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					                                     INSTITUTO DE EMPRESA

                  Practical Challenges of Microfinance Institutions
                                     Dilin Lim
                        Master in Advanced Finance candidate
                                    December 2009

                               Completed with direct supervision of:

                                            Prof. Eloy Gracia

This research paper discusses the optimal combinations of stable funding and operating efficiency of
Microfinance Institutions to reduce interest lending levels to the Micro Entrepreneurs.


     In all models of microfinance, what are required are optimal combinations of stable funding and operating
 efficiency. We will examine to what extent the operational aspects of developing an efficient lending structure,
 transparency, loan follow-up and stable sources of funds contribute to the reduction of interest rates paid by
 the poor i.e. the client.
     The considerable interest that has been developed in the financial world and academia for the topic of
 microfinance cannot be underestimated. In fact, one of the most impressive developments in the world of
 social economic development in the last few years has been the successful explosion and impact of
 microfinance on society at large. Ever since socio-economic development became institutionalised in the form
 of the objectives guiding development banking, the elimination of poverty has been proved elusive. However,
 well known bottom of the pyramid seems to have now found in Microfinance is most effective partner.
     In this analysis I intend to explore how is that microfinance actually contributes to empower those at the
 bottom of the pyramid by allowing them to unleash the smaller or greater degree of creativity and
 entrepreneurship inherent that is in any human being. I intend to look into some of the detail of how the
 organisations that channel the funds to the micro borrowers operate and how the pecuniary costs and benefits
 are or not transferred to these. Certainly, there is a wealth of information regarding micro-financing activities
 in general but it becomes more difficult to obtain information when it comes to analysing a specific institution;
 generally, information provided in financial statements and websites do not offer the kind of detail that would
 be necessary to perform a sound financial analysis of the cost benefit relationship.
     Nonetheless, based on the material available there are some interesting findings and conclusions that can
 provide a worthwhile analysis. For example, by analysing the Asian versus the Latin American model of
 microfinance, it can be inferred what drives each and which of the two is more profitable from the purely
 financial and from the socio-economic point of view. Furthermore, within each of these two general models
 there are different variations depending on memberships and partnerships. These also have an impact on their
 cost structure and benefits to be pass-through to their members. In the findings, we list specific situations that
 address some of these variations but, in general, these are not conclusive. Further analysis will be required
 with the kind of data that was not available for this work.
     The conclusion reached is given that the breath of activity in the micro-financing field, there are so many
 “business” models that is not possible to reach a blanket conclusion as to which is better or worse. They all
 have their own merits and weaknesses and each has to be evaluated in the context of the groups (including
 owners) which they serve. Regarding the transfer of pecuniary benefits to the borrowers and beneficiaries they
 all do receive them, otherwise the industry would not be as successful as it seems to be, but it can be
 concluded with some certainty that there is plenty of room for additional benefits to be passed-through as a
 result of more effective cost management practices and application of low cost mass communication

Professor: Eloy Garcia                                    1                                DILIN LIM - MIAF 2009

     Microfinance since its inception has evolved in different parts of the world, where the poor experience
 different needs, political, sanitary and environmental concerns. Various Entities have been setup to provide
 support to the booming industry, considering just India growing at 28% to 47% from 2003 to 2007 in loan
 disbursements. [1] There is a surge in setting up various types of institutions and NGOS, profitable or not-for-
 profit, setup to provide direct micro loans or indirect funding to microfinance institutions. Microfinance is
 among one of the very few that are experiencing growth in the current economic crisis. The main reason
 driving this growth is the availability of 2.6 billion people equivalent to over 40 percent of the world’s
 population that still live on less than USD2 per day and more than 2 billion remain “unbanked” (i.e., without
 access to traditional financial systems). [2] A conservative estimate of the total market for micro-financing
 exists for 1.5 billion people, whereby now only 10% [3] is reached, justifying the reason of high growth in
 microfinance institutions. Initially, microfinance started in India as social clubs to provide social support and
 funding through donations to the poor. Today, the presence of microfinance has spread to every corner of the
 world, India, Russia, Afghanistan, Asia, U.S.A. and Switzerland in different forms to introduce capitalization
 in the economy from the needy. There are 2 general forms of microfinance models. The first and foremost is
 the Indian microfinance model that was started by Prof. Muhammad Yunus, winner of Nobel Prize Peace Prize
 2006. The next is the Latin American Model that emerged due to the variation in demographics of the Latin
 American compared to Asian regions.

              THE ASIAN MODEL
         The Asian model replicates the Grameen model of microfinance, founded by Prof. Muhammad Yunus
 that advocates micro lending to the poor, especially women as they are believed to be less likely to default
 compared to man due to children obligations. Lending and banking facilities are made available to women in
 groups, and repayments rates are ensured through detailed business plan assessment, social and group
 pressures. Financing is obtained from banks and through in-kind donations and a spread is added on top of the
 cost of funding to microfinance clients. Management of MFIs targets reducing the MFI’s cost of distribution,
 financing, operating efficiency to reduce interests charged to microcredit borrowers.
         The Asian model of microfinance is referred as a double bottom-line company, due to its social
 objective of reducing poverty and also profit seeking objective. [4] Both the goals of these organizations are
 weighted equally and performance is judged through the achievement of nonfinancial mission, such as the
 number of children clients are able to support through high school and universities. Double bottom-line
 companies are owned by its members and micro clients, each member and loan borrower has a stake in the

          A Primer on Microfinance in India - CGAP
           The Microfinance Market Today – GC Capital Ideas
           The Microfinance Market Today – GC Capital Ideas
           History of Microfinance – GC Capital Ideas

Professor: Eloy Garcia                                    2                               DILIN LIM - MIAF 2009

 MFI rather than just enjoying the services it provides. This structure of both member and loan borrower having
 a state is more commonly seen in India compared to Asia, whereby only members have a stake in the MFI.
 The Asian model replicating Grameen’s well structured establishment has very often create a strong
 microfinance institution that plays a part through large scale disbursement of small amounts, consequently
 incurring high administration cost in the process. Nevertheless these high costs are met by timely repayment of
 up to 94% equal to that of the Chase Manhattan Bank. It is the Human Factor which Asian model/Grameen
 possess as an integrated advantage that other microfinance institutions lack.
         Indian MFIs range from Grameen-replicator NGOs to for-profit entrepreneurial ventures
 to developmental NGOs which moved from Self-Help Group (SGHs) promotion to direct financial
 intermediation. Based on asset sizes, Indian MFIs can be divided into three categories. [5] In the first category,
 institutions are able to scale up their funds under management dramatically due to their ability to attract
 commercial capital. Examples of these institutions are SKS, SHARE, SPANDANA, which were initiated in
 the 1990s as NGOs promoting SGHs or Grameen model programs but after 2000, they converted into for-
 profit, regulated entities, mostly Non-banking finance Companies (NBFCs). In the second category, both
 NGOs and for-profit MFIs (mostly NBFCs) have high growth rates. NGOs transformed into regulated, for-
 profit structures recently or are in the process and seek commercial equity investments. For instance Bandhan,
 ESAF and Grameen Koota. [6] The third category comprises of MFIs equivalent NGOs that are striving to
 achieve significant growth. There are more than 1000 of these MFIs in India that offers micro credit with
 multiple developmental activities, such as micro insurance, and international transmission services. These
 institutions normally face difficulties in accessing the profitability of their funds, as costs of management are
 extremely high.

         The Latin American model is conducted in the form of solitary lending (i.e. lending to individuals as
 opposed to groups) focused on profit maximization and has objectives that are closely aligned with financial
 institutions in developed economies. There are various variations of the Latin American model however all of
 them use a common measurement of success that is largely through the financial earnings, performance and
 ownership therefore it is similar to “commercial” MFIs, justified by raising significant amounts of capital
 through IPOs or private equity investors. One such example is Banco Compartamos, a Mexican Microfinance
 firm that had a successful initial public offering (IPO) in 2007, has been denounced by Mr. Yunus and others
 for charging interest rates of close to 100% a year. [7] The Latin American model adopted by leading
 institutions has a commercial orientation in its operations, driven by financial performance, financing and
 ownership contract.

           A Primer on Microfinance in India - CGAP
           PRESS RELEASE: Indian Microfinance Institution Grameen Koota Receives $2.3m Equity Investment - Micro
           The debate over a “bubble” in micro lending – The

Professor: Eloy Garcia                                    3                                 DILIN LIM - MIAF 2009

         In this model, the smaller the loan size involved, the more important the character of the borrower as
 the borrower’s willingness and ability to pay is the key to the approval of a loan applied. Loan officers of the
 Latin American model evaluate the applicant as well as his/her business. This model is more responsive to
 customer’s demand and demonstrates more adaptability in structuring its services to customers. Due to the
 high commercial orientation of the model, MFIs have higher urban concentration (urban centres of developing
 cities). There is a larger diversity of customers as products offered corresponds to clients needs; clients feel
 valued have higher loyalty and trust in Latin MFIs, although they typically diversify their lending with a few
 MFIs to have flexibility and obtain more capital. Compared to the Asian model, the Latin model has 38% of
 women borrowers while in Asia and Africa, there are more than 60%. [8] Clients of the Latin model are
 mainly above poverty lines, and disperse a larger average loan size. When loan sizes are measured in terms of
 percentage per capita of GDP, loan size of Latin America is similar to Asia. The average loan sizes in Latin
 Model are used as a benchmark for client’s characteristics and focus of the model is on sustainability rather
 than poverty alleviation.

