The Microcredit Summit's Challenge: Working Toward Institutional Financial Self-Sufficiency While Maintaining a Commitment to Serving the Poorest Families

Institutional financial self-sufficiency (IFS) is necessary for a microfinance institution (MFI) to obtain the large amount of funds required to reach and benefit truly large numbers of the poor and poorest households. There is no necessary trade-off between serving large numbers of the poorest households and the attainment of IFS by an MFI, as proven by the case studies in this paper. Cost-effective identification of the poor and the poorest women is essential to maximizing the effectiveness and efficiency of providing microfinance services to them. If the service is not exclusively for the poor and the poorest, it should be operated separately for them to minimize leakage to the nonpoor. The total cost of efficient microcredit to the poor, i.e., the appropriate interest rate, will vary between 35% and 51% of their average loans outstanding, depending on the conditions under which it is provided, and on the quality of the loan portfolio. The poorest women in Asia, Africa, and Latin America are proving that they can and will pay the required cost of this opportunity to reduce their poverty and to provide a better future for their children. This is made possible by the impressive returns to their microenterprises, averaging normally more than 100%. Journal of Microfinance I n t r o d u c t i o n Working toward institutional financial self-sufficiency (IFS) is essential for microfinance institutions (MFIs) to reach and benefit significant numbers of the poorest households—those living in the bottom 50% of the poverty group—with financial services for poverty reduction. IFS reflects an MFI’s “ability to operate at a level of profitability that allows sustained service delivery with minimum or no dependence on donor inputs” (Christen, Rhyne, Vogel, & McKean, 1995, p. vi), international agencies, or charitable organizations. We believe that only by pursuing commercially motivated, for-profit strategies will MFIs, particularly those working with the poorest, achieve our primary goal of reducing poverty among truly large numbers of the poor and poorest. The argument for IFS is well known: As MF[I]s begin to wean themselves away from their dependence on subsidies and start to adopt the practices of good banking they will be forced to further innovate and lower costs. Not only may this ultimately mean better service for poor borrowers, but more importantly, it is argued that as MF[I]s become profitable they will be able to increasing[ly] tap into the vast ocean of private capital funding. If this happens the microfinance sector as a whole will soon be greatly leveraging the limited pool of donor funds and massively increasing the scale of outreach in ways that it is hoped could begin to make a truly significant dent on world poverty. (Conning, 1998, p. 2) IFS is defined as the ability of an MFI to cover all actual operating expenses, as well as adjustments for inflation and subsidies, with adjusted income generated through its financial services operations. Inflation adjustments are twofold: (1) to account for the negative impact, or cost of inflation, on the value of your equity and (2) to account for the positive impact of the revaluation of nonfinancial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mr. Gibbons is managing director of CASHPOR Financial and Technical Seruices. Ms. Meehan is financial advisor for the same organization. 132 Volume 1 Number 1 The Microcredit Summit’s Challenge assets and liabilities for the effects of inflation. Similarly, there are two types of subsidies which must be adjusted for (1) explicit subsidies to properly account for direct donations received by an MFI to cover operating expenses, and (2) implicit subsidies to account for loans received by an MFI at below market rates, and in-kind donations such as rent-free facilities, staff paid by third-parties, technical assistance, and the use of a third party infrastructure (e.g., communication facilities, etc.). In analyzing an MFI’s performance, such adjustments are necessary, since MFIs often operate in highly inflationary environments and receive significant support from third parties—such as government or donors—in the form of implicit subsidies. The adjustments take this support into account and allow an MFI to understand the potential commercial viability of its financial services operations. This is done by comparing adjusted operating income to adjusted operating expenses. If the figure is greater than 1.0, we say an MFI has reached IFS. If IFS has not been achieved, the withdrawal of such “support” could ultimately result in the failure of an MFI, with potentially disastrous effects on the poor clients being served. So MFIs wanting to reach and benefit truly large numbers should consciously work toward IFS. This does not, of course, mean that IFS should be attained at the cost of the