Public Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure Authorized 18771 MICROFINANCE HANDBOOK MICROFINANCE HANDBOOK An Institutional and Financial Perspective Joanna Ledgerwood T H E W O R L D B A N K W A S H I N G T O N , D . C . SUSTAINABLE BANKING with the POOR Copyright © 1999 The International Bank for Reconstruction and Development/TH E WO RLD BA NK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing December 1998 Second printing July 1999 Third printing July 2000 The findings, interpretations, and conclusions expressed in this paper are entirely those of the author and should not be attributed in any manner to the World Bank, to its affiliated organiza- tions, or to members of its Board of Executive Directors of the countries they represent. 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Joanna Ledgerwood is consultant to the Sustainable Banking with the Poor Project, World Bank, for Micro Finance International, Toronto, Canada. Library of Congress Cataloging-in-Publication Data Ledgerwood, Joanna. Microfinance handbook: an institutional and financial perspective/Joanna Ledgerwood. p. cm.—(Sustainable banking with the poor) Includes bibliographical references and index. ISBN 0-8213-4306-8 1. Microfinance. 2. Financial institutions. I. Title. II. Series. HG178.2.L43 1998 98–21754 332.1—dc21 CIP Contents Foreword xv Preface xvi Introduction 1 PART I—ISSUES TO CONSIDER WHEN PROVIDING MICROFINANCE 9 Chapter 1 Understanding the Country Context 11 Suppliers of Financial Intermediation Services 12 Existing Microfinance Providers 14 What Role Do Donors Play in Microfinance? 16 Financial Sector Policies and Legal Enforcement 17 Interest Rate Policies 18 Government Mandates for Sectoral Credit Allocations 19 Legal Enforcement of Financial Contracts 19 Financial Sector Regulation and Supervision 20 When Should MFIs Be Subject to Regulation? 21 Considerations When Regulating MFIs 23 Country Approaches to Regulating MFIs 25 Economic and Social Policy Environment 26 Economic and Political Stability 26 Poverty Levels 28 Investment in Infrastructure and Human Resource Development 28 Government View of the Microenterprise Sector 29 Appendix 1. Risks in the Microfinance Industry 30 Sources and Further Reading 31 Chapter 2 The Target Market and Impact Analysis 33 Objectives of the Microfinance Institution 33 Direct and Indirect Targeting 34 The Importance of Adequate Cash Flow and the Capacity to Service Debt 35 v v i C O N T E N T S Minimal Equity Requirement 36 Moral Hazard 36 Market Size 36 Identifying the Target Market 37 Characteristics of the Population Group 37 Types of Microenterprises 42 Impact Analysis 46 Kinds of Impacts 47 What Kinds of Impacts Have We Seen with Microfinance? 48 Impact Proxies 49 Client-Oriented Impact Analysis 49 When Should Impact Be Assessed? 52 Methods of Impact Assessment 53 Fundamental Characteristics of Qualitative Approaches 53 Fundamental Characteristics of Quantitative Approaches 54 Comparisons of Quantitative and Qualitative Approaches 56 Integrating Methodologies 56 The Choice of Unit of Analysis 56 Appendix 1. Quantitative Impact Assessment 58 Sources and Further Reading 59 Chapter 3 Products and Services 63 The Systems Framework 64 Microfinance Institutions—Minimalist or Integrated? 65 Financial Intermediation 66 Credit 66 Savings 71 Insurance 74 Credit Cards and Smart Cards 74 Payment Services 75 Social Intermediation 76 Enterprise Development Services 78 Social Services 81 Appendix 1. Microfinance Approaches 82 Appendix 2. Matching Enterprise Development Services to Demand 86 Sources and Further Reading 90 Chapter 4 The Institution 93 The Importance of Institutions 93 Attributes of a Good Institution 94 The Importance of Partner Institutions 94 Institutional Types 97 Formal Financial Institutions 97 Semiformal Financial Institutions 101 Informal Financial Providers 104 C O N T E N T S vii Institutional Growth and Transformation 106 Expansion Within an Existing Structure 106 Creating an Apex Institution 106 Creating a Formal Financial Intermediary 109 Governance and Ownership 110 Accessing Capital Markets 113 Institutional Capacity Building 117 Appendix 1. MFI Operational Review 118 Appendix 2. Manual for Elaboration of a Business Plan 123 Sources and Further Reading 128 PART II—DESIGNING AND MONITORING FINANCIAL PRODUCTS AND SERVICES 131 Chapter 5 Designing Lending Products 133 Cash Patterns, Loan Terms, and Payment Frequency 133 Client Cash Patterns and Loan Amounts 133 How Does the Loan Term Affect the Borrower’s Ability to Repay? 