to MFIs has shifted from donors
(during start-up and growth) to commercial banks and to public and institutional investors
(maturity phase).

21. The role of donors is of paramount importance during the early years of MFI operations
– this because they finance institutional strengthening and TA on the one hand, and, on the
other hand, loan capital. To reach this objective, funding is provided through
grants/subsidies, soft loans and quasi-equity contributions. Since institutional strengthening,
TA and increased activities are closely interrelated, donor funding should be considered as a
‘package’ with no strict earmarking of funds towards one activity or the other. Use of the
‘package’ should be subject to predefined minimum performance standards and criteria to be
met by the MFI. Such a package will also avoid difficult a priori determination of an
appropriate balance between grants/subsidies, soft loans and quasi-equity contributions.

Establishing a Favourable Environment: Role of Government

22. As we have seen, financial support from donors is not sufficient by itself to develop
sustainable MFIs and should be complemented by other sources of funding – from
commercial banks, other institutional investors and access to market resources in general.
However, an unfavourable environment for the microfinance sector would undoubtedly be an
obstacle to their commitment. The government has a key role to play by promoting the
necessary changes that will create a conducive environment for microfinance. Areas where
government intervention is needed include:

                    creating an enabling environment and removing financial repression policies
                     and disrupting interventions, such as imposing caps on interest rates, funding
                     competing subsidized schemes with low-cost resources or allowing for the
                     cancellation of bad loans;

                    issuing appropriate legal framework, diversified legal status and adequate
                     financial regulations for MFIs, taking account of their specific activities.
                     Adapting and easing conversion of MFIs into licensed institutions;

                    establishing effective supervision by institutions provided with adequate
                     resources. Adjusting the level of supervision to the level of activity and
                     sophistication of MFI categories;

                    implementing measures for promoting national and international shareholding
                     (such as unrestricted repatriation of profits) and issuing specific fiscal policy
                     for MFIs, especially for those reinvesting their profits in microfinance; and

                    facilitating coordination among donor interventions in the microfinance sector.

23. As microfinance is an ever-developing field of activity and sector, governments should
pass legislation by means of decrees, when feasible, since the enactment of laws is usually
more cumbersome and time-consuming.

24. The following table summarizes the role of each party for the three development
phases described above.

Development              Members,                Donors             Banks         Investors      Government
  Phases                  Clients
  Start-up                            (a) Grant
                                      funds for TA
                                      (b) Quasi-
                                      (c) Loan                       n. a.           n. a.
                                      funds at low
                                      interest rates
                                      for developing
                                                                                                 of a conducive
                                      activities and
                       Capitalization moving
                       Savings and towards
                         deposits     break-even
                                                                                                 investors and
    Growth                            (a) Grant                   Refinancing        n. a.
                                      funds for TA                loans at
                                      (b) Loan                    market
                                      funds at low                conditions
                                      interest rates              for strong
                                      to finance                  MFIs
   Maturity                                 n. a.                 Refinancing   Capitalization
                                                                  loans at


25. Two thirds of IFAD’s current projects have a rural finance component and about 18% of
its resources are dedicated to rural finance (in December 2003, the portfolio of rural finance
projects/project components amounted to USD 628 million, for total ongoing portfolio of
USD 3.3 billion). IFAD’s target group mainly comprises small producers engaged in
agricultural and non-agricultural activities in areas of widely varying potential. The Fund is
committed to continue exploring ways to promote rural finance markets, with the objective of
expanding access for the rural poor (especially women) to the financial services they need
(credit, savings, insurance, transfers etc.) through a variety of models and approaches that
show potential for both large-scale outreach and sustainability. In this context, IFAD support
has shifted over the years from large credit lines, often provided at subsidized rates from
state-controlled rural development banks, to the promotion of sustainable rural finance
systems that reach the majority of the rural poor through broad-based institutional diversity.

