33458 FocusNote NO. 28 JUNE 2005 COMMERCIAL BANKS AND MICROFINANCE: EVOLVING MODELS OF SUCCESS There is a vast potential market for retail financial services among low-income clients, and a growing number of commercial banks have successfully entered this market. These are the findings of recent research undertaken by CGAP, the global resource The authors of this Focus Note center for microfinance supported by a syndicate of 30 multilateral, bilateral, and are Jennifer Isern, lead micro- private donors. finance specialist, CGAP; and Microfinance is the category of financial services offered to lower-income people, David Porteous, consultant. where the unit size of the transaction is usually small ("micro"), typically lower than the The authors would like to average GDP per capita, although the exact definition varies by country. Starting in the extend their thanks to several 1970s, well-known pioneers, such as Grameen Bank in Bangladesh and ACCIÓN in individuals and institutions that made valuable contributions to Latin America, demonstrated that poor people can be creditworthy. Today, microfinance this paper. This paper includes covers the full range of financial services--credit, savings, remittances, insurance, and case studies gathered through leasing, among others--which are increasingly provided by a diverse set of financial serv- CGAP research led by Jennifer ice providers. In 1998, CGAP described commercial banks as "new actors in the micro- Isern including Matthew Brown, Tiphaine Crenn, and finance world."1 Gautam Ivatury in 2003­04. Seven years later, it is not surprising that commercial banks are playing an increasingly Elizabeth Littlefield, Jeanette important role in many financial services markets across the world. Compared with many Thomas, and Ousa Sananikone, all of CGAP, existing providers of microfinance, commercial banks have potential competitive advan- made thoughtful and helpful tages in a number of areas, such as recognizable consumer brand names, existing infra- comments. The authors would structure and systems, and access to capital. also like to thank the represen- tatives of all the institutions The commercial opportunity in microfinance is catching the interest of mainstream cited in this paper for their banking. The February 2005 issue of The Banker carried a special feature on microfi- willingness to share their nance. The editorial of this issue stated: "Bankers are only just realizing that the poor experiences. have needs just like anyone else and that giving them the opportunity to help themselves not only works, but can open up the global financial markets to an entirely new customer market and asset class."2 This Focus Note highlights recent CGAP research about the different ways in which commercial banks have successfully entered the microfinance market. 1Baydas, Graham, and Valenzuela, Commercial Banks in Microfinance: New Actors in the Microfinance World, 1998, www.cgap.org/publications/focus_notes.html 2The Banker, February 2005, p. 6 Building financial services for the poor Why Enter the Market? Figure 1 In a number of countries, banks have been compelled BancoSol Bolivian banks by their governments to provide financial services, ACLEDA Bank especially credit, to sectors such as small or agricul- Cambodian banks tural enterprises that are considered social priorities. MiBanco Peruvian banks Using moral or legal compulsion generally has not K-Rep Bank led to sustainable models of service provision. Kenyan banks However, increasingly, commercial banks are CERUDEB Ugandan Banks investigating for themselves, and some are entering the microfinance market because they see sustainable 0% 5% 10% 15% 20% 25% 30% profit and growth opportunities. ROE of microfinance provider Median ROE of national peer group Commercial banks face increasing competition in All data as of end of 2003. Source: Bankscope their traditional retail markets. This is causing margin squeeze. It is also leading forward-thinking banks to How to Enter the Market explore new potential markets that can generate growth in client numbers at acceptable profit margins. The CGAP survey of banks in microfinance reveals CGAP estimates that there are up to 3 billion that there is no single approach to entering the mar- potential clients in the microfinance market.3 Some ket for microfinance. For one thing, different banks 500 million people are currently being served by will have different business goals, and the competi- socially-oriented financial institutions, ranging from tive and regulatory environment will vary. Banks have cooperatives to postal savings banks that extend a wide range of approaches to choose from when financial services beyond the traditional clients of entering the market. commercial