Recommendations for Microcredit Disbursement Policies

The World Bank Consulting Group

World Bank Consulting Group Martin Oravec, Siyi Lai, Timur Nuratdinov, Vipin Arora, Yae Jean Lee Introduction...... 3 Overview...... 3 Microcredit...... 4 Implementation...... 5 Mechanisms of Disbursement...... 6 Disbursement Mechanisms...... 7 Overview...... 7 Microfinance Institutions...... 7 Overview...... 7 Benefits...... 7 Drawbacks...... 7 Commercial Lenders...... 9 Overview...... 9 Benefits...... 9 Drawbacks...... 11 Micro-Enterprise Banks...... 11 Overview...... 11 Recommendations...... 13 Overview...... 13 Recommendation I...... 13 Recommendation II...... 14 Recommendation III...... 15 Appendix I: Additional information on Microfinance...... 16 Appendix II: Comparing Formal and Informal Financial Sectors...... 19 Appendix III: Evaluation...... 21 Overview...... 21 Criteria...... 21 Market Research...... 22 Impact Assessment...... 22 Endnotes...... 23 Sources...... 24

2 Introduction

Overview1 To most, microfinance means providing very poor families with very small loans (microcredit) to help them engage in productive activities or grow their tiny businesses. Over time, microfinance has come to include a broader range of services that includes credit, savings, and insurance among other services. Traditionally microfinance was focused on providing a very standardized credit product. The poor, just like anyone else, need a diverse range of financial instruments to be able to build assets, stabilize consumption and protect themselves against risks.

The typical microfinance clients are low-income persons that do not have access to formal financial institutions. Microfinance clients are typically self-employed, often household-based entrepreneurs. In rural areas, they are usually small farmers and others who are engaged in small income-generating activities such as food processing and petty trade. In urban areas, microfinance activities are more diverse and include shopkeepers, service providers, artisans, street vendors, etc. –Microfinance clients are poor and vulnerable non-poor who have a relatively stable source of income.

Experience shows that microfinance can help the poor to increase income, build viable businesses, and reduce their vulnerability to external shocks. It can also be a powerful instrument for self-empowerment by enabling the poor, especially women, to become economic agents of change. For instance, income generation from a business helps not only the business activity expand but also contributes to household income and its attendant benefits on food security, children's education, etc. Moreover, for women who, in many contexts, are secluded from public space, transacting with formal institutions can also build confidence and empowerment.

Figure I surveys the lending process

Figure I:

3 This paper will focus its attention on the World Bank and its activities with the most prolific part of microfinance: microcredit.

Microcredit2 Microcredit is generally understood to incorporate programs which extend small loans to very poor people for self-employment projects that generate income, allowing them to care for themselves and their families. It has proven an effective and popular measure in the ongoing struggle against poverty, enabling those without access to lending institutions to borrow at bank rates, and start small business.

The key implications of microcredit is in its name itself: 'micro': the loans made are of small size, the savings are of small size, there is a smaller frequency of loans, shorter repayment periods and amounts, and the level of activities is at a micro/local level. Hence microcredit is not the solution, but is a menu of options and enablements, that has to be put together, a la carte, based on local conditions and needs.

With the current explosion of interest on microcredit issues, several developmental objectives have come to be associated with it, besides that of only "credit". Of particular importance is savings - as an end in itself, and as a guarantee for loans. Microcredit has been used as an 'inducer' in many other community development activities, used as an entry point in a community organizing program and as an ingredient in larger education/training exercises.

Since the mid-1970s, when first microcredit programs started, the whole poverty- reduction scheme has reached huge proportions. Just in last five years, the number of poor people with access to microcredit schemes rose from 7.6 million in 1997 to 26.8 million in 2001 (growth by 350 percent) — 21 million of them women. The overall number for all people involved in Microcredit programs is even higher – as of December 31, 2001, 2,186 microcredit institutions reported reaching 54,904,102 clients. Assuming five persons per family, the 26.8 million poorest clients reached by the end of 2001 affected some 134 million family members.

However, 26.8 million very poor participants of the microcredit schemes as of December 2001 represented only about six percent of the estimated number of poor who could effectively use microcredit or other relevant microfinance services. Estimates of the global demand ranges from 400 to 500 million households of which only around 30 million are reported to have access to sustainable microfinance services in 2002. In other words, the existing 10,000 Microfinance Institutes (MFIs) reach only 4% of the potential market .The World Bank estimates that there are now over 7000 microfinance institutions, serving some 16 million poor people in developing countries. The total cash turnover of MFIs world-wide is estimated at US$2.5 billion and the potential for new growth is outstanding.3

The World Bank has effectively been involved with microcredit activities in the past, and continues to utilize this poverty reduction strategy. The next section will provide an overview of the general structure of World Bank microcredit programs.

4 Implementation4 The World Bank has significant experience implementing microcredit as a poverty reduction strategy. The steps outlined below provide a general framework of how it has traditionally been done.

 According to its action plan, the World Bank will provide a loan to Government of … for further implementation of a microfinance program aimed at poverty reduction.

 The Government of … will create the special fund (Social Fund) for providing of microfinance service. The financial funds that will be transferred to the Social Fund include: the capital loan fund and administrative costs.

 The World Bank will provide technical assistance to the Social Fund in the form of: training programs, consultation services, assistance in direct implementation of microfinance programs (by providing a full package of documentation and description of procedures), a methodology, and a financial program. The Social Fund, with assistance from World Bank microfinance specialists, will conduct a socio- economic assessment of rural districts and further process of selection of new districts and inhabited localities.  The Social Fund will conduct a preparatory phase of the microfinance program that will include: hiring of loan officers, setting up an office in the district, carrying out community meetings, carrying out orientation programs, interviewing clients, filling out application forms, and other activities that precede loan disbursement.