         Other types of MFIs are purely not-for-profit, they are associated with religious institutions,
 community-based or social-mission focused and policies are centred at maximizing society impact of capital
 deployed. By virtue of their business plans, they are also often reliant upon donor capital for support. [9]
 Each of 3 main models discussed has its benefits. The Latin American model, has a higher probability of
 ensuring long-term enterprise sustainability. Not-for-profits, have the flexibility in deploying its capital to the
 fulfilment of the organisational objectives as they are not accountable to provide satisfaction to earnings-
 driven shareholders. However, funds for Not-For-Profit MFIs are frequently subject to unpredictable donor
 support. Asian MFIs or the Double-bottom-line MFIs are the most highly debated model that combines both
 advantages of for- and non-profit MFI models to achieve the goal of poverty elevation. We need to examine
 how the different operational aspects of the Asian and Latin models highlight their challenges in providing

                - Origination, Loan approval and Disbursement process
         In our study of the Asian Model of microfinance, we will refer to the example of Grameen Philippines
 Catarman. Loan origination starts with clients submitting their business plan, key suppliers and targeted
 customers alongside with documents indicating the demographics of the loan borrower, including their family
 members, educational level, work experience, financial status and a copy of all the family’s latest water &
 electricity bill & local housing taxes bills.

             An Inside view of Latin American Microfinance (Inter-American Development bank)
             History of microfinance – GC Capital Ideas

Professor: Eloy Garcia                                      4                                  DILIN LIM - MIAF 2009

         The branch manager needs to approve the loan accessed by the loan officer and normally for clients
 availing loans for the first time, the loan officer will use the profile index with verification of actual documents
 such as checking on the electricity bill etc, visits the clients house for verification on the feasibility of the
 business project proposed by the client and attendance in training for succeeding loan releases to clients, the
 criteria is based on the performance and evaluation of project proposal. Subsequent loan requests after the full
 repayment of the first loan is based upon loan repayment, saving deposit, attendance in meetings and business
 project performance which can be accessed through the project notebook of the client that records weekly
 business                                                                                               transaction.
                Adopting the same example of the Grameen Philippines model, prudent loan approval measures
 prevent clients to make up a name and profile to take an additional loan from a different branch or loan officer
 after not being able to pay from the previous branch. In Grameen Philippine’s example, it is the centre group
 that will endorse the client. The centre group observes what we call "social responsibility" that they are
 responsible for the recruitment of additional members as well as the loans availed by the clients. This model is
 structured to access the profiles of micro lenders in-depth. Loan officers from the local municipality are hired
 to access the credit profile of the client. This helps to ensure a higher repayment rate in Asian MFIs compared
 to Latin American model. There are important emphasis on both the character of clients and often integrity of
 microfinance officers.
         In general, the owner of Asian model MFIs gives personal attention and takes a stringent selection
 process of each micro loan officers personally in order to ensure the integrity of each client assessment and
 loan transaction approved. The MFI’s assistant president, at a supervisory level authorizes the loan approval
 within 1month after origination, working closely with the president and performing weekly audit of all loan,
 on informs the client on the application status of the loan after visiting their house and neighbourhood. This
 adds another level of assurance to the loan assessment as the assistant president has more expertise in
 accessing client profiles and prevents any collusion between the loan officer and clients.
         Within 2 weeks of the next month, all approved new clients are scheduled for 3 consecutive training
 sessions. The first session is a financial lesson explaining to client how to manage their business cash flow,
 providing simple accounting tools to help them with the daily bookkeeping and explaining the importance of
 business management. Loan officers will check the bookkeeping of their clients on every weekly group
 meeting, to ensure consistency in cash flow balance.
         Next, transparency is achieved by the assistant president explaining to clients the uses of the interests
 rates/costs charged to them and also explaining how Grameen’s loan program protects the client by charging
 interest on amortising loan principle recalculated weekly. Interest of 20% is charged on diminishing principal,
 as principal is repaid first. Interest, calculated weekly on diminishing principal, is repaid only after the
 principal is paid off, allowing for an effective interest rate of 10 to 12%, Grameen sources say. [10] At the
 same time, clients are educated on the values of why they should manage their cash flow wisely and not try to

              Lender With a Mission - Bangladesh's Grameen Bank targets poorest of poor – Grameen Bank Bangladesh

Professor: Eloy Garcia                                      5                                 DILIN LIM - MIAF 2009

 provide personal loans to their group members through real examples of how clients may enter into a credit
 crisis through of excessive lending /borrowing that eventually complicates and destroy their business efforts.
 Finally in the last session, clients are taught to memorise the 10 basic commandments which has been
 amended specifically to meet the demographics of clients in that region. After the assistant president is
 confident that all his clients know the 10 commandments which will be checked by the branch manager, in 1
 week’s time, a meeting is scheduled with clients at the central office of the MFI for the loan disbursement.
         To ensure safety of clients, if required state police and loan officers will escort the clients after
 receiving loan disbursements. The Asian model by adopting this clear process of loan approval avoids such
 problem of solitary lending as approving loans for clients with a similar name but different address, no
 documentation loans, carried out by commission-paid brokers, mentioning a business to get a loan but instead
 using loans to pay overdue bills and getting food for the family.
         Other examples of Asian models also include 3 hours of financial literacy training during the training
 classes and clients are required to pass a test indicating that they understand Interest rates, instalments, and
 other product features. However, in Grameen Philippines, a test is not required due to the expertise of working
 personals that provides an accurate character assessment of clients and an integrated approach of guiding
 clients on financials i.e. how to handle their business problems/emotions after each loan meeting.
         The Latin American model adopts solitary lending and bears similarity to the Asian model by
 providing other services such as micro housing, micro insurance. Micro lending in Latin America places a lot
 of emphasis on the personal integrity of its clients, and places little attention to the social economic
 characteristics of its clients, and risk assessments are based on value of business assets and personal wealth.
 The only non-economic Individual assessment is the character of its clients, which is key to Latin modelled
 micro credit products. Loans are approved on an individual case by case basis on the faith that clients will
 ensure repayment timely. Loans are disbursed at central urban areas to clients and there is lesser need to
 provide security services to clients around the urban areas. The Latin American model provides a diversified
 range of products available to clients; however the lack of collateral and social pressure to repay makes the job
 of loan officers more difficult in recouping the loan disbursements. A recent research of mix-market shows
 that Latin American models reap a higher profitability compared to Asian models as Latin modelled MFIs
 adopt higher shares of consumption loans issued reaping higher yields, profitability and lower portfolio
 quality. [11]
                 - Mechanisms of Loan management and Collections
         The risks of providing Asian model of microfinance is effectively reduced by peer-group monitoring
 through weekly public meetings - at which attendance is compulsory - for the repayment of loan instalments
 and the collection of savings. These meetings reinforce a culture of discipline, routine repayments and staff
 accountability. Day by day millions of poor has slogged to meet repayments and pushed Grameen, the pioneer
 of microfinance, on the World Map. This encouraged further replication of Grameen models in other Asian

              Does loan type matters for Microfinance Performance in Latin America – MIX Market

Professor: Eloy Garcia                                       6                                DILIN LIM - MIAF 2009

 models. It has effectively elevated living conditions of 2 million clients approximately equals to 14 million
 families with 94 percent women. The quality of the portfolio is maintained by quality managers that perform
 random weekly audits to each branch of a municipality, covering at least 5 branches in a week. Penalties are
 not imposed on clients for not attending loan meetings as long as clients are able to pass their loan repayments
 to the leader in the group and provide a valid reason for not being able to attend. Failure to do so will deter
 clients from achieving future loan draw downs.

         The risks of Latin American model is that micro borrowers perform activities with limited productivity
 that do not require many assets which may make them more vulnerable to market changes and business cycles,
 for instance personal services such as hair dressing and providing tricycle-taxi services. Clients are given small
 initial loans that are within their ability to pay, next the clients are given a larger amount if repayment was
 reliable for the previous periods. There is motivation to honor obligations that is reinforced through a firm, and
 lenders adopt an aggressive attitude towards arrears. Loan officers do not tend to drop a loan if it’s more than
 30days overdue capital or interest repayment.

