Last week, the Financial Times (FT) carried news of Deutsche Bank’s securitization of microfinance loans from Finca International, a US-based microfinance institution (MFI). The size of the collateralized debt obligation (CDO) note is not big at $21.2 million. FT reports that the affiliates of the MFI in Congo and Azerbaijan would leverage this money five times and lend it in $500 parcels to small and would-be entrepreneurs. So far, so good. It is a neat demonstration of harnessing the power of capital markets to achieve financial inclusion for the poor.
It might sound premature to talk of a boom-bust cycle in microfinance loans when the sums involved are minuscule. The surface has been barely scratched. Even if there is a problem, it is unlikely to be a systemic issue either for individual countries or globally. But there is no point in closing the barn door after the horse has fled. Second, cycle times have shortened in the world of capital markets. Booms turn into bubbles and then bust even before investors realized that there was a boom. Hence, better an unneeded warning than an unheeded one.
Let us study the CDO deal a bit more closely. FT reports that investors in this deal include the insurer MetLife, the bank State Street and Hewlett-Packard. They would apparently receive a fixed rate of 7.5% annually on the tranches they purchased. It is not clear if this rate is applicable to the highest rated tranche of the CDO. But the riskiest slice of the CDO is expected to earn 16% return per annum. Based on this, one could deduce that the three institutional investors mentioned in the article subscribed to the highest rated tranches of the deal.
This is the time to pause and think about the yield for investing, presumably, in the AAA-rated tranche part of this microfinance loan-based structured debt. This expected return is not on offer from most financial assets. Hence, investors’ appetite for this product would build up rather quickly. That is how the “finance” tail begins to wag the “economy” or the “society” dog.
The demand for securitized microfinance loans would end up driving the creation of microfinance loans instead of the former being a mechanism to relieve the balance sheet burden on MFIs to achieve greater financial inclusion. Private equity investors who invest in microfinance institutions would favour such an increase in volume of loans, given the repayment record for these loans that has been the strongest attraction for commercially oriented institutional investors.
This would result in multiplicity of loans and enhanced risk of default. Initially, when the loan repayment record comes under strain, MFIs might try to delay reporting the inevitable by ever-greening the loans. Later on, if the situation got out of control, then politicians would take over.
The other danger lurking in the scenario where securitization drives the loan generation process is that the social objectives are progressively given the go-by. Already, it is evident. Not all microborrowers are able to use the loan to engage in income-generating activities. It is equally misleading to call them microentrepreneurs if each one of them manages to buy a buffalo or goat or open a petty street-corner shop. Entrepreneurship involves sustained risk-taking and an understanding of the business risks in sourcing the right input and output delivery. Neither the borrowers are equipped to do that nor do MFIs help plug these gaps.
The primary purpose of microfinance has to be financial inclusion. But the secondary purpose is to raise the standards of living of the borrowers permanently. Without the latter, the former would eventually result in financial exclusion. Raising standards of living requires skills augmentation and consequent employment. Industries require a range of skills today—from plumbing to carpentry to painting to low-level maintenance of installations. These skills have to be imparted to the rural youth by MFIs. Very few of them do it.
To reiterate, the availability of private capital to facilitate financial inclusion is welcome and essential for its sustainability. However, the rush of investor attention on the sector is a double-edged sword. Indeed, initial public offerings (IPOs) by MFIs are clearly a sign of the existence of supernormal profits. We know that profit is not a four-letter word. But IPOs and the valuation gains that come with them should lead MFIs to reflect on whether enough was done to the cause of borrowers who enabled those returns.
The record of private capital in profiting from the poor and then relying on taxpayer-funded bailouts is too recent to be forgotten. If this happens in a developing country, economic and social consequences would be severe.
MFIs must be committed to ensure that the interests of private capital do not dominate those of financial inclusion and elimination of poverty through livelihood support. The social responsibility of microfinance corporations is more important than their responsibility to their promoters and their investors.