RESPONSIBLE LENDING: AVOIDING THE PITFALLS OF MICROFINANCE
Micro- and SME finance is a key driver of financial inclusion in emerging economies. As with most good things, this business needs to be handled responsibly to avoid potential negative side effects which, time and again, critics are only too keen to decry. In this interview, Quang Duy Bui, who is handling investments in Southeast Asia on behalf of responsAbility, explains how a responsible investor can avoid pitfalls and deliver the desired development impact by ensuring portfolio companies lend responsibly.
Duy, you oversee the South-East and East Asian region for responsAbility. Which markets are involved and how big is the portfolio?
In the area of debt financing and green lending for financial institutions, responsAbility currently works with 11 microfinance institutions and SME commercial banks across Cambodia, China, Myanmar and Vietnam. At this point, we have some USD 230 million of exposure in the area.
Quang Duy Bui, a Vietnamese citizen working out of responsAbility’s Bangkok office, has closely followed the evolution of South-East Asian microfinance markets for years
How do you ensure responsAbility only finances responsible lenders?
We have a strong and standardized evaluation process in place which allows us to identify financial institutions that are lending responsibly and sustainably. We start any investment process with an eligibility screening to ensure that the prospective investee’s business model matches our criteria for financial inclusion, i.e. that the bank focuses on low-income clients. In a next step, we carry out detailed desk analysis followed by an on-site due diligence to review aspects such as operations, financial performance, risk management, ESG and client protection. Once these reviews are completed, we will have internal discussions with our risk management team and investment committee. An investment will only be made we are satisfied on all levels. In other words, all financial institutions in our portfolio need to have a suitable business model for financial inclusion as well as possessing a strong framework of risk management, corporate governance and client protection.
“All financial institutions we work with must possess a strong framework of risk management, corporate governance and client protection.”
Quang Duy Bui
When talking about the pitfalls of microfinance, over-indebtedness is usually the main complaint. This is often a by-product of overheated market growth. Which markets are challenged in this way at the moment?
Among my target markets, Cambodia has the highest risk of over-indebtedness. This is due to the rapid expansion of the country’s finance sector which has long been one of the fastest-growing in the world. This fact is directly reflected in our investment strategy: In Cambodia, we focus on microfinance institutions whose strong underwriting standards mitigate risks and restrain investments into players with more aggressive growth.
That said, Cambodia’s microfinance sector benefits from having a strong self-regulatory body, the Cambodia Microfinance Association (CMA). which has issued strict lending guidelines as a countermeasure against market overheating. These lending guidelines have helped put multiple lending under control: For the whole sector, as of June 2019, only 3.8% of the clients get loans from more than two microfinance institutions. CMA also recommends all microfinance institutions keep their high-risk refinancing (early refinance accompanied by large increase in loan size) below 5% of all disbursements. Most institutions have already achieved this recommended level; as of June 2019, the sector’s high-risk refinancing ratio was only 4.4%, compared to 5.7% in June 2018.
What is the role of credit bureaus in avoiding over-indebtedness?
Credit bureaus play an important role in this context: First and foremost, their database helps financial institutions access reliable credit information, manage credit risks, avoid multiple lending and, thereby, over-indebtedness. Credit bureaus allow financial institutions to make more accurate lending decisions. In a wider context, the existence of credit bureaus allows the economy to grow sustainably.
“Credit bureaus play an important role in avoiding multiple lending and over-indebtedness.”
Quang Duy Bui
Are there functioning credit bureaus in all of your investment markets?
There are functioning credit bureaus in Cambodia, China and Vietnam, all of them with a very high coverage rate relative to the population of borrowers. Myanmar, being a newly opened economy, is developing its credit bureau and expects to have it operational by end of 2019 or early 2020.
How can financial institutions compensate for the lack of this vital infrastructure?
Microfinance institutions operating in Myanmar currently use a platform called Microfinance Credit Information Exchange (MCIX), which is a credit bureau-like database jointly created by 20 microfinance institutions that covers approximately 1.3 million clients, out of an estimated total of four million microfinance clients across the sector.