         Latin American MFIs have a more decentralized management structure compared to Asian Models.
 Loan officers and branch manager’s makes the majority of the decisions for individual microcredit. Successful
 institutions with good credit methodologies and internal controls are able to manage portfolios of thousands of
 small uncollateralized loans and achieve high recovery rates with the help of technology. The benefits of
 decentralization are boundless, as branch managers with the availability of technological infrastructure such as
 PDAs (Personal digital assistant) are able to provide timely information of daily frequency to inform loan
 officers of repayment performance. The timeliness and reliability of information is a critical advantage
 compared to the Asian model that are prone to mistakes of human error through updating excel spread sheets
 of clients entry by entry manually. The Latin American Model also performs strong internal control through
 routine and surprise audits so as to ensure compliance and clear reporting if any restructuring of loans are
 performed. There are strong credit policies in place to prevent delinquent borrowers from organizing pressure
 large scale loan rescheduling, lower interest rates, or even debt forgiveness, as what happened in Bolivia. The
 Inter-American development bank has developed general best practices for credit and risk assessment of
 clients summarized as follow: [12]

              An inside view of Latin American Microfinance (Inter-American Development Bank)

Professor: Eloy Garcia                                       7                                  DILIN LIM - MIAF 2009

              Fig. I - Best practices for Credit and Risk Assessment by Inter-American Development Bank

                 - Human resources, promoting and marketing costs

      Research by the World Bank has shown that the Asian models of microfinance are increasingly
 incorporating technological advances13 to facilitate lending, expanding outreach and lowering costs. For
 example, while mobile phone-based banking (also known as “m-banking”) has exploded in the Philippines,
 South Africa and India, there are only a few examples of this application in Latin America, despite the
 enormous opportunities in the region. [14] New operational technologies such as phone banking, smart cards
 supermarket kiosks can reduce collection, loan processing and approval costs with reduced response times and
 timely information. Due to the intensive involvement of loan officers with their client’s assessment, human
 resources or manpower makes up the highest part of the cost in the Asian models. Promoting is usually
 through the word of mouth and is seen as an effective and trustworthy source as rural populations have least
 access to advertisements and have a biased view towards advertisements to be a marketing tool of capitalists
 made to tap their community, therefore reputation of MFIs, word of mouth and success stories of clients are
 critical as a natural promoting mechanism in Asian models. In this sense, marketing and promoting costs have
 a high correlation with the way an Asian MFI is managed and is highly correlated with the non-profit
 objectives of the MFI. This leaves the Asian MFI to continuously try to lower their costs of human resources,
 and be able to deploy human resources more effectively by reducing human commitment in the manual entry
 of each loan repayment and the problems of balancing the accounts in the month end.

              Refer to Annex I for elaboration on technological advances in Microfinance
              Building a dialogue to create best Microfinance practises in South America (World Bank)

Professor: Eloy Garcia                                        8                                  DILIN LIM - MIAF 2009

      Technology is used at 3 levels in microfinance, institutional level, institutional-client interface level and
 sector/industrial level. [15] At the institutional level, technology is typically used for delivering (low cost)
 retail solutions. A good use of technology helps to promote efficiency and client oriented products/processes
 so that the overall cost of delivering market led financial services is minimized. At the sectoral/industrial
 level, technology helps to provide the sector with information on various aggregate segments of individual
 clients and also individual institutions, in effect it acts like a financial services information bureau. [16]
      The Latin American models demonstrate innovation, flexibility and emphasizes on customer services.
 Latin American MFIs adopt low-cost alternatives such as the personal digital assistants (PDAs) for computing
 and information storage and retrieval, or smart cards for automated teller machines (ATMs) or m-banking in
 loan collection. Technology use helps to reduce time and number of documents required, and the MFIs are
 able to have a digital backup of all client data, to insure them against natural disasters or fires. One example in
 Peru and Bolivia, clients such as Quechua and Aymara speakers that do not read or write and speak the
 dominant language of the country are able to use smart card with fingerprint recognition technology facilitates
 repayment processes. [17] Both the Latin American MFIs and clients appreciate these solutions because it
 would help to dramatically reduce cost of human resources, transactions costs, including transportation and
      In the Latin American regions, marketing emphasizes on the ease of obtaining loans and the convenience
 of loan maintenance made possible by ATMs, Smartcards, credit scoring and biometrics are part of the
 packages offered to clients. Some Latin MFIs partner with retail stores and supermarkets to ensure repayment
 facilities possible even at supermarkets and some major retail stores. Despite the benefits of cooperating with
 large supermarket chains, the branding of MFIs and the partnering bank’s reputation might be a concern as it is
 unknown if the use of supermarket chains for repayment is perceived negatively by clients. Some clients may
 prefer to deal with bankers or loan officers instead of cashiers at supermarket chains. In Brazil, Lemon Bank is
 an example of a completely branchless bank that provides mainly bill payments through a net work of 6,500
 locations, has low brand recognition, due to the restrictions placed by regulators on brand prominence when
 using agents.
         From July to September 2008, CGAP conducted a survey of 152 MFIs to gather information about
 how MFIs use technology today, and how they approach future technology investments and identify weakness
 and opportunities in the microfinance technology market. [18] Among the 152 completed surveys, there are 48
 countries, with 44% non-governmental organizations and 60% less than 10,000 clients. Research by CGAP
 has shown that technology use in 2008 is more widespread that in 2004. Despite that in 2004 the survey is
 based on 270 sample size, percentage of respondents that were using manual systems or spreadsheets to

            Microfinance and Technology – Critical Issues, Lessons and Future Implications; Ramesh S Arunachalam
            Microfinance and Technology – Critical Issues, Lessons and Future Implications; Ramesh S Arunachalam
            Building a Dialogue to Promote Microfinance Best Practices in South America World Bank
            2008 Microfinance Technology Survey CGAP

Professor: Eloy Garcia                                      9                                  DILIN LIM - MIAF 2009

 manage loan portfolio decreased from 46% to 18%. In 2008, 53% use custom built software and 29% use
 commercially available off-the-shelf products (Refer to Fig. II).

                                           Fig. II - Loan Portfolio Management

                          Fig. III - Important results in technology system types by region19

           EAP: East Asia Pacific, ECA: Europe and Central Asia, LAC: Latin America and Carribean, MENA: Middle East
         and North Africa, SA: South Asia, SSA: Sub-Saharan Africa

Professor: Eloy Garcia                                     10                                 DILIN LIM - MIAF 2009

                       Fig. IV - Important results in technology system types by type of institution

                                 Fig. V - System constrains by number of clients

 Results show that the Sub-Saharan Africa, South Asia, East Asia and Pacific have the greatest number of MFIs
 using manual systems and spread sheets. Among them, the majority of MFIs reporting use of spreadsheets are
 NGOs and the majority of organisations with manual systems are Banks and Rural Banks. Automated systems
 are widely used to manage loans deposits, remittances, client information and MIS reports. However, many
 functions remain largely manual, including cost accounting, insurance, social performance and human
 resources. 41% of MFIs feel that their information systems prevents them from achieving goals while 57%
 report that funding is an obstacle to improving their systems, of the MFIs reporting that funding is a major
 constraint, 60% have less than 10,000 clients.[20]

              2008 Microfinance Technology Survey CGAP

Professor: Eloy Garcia                                   11                              DILIN LIM - MIAF 2009

                         Fig. VI - Advantages and disadvantage of different information systems

                  -   Demographics & Geographic limiting factors

         In a standard Asian model, MFIs work closely with local Rotary Club21 to encourage a well-balanced
 distribution of different types of businesses around the municipality. This solves the problems of micro
 entrepreneurs replicating existing small businesses that are already exiting. In Grameen Philippines, micro
 entrepreneur’s loans will not be approved if it is used to set up “buy and sell stores” in an area with more than
 5 existing within 5 kilometres in the same area. The rotary or local government regulates the agricultural
 activities to prevent over cultivation of lands in a same area, therefore if micro entrepreneurs requests for loans
 in such areas to build their business approval is possible only after consulting a pre-defined environmental plan
 of the area. Environmental constrains, deters the poor from building business activities as sometimes it is
 impossible to build or add to the existing businesses in the municipality due to frequent floods and rain. The
 Asian model also takes into consideration of the overall “wealth level of clients”. For instance, the problem of
 having few people that can afford “ice water” deters the business plan approval of women wanting to profit
 from making ice from refrigerators. Geographic conditions also affects the cost of distribution of micro-loans
 and the lack of proper infrastructure such as roads, sanitation and water are the main reasons why MFIs (both

           An example is the Rotary Club of Manila, first Rotary in Asia and the biggest in Philippines developed to
         encourage and foster the ideal of service as a basis of worthy enterprise and, in particular, to encourage and
         foster poverty elevation (

Professor: Eloy Garcia                                      12                                   DILIN LIM - MIAF 2009

 Latin and Asian) did not reach the deserted areas. Latin American model is structured to Fight unfavourable
 regulatory environment, poor economic conditions and also unfair competition.

         -        Training, education, and insurance services to unlock the entrepreneurial power of the
                  micro borrower.