Figure II lays out the procedure graphically.

Figure II: SF

Filling an application form WB Preparation of program budget

Preparation of Agreement

Signing of Agreement

Determination of program Technical assistance implementation areas

Monitoring of SF activities Conduction of preparatory phase

5 Financing Disbursement of loans

Control over financial activities Quarterly progress report of SF

Evaluation mission at the end of Fulfillment of all requirements of the duration of Memorandum of Memorandum of Understanding Understanding

Signing of Final Agreement

While this structure may be theoretically appealing, in practice the World Bank has had considerable difficulties with implementation. While these difficulties are numerous, this paper will focus on the problem in disbursing money to the poor.

Mechanisms of Disbursement Traditionally, the disbursement of funds for microcredit activities has been done by NGOs, often called Microfinance Institutions (MFIs). Recently, however, this approach has come under increasing criticism. Alternative methods of disbursement have been advocated, with the major response advocating a more market-based approach through commercial banks.

This has led to major questioning within the World Bank and other microlending organizations. Are there better ways to disburse money for microcredit activities? What are they, and what are their benefits? These are particularly important issues for the World Bank, and these disbursement concerns are the subject of the remainder of this paper.

First, we will review the generally accepted methods of disbursement: MFIs and commercial banks, and survey the benefits and drawbacks of each. Next, we will introduce an alternative, Micro-Enterprise Banks, something the World Bank has not yet tried. Finally, we will provide three major recommendations for when we believe the World Bank should use Micro-Enterprise Banks. The World Bank should utilize Micro- Enterprise Banks in developing countries as a model for best practices, and in hopes of further development of the financial sector. Secondly, the World Bank should use Micro- Enterprise Banks in more developed countries to assist in concentrating their efforts on the ‘poorest of the poor’. Finally, the World Bank should aim to utilize the Micro- Enterprise Banks as a bridge between MFIs and commercial banks.

6 Disbursement Mechanisms

Overview There are two traditional mechanisms that have been utilized in microcredit lending activities for the disbursement of money: MFIs and commercial banks. MFIs are simply NGOs dedicated to assisting the poor through microlending activities, and have been by- and-large the dominant force in disbursement. Commercial banks have recently become more of an option as capitalism takes hold in more countries, and their financial sectors develop. An alternative between the two are Micro-Enterprise Banks, which have yet to see use by the World Bank. This section will outline the benefits and drawbacks of MFIs and commercial banks, and introduce Micro-Enterprise Banks.

Microfinance Institutions

Overview Microfinance Institutions are the traditional method for disbursing funds in microlending activities. As noted above, there has recently been much criticism of these NGOs and their central role in microfinance. This section outlines the major benefits of having these NGOs disburse money, and then surveys the most significant of the arguments against, with the purpose of reviewing alternatives in later sections. The benefits are difficult to measure, as most microlending disbursement is done in this way, while the problems can be grouped into three categories: financial sustainability of microfinance institutions, institutional sustainability of MFIs, and the policy environment.

Benefits5 Since its inception, microcredit has gone a long way in improving the lives of the poor, and its overall impact has been positive. Its contribution in terms of capacity building, awareness raising and empowerment is further notable. These noteworthy outcomes are a result of certain characteristics of microcredit NGOs, which include:

 Microcredit NGOs offers favorable lending policies, combing lower interest rates and very little pre-commitment, which makes it possible for those who are not eligible for bank loans to have the opportunity to step out from the vicious cycle of poverty.

 Microcredit NGOs are good at interacting with clients. Since these NGOs are mission-driven, instead of profit driven, their staffs are more devoted to the mission of poverty reduction. They have closer relations with the clients and are willing to respond to individual needs faster and better.

 Microcredit NGOs often offer good training programs. Since most of the NGOs put the goals of education and empowerment as high priorities, they aim to reach more poor people through successful training programs.

Drawbacks

7 Financial sustainability of microfinance institutions

Lack access to capital There are many microfinance institutions that have lack access to capital. As microfinance institutions are non-for-profit institutions, only few of them can get soft loan from banks or other financial institutions, most of them depend on donor funding. There is a tendency, that financial resources provided by donors are decreasing. Access to capital is not the only constraint for MFIs to grow, but it is considered an important problem in developing MFIs. At present, there are more financial institutions that want to lend financial resources to MFIs but only few of them believe that MFIs would be financial viable.

Interest rate Most of microfinance institutions will never reach the sustainability and will be depending on donor funding because of efficiency of services and interest rate. Most of MFIs do not adopt a commercial approach in pricing their products and services or consider their operations to be commercial. The widespread perception among microfinance providers appears to be that social considerations should predominate and overshadow profit concerns, because their operations target poor households. As a result, the interest rates charged by many MFIs are insufficient to cover their operating costs. Their pricing policies do not aim to protect the erosion of capital from inflation.

Operational mechanism Some MFIs does not have clear and efficient operational mechanism. A basic characteristic of microfinance is its informal, decentralized process of gathering credit information. MFI loan officers gather the financial information used for making credit decisions at the business site; they have no annual reports from clients. Thus, MFI supervisors do not have the ability, as is the case in traditional banking, to check credit files for audited financial information to review a credit decision. Further, many MFIs lend to their clients without the traditional guarantees received by non-microfinance lenders. This lack of “fallback” requires that loan officers be clear about the institution’s credit policies and consistent in applying these policies. In recent years, several MFIs reported on fraud and corruption due to poor operational mechanism in these organizations.