26. This approach is reflected in IFAD’s rural finance policy that supports innovations
related to key challenges in rural finance, such as building a strong rural financial
infrastructure, based on a variety of institutional models, that shows promise of large-scale
outreach and sustainability (see Boxes 1 and 2); promoting a conducive and regulatory
environment; and encouraging stakeholder participation, including the poor, in the
development of rural finance (definition of products and services offered, participation in
management, participation in equity and/or saving mobilization).

                                 Box 1: Financial Service Associations in Africa
IFAD has recently introduced a new type of institution in western and eastern Africa:
financial services associations (FSAs), which are self-financed through mobilization of local
resources in the form of equity, self-managed and profit-related incentive structures. IFAD’s
loans are used by local governments to fund TA for FSAs. The TA is provided by local non-
governmental organizations (NGOs) while the funding of FSAs loan capital is vested in the
shareholders. While many FSAs have broken even, the cost of TA is still not internalized – a
challenge for the future. The fact that FSA funds for onlending are still limited in scale has
restricted leverage possibilities to date. As the model matures, further options to overcome
these constraints will be examined.

                    Box 2: Rural Micro-enterprise Finance Project in The Philippines
Initiated in 1997 and closed in December 2002, this countrywide project was cofunded by the Asian
Development Bank and IFAD, based entirely on Grameen replication (162 replicators, including
banks, cooperatives and NGOs). The basic project facts include a cumulative outreach of 520 000
clients (December 2002), of which 98% were women. Over 92 000 small groups, 15 000 centres and
450 branches act as intermediaries in supplying credit totalling USD 34.1 million. Loan repayment
rates from clients to MFIs average 96.2%.
The driving force behind the project has been private rural banks and NGOs that have established
rural banks, thus contributing to the ‘commercialization’ of Grameen banking through vigorous
mobilization of deposits from poor and non-poor savers. Due to its high profitability, several banks
have been attracted to Grameen banking in The Philippines. Some people, who now have financially
sustainable operations with rapidly increasing outreach, have launched the idea of ‘franchising
Grameen’ as a commercial proposition for expansion throughout the country. Sector-based reforms,
which have led to the removal of interest rate caps and the phasing-out of subsidized credit
programmes, have also contributed to the profitability and viability of Grameen banking in The
There is scope for IFAD to support the further gradual expansion of financially sound MFIs to the
poorest areas of the country through quasi-equity investment, TA and loan capital. There is also
scope for improving the efficiency of rural financial service delivery through increased competition.

27. IFAD’s principal funding instrument has been long-term lending to governments, based
on different interest rates (intermediate, concessionary, etc.). The most concessionary term
is based on an interest rate of 0.75% and a 40-year repayment period with a 10-year grace
period. The Fund’s resources may be used in rural finance for TA or for providing liquidity to
MFIs. Liquidity may be provided in the form of credit lines, equity participation in apex
institutions or MFIs, or guarantee schemes. Credit lines are used to bridge a temporary
shortage of loanable funds in expanding or innovating institutions, but they should not be
seen as a lasting solution in the absence of local resources, institutions or term finance.
Equity participation strengthens the capital base of apex and rural financial institutions and
leverages additional domestic resources in the form of savings deposits (from clients,
members), refinancing loans (from commercial banks) or additional equity (from local or
international investors).

28. In the past, IFAD’s credit lines for the rural poor focused on financing agricultural
production and purchasing capital equipment, and were channelled through banks or
through integrated rural development projects. As a result, repayment rates and social
impact have been very mixed and in most cases disappointing. Today, IFAD places more
emphasis on strengthening the capacity of autonomous MFIs in rural areas and, as a result,
faces the challenge of adjusting its financial tools accordingly.

29. In addition to long-term lending, IFAD also provides grant funds that represent 8% of its
annually committed resources. These grants may be awarded to regional or local institutions
for innovative projects and action-oriented research and training activities, and for project
preparation. High priority is accorded to activities that strengthen the technical and
institutional capacity essential to agricultural and rural development, including rural finance.