134 Frequency of Loan Payments 136 Working Capital and Fixed Asset Loans 136 Loan Collateral 137 Collateral Substitutes 137 Alternative Forms of Collateral 138 Loan Pricing 138 Calculating Interest Rates 140 How Do Fees or Service Charges Affect the Borrower and the MFI? 142 Cross-Subsidization of Loans 143 Calculating Effective Rates 143 Estimating the Effective Rate 144 Calculating the Effective Interest Rate with Compulsory Savings or Other Loan Variables 146 Calculating the Effective Interest Rate with Varying Cash Flows 147 How Does the Effective Cost for the Borrower Differ from the Effective Yield to the Lender? 148 Appendix 1. How Can an MFI Set a Sustainable Rate on Its Loans? 149 Appendix 2. Calculating an Effective Interest Rate Using the Internal Rate of Return Method 150 Appendix 3. Calculating the Effective Rate with Varying Cash Flows 152 Sources and Further Reading 153 Chapter 6 Designing Savings Products 155 Demand for Savings Services 156 Is There an Enabling Environment? 157 Legal Requirements for Offering Voluntary Savings Services 157 Deposit Insurance 158 Does the MFI Have the Necessary Institutional Capacity to Mobilize Savings? 160 Ownership and Governance 160 Organizational Structure 160 Human Resources 161 Marketing 162 Infrastructure 163 v iii C O N T E N T S Security and Internal Controls 163 Management Information Systems 163 Risk Management and Treasury 163 Sequencing the Introduction of Savings Services 164 Types of Savings Products for Microentrepreneurs 164 Liquid Accounts 165 Semiliquid Accounts 165 Fixed-Term Deposits 166 Costs of Mobilizing Voluntary Savings 166 Pricing Savings Products 167 Sources and Further Reading 168 Chapter 7 Management Information Systems 169 An Overview of Issues Related to Management Information Systems 170 Three Areas of Management Information Systems 171 Accounting Systems 171 Credit and Savings Monitoring Systems 172 Client Impact Tracking Systems 178 Installing a Management Information System 178 Institutional Assessment 178 Configuration 178 Software Modifications 179 Testing 179 Data Transfer 179 Training 180 Parallel Operations 180 Ongoing Support and Maintenance 180 Appendix 1. Overview of Commercial Management Information System Software Packages 180 Appendix 2. Criteria for Evaluating Loan Tracking Software 183 Sources and Further Reading 183 PART III—MEASURING PERFORMANCE AND MANAGING VIABILITY 185 Chapter 8 Adjusting Financial Statements 187 Accounting Adjustments 188 Accounting for Loan Losses 188 Accounting for Depreciation of Fixed Assets 192 Accounting for Accrued Interest and Accrued Interest Expense 193 Adjusting for Subsidies and Inflation 194 Accounting for Subsidies 195 Accounting for Inflation 197 Restating Financial Statements in Constant Currency Terms 199 Appendix 1. Sample Financial Statements Adjusted for Subsidies 200 Appendix 2. Sample Financial Statements Adjusted for Inflation 202 Sources and Further Reading 204 Chapter 9 Performance Indicators 205 Portfolio Quality 206 Repayment Rates 206 Portfolio Quality Ratios 207 Loan Loss Ratios 211 Productivity and Efficiency Ratios 212 Productivity Ratios 212 Efficiency Ratios 213 Financial Viability 215 Financial Spread 216 Two Levels of Self-Sufficiency 216 Subsidy Dependence Index 218 Profitability Ratios 220 Return on Assets Ratio 221 Return on Business Ratio 222 Return on Equity Ratio 223 Leverage and Capital Adequacy 223 Leverage 224 Capital Adequacy Standards 224 Scale and Depth of Outreach Indicators 225 Performance Standards and Variations 227 Appendix 1. Sample Balance Sheet 233 Appendix 2. Sample Income Statement 234 Appendix 3. Sample Portfolio Report 235 Appendix 4. Adjusted Sample Financial Statements (Combined) 236 Appendix 5. Analyzing an MFI’s Return on Assets 238 Sources and Further Reading 241 Chapter 10 Performance Management 243 Delinquency Management 243 The Effect of Delinquency on an MFI’s Profitability 244 Controlling Delinquency 245 Rescheduling or Refinancing Loans 246 Productivity and Efficiency Management 248 Improving Staff Productivity 248 Managing Costs 251 Risk Management 254 Asset and Liability Management 254 Operating Risk Management 258 Appendix 1. Gap Analysis 260 Sources and Further Reading 261 GLOSSARY 263 INDEX 271 C O N T E N T S ix [...]