Lack of transparency All MFIs have its own mission and its operations can be observed only by donors. It is difficult to determine the sustainable MFIs, as only few of them publish the reports on its success.

High operational costs Delivering small loans to high number of clients

Institutional sustainability of MFIs

Low quality of human resources

8 Microfinance services are not just disbursement and collection of loans, but they are financial transactions. The capacity of MFIs largely depends on the quality of human resource, operating system, procedures and practices, and the availability of support services. Most of specialists that work in microfinance come from social background and have lack of knowledge on formal financial system. Thus, most MFIs suffer from low levels of managerial and technical understanding of banking and finance, leading to adoption of inappropriate accounting practices, insufficient attention to developing an accurate and timely management information system, inadequate internal control, and ineffective risk management.

Capacity building and effectiveness of MFI There are many small microfinance NGOs that lack institutional intermediary. In particular, they suffer from lack of clarity in their mission, weal governance, and low level of the technical skills required of banking and finance. Manu of them lack transparency in their accounting and operations, especially as a result of mixing “credit plus” activities in their books.

Policy Environment Regulation and supervision are the critical issues in field of microfinance for the past several years. In most of developing countries, microfinance activities does not have clear legal basis for its operation. It is believed strongly that the future of microfinance lies in a licensed setting, because it is the only setting that will permit massive, sustainable delivery of financial services to the poor. Thus, the cautionary overall message of this paper is not meant to question the importance of microfinance regulation and supervision, which are essential to any licensed framework. Rather, we are raising questions about timing, and about certain expectations that may turn out to be inflated. In focusing heavily on certain problems, we don’t want to imply that they have no solutions—only that they are problems that need to be dealt with realistically.

Commercial Lenders

Overview Commercial lenders are a widely-proposed alternative to MFIs in microcredit lending. This is true even though there have been very few attempts to actually utilize them in these activities. This section will survey the benefits and drawbacks of commercial lenders in microcredit. The benefits stated include: regulation, infrastructure, accountability, funding, and sound governance. The drawbacks identified are: commitment, organizational structure, financial methodology, human resources, cost- effectiveness, and supervision.

Benefits Many proponents of microcredit activities believe that transferring most of the activities of microfinancial institutions to commercial banks will not only have positive effects on national market and macroeconomics as such, but will increase the long-term sustainability of the microcredit program, and also free the space for MFIs to address the concerns and needs of “the poorest of the poor”, who are so neglected nowadays.

9 The key point when arguing for more intensive involvement of commercial sector loans providers is the fact that microcredit programs are, contrary to what most people believe, financially profitable. The only thing the poverty-reduction organizations need to do is to persuade the commercial subjects that conducting microcredit program is in their (commercial) interest and to provide assistance for first couple of years.

Transferring vast majority of microcredit providing activities to commercial banks does not only mean that the programs will outreach to much larger numbers of target costumers, as the banks will reinvest the profits they earn. Another positive effect will be the improvement of market environment. The banks can thus establish better relationship (trust) with poor people as their potential customers in the future. As the money will come from the profits of the banks themselves, no crowd-out investment effects will take place anymore.

Thus, as the latest experiences on the field show, the long-term financial sustainability of microcredit programs mean that the World Bank and other institutions can shift their attention and aid from (just) poor people, in future to be served by commercial subjects, to people which most need it – the poorest of the poor. These people are largely omitted from current schemes, as it was already mentioned, for various reasons. The challenge of upcoming 2nd microfinance revolution, as Garry Woller puts it, is make the MFIs place borrowers at the center of the microfinance “universe” and shift the practices of the lenders from product-oriented to the market-oriented. In other words, this means to change the definition of MFIs’ success from achieving financial self-sufficiency and serving as large number of people as possible to identifying and satisfying “needs and wants (expressed and latent) of the very poor”.

Listed below are advantages of commercial banking:6

 Banks are regulated institutions fulfilling the conditions of ownership, financial disclosure, and capital adequacy that help ensure prudent management.  Many banks have extensive physical infrastructure, including a large network of branches from which to expand and reach out to a substantial number of microfinance clients.  Banks have well-established internal controls and administrative and accounting systems to track large numbers of transactions.  Bank ownership structures that include private capital tend to encourage sound governance structures, cost effectiveness, and profitability, all of which lead to sustainability.  Banks can rely on their own sources of funds, deposits, equity capital, and therefore do not have to depend on scarce and volatile donor resources.  Banks offer a complete line of financial products, loans and deposits, which are, in principle, attractive to a microfinance clientele.

Drawbacks7 On the other hand, the commercial banks taking their part in microcredit programs seriously have to overcome some of their reservations against the microcredit world.

10 These include perception of microfinance as a high risk business, and socioeconomic as well as cultural barriers between bankers and micro entrepreneurs. During this process, at least six issues need to be addressed:

 Commitment The commitment of commercial banks (particularly larger banks) to microenterprise lending is often fragile and generally dependent on one or two visionary board members rather than based solidly on institutional mission.

 Organizational structure Microfinance programs need to be inserted into the larger bank structure so that they have relative independence and, at the same time, have the scale to handle thousands of small transactions efficiently.

 Financial methodology Banks need to acquire an appropriate financial methodology to service the microenterprise sector, financial innovations that permit a cost-effective analysis of creditworthiness, the monitoring of a large number of relatively poor clients, and the adoption of effective collateral substitutes.

