The pain of failure: Liquidation lessons in microfinance
- Wednesday, September 16, 2009, 13:04
- Featured News, Investments
- 6 comments
By Daniel Rozas in Brussels
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Microfinance Focus, Sept. 16, 2009:
When Washington Mutual, one of the largest US banks, was shut down in September 2008 following the sub-prime crisis, its depositors and secured creditors suffered no losses, though shareholders and unsecured creditors lost around $12 billion. That was still about 4 per cent of the company’s assets.
However, in June 2006, FOCCAS, a once promising Ugandan MFI with an unusually committed client base, became insolvent and was closed. Its socially responsible (SR) creditors recovered nothing on their outstanding loans. A year later, WEEC, an up-and-coming Kenyan MFI lost its founder-director to an untimely death, and defaulted on its debt soon after. Its SR creditors too recovered nothing.
In the microfinance world, recoveries by creditors following an MFI’s collapse are rare. When MFIs fail, pursuing liquidations, even in the presence of relatively strong portfolios, is often deemed too costly and too difficult.
Though MFI failures are relatively infrequent, liquidations need to be examined by the microfinance community. So what is the evidence from prior cases? First, there is anecdotal evidence suggesting that borrowers view the closing of their MFI as a forgiveness of the loan. For example, when an NGO in Bolivia was merging with others to form Eco Futuro, rumors spread among borrowers that it was closing, and they stopped paying.
In addition, defaults among clients become self-reinforcing – as more clients see others not paying, they stop too, and this happens even faster in group lending, where after a “tipping point” of defaults is reached, the whole group falls apart. An example is the current case of Fundación San Miguel Arcángel (FSMF), a Grameen replicator in the Dominican Republic. Following extensive fraud by members of executive management, and subsequent scaling back of new disbursements due to losses, it found itself dealing with delinquencies of over 50 per cent and still rising.
The main obstacles to reasonable portfolio recoveries after an MFI failure have been two-fold: the difficulty of transferring servicing of microcredits to other parties, and the expectation of future loans as a key incentive for borrower repayments. These two issues interact to reduce creditor recoveries, causing them to suffer losses significantly in excess of what the MFI’s balance sheet would indicate.
Here, Paul Mayanja of the Stromme Foundation in Uganda has a suggestion – consider adding some physical collateral to the loan, even if it’s a symbolic amount, to ensure that the MFI management’s incentives after default would be aligned with your own. If, as a creditor you can gain control of the MFI quickly after default, or have a contingency operating fund to draw upon, if needed, chances of recoveries will be further improved.
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NB: “This featured News is based on research conducted by the author, which includes examples drawn from every continent, along with five in-depth case studies of MFI liquidations. The full results of the research are available here.” Download
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6 Comments on “The pain of failure: Liquidation lessons in microfinance”
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Thanks for sharing this. It is rare that MFI failures are openly discussed, which is a shame as we can all learn lessons from these “failures.” One point made in the article that is very important in the MF sector is the linking of repayment to loan renewal. This is one of the strengths and weaknesses in this sector – clients repay because they expect to receive a new loan if they do and generally MFIs renew loans almost automatically to good clients. In good times this leads to client retention and high repayment rates, but what happens in bad times, or even during a temporary funding gap? If this relationship unravels it is a big problem for the MFI. As for the value of collateral, it is different in different countries, but rarely easy to value, to seize and to sell so probably not worth much in terms of aligning incentives.
Karla — thanks for your thoughts. This is a short excerpt of a longer article that’ll be out in the upcoming issue, which in turn is based on a study of MFI liquidations I recently completed. With respect to collateral, Paul Mayanja was responding to what he saw in a particular case (failure of WEEC in Kenya). In that situation, the founder-director died unexpectedly, and her husband, who took over the reigns, had no interest in continuing the organization — his only focus was on unwinding his personal exposure to the debts. So all the MFI’s creditors who had physical collateral were fully repaid, but those who only had liens on the MFI’s portfolio got nothing. So the idea here is to enhance the MFI management’s incentives to cooperate with the creditors when the MFI is being wound-down. This would probably work in only a few situations — the article addresses many other options as well.
Daniel Rozas | Microfinance Focus
This is an interesting news item you have posted. It gives another dimension to the whole liquidation process. Armendariz & Morduch (2005) already indicate that if people expect a MFI to liquidate, they won’t pay back, because they are getting the money free.
I was recently discussing with the General Manager of Banque Regional de Solidarité of Togo and he adds another problem. Most loans to MFIs are working capital loans. By their nature, the working capital needs are permanent (and hopefully growing). Therefore, businesses require standing lines of credit or increasing lines of credit. If the money stops coming in (withdrawal of donors, withdrawal of wholesale credit), the default rate is forced to go from 5% to 80% because its not as if you could sell the asset and get the money back. You would almost have to halt the business.
By Arvind Ashta
Thanks also for the clarification on collateral. This may give pause to lenders who are taking a pledge on a portion of the portfolio. I always wondered what they would do if the MFI went under and/or they would actually have to take over ownership of the portfolio since, as you highlighted, there are not a lot of loan servicers available in these markets. The obvious solution would be to sell the portfolio to another MFI operating in the same area according to the same general principals, but I’ve not yet seen that happen and wonder how easy it would be.
Hi Karla and Arvind,
in fact you both touch upon two closely related points. The presence of collateral (at the borrower level — not the MFI level I was describing earlier) appears to be one of the best guarantees for a successful liquidation, as it effectively replaces the usual repayment incentive — expectation of future loans — with the desire to prevent loss of an asset. However, to collect this, you still pretty much need the original MFI’s organization — it’s difficult and costly to establish credible contact with the borrowers and carry out collections without it.
Arvind, on your point, I suppose for those borrowers who depend on the continuing rollover of the MFI loan for their business, and if they don’t have other credible sources (moneylenders, other MFIs, etc.), then you would see “true” defaults, in that borrowers would be defaulting out of necessity as opposed to by choice. However, since a large proportion (by some accounts a majority) of MF is used for consumption smoothing, and with MF being one of only several sources of capital for most borrowers (see Collins et. al. Portfolios of the Poor), I suspect that most defaults in such cases are in fact be driven by choice, exactly as suggested in the Armendariz & Murdoch’s work you cite.