Commercial Banks in Microfinance

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					Focus                              Commercial Banks in Microfinance:
                                                                                                                                        No. 12
                                                                                                                                        July 1998




                                   N e w A c t o r s i n t h e M i c ro f i n a n c e Wo r l d


                                    Little has been written about the role of                      Commercial Banks in
                                    commercial banks in microfinance. The                          Microfinance
                                    reason is simple: there has been little to tell
                                    because commercial banks have been so nota-                    Bankers in large commercial banks typically
         CGAP
                                    bly absent from this field. In their absence, a                mention the risk of default, high costs, and
The Focus Series is CGAP’s
                                    large number of non-governmental organiza-                     socio-economic and cultural barriers as the
primary vehicle for dissemi-        tions (NGOs) and other specialized institu-                    chief reasons that prevent their entry into
nation to governments,              tions have created financial technologies that                 microfinance. They also face some internal
donors, and private and             serve increasing numbers of the poor and sus-                  constraints such as:
financial institutions on           tain loan repayment rates that are not only
best practices in microen-          competitive with traditional commercial banks
terprise finance.
                                                                                                   q
                                                                                                         Institutional Commitment – The foray
                                    but also offer profits without subsidies.                            of larger commercial banks into micro-
Please contact FOCUS,                                                                                    finance is frequently dependent on a
CGAP Secretariat with               Now commercial banks in developing coun-                             handful of visionary board members rather
comments, contributions,            tries have begun to see microfinance not only                        than based on an institutional mission.
and to receive other notes          as a valuable public relations tool but a profit-              q
                                                                                                         Organizational structure – Commercial
in the series at:                   able venture and are beginning to examine the                        banks find it difficult to integrate micro-
                                    micro-finance market. At the same time, some                         finance within a larger bank culture and
1818 H Street NW,                   NGOs have transformed themselves into
Washington DC 20433
                                                                                                         structure that is not geared toward a high
                                    regulated banks. Today’s microfinance land-                          volume, small loan size business.
Tel: 202. 473 9594                  scape is being shaped by regulated micro-                      q
                                                                                                         Financial methodology – Most commer-
                                    finance banks created from these two different                       cial banks lack the financial methodologies
Fax: 202. 522 3744
                                    backgrounds, each offering their own distinct                        to reach and retain low-income clients who
e-mail:                             strengths and weaknesses.                                            require small amounts of capital.
CProject@Worldbank.org                                                                             q
                                                                                                         Human resources – Issues of recruitment,
                                    In November 1996, the U.S. Agency for                                training, and performance-related incen-
WWW:                                International Development (USAID) spon-                              tives require specialized consideration and
http://www.cgap.org                 sored a conference to examine the expansion                          effort, because microfinance operations are
                                    of banking services to microenterprises in the                       labor-intensive and require special people
                                    developing world. The first event of its kind,                       skills.
                                    the conference brought together bankers from                   q
                                                                                                         Cost-effectiveness – Traditional bank
                                    17 regulated financial entities in 16 developing
                                                                                                         mechanisms and overhead structures make
                                    countries to capture and share experiences,                          it difficult for banks to minimize process-
                                    learn about each other’s practices, and discuss                      ing costs, increase staff productivity, and
                                    obstacles. There were large, multi-service                           rapidly expand microfinance loan portfo-
                                    and state-owned banks and small, specialized                         lios – efforts necessary to cover costs and
                                    banks and finance companies.                                         earn profits.
                                                                                                   q
                                                                                                         Regulatory compliance – Fulfilling
                                    The purpose of this note is to share the find-                       reporting and regulatory requirements
                                    ings of a survey of these banks that were pre-                       to reflect microfinance operations calls for
                                    sented in a study published by USAID last                            new procedures that both commercial
                                    year (see citation). In this note, the word                          banks and government regulators have
                                    “banks” is used loosely to refer to commercial                       yet to develop.
                                    banks that participated in the conference.


