MICROFINANCE PAPER WRAP-UP: "The Microfinance Sector: Its Success Could be its Biggest Risk", Fitch Ratings

MICROFINANCE PAPER WRAP-UP: “The Microfinance Sector: Its Success Could be its Biggest Risk”, Fitch Ratings

Produced by Fitch Ratings, June 2008, 20 pages, available at: http://microfinancegateway.org/files/49914_file_Microfinance_Success_Could_Be_its_Biggest_Risk1206.pdf

This paper presents what Fitch Ratings believes to be the key risk factors of commercial microfinance. While the title of the report suggests that the paper presents risk factors directly associated with the sector’s rapid growth, the report actually includes a wide array of perceived risks that may not necessarily be a result from the sector’s success. Below are summaries of the risk factors that Fitch seems most concerned with in its report. For the complete report containing all risk factors, please click here.

Risks Associated With Transformation

Following the success of many large scale commercial lenders, many nonprofit MFIs sought to transform into commercial institutions. Fitch believes there are two risk factors associated with this legal transformation that should be heeded by microfinance practitioners.

First, Fitch asserts that a commercial MFI runs the risk of becoming too bureaucratic and as a result may not be able to retain a connection with the communities they serve, which is often seen as a key ingredient to an MFI’s success. Fitch raises an important concern here, but unfortunately does not endeavor to explain why, upon transformation, commercial lenders would be particularly more apt to suffer a “disconnect” from the communities they serve than would a bureacratic microlender of nonprofit legal status.

Fitch also believes that following transformation, nascent commercial MFIs may be more prone to “mission drift”. That is, an MFI’s search for profit increases its temptation to shift toward higher loan amounts or into higher yielding consumer loans, both of which are less costly to provide. Ultimately, Fitch is concerned that this adjustment of service may lead some commercial MFIs to serve fewer individuals in the most impoverished segment of its client base.

Reputation Risks

Fitch is particularly concerned with reputation risks of the microfinance sector. It believes that, because the majority of MFI funding comes from socially-motivated as well as financially-motivated investors, an investor’s discovery of an MFI in its portfolio performing unethically may leave them with a sense of disillusionment about microfinance as a whole. Fitch believes that this disillusionment could potentially lead to capital outflows by some investors.

Foreign Currency Risk

As an emerging market investment, currency risk should also not be ignored, says Fitch. Seventy percent of microfinance investments are made in foreign currency (usually USD), rather than the local currency where the MFI operates. Consequently, this creates currency risk for either the MFI or its clients: the MFI is at risk if its assets are in the local currency; the clients risks facing repayment problems in the event of the local currency’s devaluation.

Political Interference

Finally, the report stresses the detrimental effects of governmental interference with commercial microlending, the most damaging forms of which are interest rate ceilings and direct lending from government funds at below market rates.

It cites an example in Ecuador, where in 2007 policymakers introduced “hard caps” on effective interest rates in an effort to create fair disclosure of the full effective costs of an MFI loan (whereas the previous “soft cap” on interest rates could be circumvented by MFIs adding disbursement fees). The existence of such hard caps has the potential to stifle the growth of commercial MFIs, as they restrict the firm’s ability to charge interest rates high enough to cover relatively high operating costs and to generate sufficient capital.

By Ryan Benson, Research Assistant

MICROFINANCE PAPER WRAP-UP: “The Microfinance Sector: Its Success Could be its Biggest Risk”, Fitch Ratings

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