banks. Nonetheless, a significant number The current approaches can be divided into two of potential clients remain unserved. main categories--direct and indirect--based on how A recent CGAP survey identified over 225 com- the bank makes contact with the client. Some banks mercial banks and other formal financial institutions enter the market directly by expanding their retail that are engaged in microfinance.4 For some, micro- operations to reach the "micro-level" by creating finance has been highly profitable. Certain microfi- an internal unit or launching a separate company, nance-specialized banks are now more profitable than such as a service company or specialized financial the banking sector average in their country (see institution. Others take an indirect approach by figure 1). working with existing microfinance providers. CGAP Success is not guaranteed, however, as some banks has identified six discrete approaches banks use to have attempted to serve this market and failed enter the microfinance market. because they did not understand the market or tried Provide services directly through: to move too quickly. Those that have succeeded offer an internal microfinance unit, or a number of lessons to those now considering a specialized financial institution, or this market. a microfinance service company. Work through existing providers by: outsourcing retail operations, or 3Christen, Rosenberg, and Jayadeva, Financial Institutions with a "Double Bottom Line," 2004 providing commercial loans to MFIs, or 4Isern, Ritchie, Crenn, and Brown, "Review of Commercial Bank and providing infrastructure and systems. Other Formal Financial Institution Participation in Microfinance," 2003. 2 Choosing the approach that fits both the bank and and systems of the bank. An internal unit requires the circumstances at the outset is an important factor adaptations of the bank's systems and procedures to the in future success. Each approach has its particular specialized requirements of microfinance-related opera- rationale, risk profile, success factors, and costs. The tions. Banks may give further autonomy to the internal section that follows sets out the basic model and vari- unit by creating separate systems, loan procedures, ations in each case, together with selected examples of staffing policies, and governance. The unit can be banks following each approach. The decision tree in linked with various bank departments such as retail or figure 2 shows how different factors may give rise to a consumer finance departments. different choice of model. The Agricultural Bank of Mongolia, which chose an internal unit, has the largest branch network in Providing Services Directly Mongolia with 379 locations (93 percent in rural areas). It successfully emerged from state ownership fol- Internal Unit lowing an ambitious turnaround strategy launched in Under this model, the bank provides microfinance 1999. Once the new management team took over, the services within its existing institutional structure. first loan product they proposed was a working capital It may form a specialized unit within the bank (the loan for micro and small businesses. Since then, the internal unit) to manage microfinance-related oper- bank has added other products, including transfer ations. The microfinance unit is neither a separate payments; an array of savings products; loans for legal entity nor regulated separately from the bank. medium entrepreneurs, pensioners, and herders; payroll The microfinance operations leverage existing staff deduction loans; and agricultural loans. The bank Figure 2 Decision Tree for Commercial Banks in Microfinance Key Considerations Selected Approach Examples Rationale Ag Bank Business goals Internal unit Mongolia Business decision Competition Specialized Finadav Regulatory financial Provide Benin environment institution services Considering directly microfinace Market size Service Sogesol company Haiti Existing infrastructure and Mandated by systems government Outsource ICICI Bank retail India Work operations Other factors through existing providers Commercial Bank of loans to MFIs Africa Provide infrastructure Garanti Bank and systems Turkey Summary two-page profiles for each of the six models are available online at www.cgap.org/commercialbanks/profiles.html 3 developed products specifically for a large segment of loans to microfinance institutions (MFIs). During this the market to diversify their client base. All products time, it began to offer free cashier services to MFIs that were designed to be integrated into the branches by borrowed from the bank. This experience allowed existing staff. As of February 2004, the bank reported Financial Bank to learn more about a microfinance the