         The poor is unable to emerge out of poverty due to such factors as lack of access to technical business
 making skills and viable business ideas that deters the proper use of borrowed funds from MFIs. The next
 critical factor of the lack of capital (Dead Capital22) will be discussed in Section B2. The practice of offering
 business to the poor whom have no existing business or business plan and no demonstrated business expertise,
 creates further repayment problems for the client and collection problems for the Microfinance institutions as
 clients are expected to not only run the business but also know accounting, financing and cash management.
         The Asian model of microfinance includes the delivery of skills to micro lenders. For instance, in
 Grameen Philippine Catarman collaborates with the University of Catarman to teach micro lenders
 environmental friendly ways of rearing pigs and simple ways of bio-mass technology that helps to sustain part
 of the electricity needs of maintaining the piggery. Grameen MFI collaborates with the local Rotary Club23 and
 through allocation of business plans and proper training, for instance micro lenders are taught how to make
 local delicacies, which requires techniques that are only known by family business to prepare the traditional
 food and start their own local eatery for the local agricultural/construction workers that travels by foot for
 more than 2 hours to their existing jobs. Other types of business techniques taught includes, clothes making,
 hair dresser services, beauty parlour services, dancing expertise, tricycle-taxi services etc.
         Both the Asian and Latin model of microfinance provides complementary medical and life insurance
 to its clients. A good example of life insurance is TATA AIG that has conducted a pilot with CRIG Agents for
 insurance premium collection – under the DFID FDCF projects. The use of technology should scale up
 operations (under new, more flexible micro insurance regulations), enhance controls, and improve front-end
 processes (cash collecting and receipting) – DFID FDCF24. TATA AIG, a life insurance in AIG also uses
 Audio visual vans in Andhra Pradesh to promote its products to low income people in a friendly and
 transparent manner as the marketing of insurance is not easy to the poor due to past bad experience of micro
 borrowers.25 The provision of such services is seen as a value added factor by clients and helps to attract new
 customers. TATA also has a web platform used by TATA-AIGs rural community insurance groups (called
 CRIGs) to track claims and inform anxious customers who otherwise would have to wait long to know about
 the status of their proposal, especially given the remoteness of some areas.[26]

            The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else - Hernando de Soto
            Refer to footnote 20
            Cited and quoted from FDCF on website
            Microfinance and Technology – Critical issues, Lessons and Future implications; Microfinance Consulting
            Microfinance and Technology – Critical issues, Lessons and Future implications; Microfinance Consulting

Professor: Eloy Garcia                                    13                                 DILIN LIM - MIAF 2009

         One of the secrets of microfinance in Latin America and other parts of the world is customer loyalty.
 MFIs realize that for financial institutions, face time plus good service equals trust, and that translates into
 loyalty. In the Latin American model, loan officers develop new products such as micro-insurance and many
 more by first knowing their customers well, so that the products offered will correspond to customer’s needs
 and make customers feel valued. [27]
         In contrast, the Asian model expand by partnership with corporate, for instance Grameen has ventured
 into a partnership with a French company Danone to supply yogurt, modified to Bangladesh taste by reaching
 the poor through agents the process not only created jobs but also contributed to the development of rural areas
 in the process Grameen Danone’s sales and reputation increased tremendously. This Worldwide strategy is
 also adopted by Hindustan Lever Ltd in India and has proven to be successful in bring capital to the poor.28

         B2.     Funding aspects influencing Balance sheet

                 -    Efficient capital structure: Donations, Bank financing and NGO financing

     The most critical factor that deters the poor from emerging out of poverty is not only the lack of capital but
 also being trapped in a phenomenon of Dead Capital, that is to have the capital however having no legal
 title/claim to it. International funding of microfinance is in strong demand due to high growth in the
 microfinance industry. Typically MFIs look for 3 conventional types of funds namely own funds such as
 grants, donations or for more advanced MFIs, equity capital, or debt related funding in the form of loans debt
 securities or retail deposits that are available only to more advanced MFIs allowed to collect savings. [29]
 Currently, domestic sources account for 85% of microfinance funding while foreign sources account for 15%.
 [30] Although 15% seems a small percentage given the amount of attention given to private entry of inclusive
 finance, there is a large up surging market potential for continual growth in private inclusive financing of
 MFIs. The Fig. VII below shows the huge gap between supply and demand of the actual breakdown of funds
 in MFIs Source: McKinsey’s “Optimizing Capital Supply in Support of Microfinance Industry Growth”
 presented October 2006, Study drew upon 2004 data.

            An inside view of Latin American Microfinance - Inter-American Development Bank
            Hindustan Lever Ltd Case – Tuck School of Business At Darthmouth
            International Funding of Microfinance Institutions: An Overview, Ada Microfinance Expertise.
            Cf. Omtrix, “Giant Leaps in Microfinance” presentation, October 2007.

Professor: Eloy Garcia                                     14                                  DILIN LIM - MIAF 2009

                                           Fig. VII - Demand and Supply of funding needs31

                                                    Fig. VIII - MFI Funding Sources

              Optimising Capital Supply in Support of Microfinance Industry growth - Mckinsey

Professor: Eloy Garcia                                       15                                 DILIN LIM - MIAF 2009

                 Foreign funding was initially dominated by non-profit investors like development institutions,
         charities foundations and NGOs. They provide grants and subsidies usually to smaller or newer MFIs
         that are accompanied by technical and equipment assistance. [32] Followed by commercial investors
         entering the market the last. The first investment fund guided by dual bottom lines (financial and
         social) that was not launched by private donors or development agencies was Dexia Micro-credit Fund
         in 1998. [33] It is the recent 2 or 3 years that capital market structures such as portfolio securitizations,
         collateralised debt obligations (CDOs) and initial public offerings (IPOs) have emerged. Banco
         Compartamos is the first public offering by a microcredit lender in Latin America, the first initial
         public offering by any Mexican bank, as opposed to a financial group, and one of the first offerings
         out of Latin America by entities that define themselves by a social mission. Compartamos has reached
         more than 700,000 poor entrepreneurs in Mexico, 98 percent of who are women, with loans averaging
         $300 each. [34] A recent announcement of Deutsche Bank AG and Finca International, a microfinance
         company, working to revive the collateralised debt obligation market to help provide money to the
         poor in November 2009 is a justification of the start of untraditional forms of financing to MFIs. In
         this transaction, $21.2 million CDO is used as leverage to finance projects in the Congo and
         Azerbaijan. [35]

                 Structuring partnerships with commercial banks are a form of financing, it is essential to
         ensure that solid business principles prevails and that no one of a company’s business will depend on
         an ongoing subsidy for its success, through start-up subsidies often help reduce the risk of
         experimentation, but dependence on subsidy will lead to operational hiccups and failure. [36]
         Certainly, one of the main resources of these unions is a considerable gain in efficiency thereby
         producing savings that maybe pass through the final micro borrower.

                 Commercial banks have the main advantage of access to plentiful funds which make them
         potentially successful competitors in the microfinance market. An example of a highly successful
         commercialized bank in microfinance is Banco Azteca that has amassed 1500 branches around the
         country and becoming Mexico’s third largest banking network. [37] On the contrary to Banco Azteca
         that uses a highly commercialized approach to microfinance, ANZ Bank, an Australian commercial
         bank has infuses funds into the microfinance industry in a highly social manner through the

            Cf. Omtirx, “Giant Leaps in Microfinance” presentation, October 2007.
            Cf. ADA and P. Goodman, “Microfinance Investment Funds, Key Features” 2005
            Press Release: Mexico's Largest Microfinance Bank Taps Global Equity Markets in the First IPO by a Latin
         American Microcredit Lender.
            Deutsche Bank to use CDO market to help assist the Poor,
            Microfinance for bankers and investors - Elisabeth Rhyne
            Banco Azteca Exports Microfinance Formula from Mexico Southward - Microcapital

Professor: Eloy Garcia                                      16                                  DILIN LIM - MIAF 2009

         development of the program mobile rural banking scheme, and at the same time ANZ is also providing
         “financial training” to its clients in Fijian on topics such as savings, budgeting, and investment. [38]

                  Downscaling is evident in the Latin American model where existing financial institutions
         deepen the reach of their financial services-particularly credit-to smaller scale businesses and lower-
         income individuals. With competition increasing in the financial services industry in Latin America,
         formal banking institutions have become much more interested in downscaling.39 While MFIs are
         increasing the commercial equity in their funding structure, they should also have client’s needs at the
         top of their minds, if financial institutions do not protect the consumers, for instance by the subprime
         mortgage debacle in the US, the reputation and returns of the entire microfinance sector will be
         tarnished. As a result, much focus is drawn to the recent Deutsche Bank’s use of CDO as leverage to
         finance projects in the Congo and Azerbaijan.