overriding goal of poverty reduction. That would defeat the purpose for which we are working—which is not profit as an end in itself, but poverty reduction. Rather it means that IFS should be pursued at a rate that is consistent with substantial poverty reduction. Attainment of both goals must be monitored so as to ensure that IFS does not displace the more important goal of poverty reduction. Even with this qualification, many may disagree with the need to work towards IFS. Perhaps most would argue that nongovernmental Volume 1 Number 1 133 Journal of Microfinance organizations (NGOs) have important social objectives that cannot be executed in a financially sustainable manner. Requiring that an institution do so would result in goal displacement. Outreach and service to the poor and poorest are more important, some might well argue, than making profits. A major purpose of this paper is to try to convince those who want to reach and benefit truly large numbers, say at least 500,000, of the poorest households with microfinance, aim for IFS, and support, rather than displace, their efforts in poverty reduction. The most important reason is funding. Reducing poverty significantly, that is, reaching and benefiting truly large numbers of poor and poorest households, even the 500,000 mentioned above, requires vast amounts of funds. Assuming an average loan outstanding per client of only US$150, for example, the total annual loan fund requirement alone would be US$75 million. Add to that the equity requirements to cover operating losses in the early years of operations and large-scale expansion, and the figure rises further. Attainment of the Microcredit Summit goal of reaching 100 million of the poorest households is estimated to cost around US$21 billion. From where are such vast amounts of funds going to come? Not from donors, whose funds for supporting microfinance are limited, and probably not from governments either, because of competing claims on their funds: though in countries where funds are made available by governments, MFIs should take advantage of them— provided they can do so without incurring crippling interference in their operations. Grants and soft loans have played, and continue to play, major roles in financing MFI start-ups. They are particularly useful at that early stage when equity is usually nonexistent and deficits are large. Guarantees and quasi-equity, which are themselves soft loans, can 134 Volume 1 Number 1 The Microcredit Summit’s Challenge also be of critical importance when the MFI seeks to establish relations with banks. However, grants and soft loans are always limited in supply and time-consuming to secure. For these reasons they are likely to be insufficient for financing the scaling-up of MFIs to reach truly large numbers and IFS. In the likely event that grants and soft loans do not meet funding requirements for scaling-up, MFIs must search elsewhere. Only formal financial institutions are likely to be able to provide the vast financial resources required to reach large numbers of the poor and poorest with microfinance. If profit-oriented, formal, financial institutions are to be interested in entering business partnerships with MFIs, the latter will have to convince these institutions of the strength of the MFI’s operational and financial management, in other words, that the MFIs operate as commercially minded, for-profit entities, just like the other clients of the financial institutions. In order to maximize the potential of this partnership, MFIs will have to build their equity, because it serves as a lever to obtain debt from formal financial institutions and savings deposits (where appropriate) from members. Currently, for MFIs, the most reliable long-term source of such equity is retained earnings. To build retained earnings, MFIs will have to make profits from their outreach to the poor and poorest by reaching truly large numbers. Making profits, in the medium to long term, means the attainment of a sufficient degree of IFS and reasonable adjusted, return on assets (AROA). There is no other way. So it is not a question whether or not we need to pursue IFS so as to be able to reduce extreme poverty in a big way, but rather how best to go about it without losing sight of our overriding concern for poverty reduction. The rest of the paper focuses on this point. Volume 1 Number 1 135 Journal of Microfinance Trade-off between Working with the Poorest and IFS? A few years ago, an influential book that included case studies of 12 MFIs in Asia, Africa, and Latin America argued that MFIs working with the poorest would experience a trade-off with IFS. Specifically, it concluded that “at a given point in time [MFIs] can either go for growth and put their resources into underpinning the success of established and rapidly growing institutions, or go for poverty impact . . . and put their resources into poverty-focused operations with a higher risk of failure and a lower expected return” (Hulme & Mosley, 199