 Human resources Given that microfinance programs differ so radically from traditional banking, banks must recruit and retain specialized staff to manage these programs. Issues of recruitment, training, and performance incentives require special consideration.

 Cost-effectiveness Microfinance programs are costly because of the small size of their loans and because banks cannot operate them with their traditional mechanisms and overhead structures. Strategies must be found to minimize processing costs, increase staff productivity, and rapidly expand the scale of microenterprise portfolios, that is, increase the number of loans. Banks must cover the costs of microfinance operations and specialized training through scale economies.

 Regulation and supervision Banks must communicate with banking authorities to ensure that reporting and regulatory requirements take into account the specialized nature of microfinance programs.

Micro-Enterprise Banks8

Overview Micro-finance has been developed primarily to provide access to financial resources for very small, private-sector entrepreneurs who otherwise have little opportunity of securing debt financing on acceptable terms. Commercial banks usually deemed micro-lending as unprofitable due to the labor-intensive and risky features. As the result, small, new and unknown, micro-enterprises are frequently forced to operate in the black economy

11 without providing tax returns or preparing business plans. Within the boundary of the black economy, they cannot communicate to lenders information about their creditworthiness, if the lenders use traditional credit techniques.

Although the role of micro-finance must be evaluated from the perspectives of its mission, providing an institutional credit and savings facility to the poor, a certain level of profit shall be required for micro-finance providers to ensure long-term sustainability and contribute to the overall economic development. After a few decades of experience in micro-finance, the importance of considering such a reasonable balance between social and economic goals has been recognized. The way which enables to grant, with tolerable costs and a low repayment default rate, microcredit to people who are not considered creditworthy by conventional bankers shall be sought. Lending to poor clients can be profitable via a suitable and efficient lending technique, such as appropriate interest criteria.

One approach that has gained popularity in recent years is the establishment of new institutions, “Micro-Enterprise Banks,” which focus solely on micro lending. Since the financial industries of most developing countries are vulnerable in terms of institutional stability and transparency, the idea of establishing new specialized institutions under the participation of the international donors seems to be a better solution than using existing commercial banks in those countries as vehicles of disbursement. So far, the EBRD unlike World Bank or Asian Development Bank has participated in the capital in these new institutions and invested together with other IFIs (International Financial Institutions), bilateral agencies, micro specialist institutions and in some cases local commercial banks. These micro-finance institutions are recipients of substantial grant and subsidized donor funding which supports start-up costs and constitutes the initial funding bases for lending activities while the institution becomes locally known and starts building up its own deposit base. Governance and own financial fragility problems are obviously overcome through this approach.

About a dozen of banks have been set up so far by EBRD along with other IFIs throughout Eastern Europe. Setting up a micro-finance bank in a developing country involves four phases as illustrated in the case study of Micro-Enterprise Bank Kosovo:

(i) Project identification: determining whether a bank, or other organizational entity, is needed and would help meet development objectives (ii) Assessment: determining whether a bank would be economically sound and politically feasible (iii) Reaching provisional consensus among potential investors and sponsors who would be responsible for setting up the bank and managing it at the beginning. In addition, knock-on financing from one or more donors must be secured. (iv) Developing a business plan, which forms the basis for a binding commitment by the investors, the sponsors and, if applicable, the donors.

12 Micro-Enterprise Banks can improve performance via certain provisions matching those of regular commercial banks, such as performance-related pay or promotion prospects for skilled employees. Additionally, MEBs deliver better services to the target groups by providing training and motivation to their staffs.

Recommendations

Overview Our analysis has resulted in three recommendations for the World Bank in how Micro- Enterprise Banks should be utilized moving forward. First, the World Bank should utilize Micro-Enterprise Banks in developing countries as a model for best practices, and in hopes of further development of the financial sector. Second, the World Bank should use Micro-Enterprise Banks in more developed countries to assist in concentrating their efforts on the ‘poorest of the poor’. Finally, the World Bank should aim to utilize the Micro-Enterprise Banks as a bridge between MFIs and commercial banks.

Recommendation I To overcome the current constraints associated with the disbursement of funds for microcredit activities, the World Bank shall develop the appropriate type of the disbursement vehicle. Today, the importance of the profitability and efficiency of the microcredit institutions become more emphasized than ever before, as a result of a few decades of the experience in microcredit. Without the assurance and confidence in long- term sustainability of those institutions, the real goal of the microcredit, the poverty reduction by providing access to financial resources for the poor, may not be reached.

With respect to the issue of profitability and efficiency, if the disbursement vehicles can maintain the same level of competency as stable commercial banks’ while performing their own mission, it would be an ideal situation. However, in most cases, it is not practically possible for the World Bank to use private commercial banks in the beneficiary countries as disbursement vehicles since the banking sectors of most beneficiary countries are neither stable nor developed. There may be no privately owned commercial banks, or the interest rates in savings and deposits may be directly regulated by the government at a certain level, where microcredit cannot be viable. Further, lack of the transparency issues and the absence of the appropriate banking law would be next hurdles to be overcome.

Considering all these practical limitations, Micro-Enterprise banks (MEBs) are likely a good compromising solution to overcome the problems due to the undeveloped banking sector in the beneficiary country. Currently, the World Bank has not been actively involved with setting up MEBs either as a shareholder or as a credit donor. Only its investment affiliate, International Finance Corporation (IFC) has participated to establish a couple of MEBs along with EBRD in eastern central Europe, such as Micro-Enterprise Bank Kosovo, where there is no bank of its own.