                  The difference between working with banks and traditional microfinance institutions (MFIs) is
         in terms of the organization, operations and product offerings of commercial banks entering the
         microfinance market. As innovative practices and models materialize, MFIs partnerships have more
         centralised operations and greater reliance on technology. [40]

                  As a result, some of the world’s best-known MFIs have transformed into banks to take
         advantage of the benefits a bank structure offers for microfinance. Existing commercial banks has
         proved to be profitable in the microfinance market due to branch networks, access to capital, diverse
         financial products, and qualified human resources all provide banks with the fundamentals to launch
         and grow successful microfinance businesses. [41] Over the past decade, banks have entered the
         microfinance market, and recently a number of them have shown promising results in terms of
         profitability and growth. [42] In several of these more successful cases were found in countries as
         diverse as Ecuador, Haiti, Mongolia, the Philippines, and South Africa. Private banks that have
         succeeded in microfinance include Banco del Pichincha and its service company Credife (Ecuador),
         Khan Bank (Mongolia), Capitec Bank (South Africa), and Hatton Bank (Sri Lanka); successful public
         banks include Bank Rakyat Indonesia (BRI) and Banco do Nordeste (Brazil). [43]

                  The high growth in microfinance sector is evident across the globe and MFIs are facing global
         competition in donations, private equity, debt financing, investors such as non-governmental
         organizations (NGOs), development agencies and not-for-profit organizations such as World Bank and

   Story: Australian Bank ANZ Amasses 10 million Fijian Dollars (USD 5.3 million) in Deposits
         through Mobile Rural Banking Program
            An Inside View of Latin American Microfinance – Inter-American Development Bank
            Banks in Microfinance: Guidelines for successful partnership
            Banks in microfinance, guidelines for successful partnerships
            Banks in microfinance, guidelines for successful partnerships
            Banks in microfinance, guidelines for successful partnerships

Professor: Eloy Garcia                                      17                                   DILIN LIM - MIAF 2009

         UNDP. In India high-performing MFIs grow at sub-optimal rates due to capital constraint and often
         wholesales funds for on-lending and equity are seen as a single type of funding when judging capital
         availability. [44] In India, regulations require banks to devote at least 40% of their net bank credit to
         agriculture and weaker sections, historically disadvantaged communities and microcredit. Due to the
         large demand for funds on growth prospects in numerous sectors, flow of domestic funds to
         microcredit sector has been limited. The problem is that there are no “natural providers” of equity for
         MFIs, as a result growth of MFIs were constrained and unstable. In actual fact, equity for MFI in India
         is a constraint not only for microfinance but also for other small-scale enterprise and infrastructure
         sectors. [45] As a result of the lack of capital, we will discuss the 3 most commonly found financing
         models both in Asia and Latin America. They are namely the self-help group (SHG)-bank linkage
         model, financial intermediation by the microfinance institution model, and the Partnership model with
         MFI as the servicer.

                    The Self-Help Group (SHG)–bank linkage model is the most widely used model that
         accounts for nearly 20 million clients. Under this model, the non-governmental organization (NGO)
         also known as a self-help promoting institution (SHPI) helps groups of 15-20 individuals through a
         preparation period before they are provided with lending by the banks after this preparation period.
         The bank will provide single- or multi-period lending after the preparation period.

                    SHPI will incur expenses such as group promotion during the preparation period and barely
         receives, if they do, below cost reimbursement from the bank or even clients. SHPI supports these
         expenses of typically $35-250 per group by sources of external grant, and once the groups is linked to
         the bank, the SHPI takes on a supervisory role of the MFI portfolio.

                    Disadvantage of this model is that there is no incentive for the SHPIs to continuously monitor
         the MFI portfolio due to the fact that cost of manpower, time, cost of promotion and those of
         transactions are not fully charged to the clients. As the SHPI is not a financial intermediary, it does not
         allocate capital against the lending functions of MFIs. As a result, SHPIs are normally trusts funds or
         societies that do not take credit risk of the portfolio. It is the bank that takes on the linkage to MFI
         groups that bears the entire credit risk, in another words micro-lending has no recourse to SHPI that
         initiated the group in the event of default on loans. This pose a problem as the SHPI does not have the
         incentive to continuously originate high-quality groups and supervision of the portfolios are weak.
         Therefore high repayment rates of SHG-bank linkage program do not reflect the problem of the
         possible poor supervision due to a smaller portfolio that is not comparable to MFIs. Nevertheless there
         are cases whereby NGOs raise resources from donors and other agencies to maintain a high
         supervision level as repayment rates is directly correlated to the NGO’s reputation. As SHPI and bank
              Financing Microfinance – The ICICI Bank partnership model
              Financing Microfinance – The ICICI Bank partnership model

Professor: Eloy Garcia                                       18                             DILIN LIM - MIAF 2009

         branches scales up in micro-lending, more funding from donors is required for supervisory control and
         repayment rates are affected if funding is unavailable. Due to the limited number of rural branches, the
         SHG–Bank Linkage model is not viable to cover large villages and is not quick enough for expansion
         as it is seen as an initial testing ground approach to microfinance.

                   As the Asian model of MFIs has higher reliance on donor funds/grants compared to Latin
         American models, Fig. IX below [46] justifies that MFI sustainability decreases with higher reliance
         on donor funds/grants.                            Fig. IX - MFI Sustainability

         It is also observed in Fig. X [47] below that cost per borrower is higher for MFIs that have a lower
         sustainability percentage shown in Fig. IX below.

            Table is computed based on MIX market data of all of the MFIs with over $US 1.3 million in total assets, at least a high
         level of disclosure rating on MIX Market, and audited financial statements that are in English, French, or
            Table is computed based on MIX market data of all of the MFIs with over $US 1.3 million in total assets, at least a high
         level of disclosure rating on MIX Market, and audited financial statements that are in English, French, or

Professor: Eloy Garcia                                            19                                       DILIN LIM - MIAF 2009

                                               Fig. X - Average MFI Cost per Borrower

                    Financing Model 2: Financial intermediation by the MFI that borrows from commercial
         sources and on-lends to clients (groups/individuals). There are increasing amount of participation by
         commercial banks in the microfinance sector that eases the problem of lack of resources for growth in
         MFIs as they cannot take deposits and face limited availability of grant funds.

                    Most MFIs in India started operations with grants and concessional loans and gradually made
         the transition to commercial funding. [48] For instance, Bharatiya Samruddhi Finance Ltd (BSFL),
         one of India’s leading MFIs, financed much of its growth in the initial years with concessional loans
         from funding agencies and followed by raising equity from various domestic as well as international
         sources from 2001 onwards.[49]

                    In this model, the same portfolio receives capital allocation at two stages during its financing
         period. For instance an MFI requires a loan of $250,000 for its clients, the bank lends it to the MFI as
         an “organization-based lending”, and instead of finance for the underlying pool of borrowers “Asset
         based lending”. As MFI ratings are affected indirectly by the interests recovered from the poor as there
         is a need to pass costs to the poor due to the low level of equity capital, this is entirely different from
         traditional rating is benchmarked on historical loss rates on loans pool. MFIs is able to obtain capital
         according to the quality of their rating, when the initial capital is secured for lending (in this example,
         $250,000) it further allocates capital to provide for unexpected loan losses on the portfolio in order to
         satisfy its internal capital adequacy requirements. This explains the effect of double accounting of
         capital requirements for the portfolio of microloans first by the bank and secondly by the MFI. Prices

              Financing microfinance – The ICICI Bank Partnership model
              Financing microfinance – The ICICI Bank Partnership model

Professor: Eloy Garcia                                       20                             DILIN LIM - MIAF 2009

         of microfinance governed by the level of interests quoted to the poor will thus include capital charges
         at both of these levels. The MFI bears 100% of credit risk on the portfolio, and has the incentive to
         maintain high supervision levels, while the bank’s concern is directed at ensuring the MFI’s solvency.

                    Financing Model 3: The partnership model – MFI as the servicer

                    In 2002, an internal analysis by ICICI Bank revealed that despite consistent evidence of viable
         demand from clients, access to MFIs was constrained due to the organization-based financing model
         adopted until then. [50] Key characteristics of the partnership model of finance includes, loan not
         reflected on the balance sheet of MFIs as the arrangement of loan contract is made directly between
         the bank and borrower, this is similar to the SHG-bank linkage model. As the MFI services the loan
         till maturity, it has a financing structure designed differently compared to the financial intermediation
         model however the operational methodology is identical. In both the financial intermediation and
         partnership model, the bank relies on MFI’s sound operating policies for collection and supervision of

                    The partnership model is helps to separate the credit risks of MFIs portfolio from the banks
         and ensures that banks have the continuous incentive to provide funding to the partner MFI as both
         entities share the same objectives. For instance in some cases, the microloan borrower took the loan
         contract directly with the bank, and MFI acts as an agent in maintenance of this loan and ensures its
         collection. The partnership model solves this problem that most MFIs do not have risk capital in large
         amounts, which limits their ability to obtain funding from banks, despite that the there is a high
         potential of the bank is able to provide implicit capital.

                    The important advantage of separating the credit risks of MFI operations from banks is the
         factor of recourse of loans. Through direct lending to the underlying borrowers i.e. without funds
         entering MFIs balance sheets, MFIs are able to have recourse to the borrowers. However if the MFI
         managing the portfolio closes down the bank may not be able to recover the loan portfolio, even when
         the bank can appoint other MFI agency to for its portfolio as the key factor that ensures recovery of
         loan disbursed is the relationship of loan officer and loan borrower.

