Daniel Rozas, Micro Opus

MicrofinanceFocus, 8 November 2010

The crisis in Andhra Pradesh has highlighted how exposed MFIs are to mass non-payments.  Industry insiders have suggested that even some of the largest MFIs simply might not survive if the crisis is not resolved soon.  And if that were to happen, is the industry prepared to deal with the process of unwinding one of these giants?

The top MFIs in India are large by any standard, with assets in the multiple $100s of millions, most of which are held in the form of outstanding microcredits.  Once an MFI is hobbled to the point that it cannot survive as a going concern, what happens to these assets?  Experience from other MFIs suggests that prospects for recouping them are not good.

Microcredits are unusual assets in that their value is tied to the MFI that created them.  When an MFI is closed, its borrowers will simply not pay anyone else unless provided with clear incentive to do so.  Examples where liquidations of MFIs through sale of their assets were successful are rare, and usually involve elements in the MFI’s business model that limit the importance of the borrower-MFI relationship, such as the use of collateral.  None of these elements are used in any significant way by Indian MFIs.  Thus, the commonly-used approach in liquidations – closing down the institution and selling off its assets – is guaranteed to result in near-complete loss of those very assets.

A successful windup must thus provide for retaining the MFI’s operations for some period.  However, that alone is not enough.  One of the greatest incentives for borrower repayment in microfinance is the expectation of future loans.  Once borrowers perceive that those loans are not forthcoming, they will stop repayments in droves.  That poses an inherent dilemma – if an MFI is to be closed, it can’t be making new loans, which would in turn have to be followed by additional loans, and so on.

Recoveries through merger

The most obvious option is through a merger with a stronger institution, which can retain the MFI’s operational capacity and provide the needed capital to continue issuance of new loans.  Unfortunately, the breadth of the current crisis reduces the chances that other large MFIs would be in a position to effect such a buyout.  It is possible that an outside party might seek to take over, but it is not a given – microfinance in India is not a sector whose future prospects are in any way clear at this stage.  However, if a buyer did emerge, it would find that while challenging, effecting repayments on long-overdue loans is not impossible.

One could draw useful lessons from the 2006-07 AP crisis in the Krishna district.  That crisis had a similar pattern – repayments were stopped by way of government action, but after a year-long hiatus, MFIs were able to restart collections.  Though the final results of these collections have not been made publicly available, a source familiar with the effort has estimated the ultimate recovery rate for one of the large affected MFIs at 60-65%, collected over a period of two years.

It’s worth noting that a similar recovery rate from the current crisis could be catastrophic for the MFIs most exposed to AP, even if collections happened over a shorter time period.  The scale of the crisis this time around is far broader, affecting the entire state (and potentially more), as opposed to a few districts.  Moreover, the current political climate and lack of liquidity from banks suggests that MFIs will probably not have the option of relying on rapid growth to escape the overhang from so many bad loans.

However, for creditors seeking recoveries, a 60% recovery rate for affected microcredits is not bad at all.  Though unlikely to cover everything, their losses would be mitigated the unaffected parts of the portfolio and the additional cushion of equity that could absorb some 15-20% of losses.  So absent acquisition by a well-capitalized entity, do creditors have another option for recovering on these loans?

Recoveries via receivership

Before effective recoveries could begin, a receiver would have to be appointed to manage the recoveries and wind down the institution.  This should be done as soon as the MFI falls into insolvency or defaults, while core staff is still in place.  Ideally, the MFI would be taken into receivership by way of early regulatory action under pre-existing statutory authority (see, for example, the US FDIC).  However, it’s unclear that such authority could be established in the present political environment, and moreover, it would take some time to set up.

Nevertheless, the absence of a statutory authority to take an MFI into receivership does not prevent creditors from appointing a receiver through court action.  The difficulty in such a circumstance is two-fold:  1) the selected receiver must be experienced in microfinance and understand the complications that arise when attempting to liquidate MFI portfolios, and 2) the legal process must avoid creating roadblocks that undermine the receiver’s ability to effectively discharge its duties.

Once a receiver takes over the MFI, its task requires following two parallel tracks:  to seek out MFIs that would be interested in one or another portion of the portfolio, while maintaining collections with the clients.  Obviously for the latter it cannot use any pressure tactics, as these would in any case undermine the very efforts to collect.

The tie-up with other MFIs is particularly critical, for that is the means by which a winding-down MFI can maintain its borrowers’ repayment incentive.  Generally speaking, there are several ways of accomplishing this.  Once could sell the full portfolio at deep discount, and let other MFIs attempt to collect.  This is probably the least effective approach.

Another approach is to agree with the purchasing MFI on a threshold of re-performance after which the loan would be purchased.  For example, once a borrower makes 5 payments, the MFI would buy the rest of the loan at some pre-agreed price.  To achieve this, the two entities would have to effectively communicate the plan to the borrowers, ideally by making joint presentations of the new plan to the borrower groups.

A similar approach would be to have the borrower fully repay the loan, and then become eligible for the next cycle loan from the transferee MFI.  Importantly, the failing MFI should not expect to necessarily receive additional payment for such a transfer, and in some cases it should even be prepared to share some of the repayment proceeds with the transferee MFI.  The ultimate outcome depends on the level of trust and the transferee MFI’s interest, but it is critical that the receiver and creditors realize that the primary objective of the transfer is to maintain the borrower’s repayment incentive.  This is not a theoretical point – a very similar situation during the liquidation of FOCCAS in Uganda in 2006 resulted in creditors rejecting exactly such an arrangement out of concern that they were “giving away” their clients for free, but which ultimately cost them far higher losses when clients stopped paying altogether.

Throughout the collection period, it is imperative that extensive consideration be made of staff incentives.  Staff would normally have little motivation to help transfer a client to a new MFI, thus helping themselves out of a job.  Thus, provisions should be made either for transferring staff to the new MFI, or providing bonuses or other incentives for collections.  Similarly, the receiver’s interests should be aligned with those of creditors, by insuring that the bulk of its fees are paid as a share of the proceeds.

A successful failure

Failure is a normal part of the business landscape.  It helps weed out weaker players, provides object lessons for others, and is a necessary counterpoint to the evolutionary process of creative destruction.  But there are different kinds of failures.  The impact of some might be so minimal that they are only felt by management and shareholders, with clients and creditors experiencing no direct impact.  Other cases can result in massive losses not only to investors, but also creditors, clients, suppliers, and the rest of the economic ecosystem that was dependent on the failed enterprise.

Failures resulting from the current crisis could go either way.  If badly handled, they could well cause banks and investors to shun MFIs for years to come, bringing the sector to a standstill.  But a well-handled failure could actually strengthen the sector.  If a failure of an MFI can demonstrate that resulting losses to creditors are manageable, it could also serve as an important demonstration that a savings-based MFI would also not present an undue risk, perhaps leading RBI to allow deposit gathering by MFIs.

In the end, a chastened, more experienced microfinance sector could ultimately provide better quality services to the poor than has been the case during the go-go years of the past half-decade.