30. In the past, governments have been inclined to use IFAD resources for lending to MFIs
for their own onlending rather than for financing TA. However, the different strategies and
approaches that have emerged highlight the need for more flexibility in the use of IFAD
resources. First, more and more governments have been sensitized to using part of IFAD
loans for capacity-building and institutional strengthening, recognizing that this is where they
may have the most impact in promoting strong retail institutions and creating a conducive
environment. Recently approved project/programmes, such as the Rural Financial Services
Programme in Uganda, have allocated the vast majority of IFAD loans to capacity-
building/institutional activities. Moreover, even when governments did not wish to incur a net
‘cost’ (to their national budget) for financing rural finance programmes, innovative solutions
have been found to ensure that sufficient funding goes to capacity-building/institutional
strengthening (see Box 3).
                       Box 3: Financing a Support Mix in an Asian Country
IFAD and the government of an Asian country have been negotiating a credit line on
concessional terms (repayment over 40 years, including a 10-year grace period). Should this
project be finalized, the government would agree to onlend part of the IFAD loan funds to a
rural financial institution under a subsidiary loan agreement (repayment over 10 years,
including an eight-year principal grace period and the same concessionary interest rate).
The subsidiary loan agreement would cover 40% of the amount of the IFAD loan while the
remaining 60% would be used as grant funds to finance TA for the rural financial institution.
Interest payments and repayments of the principal of the subsidiary loan would be invested
by a commercial bank, which would function as a funds manager for the Ministry of Finance.
The net present value of the stream of returns on these investments would largely exceed
the net present value of the flow of interest and principal payments due to IFAD by the
Ministry of Finance. As a result, investments of the repayments of the subsidiary loan would
earn back the total IFAD loan. In other words, the rural financial institution would benefit
from a reimbursable loan for their onlending activity while also benefiting from grant-funded
TA. Thus, this would not represent a financial cost for the Ministry of Finance.

31. Since the primary need for MFIs is to have access to grant funding to finance capacity-
building and institutional strengthening, the above-mentioned approach would allow for
flexibility in the use of IFAD loan funds. The approach takes account of specific MFI needs in
accordance with each development phase. It also opens up the possibility for a global
financing strategy for the MFIs involved that would balance funding for capacity-building and
loan capital with periodic evaluations based on performance criteria for the continuation of
disbursements of IFAD loan funds. Thanks to this global approach, an appropriate balance
may be struck between institutional strengthening and TA, on the one hand, and the
provision of loan funds on the other hand, which would enable MFIs to more rapidly reach

32. Governments should consider that, in the long run, investing in TA and institutional
strengthening will enable MFIs to leverage a considerable amount of loan funds as they
convert into licensed institutions and are able to mobilize loan/equity from commercial banks
and/or investors. As mentioned above, financing the cost of TA and institutional
strengthening through grants can even be achieved at zero net cost for the government
while borrowing the resources from IFAD.

33. As far as MFI financing is concerned, an optimal approach would combine the flexible
mechanism for grant/loan funds with the conversion of loan funds into equity subscribed in
the name of local stakeholders. Such an approach, as in the case above, would require that
the government repays IFAD’s loan from resources other than incomes generated by the
investment of the subsidiary loan repayments.

34. IFAD’s contribution to MFIs in the form of quasi-equity has also been experimented in
two seven-year rural development projects in Algeria. These projects encourage the
development of a network of local credit unions (Caisses Mutuelles de Proximité: CMP) from
the national network (Caisse Nationale de Mutualité Agricole: CNMA – see Box 4).