                    Another significant advantage of this model is that as the balance sheet does not reflect the
         liability of funding from banks, MFIs cease to require regulatory capital. As a result, the MFI turns to
         be asset based instead of organization based in its operations. This shift has crucial implications for
         rating, pricing and consequent marketability of the MFI. [51]

                    In order to incentivize MFIs that have an agent role, to continually guarantee the portfolio
         quality, the partnership model is made with a first-loss guarantee structure where by the MFI is

              Financing microfinance – The ICICI Bank Partnership model
              Financing microfinance – The ICICI Bank Partnership model

Professor: Eloy Garcia                                       21                             DILIN LIM - MIAF 2009

         required to provide a guarantee (typically a “first-loss default guarantee” (FLDG)) which it shares with
         the bank the risk of the portfolio up to a certain percentage typically ranging from 5% to 20%. This is
         different from partial guarantees where the guarantor is liable for a fraction of losses, say 50 per cent
         of all losses on the portfolio. The FLDG is a compatible strategy with the partnership model as it
         forces the guarantor to prevent losses from the start and the pricing of the FLDG is dependent upon the
         operating capability and maturity of the MFI. [52]

                    In essence, the lower the defaults the more profitable the MFI is in the long run, as there are
         less penalty charges from the guarantee it provides. The MFI collects a service charge from the
         borrowers to cover its transaction costs and margins. Overtime, the MFI accumulates retain earnings
         and built its core Tier I capital through the partnership model.

                     The problem of partnership model is its ability to ensure that MFIs have enough risk capital
         to provide the risk capital required in FLDG. In order to resolve the capital issue for MFIs in the
         partnership model, the availability of both debt and mezzanine finance is required. The provision of
         both debt as well as mezzanine finance and along with advancing the credit to meet the demand of the
         clients, Banks typically provide an overdraft (OD) facility to the MFI equivalent to the amount which
         the MFI is liable to provide as the FLDG.

                    Banks in the partnership model is able to acquire a risk-return profile that is similar to AAA
         asset, as it receives a fixed pay off from the fixed interest of the loan and transfer the dynamic benefits
         or losses of higher than expected recovery or losses are limited to the band defined by FLDG. With
         OD facility, the MFI is able to utilize funds in the event of a sequence of defaults to prevent
         insolvency and has to pay an interest rate equivalent to market rate on the OD drawdown. MFIs that
         have OD facility is equivalent to have access to mezzanine equity, acquiring leverage on its wholesale
         funding. In this way, MFIs are able to provide explicit capital, and implicit capital allocation by the
         bank is adjusted by the OD limit advanced to the MFI. Both explicit and implicit capital is separate
         from the capital that the bank provides for lending in the microfinance portfolio. This means that MFI
         is has the ability to leverage its portfolio, providing an upside for the MFI profitability and return on
         equity, without affecting the way operations are conducted at the ground level. [53]

              Financing microfinance – The ICICI Bank Partnership model
              Financing microfinance – The ICICI Bank Partnership model

Professor: Eloy Garcia                                       22                             DILIN LIM - MIAF 2009

                    The beauty of the partnership model is that MFIs are able to help themselves and also their
         partnering banks grow their loan portfolio sustainably without capital constrains. In fact, this model is
         widely adopted as a growth impetus in both Latin American and Asian MFIs that are maturing and
         faces high client demand. (Refer to Fig. XI Equity according to size and age of MFI)54 The age of
         transformation on Fig. XI depends on a number of factors highlighted in Annex II.

                               However the problem with heavy reliance on the partnership model will mean that
         microfinance will cease to be an anti-cyclical asset and it will be tough to decouple from future capital
         market trends unless the MFI has a accumulated a reasonable amount of Tier 1 capital and deposit

                               Microfinance Investment Vehicles (MIVs) provide fixed income and equity
         investments to MFIs. MIVs are managed by investment managers such as Blue Orchard, BBVA,
         Calvert Social Investment Foundation, Credit Suisse, Deutsche Bank, Developing World Markets,
         Microvest and Oikocredit. MIVs became increasing evident in the microfinance sector in the last five
         years and currently there are 103 MIVS in operation as 11 new MIVs entered the market in 2008,
         bringing the total number to 103, with a greater emphasis on equity investments and products like
         micro-insurance. Total assets under management in MIVs increased from $3 billion in 2006 to $5.5
         billion in 2007. More than 75% of these assets are invested in microfinance. The remaining 25% are
         invested in cash, cash
                                              Fig. XI - Equity according to size and age of MFI
         equivalents and small
         and medium enterprise
         institutions. [55] In 2008,
         MIVs recorded a 31%
         growth       amounting          to
         $6.6      billion,        although
         estimates show that MIV
         grew a further 16% in
         annualized Figures in the
         first     half       of     2009,
         manager of many MIVs
         are not expecting more
         than 29% growth by this
         year end. [56]                The

              Optimising Capital Supply in Support of Microfinance Industry growth - Mckinsey
              CGAP MIV Benchmarking Report 2008
              MIV investments in 2008 grew by 31%: CGAP survey published by Microfinance Focus

Professor: Eloy Garcia                                        23                                DILIN LIM - MIAF 2009

         largest class of MIV with over $1.8million in assets are registered mutual funds that have a steady
         performance over the past 3 years returning 5.8% in 2006, 6.3% in 2007 and 5.9% in 2008. However,
         returns are expected to fall below 3.5% in 2009 due to weaker demand for loans from microfinance
         institutions (MFIs), and increased hedging costs due to volatility in currency markets.57 Other findings
         of equity capital investments include: [58]

         • International Equity investments grew by 47%, out-pacing fixed income growth of 32% for the
         second year in a row. Major factors included growth in private equity funds with 13 funds totalling
         $253 million in assets in 2008 and in the number and size of holding companies. This shows a danger
         of bubble and overheating in the microfinance industry.

         • Region wise, Eastern Europe and Central Asia attracted 47% of investment, followed by Latin
         America and the Caribbean at 29.1%, Sub-Saharan Africa 6.2%, East Asia and Pacific 6.1%, South
         Asia 4.7%, and Middle East and North Africa 1%.

         • MIV investments remained highly concentrated, with top five countries with an exposure of 57.5%
         and top five investment exposure at 40.6%.

                  To qualify as an MIV for the survey these entities must have at least 50% of their assets
         invested in MFIs in emerging countries. 80 MIVs participated in this year’s survey, representing 93%
         of all MIV assets. CGAP, the Consultative Group to Assist the Poorest, classifies MIVs into the
         following peer groups: [59]

         • Registered Fixed Income Mutual funds: generally subjected to standard compliance regulations
              (Luxembourg, the Netherlands and the U.S.); open through share subscriptions
         • Commercial Fixed Income Investment funds: generally closed limited partnership funds
         • Structured Finance Vehicles (active and passive): closed special purpose vehicles (ex. CLOs)
         • Blended Value funds: foundations and limited liability companies
         • Holding Companies of MFIs: invest only in MFI partners
         • Private Equity funds: closed limited partnership funds

                  In order to determine what environments best fits the commercial equity for MFIs, the
         management of MFIs needs to analyze the maturity of the industry and scale of operations, whether
         the commercial equity is suitable for the current regulatory environment, political and economic

            MIV investments in 2008 grew by 31%: CGAP survey published by Microfinance Focus
            MIV investments in 2008 grew by 31%: CGAP survey published by Microfinance Focus
            How MFIs are Sourcing Capital Blue Orchard Microfinance Investment Managers

Professor: Eloy Garcia                                   24                                DILIN LIM - MIAF 2009

         environments whether it is supported by equity investments and shareholder rights. MFIs must meet
         the following requirements in order to accept commercial equity: [60]

                                            Fig. XII - Commercial Equity requirements

                                  Fig. XIII - Financial Integration and level of regulation

                    The development of debt capital markets for microfinance are is becoming a focus as the main
         source of funding and typically MFIs have issued bonds in their local markets with partial guarantee
         support from one of the development banks in their country or in the region. There have also been
         private placements of Debt capital in MFIs. Other trends of debt financing including securitization are
         done locally in Bangladesh and India and Structured finance transactions such as CLOs have been
         done on a global basis as mentioned above.[61]

              Unitus Equity Fund LP
              How MFIs are Sourcing Capital Blue Orchard Microfinance Investment Managers

Professor: Eloy Garcia                                     25                               DILIN LIM - MIAF 2009

                 -   DEPOSIT BASE STRUCTURE

                 Deposits are the cheapest funding source as it is easier to obtain compared to other forms of
         debt. However, MFIs must have appropriate regulatory structure to collect and mobilize savings. MFIs
         typically view deposit services as value adding to the operations and highly valued by micro
         borrowers. Despite that MFIs are aware of the interest rates of fixed and short term deposits, the
         problem is that not all MFIs is able to calculate the true cost to implement and manage and its impact
         on reserves required by supervisory authorities. Although it is not profitable to take small deposits
         amounts however these small amounts for the MFIs that have typically more than 30,000 clients help
         to improve the long term viability of MFIs, as it is a value-added marketing factor used to attract new
         clients, it is also a source of stable funds, it reduces debt capital requirements and serves as a platform
         for cross-selling other microfinance products. [62]

                 In both the Asian and Latin American MFI models, those that are financed by Banks, credit
         unions and rural banks can mobilize savings while NGOs and Non-Banking Financial institutions
         (NBFIs) generally cannot. [63] Rural banks had the highest deposits to total asset ratio at 68%
         followed by credit unions, 58%, and banks, 35.6%. [64] In Africa and Latin America and Caribbean,
         the deposit to loan ratio is typically more than 50%, for the large and financially self-sufficient MFIs
         (number of borrowers > 30,000 and FSS is > 100%).[65] This represents 109 MFIs in the Micro
         Banking Bulletin database and almost half of all 231 financially self-sufficient MFIs. [66]