CGAP      T H E C O N S U LTAT I V E G R O U P T O A S S I S T T H E P O O R E S T [ A M I C R O F I N A N C E P R O G R A M ]
Despite these constraints, commercial banks have several                      program at the Standard Bank of South Africa and the
organizational and structural features that can lend themselves               stunted outreach in Ecuador’s Banco del Pacífico, which
to successful microfinance operations:                                        after 23 years of operations in microfinance has only 4,000
                                                                              active loan clients.
q
    They are regulated institutions fulfilling conditions
    of ownership, financial disclosure, and capital                           Microfinance methodologies are so different from conven-
    adequacy to help ensure prudent management;                               tional banking that they are generally not understood by
q
    Many have the physical infrastructure, including                          most mid-level bank managers and sometimes are considered
    branch networks, to enable them to reach a large                          a second-class activity. Moreover, in instances where the
    number of microfinance clients;                                           microfinance program competes for resources and status
q
    They have well-established internal controls and                          with other divisions in the bank, it faces threats from within
    administrative and accounting systems to keep track                       the institution. Thus, a strong and committed leadership to
    of large numbers of transactions;                                         design, implement, and steer the development of the
q
    Their private capital ownership structures tend                           micro-finance operations is crucial.
    to encourage sound governance structures,
    cost-effectiveness, profitability, and sustainability;                    Administrative Mechanism
q
    Access to their own source of funds (deposits and                         Among the banks studied, four administrative structures
    equity capital) free them from depending on scarce                        were used to carry out microfinance operations:
    and volatile donor resources, and;                                        a) Fully independent retail centers, affiliated to the bank
q
    The ability to offer loans, deposits, and other financial                     but with their own lending policies, staff, and informa-
    products make them attractive to microfinance clients.                        tion systems that report to the larger bank (Banco del
                                                                                  Desarrollo’s microfinance subsidiary in Chile, the Unit
                                                                                  Desa of Bank Rakyat Indonesia, and the Social Enterprise
                                                                                  Program of the Bank of Nova Scotia in Guyana).
Key Findings
                                                                              b) Lending through NGOs that, in turn, on-lend to
                                                                                  micro-enterprise clients (Banco Wiese in Peru).
The study examined some of the factors that influenced
the entry of commercial banks attending the conference                        c) Semi-independent microfinance units lending directly
                                                                                  and/or specialized windows in each bank branch, staffed
into microfinance and the ways in which these banks had
                                                                                  with a microfinance credit officer. Administrative and
integrated microfinance into their operations.
                                                                                  financial functions are integrated into the larger bank
                                                                                  (Banco Agrícola Comercial, El Salvador; Banco del
Policy Environment
                                                                                  Pacífico, Ecuador; and Financiera Familiar, Paraguay).
It was clear that countries experiencing substantial financial                d) Fully integrated operations, wherein small business credit
liberalization offered a far more promising opportunity for                       officers also handle microenterprise clients. All adminis-
experiments in microfinance than those under a regime of                          trative, personnel, and financial systems are integrated
financial repression. The banks attending the conference                          (Centenary Bank, Uganda; Multi-credit Bank, Panama;
(see table) largely operate in countries that have undertaken                     Caja de Ahorro y Crédito Los Andes and BancoSol,
stabilization efforts in the late 1980s, and all but one have                     Bolivia).
deregulated deposit and loan interest rates. These develop-
ments allowed banks to charge the relatively high interest                    Most of the commercial banks attending the conference
rates on micro-loans and cover transaction costs, default risk,               offered micro-loans through a separate window or part of
and the opportunity costs of funds, thus encouraging their                    the branch office that handles only microfinance clients.
entry into the microfinance market.                                           This separation allowed both the staff and clients to recognize
                                                                              the terms and differences between the traditional commercial
High reserve requirements also pose an impediment to com-                     banking services and microfinance services. The study
mercial banks entering microfinance. The higher the reserve                   suggests a positive correlation between the degree of
requirement, the less the deposit base available for on-lending               independence of the microfinance unit and the scale of
and the lower the profits. The commercial banks from Latin                    the operation.
America did not enter into microfinance until the early 1990s
when reserve requirements declined from around 50 percent                     Moreover, banks with specialized independent microfinance
to more modest levels of between 10-30 percent.                               units or subsidiaries found it easier to institute microfinance
                                                                              lending policies, procedures, and methodologies and avoid
Management Commitment                                                         interference from the larger bank culture. Perhaps the most
In addition to a favorable policy environment, commitment                     dramatic example is Bank of Nova Scotia that operates a
to micro-finance at the highest levels of management and                      group-lending program in Guyana with loans mostly under
board of the bank is a necessary condition for successful                     US$300 under the umbrella of a large, sophisticated,
microfinance operations. The lack of strong commitment                        foreign-owned commercial bank.
appears to explain in part the short life of the microfinance

           CGAP     T H E C O N S U LTAT I V E G R O U P T O A S S I S T T H E P O O R E S T [ A M I C R O F I N A N C E P R O G R A M ]
Start-up and Funding Sources                                                 come a source of tension because of other (non-micro-
Typically, most banks cross-subsidized the micro-finance op-                 finance) bank employees who do not receive these bonus
erations from their own resources to cover initial sunk costs                remunerations. Some banks have managed this tension by
and operating costs for a period of two to three years. Some                 ensuring that microfinance staff salaries plus incentives do
banks, such as Bank Rakyat Indonesia and Centenary Bank                      not exceed salaries of other bank employees. Others (Bank
(Uganda) benefited from donor-subsidized technical assis-                    Dagang Bali, Banco Empresarial, National Bank for Develop-
tance. Others such as Family Finance Building Society (Kenya)                ment) gave the same incentives to all bank staff which
also had access to donor funds for on-lending, although these                eliminated the potential for tension.
amounts were less than 10 percent of their microfinance port-
folio. Few banks such as Caja Los Andes (Bolivia), National                  Financial Products and Services
Bank for Development (Egypt), Financiera Familiar (Para-                     There are some interesting departures and similarities in the
guay), and Workers Bank (Jamaica) received donor funds for                   savings and credit services offered by commercial banks from
on-lending and to cover their initial operating costs.                       microfinance NGOs.

