Role of Commercial Banks in Microfinance - Literature review Example

Role of commercial banks in microfinance An analysis of the financial landscape reveals three mains types o microfinance service providers: formal, semiformal and informal (Churchill and Frankiewicz, 2006). The primary distinction between them is the degree to which they are overseen by external organizations; formal financial institutions are subject not only to general laws, but also to specific regulations and supervisions of the central banks, ministry of finance or an agency thereof (Churchill and Frankiewicz, 2006). Semiformal institutions are registered entities subject to relevant general laws, but not usually subject to oversight by a banking or finance authority. In other words, they are authorized by governments but are monitored by their individual boards of directors, a federation or other stakeholders (Churchill and Frankiewicz, 2006). Informal service providers are typically not recognized or register by government bodies and are monitored only by their members or the communities they serve (Churchill and Frankiewicz, 2006). These are MFIs. Development banks that enter the microfinance scene have three competitive advantages. First, an extensive branch network that offers immediate channels for market penetration; second the ability to offer payment services and savings, with implicit or explicit government guarantees; and access o the resources needed for transformation (Churchill and Frankiewicz, 2006). If development banks get it right, they can be formidable competitors but getting it right is not easy (Churchill and Frankiewicz, 2006). Transforming these banks involves overcoming a corporate culture that is antithetical to microfinance (Churchill and Frankiewicz, 2006). Most MFIs function as non banking financial institutions that specialize in microfinance (Churchill and Frankiewicz, 2006). In these cases, it is up to the MFI to attain the status of a financial institution (Churchill and Frankiewicz, 2006). Besides these legal denominations, some MFIs operate as financial institutions by assuming an existing non bank legal identity (Churchill and Frankiewicz, 2006). Since the 1980s microfinance has become an important component of development, poverty reduction and economic regeneration strategies across the world (Rhyne, 2009). By the early twenty first century tens of millions of people in more than 100 countries were accessing services from formal and semi formal microfinance institutions (MFIs). It has become a vast global industry involving large number of governments, banks, aid agencies, non-governmental organisations (NGOs), cooperatives and consultancy firms and directly employing hundreds of thousands of branch level staff (Rhyne, 2009). Much of the initial excitement about MFIs centered on Bangladesh’s much lauded Grameen Bank, which talked of the transformation of economic and social structures through a bottoms up approach that made the social mobilization and marginalized communities and particularly that of women its main focus (Rhyne, 2009). In understanding the role that commercialized banks play in the development of the MFI industry, it is essential for one to understand first and foremost that access to financial services is a public good that is essential for enabling people in participating in the benefits of a modern market based economy (Rhyne, 2009).   Microfinance initiatives have emerged as an alternative to the well documented failures of government rural credit schemes in reaching small farmers and the formal banking sector to provide services to low income households (Rhyne, 2009). The following discussion will look at the place commercial banking has in the larger scheme of the microfinance institutions. In the beginning itself it becomes necessary to outline the fact that while the role of commercial banks in the financial inclusion in the developing world is important, not much has happened in the field of microfinance given the marked absence in the rural lending space. That said, the following article aims to outline the role played by, and the importance of commercial banks in the survival and growth the microfinancing industry. The article will end with a case study on the role played by the commercial banks, in rescuing the microfinance industry in India, where some of the more high profile MFIs have developed over the past few years (Baydas et al., 1997).   Commercial banks are defined as institutions that provide a wide gamut of banking and financial services including checking, time and savings deposits, deposit accounts (Baydas et al., 1997). They also provide loan facilities corporates, businessmen and people on a personal level. Commercial banks are supposed to be well suited to the role of lender, depositor and hence are supposed to have a part to play in providing institutionalized financial services to people with no access to them (Baydas et al., 1997). The reasons for this supposition include the following: 1. they are regulated and supervised institutions that function within accepted and regulated policy and fiscal frameworks which provides them with a certain level of predictability 2. Indeed, the sources of capital that are obtained reside in an entity independent from the MFI. This is a very important factor that guarantees the flow of funds to microfinance as it installs trust in donors. Indeed, one of the problems encountered by microfinance institutions is the lack of a systematic control of these organizations. There are very few credit-rating agencies supervising these institutions leading, to difficulties in the procurement of capital. (This problem will be discussed further in part III, which deals with the barriers to microfinance). 