                 The Latin American model is more competitive as it typically charges higher interest rates and
         has better returns to obtain private sources of funding to fuel growth and at the same time due to the
         scale of the operations the Latin American MFIs are able to manage and benefit from a deposits
         program thus achieving continual operations on a mix of deposits and equity for their funding. In
         contrast the young Asian model has lower level of deposits as compared to the Latin model. However,
         there are an increasing amount of matured MFIs that are able to attract and manage an increasing
         amount of deposits and one example is Grameen Philippines (Refer to Fig. XIV Funding Structure
         of Grameen Philippines)

            MFI Capital Structure Decision Making: A Call for Greater Awareness 2007 CGAP
            How are MFIs sourcing capital – Blue Orchard Microfinance Investment Managers
            Micro Banking Bulletin
            How are MFIs sourcing capital – Blue Orchard Microfinance Investment Managers
            Micro Banking Bulletin

Professor: Eloy Garcia                                   26                                 DILIN LIM - MIAF 2009

                                    Fig. XIV - Funding Structure of Grameen Philippines

         C.      ANALYSIS


                 -       OPERATIONAL ASPECT

                 I have identified the future challenges in the operational aspect of MFIs to be focused in the
         area of training of loan officers, coupled with the usage of suitable information technology and
         through providing innovative microfinance products that continually attract new clients in a socially
         responsible and sustainable way to MFI operations. Another challenge directly correlated with the
         training requirements of loan officers are due to the lack of readily available educated workforce in the
         rural areas. The problem is that MFIs cannot hire their workforce from a different country as loan
         officers need to speak the same language, demonstrate understanding and liking to the local culture of
         the loan borrowers and also be educated to a sufficient level to have a high integrity, so as not to be
         manipulated or be in cohorts with the loan borrowers to cause unforeseen losses for the MFI.
         Training continues to be an important factor for MFIs, as they are moving into a phase of rapid
         expansion with standard operating models. MFIs must continuously add quality manpower to their
         operations without delaying the growth of the operations.

                 I believe that another challenge of MFIs is to define its legal format from the start. The MFI
         has to choose a legal format that permits it to take and activate deposits for use if required in future,
         assign loans, provide guarantees and retain earnings to facilitate the smooth execution of model.
         Given the objective of MFI, if it is for-profit, is allowed to seek commercial equity however if it is

Professor: Eloy Garcia                                  27                                DILIN LIM - MIAF 2009

         not-for-profit, such as the traditional Grameen model, a trust or society format will be more applicable
         given its objective however self-help group (SHG)–bank linkage model are seldom use due to its
         limitations in efficient outreach in terms of the small concentrated scale of the model. Choosing a
         suitable legal aspect is critical to successfully integrate microfinance with commercial bank
         operations, in order to take advantage of the bank’s reputation, systems, financing and human
         resources. Not only that, the legal structure should also enable the participation of outside investors in
         the governance structure and strategic alliances.

                 The most critical underlying issue for MFIs is to have a strong management system to better
         support and equip microfinance lending. It is important for the MFI to have strategic clarity, staff
         capacity, accountability for results, knowledgeable management and adopt the use of appropriate
         instruments/technology. Hence information systems should be able to provide timely, consistent and
         comprehensive information on clients and loans. In my opinion, it is evident that through the
         partnership between MFIs, governments, private investors and information technology organisations,
         facilitate the integration of new technologies into MFIs models, thereby reducing cost and maximizing
         the outreach to clients.

Professor: Eloy Garcia                                   28                                DILIN LIM - MIAF 2009

                    -   FUNDING ASPECT

                    The Asian model is more dependent on donor’s funds and lower flexibility due to its slower
         respond to financial crisis. Also, there are constrains of not being able to meet customer’s growing
         demand for services without integration into local financial and capital markets as the Asian model is
         still a standalone microfinance entity that prefer ownership of the MFI or bank to be members or
         micro borrowers, in order to keep the objective of serving the poor in the long term.

                    The Latin American model faces challenges to improve repayment rates and performance of
         MFIs, due to the mechanisms of loan approval. There are still requirements to be efficient in credit
         services provision to reduce costs of lending to their clients and facilitating repayment that affects the
         outline of the institution eventually. The next challenge to overcome is the ability to reach un-serve
         populations at the same or lower costs. As many rural areas are lacking infrastructure, security and
         distribution facilities, the Latin American model of micro banking at central city areas of towns
         suggests that concentration of services are target at better of clients in the rural areas. While
         controversies of possibilities of money laundering in the name of elevating poverty through MFI
         investments are undocumented.

                    In large countries, Latin American model faces high competition and risks of creating a credit
         bubble. The surge in Latin American MFIs provides the availability of liquidity to micro lenders.
         What happens is that lenders typically have existing businesses and finances a loan repayment by
         taking another loan from another MFI by using the same name but different address to document their
         loan report. As the Latin American area is big, hence it might be difficult to track for Loan officers
         through solitary lending as they do not visit the house of every client and are not aware of their social
         circle on contrary to the Asian model whereby local loan officer’s assessment includes the social circle
         of their clients.

                    “This research is relevant for MFIs not just in Latin America but throughout the developing
         world as we see the industry diversify and offer a wider variety of products to a larger customer base,”
         stated Adrian Gonzalez, lead researcher for MIX and author of the paper. “Credit types offered by
         MFIs are taking many forms and are no longer specifically to finance a micro business. Through
         analysis such as this, we can better understand the trade-offs that accompany offering different product
         lines and the impact it may have on an MFI’s portfolio and performance.” When compared to
         microenterprise loans, higher shares of consumption loans are associated with higher yields, higher
         profitability, yet lower portfolio quality. [67]

                    The funding model of MFIs are shifting towards the partnership model in the Latina American
         region, while in the Asian region it is still more or less dominated by the traditional Grameen model of

              Does Loan Type Matter for Microfinance Performance in Latin America? MIX Market

Professor: Eloy Garcia                                      29                                  DILIN LIM - MIAF 2009

         solitary lending. In the Latin American region, a model of financing that starts with the partnership
         model of financing and culminates in securitization significantly relaxes the capital constraint that was
         outlined above in section B2. [68] Institutional investor’s long-term horizon and double bottom line
         perspective will deter redemptions of funds in the industry. However the general problem is flight to
         quality of microfinance investment funds to larger microfinance that has caused a liquidity shortage in
         the smaller funds.
                    The introduction of capital markets financing to MFIs has many benefits that are outlined
         above, however they may also have large implications for the entire financial system. In India, the
         introduction of capital market financing to MFIs will create a sustainable model to originate “priority
         sector assets” that are short in supply. The development of the capital markets for microfinance ill act
         as a catalyst for secondary markets. Therefore, banks with the competence to originate assets can earn
         a premium for providing funds, while banks with no originating capability can rely on existing
         originators without having to build branch networks from scratch. In addition to that, I believe that
         microfinance securitization creates a new asset class for investors such as microfinance loans and the
         overdraft facilities that mitigate risks of MFIs.

                    Despite that adopting a partnership model will attribute positively to the participation of rating
         agencies, as ratings provides assurance to potential investors by indicating the quality of the MFI to
         guarantee full payment of interest and principal timely. However, there is a pressing problem that
         rating agencies through its commercial perspective in MFIs will incentivize MFIs to operate in such a
         manner that is detrimental to the poor’s well being, such as increasing interest rates to improve
         profitability of the MFIs at an unsustainable level for its clients. This brings us to the issue of whether
         MFIs are able to disperse cost savings in the form of lower interest rates to the poor which will be
         discussed in Part III of this paper.
                    The next point to note despite the many advantages the partnership model presents is the lack
         of working capital finance for MFIs to expand into new areas or in the early stage financing of MFIs
         despite that this model solves the problem of wholesale funds. If the solution of this is to encourage
         venture capital companies and other investors to take the initial MFI risk, eventually MFIs will be exit
         at a high price to book or multiple as capitalist attempt to price synergies of MFIs and have a negative
         impact on the poor unless the poor themselves are already the shareholders of these MFIs sold. Blue
         Orchard microfinance investment managers have provided information that pre-crisis valuation of
         MFIs are at 1.3x-1.9x book (historical) and 7.2x – 7.9x earnings (historical), this reflects that the rise
         in valuation is more of an issue of demand and supply of MFIs instead of its intrinsic value.[69] Also,
         there are differences between Indian/Asian multiples versus Latin American multiples which cannot
         be calibrated as MFIs should be compared with its peers in the same region.

