By Alex Silva and Anais Concepcion

Microfinance Focus, January 7, 2012: The microfinance industry’s growth over the past forty years is best described as impressive.  In a relatively short amount of time, non-profit institutions founded by non-bankers have transformed into financial intermediaries, including full-fledged banks.  Funding has shifted from donor-dependency to a rich mix of private and public, international and local funders – some of whom created for the sole purpose of funding microfinance!  But growth spurts beget growing pains, and one of these growing pains manifests in failed institutions.  To be clear, the phrase “failed institution” does not solely mean institutions which collapsed and ceased to exist, but also includes institutions which faced a crisis so serious its net worth turned negative and the institution had to be intervened and transformed in order to survive.  Just as it is important to celebrate the triumphs of the industry, we must analyze the shortcomings.  We can only learn from the mistakes of others by examining and understanding the conditions which lend to error, and ultimately failure.  Microfinance institutions may fail for a variety of reasons, but the investigative paper “Failures in Microfinance: Lessons Learned” by Beatriz Marulanda, and others (1) in Latin America, sought to identify the most common causes of failure.  The investigation unearthed uncontrolled growth and loss of institutional focus, flaws in credit methodology, and systematic fraud as the main causes of institutional failure; all of which can be exacerbated by detrimental government policy.

Uncontrolled growth is a factor common to nearly all the failed institutions examined by the study. Explosive growth often results from a positive feed of expectations with which many of us in the industry are familiar.  First, the industry and the institution itself yield positive results and grow at a rapid pace.  This promising performance often leads to high expectations from funders and shareholders.  Then, the funding community, particularly the international, seeks to replicate past success.  Of course, performance expectations in themselves are not damaging; to the contrary, investors play an important role in guiding the institution’s success and must expect results from management. However, in an attempt to replicate past success, expectations may move beyond rational limits; for example, duplicating the portfolio every two or three years.

These extraordinary goals exceed the capabilities of the institutions, and regrettably the institutions most often adapt by losing focus on their niche and nature, slackening controls, and deviating from the established credit methods which led them to success in the first place.

An institution loses focus when it branches out to other product types, typically to serve a different client profile.  However, the MFI may not be prepared to respond to needs of a different segment of the population.  Or, worse yet, if the MFI is stretching its niche in order to respond to high expectations quickly, the institution may not take the adequate time and precautions before venturing into uncharted waters and may open a new, low quality portfolio which it struggles to manage.

Even worse still is when an institution strays from its established credit policies, typically in an effort to facilitate greater growth.  An example of this digression would be a non-bank financial intermediary which lends to groups.  In order to meet a growth quota, loan officers artificially bring individuals together to form a group, rather than letting groups auto-select.  Thus, the forged group loses the inter-member assessment quality and risk control of the group lending model; the officer-appointed cannot vouch for the credit worthiness of their fellow members.  This divergence from the proven methods leads to weakening portfolio quality for the sake of growth, a combination which is not sustainable.

Conversely, not all methodological problems arise from an abandonment of core lending principles.  In some cases, the credit methods were flawed from inception.  This tends to occur when a new institution mimics lending methods that have proven successful in other countries across the globe.  Yet, the methods which work so well in Morocco may not be appropriate for Sri Lanka or Uruguay.  To skip method adaptation to the new institution’s clients is an oversight which can end in the MFI’s ruin.

Similarly, downscaling banks often face difficulties in appropriating credit methods for one of two reasons.  The first is similar to the one mentioned above: imitating methods which apply to a region foreign to their target market.  The second difficulty lies in assumptions made about microcredit methods in order to keep operations uncomplicated.  For example, in some instances, banks who seek to downscale find similarities between microcredit loans and consumer loans: small loan sizes, requires intense and robust back-office, etc.  Thus, the bank may assume that microcredit and consumer credit can be managed in the same manner. However, in doing so, they fail to address the nuances of microcredit and ultimately their microfinance operation will fail (in some cases, in as little as two years).

On the other hand, failures do not always arise from exponential growth or flaws in credit methods.  We must recognize that systematic fraud can and has occurred in some institutions and that such fraud will lead to an institution’s dissolution.  Systematic fraud does not pertain to the handful of cashiers who may pocket money, or the loan officer who creates a ghost borrower. That type of fraud, while significant and requiring control, will not bring down an institution.

Systematic fraud refers to fraud at the executive management and board levels.  For example, imagine an NGO in which the CEO and Chairman of the Board are one in the same.  This duplication of roles in a single person weakens controls in the NGO for obvious reasons, such as weakening the board’s power to pursue the interests of the institution rather than the CEO’s reputation or family members’ businesses.  This type of fraud does not necessarily have to be sinister in nature.  Too easily can a person justify and rationalize why their interests align perfectly with the institution’s, and their intentions may be pure, but ultimately the reality of their choices may not be best for the institution and the MFI suffers for it.  Of course, more criminal fraud can occur, such as embezzlement.  However, even criminal fraud can be identified, contained and corrected if roles are not duplicated.  Thus, it is important to separate management and governance roles in order to mitigate mismanagement of the institution, regardless of the intention of the individual in question.

Finally, outside of the institution itself, bad government policy will exacerbate all of the roots of institutional failure listed above.  While microfinance needs prudent regulation to establish parameters and rules of engagement, not all policy is created equal, and some is in fact detrimental.  For example, microcredit operations are expensive by their very nature (small loans to rural areas with poor infrastructure serving clients with few mobility and communication alternatives) and therefore tend to be more expensive than traditional, larger credit lines.  This coupling of high interest rates and a poor target market leaves a bad taste in the populist mouth.  As a result, a low interest rate ceiling may be put into effect much to the detriment of MFIs who are suddenly forced to work with smaller margins by law – or no margin at all! Worse yet is a politician seeking populist appeal or votes (be wary of election season) who declares a loan holiday – “The poor don’t have to pay debts!”

Aside from policy, a government enthused by microfinance may try to participate in the market and offer microcredit of their own, nearly ubiquitously at lower rates than private sector competitors.  This unfair competition will undoubtedly cripple the existent MFIs in the country.

However, most harmful government policy tends to be short-lived, and a robust, adaptive, well-managed MFI may weather the storm despite the hard hits.  Yet, an institution already weakened by the aforementioned flaws faces almost certain collapse.  If anything, bad government policy can be seen as a harbinger of institutional failure, culling the good from the bad.

Ultimately, an institution is its own hero or ruin.  Fidelity to proven credit methods, proper controls and separation of power, realistic growth expectations, and mission focus are as critical for MFIs’ survival and success as they are for centuries-old financial intermediaries.  In other words, microfinance is not exempt from the lessons of traditional banking.

References: “Failures in Microfinance: Lessons Learned” was written by Beatriz Marulanda, Lizbeth Fajury, Mariana Paredes, and Franz Gomez. Their investigation and report was sponsored by Calmeadow, The Center for Financial Inclusion, IDB’s Multilateral Investment Fund, the International Association of Microfinance Investors, and Deutsche Bank.

About the Author: By, Mr. Alex Silva, Executive Director of Calmeadow Foundation and Founding Partner of Omtrix and Anais Concepcion, Investment Associate, Omtrix

(Disclaimer: The opinions expressed are solely those of the author and do not necessarily represent opinion of Microfinance Focus. Microfinance Focus does not take any responsibility for correctness of the data presented by contributors.)