3. The third reason why these banks are apt in the role of microfinancing providers is to do with the very nature of their ownership patterns. Here, the important point of consideration is the fact that they operate under a private status, which would automatically then imply that there would be a requirement on the part of the business to make a success on each project, which would then imply a systematic success seeking mechanism. The institution would therefore then be robustly committed to the achievement of certain goals, such as financial viability. While commercial banks are intrinsically equipped to make profits, the present structure of microfinancing institutions is that of NGOs, which tend to encounter serious issues related to sustainability (Kiendel, 2003). This suggests that there are flaws built in to the NGO approach which tend to emerge from the very organizational designs of the MFIs (Kiendel, 2003). There are problems with property rights and governance structures, both of which are interestingly enough features which strengthen commercial banks. At the same time, NGOs usually are not responding to the widespread demand for deposit services from their clients, demand effectively serviced by banks . Finally, the most successful, path-breaking NGOs, two of which are investigated in this study, have transformed themselves into regulated financial intermediaries that incorporate deposit services as a growing part of their services (Shari and Churchill, 1997).   Commercial banks play the role of lending directly to micro entrepreneurs. Often, endeavors of this sort are common to banks that have been founded with the primary purpose of serving a clientele in the rural areas. These kinds of banks are referred to as regional rural banks and aim solely at servicing the microfinance sector. Among the better known examples in this case is the example of the Grameen Bank, founded by a certain Muhammad Younis in 1976 (Chavez and Gozales, 1996). The bank was set up with the sole purpose of helping the impoverished through the provision of small loans to a group of borrowers. Group lending consists of the attribution of a loan to each person in the group, but the loans are not renewed to anyone in the group if ever one borrower defaults on the loan. Consequently, through social pressure, the group lending method gives individuals incentives to be financially disciplined and to repay their loans (Schrevel and Phillipe, 2005). Another example is the ProCredit group which provides loans to small and medium-sized enterprises through its development oriented banks in Africa, Europe and Latin-American (Ledgerwood and White, 2006)..   Another important role is that of securitization. Securitization is the process opposite of the establishment of a fund. Conventionally securitization relates to the converting of loans of various sorts into marketable securities by packaging the loans into pools and then selling shares of ownership in the pool itself (Ledgerwood and White, 2006).. Loan securitization is emerging as a viable method for larger MFIs to manage their liquidity and credit risks. The securitiues are secured (or collateralized) by the assets themselves or by the income derived from them. The resultant income from the assets represents the primary source of payment of income to the investors (Ledgerwood and White, 2006).. Although used extensively in the United States by mortgage lenders and credit card companies securitization had not been widely used in the microfinance industry until recently. As highlighted by Janson (2003) this is due to a tranhe of variables that include the typically large (greater than Us $ 25 million) amount needed to be cost effective and various legal requirements that make securitization of a large number of small loans a prohibitively onerous and expensive process (Ledgerwood and White, 2006).. Although not unique to transforming MFIs, securitization van offer an interesting option for MFIs in the need of funding or those constrained by limited leverage ability. In a securitization deal, assets of the MFI, such as the loan portfolio are sold to another institution providing an infusion of cash into the MFI and perhaps even more relevant for transformed MFIs, removing the assets from the MFIs balance sheet, thus reducing the amount of required reserves that are associated with the assets being sold (Ledgerwood and White, 2006).. As such instead of having to wait for loans to be repaid to realize liquidity, securitization results in cash for the regulated MFI as well as frees up the amount of capital required to be held on reserve. The transaction costs and legal requirements associated with a securitization limit its cost effectiveness for most MFIs (Ledgerwood and White, 2006).   The issue of securitization, and of the relationship between commercial banks and MFIs  also needs to be understood in the larger policy framework (Hassan and Martan, 2003). On the policy level, microfinance has been embraced by politicians and the development community with the predictable result that some of its merits have been oversold. To achieve the fill potential of microfinance to serve poor households, MFIs need to become fully integrated with the mainstream financial system in the countries in which they operate. This will require financially sound professional organisations capable of competing, accessing commercial loans, becoming licensed to collect deposits and growing to reach significant scale and impact, the majority of MFIs do not yet fit this category, most are weak, heavily donor dependant, and unlikely to ever reach scale or independence. The encouraging sign till a year back, however remained the commercial success that some MFis were able to attain. Based in Hyderabad in India, SKS Microfinance, was able to list successfully on the bourses, with one of the more successful initial public offers (IPO) in recent history.   