following operations: client base and the patterns of their transactions. In Micro and small loan portfolio of $19 million, November 1998, the bank decided to expand opera- with more than 13,400 outstanding loans (39 tions and create an internal unit to manage its microfi- percent of total). The bank's total loan portfolio nance operations. Building on its growing success, the is $50 million with more than 128,200 outstand- bank spun off its internal microfinance unit as Finadev, ing loans. The average outstanding loan is $382. a specialized financial institution. The new institution $75.5 million in 377,400 savings accounts. The began operating in July 2001 with these shareholders: average deposit account balance is $200. Dutch FMO, LaFayette Participations, Financial Bank More than 15,400 domestic transfers for the Benin, and Financial Bank Holding. month representing $260,000. The average Finadev rents offices in five of six Financial Bank transfer is $17. A return on equity of 44.2 percent in 2003 and branches and has two independent branches. While the top two managers are seconded employees of the bank, an arrears rate consistently below 2 percent.5 The Agricultural Bank is one of the most profitable the rest of Finadev staff are specially recruited. Initially, banks in Mongolia. many procedures were similar to the bank's, but over The internal unit model is seen throughout the world, time Finadev developed its own procedures for loan including in Akiba Commercial Bank, Tanzania; Bank review, information services, human resources, etc. As Rakyat Indonesia; Banque du Caire, Egypt; Banco of December 2003, Finadev served 14,000 loan clients Solidario, Ecuador; and Cooperative Bank, Kenya. with an outstanding loan portfolio of US $9.8 million; Finadev reached a return on equity (ROE) of 5.2 per- Specialized Financial Institution cent while maintaining high portfolio quality with Rather than set up an internal unit, the bank may portfolio at risk (PAR) > 30 days of 1.05 percent.6 decide to form a separate legal entity (the specialized A number of other specialized financial institutions financial institution, or SFI) to undertake microfinance have been created in the past few ears, such as Jordan activities. The SFI is licensed and regulated by the local National Bank's AHLI Microfinancing Company; banking authorities, usually as a finance company or Jamaica National Building Society's JN Small Business other non-bank financial institution, and may be Loans, Ltd.; Banco del Estado de Chile and Banestado wholly-owned or a joint venture with strategic partners Microempresas; and Teba Bank and Teba Credit, and investors. The SFI provides retail microfinance South Africa. services, including loan origination, disbursement, and collection as well as other financial services as defined Service Company by its charter. The SFI maintains separate corporate In a service company model, the bank forms a non- identity, governance, management, staff, and systems financial legal entity (the service company) to provide from those of the parent bank. As a variation on the microloan origination and portfolio management serv- model, the new institution may use parent-bank infra- ices. In contrast to the specialized financial institution, structure (office space, information technology, accounting, treasury, etc.) or be more independent and stand alone. 5Dryer, Morrow, and Young, "Case Study: The Agricultural Bank of In 1995, Financial Bank in Benin started microfi- Mongolia," 2004. 6Interviews with the Finadev chairman in May 2004, and deputy direc- nance operations by offering retail housing and tor in April 2004; Finadev 2003 financial statements and performance consumer loans to salaried workers and by wholesaling reports; and Finadev web site, www.finadev.org. 4 the service company usually undertakes more limited SOGESOL representing the difference between all operations and is not regulated separately by the income accruing to the loans originated by SOGESOL banking authorities. Loans and other financial service from interest and fees, and all costs and risks accruing products (savings, transfers, payment services, etc.) to the managed portfolio, including loan loss expense, offered to service company clients are registered on the market cost of funds, a support service commission books of the parent bank. The service company (contractual), and an ad valorem transaction fee. At the typically maintains separate corporate identity, gover- end of three years of operations, SOGESOL was serv- nance, management, staff, and systems (although the ing over 6,000 active clients and managing an outstand- information systems are usually linked directly with ing portfolio valued at close to US $3 million. Average those