The not so micro business of Microfinance

Mainstream and social media have recently been inundated with horror stories of predatory practices by loan sharks – many citing tales of high interest rates and exploitation of poor borrowers.

At first glance, it would seem that the criticism is fair. How can charging such exuberant prices to a person in need be anything other than exploitative? So Profit came out to figure out the problem and the astronomical numbers involved.

The industry says there’s more to that number than just profit and greed.

The microfinance sector, over the last decade, has become the main lender to the financially underserved segment of society. However, as the sector grew, it came to public attention and has since come under scrutiny for practices that raise questions about its ultimate purpose.

A key player in the sector is the microfinance banks (MFBs) which are involved in about 75% of the country’s microfinance loans. Yet some of these banks have a questionable approach to their operations, which are driven by a fragile business model.

A constant criticism of these banks has been their relatively high interest rates. They charge between 35% and 40% per year to lend money.

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Kabeer Naqvi, president and CEO of U Microfinance Bank, says he understands why there are criticisms, but there is a need to understand the MFB model and the costs involved. There is the cost of vetting borrowers, setting up branches in remote areas where microfinance is more needed, among other costs. Then there is the cost of compliance with banking and financial laws.

“It increases the cost, especially when you factor in the small size of the loan ticket,” Naqvi told Profit.

The reality is that the average loan size of these banks was around Rs 60,000 according to a Pakistan Credit Rating Agency (PACRA) report released in 2021. Hence, the benefits of economies of scale lacking in the sector.

According to “The How & the Why of Microfinance Lending Rates”, a study conducted by Pakistan Microfinance Network in 2019, operational costs accounted for approximately 22% of the average gross loan portfolio for the entire microfinance industry, including corporates. non-bank microfinance. Moreover, the cost of funds for these institutions is also high as they have to offer premium rates in order to compete with conventional alternatives to attract depositors.

“Yet with an interest rate of over 35%, we only have a margin of around 4-5% and that does not take into account the negative impact of calamities like locusts or recent floods. which dramatically increase the default rate in the industry,” says Kabeer.

Kabeer said: “Recently the sector has come under a lot of criticism and been cited as a predatory lender. The point is, MFBs cater to a segment of society that for a very long time was left at the mercy of local loan sharks who charged exuberant interest rates of over 100% and had tyrannical methods of recovery. .

“The need for a bank in the segment comes from the fact that the NGO model is not scalable. Until you are able to raise funds from the wealthy to lend to the excluded segment, there is no way eight million people could have been served.

Are MFBs durable?

Not so long ago, the sector was advocating for regulatory relaxation with the SBP after the pandemic shook its fundamentals – and there was more criticism for the sector. With so many apparent issues involved, the question remains whether the MFB model is sustainable or viable, and how these issues can be resolved.

“When Covid hit, the most vulnerable socio-economic sector was unfortunately our borrowers. The industry’s communication with SBP, which was later featured in the media, was taken out of context. The figures we presented were representative of the worst-case scenario. It was an exercise in understanding the magnitude of the challenge ahead. Still, the SBP was very accommodating as it allowed the industry to reschedule loans and other easing was also planned.

According to sources, SBP’s microfinance department has asked banks to provide rescheduled loans earlier, especially this portfolio where interest has ballooned to levels of the principal amount.

“I cannot comment on other banks, but U Bank’s rescheduled portfolio has grown from Rs 12 billion in 2021 to Rs 3 billion so far. Additionally, we are the only bank in the country, programmed or micro, to have implemented IFRS-9 and accelerated loan provisioning. Therefore, the SBP was able to take advantage of the quality of our portfolio,” explained Kabeer.

Despite the problems, the big boss of U Bank presents an optimistic outlook for the industry: “In terms of the sustainability of the model, the sector has ventured into high value financing such as a housing loan of 3 million rupees or a tractor loan. As the disbursements of these products accelerate, the interest yield will inevitably decline. If the sector maintains the right balance between micro-consumer loans, MSME loans and premium loans, you will see a turnaround in the next few years. »

The case of bank U

U Bank operates as a commercial bank. It has invested more in securities than it has lent and it has substantial borrowings, nearly five to nine times the borrowings of other BMFs in the sector. In addition, the bank’s effective tax rate was around 16%, the lowest in five years.

Kabeer told Profit: “The reason U Bank’s balance sheet composition looks like an anomaly in the industry is purely strategic. Conventional microfinance lending is an extremely risky business and, coupled with our aggressive growth strategy of expanding branch operations, we needed to hedge the risk. This is mainly what drove our investment frenzy.

“Additionally, our effective tax rate went down because the bank had incurred tax losses which we decided to realize and the fact that tax on treasury investments is only 15% of half the tax rates. corporate taxation also explains the effective tax rate.”

U Bank, through U Paisa, has a stake in the mobile financial services segment, like other banks backed by telecom operators. However, when the pandemic started, the SBP issued a circular asking banks to remove interbank funds transfer fees to promote digital payments. This was one of the main winning points for mobile financial service operators. Coupled with the opening of the market to FinTechs and commercial banks venturing into the digital banking space, existing players are now being challenged to dominate the mobile banking market in Pakistan.

“U Bank’s growth strategy is a bit different. To sum up what we are trying to achieve, we need to look at where the resources are being invested. The bank now has six verticals; Rural Retail, Urban Retail, Islamic Banking, Business/Investment Finance, Business and MSMEs and Digital Banking,” Kabeer explained.

“On the digital front, we aim to leverage our existing customer base and transition them completely to digital accounts. Our AI-enabled UBot app and Temenos Infinity banking software will help us make this change. So basically anyone who opens an account at the U Bank branch will be opening a Level 2 digital account.”

“This will serve as a pathway for us to venture into a full-fledged digital banking space without getting entangled in the complexities of a digital banking license,” he added.

In line with SBP’s Strategic Plan for the Islamic Banking Industry 2021-25, “The plan identifies improving liquidity management by inspiring the industry to develop innovative products to address unserved/underserved sectors and regions. It will also enable the industry to reach the target of 10% and 8% share of its private sector funding to SMEs and agriculture, respectively, by 2025.”

“Islamic banking has huge potential in the country as people resonate with the idea. U Bank has also ventured into this area and we are growing. Over the next few months the bank will inaugurate about 30 Islamic banking branches which will focus on lending rather than parking money in sukuks.

However, the main driver of growth in the country’s Islamic banking segment has been Meezan Bank, which is likely to take on any new entrant head-on.

While MFBs have their share of liquidity problems, some commercial banks are not so well off either. The government, in the memorandum of economic and financial policies, early last month, said: “We remain closely engaged with two undercapitalized private banks and are committed to ensuring compliance with minimum capital requirements.”

“I am very clear that MFBs should operate like banks rather than just lending shops. Banks need to invest, lend and raise funds, and work on product innovation. We recently converted U Bank’s Tier 2 capital to Tier 1 capital and also issued preferred shares. This was all for the growth funding that is needed to compete as a challenger retail bank, especially when total assets are rapidly approaching a figure of Rs 150 billion, which is by no means micro and is comparable in size to some smaller commercial banks,” Kabeer reiterated. .