                          Box 4: Quasi-Equity Contribution in Local Credit Unions
Some of IFAD’s loan funds are used for a quasi-equity contribution that matches members’
contributions by 4:1 on average during the first three years of each CMP’s operations.
Disbursements of quasi-equity are subject to annual evaluation of performance indicators,
institutional capacity and mobilization of funds from members. Another part of IFAD’s loan
funds is used to cover initial investments and losses during the first three years. The major
part of IFAD loan funds is allocated to TA, mainly for the training of elected and non-elected
members and staff, product and service development with focus on savings mobilization,
implementation of an efficient MIS, and for preparing procedural manuals. No credit line is
funded as CMPs are allowed to collect savings and deposits from their members. Finally,
some IFAD loan funds are also earmarked to strengthen the institutional capacity of the
CNMA regional offices that maintain supervision and control over the local CMPs. When
performance standards are met, the quasi-equity contribution is converted into equity
subscribed in the name of local stakeholders.

As a result of this scheme, the achievement of expansion and financial sustainability will be
accelerated, with the largest amount of IFAD funds dedicated to TA and institutional
strengthening of both local and regional institutions of the CNMA network. At the end of the
IFAD projects, CMPs are expected to have become sufficiently strong, both institutionally
and financially, to refinance their activities and to leverage significant funds within the CNMA


35. The microfinance industry has witnessed many examples of MFIs with large-scale
outreach towards the poorest, and of MFIs that have reached financial sustainability. In a
number of countries, macroeconomic stability and deregulation have created a policy
environment that is conducive to reforming rural financial markets and institutions. In some
countries, new banking legislation has provided a legal framework for licensing MFIs on a
commercial basis, as a result of which increasing numbers of poor people now have access
to financial services. However, in the vast majority of countries, there are still major
shortcomings in rural finance that call for country-driven, coordinated interventions. In
particular, close attention should continue to be paid to the financing side of MFIs.

36. There are many constraints and challenges on financing microfinance. The right
combination of TA and institutional strengthening, on the one hand, and provision of loan
funds, on the other hand, are key factors in ensuring strong and sustainable MFI
development. The funding of MFIs involves different players – donors, members/clients,
commercial banks and investors – depending on the development phase reached. Apart
from clients/members’ contributions, support from donors is often the only way of financing
MFIs during the early stages of their development. This support takes the form of grants and
loan funds (often at concessionary rates). Grant funds should be used for TA and loan funds
for onlending until the MFI breaks even. At this point, MFIs should be able to finance an
ever- increasing proportion of TA out of their own revenues. During the maturity phase,
donor support is no longer needed as commercial banks can provide loan capital at market
rates and MFIs may seek equity or quasi-equity funding from various sources as they
transform into licensed institutions. Governments should support this process from the outset
by removing financial repression policies (i.e. interest rate caps) and creating a favourable
environment, including adequate legal frameworks, efficient supervision and adapted

37. Financing MFIs through loan funds, however, raises important issues that need to be
carefully addressed by donors. These include a possible negative impact on the MFI’s
saving mobilization policy (when applicable); the MFI’s absorptive capacity for external
capital and its ability to maintain strong portfolio quality through rapid growth; and the need
to adopt a long-term strategy to replace loan funds, once they are due for repayment.
Borrowed funds, whether from donors or from commercial banks, are moreover limited by
prudential ratios based on maximum leverage and equity, the latter being in most MFIs
notably insufficient (except for MFIs that are allowed to mobilize equity from members).

38. To overcome this problem, alternative funding mechanisms have been developed to
substitute credit lines by quasi-equity contributions. Such substitution results in a larger
capital base, leading in the long run to greater borrowing capacity on the part of MFIs. In its
most recent projects, IFAD has also tested several innovative approaches instead of the
classical credit lines extended by governments to MFIs under IFAD subsidiary loan
agreements. This is the case when (i) the subsidiary loan is converted into institutional equity
subscribed in the name of local stakeholders; or (ii) when the subsidiary loan combines loan
funds for onlending activities and grant funds for TA and institutional strengthening, whereby
the investment of loan fund repayments earn back the total donor loan.