The establishment of MEBs will support the development of the banking sector of the beneficiary country by operating as a best practice institution committed to the principles

13 of complete transparency and strong corporate governance. As a major shareholder, the World Bank can be directly involved with the management of MEBs in accordance with its CIGAP guideline. As the result, MEBs can demonstrate how a properly structured, specialized financial institution targeting the poor can earn profit to ensure long-term sustainability and contribute to the overall economic development. By becoming a part of the Country’s financial institution, MEBs can also play a certain role to build up the Country’s financial sector by recommending a right direction of development to its government such as the creation of proper legal framework.

Therefore, more active involvement in establishing MEBs is highly recommendable for the World Bank to improve its disbursement vehicles implementing microcredit activities as well as to contribute the development of the financial sector of the beneficiary countries. The World Bank’s equity injection including through IFC to those MEBs along with other IFIs shall be more focused on the region such as Latin America or Southeast Asia other than the eastern central Europe where EBRD actively provides microcredits through the establishment of MEBs.

Recommendation II For countries with more developed commercial banking sectors, Micro-Enterprise Banks are also helpful to target their client group more properly to the poor clients who have economic ability but not covered by bank services usually. In targeting clients, Micro- Enterprise Banks can deliver the services on better quality with the following respects:

 Micro-Enterprise Banks can serve the segment of population that cannot be reached by commercial banks. Target clients of Micro-Enterprise program are woman with low-income families that have economic opportunities and have sustainable economic activity. This segment of population cannot be reached by commercial banks due to high transaction costs of delivering of small loans.  Micro-Enterprise Banks can achieve the deep outreach; one of the fundamental goal of Micro-Enterprise. As MBI would follow the professional financial procedure, it can provide the financial services on sustainable manner in the long- run period. The profit received would be used for new product development or diversification of existing financial services such individual loan program, leasing program, agricultural loan program etc., and would be able to attract more clients.  Micro-Enterprise Banks can keep the social aspects of the Micro-Enterprise program. MEBs would not be fully commercialized its service; it would focus on the social aspects as well and would provide not only financial services but also training on how to rational use the loan, basic accounting etc.  Micro-Enterprise Banks can provide better monitoring of clients’ activities. By conducting regular monitoring, MEBs can ensure the rational use of the financial services and support the clients on period of using the loan.  Micro-Enterprise Banks can conduct research and development on clients’ activities and identify the sustainable economic activities on the market.  Micro-Enterprise Banks can provide services of better quality; MFI can use the profit for improving the quality of financial services.

14  Micro finance NPOs can concentrate their services on poorest of poor that are not served by any of the mechanisms. By focusing the social mission, these NGOs can provide the financial services to poorest of poor.

Recommendation III Our final recommendation is that the World Bank utilizes Micro-Enterprise Banks as a bridge between commercial banks and MFIs. It can be generally agreed that neither commercial banks, nor MFIs are the answer to disbursement issues in Microcredit activities. Each of these disbursement vehicles have benefits and drawbacks that are inherent and cannot be overcome. It is clear, however, that it is in the best interests of the World Bank to maximize the benefits of each disbursement mechanism.

This means striking a balance between the activities of MFIs, which currently dominate the market, and the lending via commercial banks. Our previous two recommendations are concerned with the benefits that can be accrued through Micro-Enterprise Banks in developing and more developed countries. While they address the situations where a Micro-Enterprise Bank will help with, they don’t include much on the transitions.

That is why we feel that Micro-Enterprise Banks, with their unique characteristics, are in a prime position to be a bridge between commercial banks and MFIs. MEBs have enough characteristics of each to be wholly flexible and adaptable to the needs of either. Additionally, MFIs and commercial banks can easily (at least in theory) take on the particular characteristics of MEBs.

It then becomes advantageous to utilize MEBs in situations where there is a distinct gulf between MFIs and commercial banks. This is often the case in countries where MFIs are active and commercial banks have existed only as part of the state-socialist structure. It is further the case in countries where most financial activities are in the private sector, and non-governmental organizations are ignored or misunderstood. MEBs then become a powerful mechanism for distilling the benefits inherent to MFIs and commercial banks in countries with microcredit activities.

Moreover, as shown in the cases of eastern central Europe, the successful MEB in a specific beneficiary country can later participated with the new establishment of other countries’ MEBs in the region as a shareholder. Therefore, successful establishment of MEBs in one country can contribute to the overall improvement of microcredit activities in the whole region through the spillover effect.

15 Appendix I: Additional information on Microfinance

Implementation agency: Social Fund.

Target Beneficiaries: Potential beneficiaries of micro-finance are low-income families, who are involved in some types of enterprises – sewing of clothes, petty trading, animal husbandry, etc. This business requires support in order to become more sustainable and profitable. Clients will not be only provided with loans, but with training programs on how to create and maintain business in a market economy environment.

Product: Micro-finance program – loans that are equivalent from $50 to $500 for each borrower.

Interest Rate: On the basis of current factors of interest rate components (inflation rate, operational costs of SF, institutional development, loan loss rate), micro-finance organizations will set up interest rate in amount of 6% per month and will decrease it to 4.5% per month at the end of implementation period, when micro-finance organizations begin to cover their own costs.

Client Population: Clients must be residents from the areas of implementation. They must either have an ongoing micro-enterprise, or – intention to start their own business. Loans will be preferably provided to those clients who have some experience in running a business.