The degree to which the larger banks used their deposit base                 Overall, the average loan size of the banks in the conference
to finance microfinance portfolios depended largely on the                   was less than US$1400. This loan size is larger than the aver-
opportunity costs of using deposits for this purpose compared                age loan size reported by microfinance NGOs. Moreover,
with returns for other uses. For many, the ability to charge                 loan maturities ranged from only one month to four years,
higher interest rates for micro-finance loans significantly                  with most banks offering loans with maturity dates beyond
closed this gap and made micro-finance lending an attractive                 one year (longer than is characteristic of NGOs). Most banks
alternative.                                                                 offered individual loans rather than group loans. Few such as
                                                                             BancoSol, Banco Empresarial, and Bank of Nova Scotia in
Cost Effectiveness                                                           Guyana also have group loans. Banks that offer smaller loans
Although most of the microfinance operations were                            rely more heavily on character references while banks with
profitable, the bankers generally considered the costs of                    larger loans require clients to offer household goods or find
microlending to be too high. While costs for microfinance                    cosigners as collateral.
are higher than conventional banking, there are several
strategies to reduce costs. For example, the smart card option               Among the similarities between commercial banks and NGOs
of Financiera Familiar appeared to be an excellent cost-cutter               is the frequency of repayments. Bi-weekly, weekly, and even
for processing repeat loans. A similar approach by Caja Los                  daily repayments characterize a number of the institutions in
Andes and Centenary Bank through the use of a credit line                    the conference. Also, like NGOs, these banks had very short
for repeat customers also seemed cost-effective.                             processing times (between one to seven days) for micro-loans.

Some banks may need to increase their interest rates to reflect              Unlike NGOs, all of the banks offered deposit services. Only
the fact that microfinance operations are more costly, but                   four of the banks (Bank Dagang Bali, Bank Rakyat Indonesia,
bankers often cite image or bad publicity problems associated                Standard Bank, and Workers Bank) had instituted explicit
with charging higher interest rates to poorer clients.                       initiatives to attract very small depositors. However, all of the
                                                                             banks reported having small savings accounts with balances
But the actual costs of microfinance operations within com-                  under US$500. Although Centenary Bank did not have a
mercial banks are unclear, especially when the operations are                special strategy to reach small depositors, by lowering its
integrated into a larger structure. Until there is greater sepa-             minimum balance requirement to US$10 (compared to
ration of costs in these institutions, and until banks with                  US$50 required by other Ugandan banks), it was able to
microfinance operations feel free to share income and                        attract a large number of small savers and had over 42,000
expense data, the question of whether or not microfinance                    savings accounts with balances under US$500.
operations are costlier for traditional commercial banks than
NGOs or specialized banks (such as BancoSol) will remain open.               In sum, although all of the banks had instituted some micro-
                                                                             finance techniques and innovations, many still need to adjust
Human Resource Management                                                    their products, operating procedures, and loan prices to tailor
Given the labor-intensive nature of microfinance services,                   their products and services and make them more suitable for
banks face a special challenge in the recruitment, training,                 microfinance clients.
and motivation of staff. Most banks at the conference hired
microfinance staff outside the bank and preferred young                      Role of Donors
university graduates with little experience. This made                       The study also discussed the role of donors in facilitating the
them more receptive to the special mission and practices                     entry of commercial banks into microfinance operations.
of the microfinance program.
                                                                             Donors can make an important contribution in improving the
Performance-based incentives as remuneration for loan offic-                 financial sector environment for commercial banks to enter into
ers, a common practice in microfinance institutions, can be-                 microfinance. For example, donors can urge governments to