When evaluating financial institutions in your markets, what kinds of questions do you ask to ensure they lend responsibly?
With regards to over-indebtedness and multiple lending, we focus on evaluating the investees’ underwriting practices, such as policy on maximum number of outstanding loans, clients’ repayment capacity and how they assess clients’ cashflow, policy on refinancing loans, use of credit bureau, loans approval process and authority. We also evaluate the macro economic conditions and the finance sector’s characteristics. This focus helps us manage exposure risk to overheating markets, as well as to financial institutions that are growing too aggressively or unsustainably.
“We closely assess every investees’ operations as to client protection.”
Quang Duy Bui
When it comes to client protection, we have an evaluation checklist which allows us to gain a comprehensive understanding of the investees’ operation. To give you an example: We will review and ensure that the investees’ sales techniques and collection practices are not aggressive or abusive; the investees’ staff are well trained and able to provide clients with detailed facts and consultancy about the loan products; investees have established sufficient policies, codes of conduct, and systems for transparent and fair client treatment.
Our evaluation also includes environmental, social risk, operational risk, and corporate governance reviews, to help us separate low-risk investees from high-risk ones. And we encourage investees to obtain the Smart Campaign certificate as a seal of approval that investees are following global standards for client treatment (see below).
The Smart Campaign Client Protection Principles
Responsible financial inclusion encompasses core Client Protection Principles to help financial service providers practice good ethics and smart business. The Client Protection Principles are the minimum standards that clients should expect to receive when doing business with a financial service provider. There is consensus within the financial inclusion industry that providers of financial services should adhere to these core principles:
- Appropriate product design and delivery
- Prevention of over-indebtedness
- Responsible pricing
- Fair and respectful treatment of clients
- Privacy of client data
- Mechanisms for complaint resolution
What sort of documentation/reporting do financial institutions need to provide?
Our reporting system is comprehensive with multiple layers. At the time of entering a relationship with investees, we require them to provide financial, operational and ESG templates, alongside with their internal policies, financial/ regulatory reports, and know your customer (KYC) documents. Once we have an on-going relationship with investees, we conduct regular update and full assessments, and ask investees to provide the most updated version of these documents. In addition, investees are required to provide a reporting form on a monthly/ quarterly basis on top of submitting their annual audited financial statements.
“Complete and accurate data and documentation is a prerequisite for any investment.”
Quang Duy Bui
Do financial institutions you work with find it easy to provide this type of documentation?
Complete and accurate data and documentation is a prerequisite for any investment. This also goes for newly-opened markets like Myanmar, and is even more obvious for more developed markets. As a result, all of our investees fully meet these requirements. In Cambodia, for instance, we only work with large, established deposit-taking microfinance institutions that are excellent at sharing data. The same goes for China, where we have investees backed by large international shareholders with strong standardized organizational systems in place. In Vietnam, we work with public banks with thousands of shareholders and a strict regulator, so here too, the quality and availability of data is top-notch.
In the area of E&S risk management, some of our investees do not have a well-developed system in place which makes it difficult for them to provide information on that part. However, we have the capacity to support them in developing such a system, which they appreciate and are willing to embrace.
How do you ensure the information financial institutions provide is correct?
We have tools in the templates and reporting system that allow us to check for inconsistencies and incorrect data. In addition, we always review the data provided by investees against audited and regulatory reports when applicable to ensure accuracy. We also typically review investees’ internal policies, board meeting minutes, and other approved documents to crosscheck the information received.
Have there been cases of attempted fraud in your portfolio?
There have been some instances of fraud where investees’ loan officers artificially inflate clients’ cashflow or collateral value in order to disburse a larger loan amount or where staff misappropriate the bank’s or clients’ assets. Luckily, the impact from these cases are small, thanks to the investees’ existing procedures for internal control and their active internal audit function. Such cases usually lead to actions to improve the effectiveness of internal control. On our level, we acknowledge that internal audit and internal control are critical functions, and always focus on reviewing these functions during our evaluation of the investees.