Decentralized Operations: The Loan Officers should have full awareness of current client’s status and of events that may have influence on borrower’s activities. According to this, office should be located in the same area where clients work. The Loan Officers should have all information about potential clients and prepare recommendations for decision making on disbursement of loans.

Use of Loans: Loan is provided only for working capital. Clients should use a loan, basically, for small-scale production, services, petty trading, animal husbandry, and small-scale agriculture. Loans for construction work or expensive equipment will not be encouraged, as the loan cycles for this type of activities will be too short. After receiving of loans loan officer visits clients for the purpose of control the purposeful use of loans.

Group Guaranteed Lending: Clients who know and trust each other should join the groups of 5 to 10 people. The self-selection feature is vital, because group members share collective responsibility. The group will guarantee the loan of its fellow members, meaning that if one member defaults on his/her loan the other members will repay his/her loan. Members of the group will not be able to receive a second loan as long as all loans within the group have not been repaid. No members of the same household or family can be in the same group as they will not be able to repay loans in case of default.

16 Group Meetings: Clients have to attend compulsory fortnightly group meetings to discuss their commercial activities, exchange ideas, and, once a month, repay and receive their loans.

Group Formation: Newly formed groups have to attend a two day orientation program and two group meetings, and interview with Loan Committee that consists of SF staff prior to first loan disbursement. New members can join the already existing groups in the middle of loan cycle. They will have to wait for the next loan cycle in order to receive their first loan.

Group Structure: Groups will elect a group leader and a treasurer who will keep the group meetings records. The group leader will be responsible for attendance of group members on the group meetings and meetings on collection and disbursement of loans.

Loan Application: After filling out application forms the loan officer gives each application form to group members for review and checking. The loan officer, on the basis of analysis, can reject one or another application, even if group members approve loans of each other.

Selection of districts for activities: Expansion of sphere of activities is conducted on the basis of visits and thorough socio-economic analysis of situation in possible districts for micro-finance activities.

Interest Rate: An appropriate interest rate in amount of 6% is set in order to cover the inflation rate, operational costs of SF on micro-finance activities, institutional development and loan loss rate. As such potential clients learn about interest rate before group formation and beginning of loan cycle. Clients pay interest rate on declining balance for the period of use of loan.

Grace Period: There will be no grace period for clients. Clients will have to repay the loans starting one month after beginning of loan cycle.

Gender: In all implementation areas of micro-finance subcomponent will take part people of both sex, but preference will be given to women.

Repayment Schedule: Clients can not pay the whole loan after first month in order to receive next loan. After one month they can only repay the principal and interest. Only after the second month clients can repay the whole loan and receive next loan. Exception can be made in case if clients refuse to take the next loan.

Penalty: If client is not repaying on the set date he will have to pay penalty in amount of 1% of monthly installment (principal + interest).

17 MFO Clients

Informing community Receiving of information

Loan officer Preliminary registration

Preparation of orientation program

Orientation program

Loan group formation

Preliminary group meeting. Interview

Analysis of economic Provision of information on activities of clients type of economic activity and on financial status of enterprise

Registration of applicants in Database Filling out documentation for receiving of loan

Loan officer’s recommendation

Loan Committee’s conclusion

Orientation program

Disbursement of loans Receiving of loans

Monitoring of clients activities Running business, participation in group meetings

Repeated analysis of economic Payment of principal and interest activity

Disbursement of loans Next loan cycle

18 Appendix II: Comparing Formal and Informal Financial Sectors9 INFORMAL FINANCIAL SECTOR FORMAL FINANCIAL SECTOR 1. The informal financial sector provides savings 1. Formal financial institutions ignore small and credit facilities for small farmers in rural farmers, lower-income households, and small- areas, and for lower- income households and scale enterprises in favor of a larger-scale, well- small-scale enterprises in urban areas. off, and literate clientele which can satisfy their stringent loan conditions 2. The procedures of informal schemes are 2. Complex administrative procedures are beyond usually simple and straightforward; as they the understanding of the rural masses and small emanate from local cultures and customs, they are savers. easily understood by the population. 3. The informal sector mobilizes rural savings and 3. Formal financial institutions do not mobilize small savings from low-income urban households. rural savings or small-scale deposits. Commercial banks could contribute to rural and small savings mobilization if they had adequate branch networks and if they adopted the relevant procedures. 4. Informal groups operate at times and on days 4. The working days and opening hours of formal which are convenient for their members. financial institutions do not take rural work schedules into account; banks are open at times when farmers are at work in their fields 5. Informal sector associations accept any amount 5. Formal sector institutions are selective of regular savings, even the most modest sums regarding clientele, so as to avoid having clients which a saver can afford to set aside. The who make only small deposits. Their financial financial techniques on which such informal technology is not suited to the management of groups are based lend themselves to the modest sums from a large number of savers. management of a large number of small accounts. 6. Access to credit is simple, non- bureaucratic, 6. Loan application procedures are complex and and little based on written documents. Literacy is require reading and writing skills so that a file on not a requisite. the borrower may be established 7. The simple and direct processing of loan 7. Processing of loan requests is complex, requests allows for their prompt approval and a resulting in long delays before final approval or minimum delay in disbursement. Rejections are rejection. Even when approval is obtained, loan rare; but the level of risk is reflected in the delivery is slow. interest rate charged. 8. Collateral requirements on loans are to local 8. Collateral requirements correspond to the conditions and borrowers capacity. The situation of relatively well-off urban-dwellers: conditions may be based either on regular deposits or savings accounts in a commercial contributions to ROSCAs or on precise bank, property which can be mortgaged.