              Financing Microfinance – the ICICI Bank partnership model by BINDU ANANTH
              How MFIs are Sourcing Capital - Blue Orchard Microfinance Investment Managers

Professor: Eloy Garcia                                       30                               DILIN LIM - MIAF 2009

                    The challenges of the current microfinance environment is not only to find a readily supply of
         equity or debt investors but also “responsible” equity capital that accesses MFIs not solely upon its
         numerical profitability such as repayment rates but also human resources and poor’s well being as the
         intrinsic driver of sustainable MFIs. [70]

                    II.       Lending to Microfinance Intermediary – savings on running more efficient
                              operation could be divided between micro borrower and micro lending

                    The ability of MFIs to allocate cost savings on running an efficient operation depends on their
         prior commitment to their funders or stakeholders. Hence, it is important to draft a clause in the loan
         agreement with funders specifying a limit for interest charged. Next in order to be aligned with the
         objective of poverty elevation, it is important for MFIs to indicate in their statutory registry the
         commitment to allocate a minimum percentage of their cost savings to their clients. This percentage of
         cost savings can be in accordance with their cost structure for instance if 40% of the funds are
         obtained from commercial lending, 60% of the residual cost savings should be allocated to the poor.

                    D. Findings

                    In the initial hypothesis of this paper I set out to analyze how different operational decisions
         regarding funding, management, and loan portfolio follow-up of MFIs impact on their final cost of
         operation, furthermore I also looked into if any savings could be produced in this end are transferred to
         the final clients.
         Accordingly, the general findings of my analysis are as follows:
         1.     Model Self Help Group may be considered a less efficient from its cost point of view because
                there is no incentive to monitor the loan portfolio; while the cost of manpower is reduced, the
                quality of the management and the product (i.e. loan portfolio) suffers. Certainly, it would be
                expected that a non-properly supervised portfolio would incur longer cost in the long run.
         2.     The Partnership Model, with MFI as the servicer, seems to be the most effective as it relies on
                MFI sound operating policies for collection and supervision, which adds to the cost of operation.
                In the long run as micro loan defaults are kept to a minimum and so is the cost of running the
                operation with attendant benefits to the users of the services.
         3.     MFIs in general incur a higher working capital cost and debt cost but when they take time to build
                a reasonably large deposit base, compared to other forms of more costly debt can be better
                positioned to pass through those savings of a lower funding cost to the borrowers.

              How MFIs are Sourcing Capital - Blue Orchard Microfinance Investment Managers

Professor: Eloy Garcia                                      31                                DILIN LIM - MIAF 2009

         4.   There seems to be evidence that through the partnership between MFIs, government, private
              investors and information technology organisations, facilitates the integration of new technologies
              into MFI models, thereby reducing cost and maximizing the outreach to clients.
         5.   It would seem while the Latin American model is more competitive, the benefits of that
              competition in the form of lower cost to the borrower is not achieved; it may be because the
              competition is geared to produce a higher Return on Equity (for the benefits of the owners), not
              necessary to pass through the benefits to clients in the form of lower costs.
         6.   In the special case of Grameen, where the bank is owned by the “Poor” (i.e. those borrowing from
              it) it peculiar non-profit structure guarantees that borrowers-owners benefit directly from any cost
              savings produced.
         7.   In a broader scope, it was also found that one major stumbling block to micro borrowers in
              reducing the cost to borrowing, is the lack of legal title to property which they de facto own; this
              topic has been widely researched by leading authors like Hernando de Soto in his book The
              Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else.

                 E. Conclusion & Recommendations

     In general, it can be concluded that different models of microfinance in different regions are driven by a
 variety of objectives when it comes to profitability. The Asian model, with society and economic development
 objective as their centre piece, seem to be more beneficial to the micro borrower when it comes to finding a
 lower cost of borrowing. In other regions, given the different variations provided by several models, it may be
 more difficult to arrive to a similar conclusion. To ascertain that they are better or worse than the Asian model,
 would require a further more in-depth analysis that is beyond the scope of this paper. As a continuation of my
 initial hypothesis, I would certainly consider researching this topic more in the future.

     There is, however, an additional point that, while not central to this analysis and anecdotal in nature, I
 think is worth mentioning since it came through while researching this topic. There is some concern that
 hidden in the large volumes of funds that are currently being directed to microfinance by investors and other
 types of providers, there may be funds of dubious origins that may be finding their way into this otherwise
 public-spirited field. While difficult to research, this could be a worthwhile topic to concentrate attention on
 particularly in the context of the regulatory framework of microfinance industry that is evolving.

Professor: Eloy Garcia                                    32                                  DILIN LIM - MIAF 2009

                                                       ANNEX I

         Below are some common technological tools used in MFIs operations.

             -   M-Banking

         M-Banking is the use of a mobile phone to conduct payment and banking transactions by MFI clients.
         It uses the existing rapidly expanding mobile phone infrastructure and has the potential to be
         deployed rapidly and affordably to expand access to financial services among unbanked people. M-
         Banking transaction costs are far less to process than a transaction at an ATM or branch so banks can
         make a profit handling even small money transfers and payments.

             -   Smart cards for automated teller machines (ATMs)

         Smart Cards are used as security measures and mobile banking transactions can be protected by a
         private key stored on the SIM card. The smart card issuer will generally be an institution of a certain
         size and all the participants in a smart card scheme are usually in some continuing relationship,
         usually contractual, with the other members of the scheme.

         E-money is in effect a conditional promise to pay any bona fide holder of the e-money in a manner
         similar to a negotiable bank note or letter of credit. Its utility depends largely on other’s confidence
         in the issuer’s ability to fulfil the promise to redeem the e-money at a equivalent value.

Professor: Eloy Garcia                                  33                                DILIN LIM - MIAF 2009

                                                            ANNEX II

                •   Key measures for Accessing commercial financing
                    An MFI is ready to access commercial financing when it has built an equity base through past
                    donor grants and has a positive net worth.71 MFIs can access commercial debt by borrowing
                    directly from commercial banks or by issuing financial paper in the market place. MFIs are
                    ready to access commercial financing if: (Source: Clark 1997).

                1. Have perfected their service delivery methods and product design to respond to the
                    demands of their market in a rapid and efficient way, ensuring an increased volume
                    operations and repeat borrowing.
                2. Have a strong sense of mission and a sound governing structure that is free from political
                    interference, so that they can make policy decisions that protect their financial health.
                3. Have a management team that focus on efficient service delivery and productivity, on profits
                    rather than volume, and sets productivity goals and incentive schemes
                4. Have information systems that produce clear, accurate, timely and relevant information for
                    management decision making and that focus on well-developed loan tracking and financial
                    reporting systems, reporting on costs and income both on a profit-centre basis and for the
                    MFI as a whole.
                5. Have a record of achieving high levels of financial performance, of incorporating appropriate
                    pricing policies based on the full cost of delivering the services, and of maintaining the value
                    of the donated equity.
                6. Maintain low levels of delinquency (well below 5 percent to 8 percent of outstanding
                    portfolio, with loan loss rates below 2 percent) to ensure optimum income and prevent asset

              Microfinance Handbook: An institutional and financial perspective

Professor: Eloy Garcia                                       34                              DILIN LIM - MIAF 2009


             1. Story: Australian Bank ANZ Amasses 10 million Fijian Dollars (USD 5.3
                 million) in Deposits through Mobile Rural Banking Program
             2. Banks in microfinance, guidelines for successful partnerships
             3. Does Loan Type Matter for Microfinance Performance in Latin America? MIX Market
             4. MFI Capital Structure Decision Making: A Call for Greater Awareness 2007 CGAP
             5. How are MFIs sourcing capital – Blue Orchard Microfinance Investment Manager
             6. Unitus Equity Fund LP
             7. CGAP MIV Benchmarking Report 2008
             8. MIV investments in 2008 grew by 31%: CGAP survey published by Microfinance Focus
             9. Financing microfinance – The ICICI Bank Partnership mode
             10. Cf. Omtirx, “Giant Leaps in Microfinance” presentation, October 2007
             11. Cf. ADA and P. Goodman, “Microfinance Investment Funds, Key Features” 2007
             12. Press Release: Mexico's Largest Microfinance Bank Taps Global Equity Markets in the First
                 IPO by a Latin American Microcredit Lender

Professor: Eloy Garcia                                 35                               DILIN LIM - MIAF 2009

             13. Deutsche Bank to use CDO market to help assist the Poor,
             14. Banco Azteca Exports Microfinance Formula from Mexico Southward – Microcapital
             15. Optimising Capital Supply in Support of Microfinance Industry growth – Mckinsey
             16. Hindustan Lever Ltd Case – Tuck School of Business At Darthmouth
             17. International Funding of Microfinance Institutions: An Overview, Ada Microfinance Expertise.
             18. FDCF on website
             19. Microfinance and Technology – Critical issues, Lessons and Future implications; Microfinance
                 Consulting Group.
             20. Rotary Club of Manila
             21. 2008 Microfinance Technology Survey CGAP
             22. Building a Dialogue to Promote Microfinance Best Practices in South America (World Bank)
             23. Lender With a Mission - Bangladesh's Grameen Bank targets poorest of poor – Grameen
                 Bank Bangladesh

              1. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else -
                 Hernando de Soto
              2. An Inside View of Latin American Microfinance – Inter-American Development Bank - Editado
              por Berger, Marguerite; Goldmark, Lara; Miller-Sanabria, Tomás.
              3. Microfinance for bankers and investors - Elisabeth Rhyne
                4. Microfinance Handbook: An institutional and financial perspective - Ledgerwood, Joanna

Professor: Eloy Garcia                                36                               DILIN LIM - MIAF 2009

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