Partnerships enable MFIs to cut costs and extend their reach, while banks can benefit from the opportunity to reach new markets, diversify assets and increase revenues. Partnerships vary in their degree of engagement and risk sharing (Nallari and Griffith, 2011). The example ere is that of ICICI bank in India, which has been partnering with MFIs since 1996. In cases such as these partnerships refer to sharing or renting front office, in others to banks making actual portfolio and direct equity investments in MFIs. More MFIs are now obtaining their own licenses as banks or specialized financial institutions (Nallari and Griffith, 2011). This allows them to secure financing by accessing capital markets ad by attracting deposits from large institutional investors as well as poor clients. Several MFIs especially in Latin America, have accessed local debt markets by local financial institutions (Nallari and Griffith, 2011). Other countries are considering legislation to create new types of financial licenses, usually with lower minimum capital requirements, specifically designed for MFIs (Nallari and Griffith, 2011). The importance of and role played by commercial banking also becomes relevant in this case given the fact that MFIs are now beginning to tap into mainstream banks and retailers (Nallari and Griffith, 2011). More than 80 MFIs in Peru are registered to use Infocorp, a private credit bureau. Similarly in Turkey, Maya Enterprise for Microfinance negotiated with a leading bank, Garanti Bankasi, to gain access to the national credit bureau (Nallari and Griffith, 2011). The central bank in Rwanda requires that MFIs communicate information about their borrowers to a credit bureau (Nallari and Griffith, 2011). In general improvements in information technology help in the creation of new delivery channels for the provision of microfinance (Nallari and Griffith, 2011). To a large extent, the conduits are already in place-retail shops, internet kiosks, post offices, lottery outlets, the challenge is to make it possible to provide financial services in a more cost effective manner in poorer and more sparsely populated areas. The only issue is that the trend poses a risk of taxing the capacity of supervisory authorities as they assume responsibility for other part of the financial sector (Nallari and Griffith, 2011). Moreover, creating the infrastructure for specialized MFIs also means that there is a risk for the diversion of mainstream commercial banks and others from becoming involved in microfinance (Nallari and Griffith, 2011). It is important to note here that where their eventual integration into the mainstream is concerned, some of the more acceptable methods would include dependence on the country’s context and the requirement of its customer (Nallari and Griffith, 2011). More importantly, it is worth noting that most MFIs are now looking to obtain licenses as banks or specialized lending institutions. This would then mean that it allows them to access more funds in a more organized manner (Nallari and Griffith, 2011). There is a problem here given the fact that where the supply of funds is concerned to a given MFI, given the nature of their work, there is a tendency for the source itself to be unstable and dependent on the economics and politics where local conditions change rapidly. This a major risk (Nallari and Griffith, 2011). The problem here therefore is that most investors tend to remain vary of investing in MFIs, making it difficult for the MFIs to finance loans (Nallari and Griffith, 2011). Another problem arises from the ceilings on interest rates imposed by governments: microfinance institutions find themselves in a tension between the willingness to achieve financial self-sufficiency through higher interest rates in order to provide better services and the limits imposed on their capacity to develop through the low interest rates (Clarence, 2001). Nevertheless, studies show that when interest rates go above a certain threshold, it lowers the incentive to borrow money (Nallari and Griffith, 2011). Another barrier to microfinance is formed by judiciary problems where the lender of capital has to face the difficulty of enforcing contracts under a week legal system, which is often the case in developing countries (Clarence, 2001). Evaluations indicate that the establishment o new microfinance banks have been more successful than the restructuring of local commercial banks committed to microfinance through the downscaling approach. One o the main criticisms of down scaling are the limited outreach to the target group that these local commercial banks achieve in providing financial services to microenterprise. Their focus on small and medium sized enterprises rather than microenterprises is often criticized as a lack of success. However it would be detrimental t microfinance to concentrate only on the Greenfield approach. Local commercial banks often imitate the successful strategy and instruments of Greenfield microfinance banks when confronted by their strong performance. This experience affirms the recent argument that greater competition in the financial sector is good for business. The latest research indicates also a strong correlation