of the bank). The service company may be ROE was over 30 percent for those three years.7 wholly or partly owned by the bank. However, the Other examples of the service company model service company structure offers the bank the ability to include Banco Pichincha's Credife in Ecuador and involve technical service providers with expertise in the Banco do Nordeste's CrediAmigo in Brazil. delivery of microfinance and other interested investors as equity partners, which it cannot do with an internal Working through Existing Providers unit. The service company may operate in designated Outsource Retail Operations areas within bank branches or in separate offices close to the bank. In this model, the bank contracts a high-caliber MFI to In late 1999, SOGEBANK, one of the largest com- originate microfinance loans that are registered on the mercial banks in Haiti, embarked on its management- bank's books, to make credit decisions, and to service driven venture to enter the microfinance market. the loan portfolio in return for a share of the interest SOGEBANK cites several reasons for launching serv- income or fees. The arrangement is similar to banks ices, including improved regulatory conditions with outsourcing transaction processing to ATM network the elimination of interest rate ceilings and reduction operators. The microfinance products, including loans, in required legal reserves; demonstration effect from insurance, and money transfers, may be branded by the other successful commercial institutions; the threat of bank or the MFI, or be a joint brand. The bank may losing customers in an increasingly competitive envi- restrict the MFI from servicing other banks. The bank ronment; and an enhanced reputation as a socially may delegate credit decisions to the MFI if the MFI has responsible actor. a history of maintaining a high quality loan portfolio on SOGEBANK was strategically positioned to enter its own, or the bank may structure a joint review pro- this market because it held a significant share of savings cess. However, this model requires that the bank and from small savers and had developed capacity to MFI share risks and incentives to maintain high portfo- process high transaction volume. To reduce risk, lio quality. Hence, the bank may ask the MFI to finance SOGEBANK created SOGESOL as a joint venture a portion of the microfinance loan portfolio or provide with strategic partners. The first loans were disbursed a first loss guarantee on a portion. Insurance companies to clients of SOGESOL in November 2000. may follow a similar agency model with an MFI. In (SOGESOL does not need its own bank license, avoid- other cases, non-MFI NGOs may provide training or ing arduous reporting requirements.) Besides credit, personal finance education to the bank's clients on the through similar arrangements, SOGESOL can offer its basis of an informal relationship with the bank. clients savings, payments, and remittance-related serv- ices. Under the SOGEBANK-SOGESOL service agreement, SOGEBANK disburses all loans and main- 7Lopez and Rhyne, "The Service Company Model: A New Strategy for tains the loans on its books. For its loan origination Commercial Banks in Microfinance," 2003; and Boisson, "Commer- cial Banks and Microfinance: Strategic Choice or Temporary Distrac- and portfolio management services, a net fee is paid to tion: The Case of SOGESOL," 2003. 5 ICICI Bank contracts MFIs in India to source deposit, or by a third party guarantee. The bank may microfinance loans and continuously monitor and stipulate covenants with respect to the provision of service these loans. As one example, Spandana, an MFI periodic financial statements, rights to inspection, as based in Guntur, Andhra Pradesh, has acted as a serv- well as other financial covenants. ice agent for ICICI Bank since November 2003, and Many banks around the world provide commercial has disbursed nearly US $3 million to over 20,000 loans to MFIs. Several factors indicate whether an MFI clients under the arrangement through the end of is ready for commercial funding: March 2004. Spandana's field staff help borrowers Readily available financial information complete loan applications and promissory notes in the Sound governance and capable management, name of ICICI Bank, make disbursements, collect with focus on profitability and efficiency repayments, and monitor the loan over its entire life. High-quality loan portfolio with appropriate pro- The cost to the borrower on the one-year term loan is visioning and write-off policies a flat 15 percent (about 30 percent effective p.a.), the Information systems that produce accurate, same rate that Spandana charges when it is the lender timely, and relevant reports of record. Of this charge, 9.25 