             CGAP     T H E C O N S U LTAT I V E G R O U P T O A S S I S T T H E P O O R E S T [ A M I C R O F I N A N C E P R O G R A M ]
                     T H E C O N S U LTAT I V E G R O U P T O A S S I S T T H E P O O R E S T [ A M I C R O F I N A N C E P R O G R A M ]    CGAP
                                             Printed on recycled paper
                                                                                   fax: (301)718-7968 or at http://www.mip.org on the web.
                                                                                   Woodmont Avenue, Suite 200, Bethesda, MD 20814, USA; tel: (301) 718-8699;
                                                                                   finance World.” The study is available from Development Alternative Inc. 7250
 EarthWise Printing, Gaithersburg, MD (301) 977-3765.                              Valenzuela titled, “Commercial Banks in Microfinance: New Actors in the Micro-
 Focus Note Series Editor: Mohini Malhotra; Production: Valerie Chisholm;          This note is a synopsis of a study by Mayada Baydas, Douglas Graham, and Liza
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          40%p.a.          $34.6M          10,019              1.06             $1.61M               1,602              27%         Philippines
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                                                                                                                                    Panabo Rural Bank,
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           6%p.m.          $13.5M           1,100              0.61              $4.5M               4,658              20%         Paraguay
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                                                                                                                                    Financiera Familiar,
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          34%p.a.            $5.8M         22,500              0.93              $1.4M               6,000              85%         Society, Kenya
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                                                                                                                                    Family Finance Building
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          46%p.a.            $9.3M         60,900              7.80              $5.8M               3,900              83%         Centenary Bank, Uganda
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                                                                                                                                    Los Andes, Bolivia
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         3.5%p.m.            $1.2M            360              0.62             $8.62M               17,854             100%        Caja de Ahorro y Crédito
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                                                                                                                                    Guatemala
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          30%p.a.            $33M          20,000              1.98                $2M               840                11%         Banco Empresarial,
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                                                                                                                                    Indonesia
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          30%p.a.           $105M         344,619              3.73             $43.1M               13,133             83%         Bank Dagang Bali,
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          48%p.a.            n.a.         45,911               0.67             $30.2M               57,745            100%         BancoSol, Bolivia
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                                                                                                                                    Small, specialized banks
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                                                                                                                  program
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             n.a.            $51M            n.a.              8.44              $3.3M               177          New credit       Workers Bank, Jamaica
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                                                                                                                                    South Africa
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          50%p.a.           $20M          287,786              0.20            $138,000                 226       Negligible       Standard Bank,
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          30%p.a.           $1.7M         20,852               0.83            $13.5M                20,852       3.7%             Development, Egypt
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                                                                                                                                   National Bank for
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          32%p.a.        $143.3M           1,750               0.23              $8.6M               1,450           10%           Multi-credit Bank, Panama
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          32%p.a.        $2.8B             15.6M               0.76              $1.6B                2.4M          program
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
                                                                                                                   Unit Desa
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321Indonesia
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
                                                                                                                   100% for           Bank Rakyat Indonesia,
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
          41%p.a.              n.a.        n.a.                1.89              $19M                4,760           10%              Banco Wiese, Peru
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
          25%p.a.              n.a.        2,700               0.25              $1.2M               9,000          subsidiary)
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
                                                                                                                  (100% for        Guyana
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
                                                                                                                      9%          Bank of Nova Scotia,
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
        57%p.a.               n.a.         8,000               0.78             $4M                   4,000           2%          Banco del Pacífico, Ecuador
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
        3.7%p.m.              n.a.         n.a.                0.28             $17.6M               17,500        100%           Banco del Desarrollo, Chile
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
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                                                                                                                                  Comercial, El Salvador
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             n.a.           $3.3M         50,459               2.27             $14.8M               9,305              3.3%      Banco Agrícola
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
                                                                                                                                  Large, multi-service banks
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765432121098765432109876543210987654321210987654321098765432109876543212109876543210987654321098765432121098765432109876543210987654321
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         Rate          Balance         Accounts      GDP per capita    Microfinance loans       Loans            Microfinance
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         Interest      Savings         Savings       Micro-loan/       Balance of               Microfinance     Loans in
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         Effective     Outstanding     Number of     Avg. Outst        Outstanding              Number of        Proportion of          Institution & Country
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          2) What is the most appropriate level of subsidy, and how long should it be granted?
          1) What is the most efficient instrument for subsidy? (cheap funds, guarantees, technical assistance, etc.); and
     and/or free technical assistance. But two important questions emerge from this flow of donor resources to commercial banks:
     Finally, there is a useful but limited role for donors in supporting commercial banks entering microfinance through funding
   authorities on the difference between microfinance and traditional banking.
   Donors should support dialogues between banks providing microfinance services and regulators to help educate supervisory
   ratios are some of the elements that need to be modified to suit microfinance operations.
   sification and provisioning, restrictions on the volume of unsecured (non-collateralized) loans, and inappropriate operational cost
   microfinance. High legal reserve requirements, burdensome reporting requirements, inappropriate criteria for loan portfolio clas-
   Donors can help develop and encourage the adoption of prudential regulatory frameworks that recognize the special nature of
   costs of capital.
   schemes. These changes will help microfinance lenders compete in open markets and cover operating costs, risks, and opportunity
   eliminate repressive financial regulations, such as interest rate ceilings and burdensome reserve requirements or targeted credit