... low-income clients 4 The contribution of microfinance to strengthening and expanding existing formal financial systems Microfinance activities can strengthen existing formal financial institutions, such as savings and loan coop- MICROFINANCE HANDBOOK 4 eratives, credit union networks, commercial banks, and even state-run financial institutions, by expanding their markets for both savings and credit and, ... policymakers, and practitioners, the handbook first covers the policy, legal, and regulatory issues relevant to microfinance development and subsequently treats rigorously and in depth the key elements in the process of building sustainable financial institutions with effective outreach to the poor The handbook focuses on the institutional and financial aspects of microfinance Although impact analysis is... stakeholders 5 Part II Designing and Monitoring Financial Products and Services Part III Measuring Performance and Managing Viability Organization of the Book The handbook has three parts Part I, “Issues in Microfinance Provision,” takes a macroeconomc perspective toward general microfinance issues and is primarily non- Micro Low Technical complexity High 6 products) and the development of management information... practitioners and consultants Donors will also benefit from part III if they want to understand how MFIs should be adjusting their financial statements and calculating performance indicators While the technical information is fairly basic, some understanding of financial statements and financial analysis is required The overall purpose of part III is to improve the level of financial understanding and management... savings and credit associations and variants Credit unions Banques populaires Employee savings funds Development banks State-owned Private Informal financial firms Indigenous bankers Finance companies Investment companies Village banks Nonregistered self-help groups Cooperative quasi-banks Development projects Other nonbank institutions Finance companies Term-lending institutions Building societies and credit... Performance and Managing Viability,” is the most technical part of the handbook, focusing primarily on assessing the financial viability of MFIs (These relationships are shown in figure 1.) Part I addresses the broader considerations of microfinance activities, including the supply of and demand for financial services, the products and services that an MFI might offer, and the institutions and institutional. .. including the financial sector, financial sector policies and legal enforcement, financial sector regulation and supervision, and economic and social policies Chapter 2–The Target Market and Impact Analysis looks at the demand for financial services among low- INTRODUCTION 7 income populations and presents ways of identifying a target market based on client characteristics and the types of enterprises they... lending Banks, savings banks, and credit unions funded their loan portfolios with client and member deposits and commercial loans I NGOs offered the smallest loan sizes and relatively more social services than banks, savings banks, or credit unions I Credit unions and banks are leaders in serving large numbers of clients with small deposit accounts The study also found that basic accounting capacities and. .. Suppliers of Financial Intermediation Services The first step in understanding the context in which a microfinance provider operates is to determine who makes up the financial system “The financial system (or financial sector, or financial infrastructure) includes all savings and financing opportunities and the financial institutions that provide savings and financing opportunities, as well as the valid norms and modes... institutions and their operations Financial markets are the markets—supply, demand, and the coordination thereof—for the services provided by the financial institutions to the nonfinancial sectors of the economy.” (Krahnen and Schmidt 1994, 3) To analyze a country’s financial system, it is necessary to look at both the demand for and the supply of financial services This section focuses on the supply of financial . AuthorizedPublic Disclosure Authorized 18771 MICROFINANCE HANDBOOK MICROFINANCE HANDBOOK An Institutional and Financial Perspective Joanna Ledgerwood T H E W O R L D. Cataloging-in-Publication Data Ledgerwood, Joanna. Microfinance handbook: an institutional and financial perspective/ Joanna Ledgerwood. p. cm.—(Sustainable banking with the poor) Includes