19 knowledge of farm size and/or crops harvested so as to determine the borrower's capacity to repay a loan.

9. Transaction costs are low 9. Transaction costs are high 10. Repayment rates are high 10. Repayment rates are low. 11. Because they emanate from local 11. Formal sector institutions do not have close environment, informal groups are aware of the contact with the environment in which they problems that members may be confronted with, operate. Sometimes they prosecute defaulters, and therefore they can deal with repayment which can have negative social repercussions, difficulties in a pragmatic manner. Debt while at other times they do not sue for rescheduling is possible. reimbursement, leading borrowers to believe that formal loans are free. 12. The informal sector has a dense and effective 12. Unfamiliar with the grass-roots environment, information network at the grassroots level for formal Institutions are ill-served by a mediocre close supervision and monitoring of borrower supervisory and monitoring network, and are activity - particularly their cash flow - whether unable to gain insight into the activities of their they are members of an informal association or clientele. not. This contributes to the efficient mobilization of savings and ensures high loan repayment rates. 13. Within the informal sector, information is 13. Formal sector institutions do not have a good widely diffused. The regular meetings of informal network for dissemination of information. In savings and credit associations serve as a forum addition, they are out of touch with the rural for dissemination of information. masses and make little to seek ways of reaching them. 14. The interest paid on deposits in the informal 14. Some institutions of the formal sector do not sector compares favorably with that paid in the even offer savings facilities. Others apply low - or formal sector, thus providing an incentive of rural sometimes even negative - real interest rates, thus and small urban households to save. putting off many a potential saver. 15. The informal sector charges competitive 15. Public institutions charge very low - lending rates; though they are sometimes high, sometimes negative - real interest rates on loans. this reflects the scarcity of loanable funds. There Commercial banks apply moderate lending rates is little connection between deposit and lending which are nonetheless considerably higher than rates. the interest paid on savings. The link between deposit and lending rates is weak. 16. There are no investment opportunities for 16. There are investment opportunities for savings savings which have been mobilized but which which have been mobilized but which have not have not been lent. been lent. 17. The informal sector usually does not keep a 17. The formal sector keeps written records on the written record on the borrowing and/or saving activities of clients, although the information activities of its clientele. When it does, the recorded is sometimes irrelevant.

20 procedures are relatively simple.

18. The volume and availability of loanable funds 18. The formal sector regularly has loanable funds are subject to seasonal fluctuations. available 19. The informal sector is not subsidized by the 19. Formal sector institutions are subsidized by government, nor does it receive grants or other the government and may also receive grants and forms of support from donor agencies. other support from donor agencies. 20. Savings and credit mechanisms in the 20. A regular supply of funds allows the formal informal sector are not geared towards sector to lend at any time of the year. This is not accumulating funds before the peak season when the case with government lending institutions, loan requests are highest. which are deprived of sufficient funds because of high default rates on their loans. 21. Despite the widespread dissemination of 21. Formal sector institutions could reach a information within the informal sector, informal widely dispersed rural clientele by collaborating groups are often unaware of new farming with government extension units. In practice, methods, and so members do not learn of new though, they do not resort to such intermediaries techniques which would allow them to increase and do not provide financial services in rural production levels and raise their standard of areas. living.

Appendix III: Evaluation10

Overview Microcredit programmes are one of the most important interventions in developing country efforts to reduce poverty. Recent years have witnessed a huge growth in terms of numbers and size of organizations, numbers of clients and scale of operation. If MFIs are to grow and meet the strong demand for their services in an increasingly competitive market, they are going to need to become increasingly sophisticated in gathering useful feedback regarding the impacts of their services on client’s business, their standard of living and their families.

Yet most MFIs do not measure the impact of their work, nor do they learn about whether there are ways in which they can improve the impact they have on the poor clients they seek to serve. Rating the performance of MFIs is an important tool to implement impact assessment. CGAP (Consulting Group for the Poor) runs rating funds to support rating activities in various regions and activities. Famous raters are ACCION, Microfinanza Ltd, PlaNet Rating, Microrate, M-CRIL, CRISIL, Equilibrium Clasificadora de Riesgo S.A Evaluation Strategy.

A sound evaluation should include: market research, institutional assessment and impact evaluation. Most evaluations of microcredit programs look at the institution itself,

21 especially focusing on financial issues, such as repayment rate, portfolio at risk and other financial ratios. But a MFI in which loans are being repaid on time does mean the people must be improving from poverty. Therefore, beyond institutional assessments, the actual impact of participation in the loan program on the lives of the clients must be carried out in order to obtain a comprehensive evaluation of the microcredit organization. Appendix III contains specific rating criteria and tables with the

Overall, MFI tend to have lower productivity and efficiency than commercial banks and NGOs have lower both productivity and efficiency than MFI. Most of the MFI NGOs do better in associating with ethnic priorities, training and have closer interaction with the clients, but are not generally well placed to provide other financial services, such as savings, insurance and payment services. Furthermore, most MFI are NGOs that cannot cater to the financial needs of the majority of the (self-employed) poor because they lack skills and equity to ensure broad outreach. If micro-customers "graduate" to a commercial level, MFI rarely have the means or will to transfer these clients to banks. Many MFI are donor- and credit-driven, not client- and savings-driven. Due to their social orientation they generally prefer group-approaches, while clients actually prefer individual financial services.11