percent is interest Good prospects for growth income and fees for ICICI Bank, and the remainder (about 20.75 percent) is a service charge collected Provide Infrastructure and Services to MFIs by Spandana. In some cases, the bank provides access to its branch or To share the credit risk, ICICI Bank requires Span- ATM networks, front office functions (including cashier dana to deposit a fixed deposit with the bank in the services), or back-office functions, such as IT services amount of 12 percent of the total committed amount. and transactions processing, to a microfinance institution As an alternative, Spandana may take an overdraft from and/or its clients. In return, the bank receives fees, com- the bank for this amount and pay a 1 percent fee missions, and/or rents from the MFI and its clients, upfront. If losses occur, ICICI Bank will draw from depending on the terms of the contractual arrangement. this overdraft, charging Spandana 19 percent interest Transactions processing is the most basic and common on the amount drawn. ICICI Bank gains from a highly form of this link between banks and MFIs, and is gener- profitable, rapidly-growing microfinance portfolio and ally the lowest risk approach. As variations on the model, links to organizations that have strong track records MFIs can place their own staff in the bank branch to but lack sufficient equity to borrow directly.8 serve MFI customers or can rely on bank infrastructure In Lebanon, Credit Libanais, Jammal Trust Bank, (e.g., ATMs and cashiers) for loan disbursements and and Lebanese Canadian Bank all outsource their repayments, domestic and international transfers, and lending operations to the microfinance institution foreign exchange transactions. Clients can have accounts AMEEN. MFIs in India manage some client relations with the bank directly or receive loan disbursements and for AIG, Aviva, MetLife, ICICI Lombard Royal repay loans to the MFI's account at the bank. Back-office Sundaram; and transfers companies, such as Western functions can be processed by the bank if MIS systems Union, Vigo, and MoneyGram, link with MFIs to are compatible. provide customer support. Garanti Bankasi, a private commercial bank, is the third largest bank in Turkey in terms of assets. It has 329 Provide Commercial Loans to MFIs domestic bank branches and a network of over 800 Banks can provide a term loan or line of credit to an ATMs; it offers internet and phone banking services; and MFI for working and/or lending capital. This is one of the most common models since it is closest to standard commercial bank lending. The loan may be unsecured, 8Interviews with ICICI senior management October 2003 and April secured by the pledging of assets as collateral or a cash 2004. 6 it is known for its customer service. In late 2001, Garanti market. For one thing, the clients and products may began providing services to Maya Enterprise for pose different risks from the risks of traditional bank- Microfinance as a small business client. Given the bank's ing. The different models outlined offer a range of risk highly developed infrastructure, Maya negotiated with levels for banks, and ways of managing them. Any bank Garanti to offer a variety of services, and the business looking to get into the market will need to take into link proved mutually advantageous. Garanti provides account the bank's own interests and institutional branch network banking and electronic banking for all capacity, competition, and other market factors. Sec- loan disbursements, payments, and reporting to Maya's ondly, banks getting involved in microfinance will need clients, who receive preferred service by Garanti staff. to develop new products appropriate to their target Maya invests any dormant capital in the bank and clientele. To deliver the products effectively, banks usu- processes its payroll through the bank. Maya's loan offi- ally need to adapt their systems and procedures and cers help clients fill out forms to establish checking and provide specialized staff training and incentives on the savings accounts and ATM cards with Garanti.9 new clients and products. Examples of this model are prevalent throughout While a variety of models are evolving for commer- the world, including Banamex and Banco Bital serving cial banks to enter the microfinance market, none is Compartamos in Mexico, Alta Bank serving FINCA doing it successfully without board and management Tomsk in Russia, and Procredit Bank serving vision and commitment. Without this vision and com- Constanta Foundation in Georgia. mitment, it is unlikely that a bank will apply the resources--human and financial--necessary to make Next Steps microfinance a profitable part of the business. Entering this market is a long-term