between the provision of financial services to small enterprises and economic growth. It seems that one of the main ways in which financial sector development accelerates economic growth is by removing growth constraints on small firms. The mixed results of classical down scaling projects have led to their modifications. The new approach stresses commercial banks commitment of their own funds and co investment in their institutional strengthening. Downscaling is a process whereby existing mainstream banks enter the microfinance sector and target lower income individuals or smaller businesses. Downscaling may be motivated by several factors which ca apply in combination., it can be introduced by bank management as a new business development strategy in response to competitive pressures from other financial institutions, banks may also wish to diversify their portfolio and speared from other financial institutions. Banks may also wish to may also wish to diversify their portfolio theory a larger number of unrelated businesses, motivated by potential profits of a new niche, banks may also downscale to emulate successful microfinance institutions that have demonstrated that under the right circumstances microfinance can yield high returns on assets. In some cases, downscaling has also been encouraged by governments and donors. For the governments and donors driven by a development agenda, the downscaling approach has been used as a means of restructuring inefficient state owned banks and reaching financially undeserved segments of the population. It has also been used as a means of rapidly scaling up microfinance by using existing bam networks and retail branches. The downscaling experience varies across regions and within countries, some banks appear to have successfully developed small scale financial products and integrated microfinance as their core business activity. In the Eastern European and the CIS countries the process has been primarily driven by donors through credit line support and capacity building technical assistance. These programmes have had mixed results. In Kazakhstan the downscaling model appears to have worked well. Seven commercial banks including the largest local banks participated in the EBRD-sponsored downscaling programme initiated in 1998. By early 2004, partner banks had opened micro small and medium enterprises lending units in 135 branches and had disbursed over $162 million. By the end of 2004, the programme had about 43,000 outstanding loans. Using an internal unit, or integrated approach to microlending, simply means that the bank does microlending in house, for example through a department or division within the bank. As shown by Valenzuela’s (2001) fairly comprehensive survey of downscales in Latin America and the Caribbean as well as by our own, more recent canvassing, this is how most banks have chosen to do microlending in the region. Setting up an internal unit to do microlending is often the fastest and cheapest way to launch a microcredit operation since no separate organization needs to be created. However, it is not necessarily the best way or the way that maximizes profits in the short or longer run. The problem however has been that Moreover, as the pitfalls of doing microlending in inflexible ways have become better known (through some of the excellent studies that have been carried out, as well as by other means such as conferences), a new breed of enlightened banks seems to be emerging in the last 2-3 years. These banks often want the cost and other advantages of the integrated model and understand that the microlending unit must be given the flexibility to do microlending properly. One must then ask what the pros and cons of the various downscaling structures are under those circumstances. In conclusion therefore it could be stated that there is an inextricable link between the commercial banks and MFIs, indeed the former is indispensible to the survival and flourishing of the latter. References: Rhyne, E., (2009). Microfinance for Bankers and Investors: Understanding the Opportunities and Challenges of the Market at the Bottom of the Pyramid. McGraw-Hill Professional.p57 Churchill, C., and Frankiewicz, C., (2006). Making microfinance work: managing for improved performance. International Labour Organization. P27 Chaves, R., and Gonzalez-Vega, C., (1996), “The Design of Successful Rural Financial Intermediaries: Evidence from Indonesia,” World Development, Volume 24, No. 1, January Baydas, Mayada M.; Graham, Douglas H. and Valenzuela, Liza (1997) “Commercial Banks in Microfinance: New Actors in the Microfinance World”, Economics and Sociology Occasional Paper No. 2372. Burritt, Kiendel (2003). “Microfinance in Turkey”, for the United Nations Development Program. De Schrevel, Jean-Philippe (2005). “Linking Microfinance to International Capital Markets”. Finance for the Poor, The Quarterly Newsletter of Microfinance, Asian Development Bank (Volume 6 Number 2) Griffith, B., and Nallari, R., (2011). Understanding growth and poverty: theory, policy, and empirics. World Bank Publications.p124-126 Clarence, N.W. (2001), A study on using Artificial Neural networks to develop an early warning predictor credit unions financial distress with comparison to the probit model. Managerial Finance, Vol. 27, No. 4 Hassan, I. and Marton, K. (2003), Development and efficiency of the banking sector in a transitional economy: Hungarian experience, Journal of Banking & Finance. Ledgerwood, J., and White, V., (2006). Transforming microfinance institutions: providing full financial services to the poor. World Bank Publications. p193 Read More