Criteria Since MFIs vary in terms of age, operation scale, and target market it is essential to separate them into different categories so that the analysis can be more appropriate. These criteria are shown below: Legal Structure NGO Commercial Bank NBFI Scale of Small Medium Large Operations Total Loan < 1,000,000 1,000,000 to ≥ 8,000,000 Portfolio (US$) 7,999,999 Target Market Low-end Broad High-end Average Loan < 20% OR Avg. 20% to 149% ≥ 150% Balance / Loan GNP per capita Balance < US$150 Age New Young mature (1-2 years) (3-6 years) (> 6 years) Lending Individual Solidarity Group Village Banking Methodology (group of 3-9 (group with ≥ 10 borrowers) borrowers)

Market Research

Micro economic indicators Profitability and sustainability GDP per capital Adjusted return on assets (AROA) GDP growth rate Adjusted return on equity (AROE) Inflation Rate Operational self-sufficiency (OSS) Deposit Rate Financial self-sufficiency (FSS)

22 Outreach indicators Real interest yield No. of branches Efficiency No. of staff Operating expense ratio Administrative expenses/ Average No. of active borrowers loan portfolio Loan portfolio outstanding (‘000 Staff productivity US$) Average loan balance (US$) Cost per borrower % of women borrowers Depth (%)

Impact Assessment A good program of impact measurement and monitoring should use a set of measures to help assess the current performance and predict future growth. There is no blueprint methodology for all the MFIs with different assessment objectives. But the main principle is to develop a comprehensive measurement to assess what the financial evaluation can not assess. Some subjective questions can be asked to access the satisfaction of the clients, such as “How does this compare with other people living in your area? Overall, how has belonging to a microcredit program affected you as a person? How has the welfare of your household been affected by the respondent joining a microcredit program?”

Endnotes

23 Sources

Ahmed, Kaniz Fahmida. 2003. Microcredit as a Tool for Women Empowerment: The Case of Bangladesh. www.foreignaid.com/thinktank/microcredit.html

Baydas, Mayada, M. et. al. 1997. Commercial Banks in Microfinance: New Actors in the Microfinance World. http://www.mip.org/pubs/mbp/commbank.htm

CGAP. Inventory of Microfinance Institutions in Latin America, 1999 and Global Numbers, 2003.

Cunningham, Gord. 2000. Microfinance: Flavour of the Month or Practical Development Alternative? http://www.stfx.ca/institutes/coady/text/About_publications_presentations_microfinance. html

EBRD, Sectors: Financial Institutions, Small business finance signed projects. Accessed between 15 Sep – 05 Dec 2003. http://www.ebrd.com/country/sector/fi/signed/micro.htm

EBRD annual report 2002. Accessed between 15 Sep – 05 Dec 2003. http://www.ebrd.com/pubs/index.htm

Empowerment Case Studies, Kosovo Microenterprise Bank. Accessed between 15 Sep – 05 Dec 2003. http://poverty.worldbank.org/files/14830_Kosovo-web.pdf

Germidis et al. 1991 Financial Systems and Development: What Role for the Formal and Informal Financial Sectors? Paris: OECD Development Centre.

Global Development Research Center. So what is Microcredit Anyways? http://www.gdrc.org/icm/what-is-ms.html

Microcredit Summit Campaign. Accessed between 15 Sep – 05 Dec 2003. www.microcreditsummit.org

The Microfinance Gateway, accessed 15 September -5 December 2003. http://www.microfinancegateway.org/extra_faq.htm

Pugelli, David. The World Bank and Microfinance: An Elephant Trying to Build a Bird’s Nest? http://www.gdrc.org/icm/puglielli-paper.html

24 United Nations Capital Development Fund. Basic Facts About Microfinance. Accessed between 15 Sep – 05 Dec 2003. http://www.uncdf.org/english/microfinance/facts.html

United Nations Population Fund. Accessed between 15 Sep – 05 Dec 2003. http://www.unfpa.org

Woller, Gary. 2002. From Market Failure to Marketing Failure: Market Orientation as the key to deep outreach in Microfinance. Journal of International Development: 315.

25 1 Global Development Research Center. So what is Microcredit Anyways? (http://www.gdrc.org/icm/what-is-ms.html)

2 The Microfinance Gateway, accessed 15 September -5 December 2003. (http://www.microfinancegateway.org/extra_faq.htm)

3 United Nations Capital Development Fund. Basic Facts About Microfinance. Accessed between 15 Sep – 05 Dec 2003. http://www.uncdf.org/english/microfinance/facts.html

4 Cunningham, Gord. 2000. Microfinance: Flavour of the Month or Practical Development Alternative? (http://www.stfx.ca/institutes/coady/text/About_publications_presentations_microfinance.html)

5 Ahmed, Kaniz Fahmida. 2003. Microcredit as a Tool for Women Empowerment: The Case of Bangladesh. www.foreignaid.com/thinktank/microcredit.html

6 Baydas, Mayada, M. et. al. 1997. Commercial Banks in Microfinance: New Actors in the Microfinance World. http://www.mip.org/pubs/mbp/commbank.htm

7 Baydas, Mayada, M. et. al. 1997. Commercial Banks in Microfinance: New Actors in the Microfinance World. http://www.mip.org/pubs/mbp/commbank.htm

8 EBRD annual report 2002. Accessed between 15 Sep – 05 Dec 2003. http://www.ebrd.com/pubs/index.htm

9 Germidis et al. 1991 Financial Systems and Development: What Role for the Formal and Informal Financial Sectors? Paris: OECD Development Centre.

10 CGAP. Inventory of Microfinance Institutions in Latin America, 1999 and Global Numbers, 2003.

11