business propo- Commercial banks that wish to take advantage of the sition. No bank should expect to make a "quick buck" opportunities in microfinance should carefully evaluate from microfinance. But the evolving models and profit the considerations listed in the decision tree above, records of successful players are encouraging more specifically their own goals, the potential market size banks to see the long-term business rationale. There is and competition, the regulatory environment, and a massive potential market for banks that approach their current infrastructure and systems. these clients successfully. Given the differences between classic banking and microfinance, commercial banks need to view microfi- 9Email correspondence with Catholic Relief Services technical advisor ance as a new business line and conduct the same kind and the director of the Maya Foundation, May 2004. See the Garanti of research that any company would entering a new Bankasi web site at www.garanti.com.tr. Box 1 Serving the Underserved--What Makes for Success? · Commitment from board and management, strong internal champions, and alignment with the bank's core com- mercial strategy · Knowledge of microfinance best practices and how to serve micro-clientele · Infrastructure located conveniently for clients · Products especially adapted for low-income and informal markets · Systems and procedures adapted to the microfinance operations, e.g., systems that support immediate follow-up on missed payments · Appropriate staff training and incentives on new clients, products, and delivery systems 7 Focus Note Suggestions for Further Reading No. 28 "Banks Can Reach Out to the Poor," The Banker (2 February 2005): 6. "Microfinance Joins the Mainstream," The Banker (2 February 2005): 12. Pierre-Marie Boisson, "Commercial Banks and Microfinance: Strategic Choices or Temporary Distraction, The Case of Sogesol," paper presented at the AFRICAP seminar "Financing Growth in Africa through Commercial Capital," Dakar, Senegal, April 25, 2003, www.africapfund.com/site/rubrique. php3?id_rubrique=45. Robert Peck Christen, Richard Rosenberg, and Veena Jayadeva, Financial Institutions with a "Double Bot- Please feel free to share this tom Line": Implications for the Future of Microfinance, CGAP Occasional Paper, no. 8 (Washington, Focus Note with your DC: CGAP, July 2004), www.cgap.org/docs/OccasionalPaper_8.pdf. colleagues or request extra Jay Dryer, Peter Morrow, and Robin Young, "Case Study: The Agricultural Bank of Mongolia," paper pre- copies of this paper or others sented at the World Bank Institute conference "Scaling Up Poverty Reduction," Shanghai, China, May in this series. 2004, www.worldbank.org/wbi/reducingpoverty/docs/newpdfs/case-summ-Mongolia-Agricultural- Bank.pdf. CGAP welcomes Jennifer Isern, Anne Ritchie, Tiphaine Crenn, and Matthew Brown, "Review of Commercial Banks and Other your comments on this paper. Formal Financial Institution Participation in Microfinance," November 2003, www.microfinancegate- way.org/content/article/detail/19104. CGAP, the Consultative Group to Jennifer Isern, Anne Ritchie, Tiphaine Crenn, Tamara Cook, and Matthew Brown, "Banks Entering Under- Assist the Poor, is a consortium of served Markets--Factors for Success," November 2003, www.microfinancegateway.org/files/ 30 development agencies that 18155_Success_Factors_of_FFIs.pdf. support microfinance. More infor- Cesar Lopez and Elizabeth Rhyne, "The Service Company Model: A New Strategy for Commercial Banks mation is available on the CGAP in Microfinance," ACCIÓN Insight 6 (September 2003), www.accion.org/micro_pubs_list.asp. web site, www.cgap.org. Liza Valenzuela, "Getting the Recipe Right: The Experience and Challenges of Commercial Bank Down- scalers," Chapter 3 in The Commercialization of Microfinance, ed. Deborah Drake and Elisabeth Rhyne CGAP (Bloomfield, Conn., USA: Kumarian Press, 2002). 1818 H Street, NW Liza Valenzuela, Doug Graham, and Mayada Baydas, Commercial Banks in Microfinance: New Actors in MSN Q4-400 the Microfinance World, CGAP Focus Note, no. 12 (Washington, DC: CGAP, July 1998), www.cgap.org/docs/FocusNote_12.pdf. Washington,DC 20433 USA Tel: 202-473-9594 For More Information on Microfinance Fax: 202-522-3744 The Microfinance Gateway (www.microfinancegateway.org) is a global microfinance portal with a large Email: searchable archive of documents, links to case studies, and a consultant database. cgap@worldbank.org The MIX (www.themix.org) provides information on microfinance institutions, funds, and other support or- ganizations, as well as specific benchmarking data to compare performance based on peer groups Web: according to geographic region, institutional size, and other distinguishing characteristics. www.cgap.org