In many parts of the world, microfinance is a lifeline to a better standard of living. Of an estimated three billion poor, around half, or 1.5 billion, could be considered working poor who are potentially eligible for loans or other microfinance services. The universe of microlenders addressing this deep demand for basic financial services has become broader and deeper over the years. Currently, millions of low-income households in less-developed regions are able to access credit through microfinance programs, making a significant difference to the borrowers and their families. Moreover, the positive effects that ripple through the local economies from the enhanced ability of individuals to be integrated into the more formal financial systems are significant. However, to continue this significant growth requires the resources of the mainstream capital markets. The need to attract and expand the flow of sustainable capital and the development of a larger and more robust group of microfinance institutions that can effectively absorb the influx of private capital are the key challenges facing the industry today.
To aid in the growth and development of microfinance institutions (MFIs), and in response to industry demand for globally accepted and standardized analytical tools for MFIs, Standard & Poor's Ratings Services is developing a microfinance rating methodology. In early 2007, Standard & Poor's created a working group (including industry experts) to explore the needs of mainstream investors and the state of the microfinance industry in the context of the broader financial system. The feedback received from this team of analysts and representatives from organizations with long experience with the MFI industry clearly indicated the need for transparent new credit metrics for MFI analyses. In response, Standard & Poor's is taking steps to create a rating methodology and a tailored ranking system to provide meaningful comparisons of MFIs within a country and across the globe and different asset classes.
Industry lending has a current annual growth rate of 15%-30%, resulting in an annual demand for available funds of up to US$5 billion. To sustain this trend, the largest and most robust of these MFIs must attract and expand the flow of private capital received. The total foreign debt and equity investment in MFIs equals US$4.4 billion, of which approximately US$2.4 billion is from international finance institutions (IFIs) and only US$2 billion is derived from the private sector. However, over the past two years, private investors have increased their participation in the microfinance arena dramatically, in large measure through microfinance investment vehicles (MIVs).
Some analysts anticipate private investment in this sector to grow to US$20 billion by 2015. To facilitate this interest, Standard & Poor's, with the support of the Inter-American Development Bank's (IADB) Multilateral Investment Fund, is undertaking a program that will select 10 MFIs for a pilot ratings program that will further our work to institutionalize standards through the development of a global credit rating framework for MFIs. Investors will then have the tools to better define the parameters of risk and reward when considering the microfinance sector. In so doing, Standard & Poor's believes that a more robust secondary market for MFI instruments may develop, along with a greater acceptance of these loans into structured transactions. Both such advances should lower issuance costs for MFIs.
Frequently Asked Questions
Beyond providing ratings to 10 MFIs, what are the long-term goals of the pilot ratings project?
Beyond developing independent and readily understood opinions about credit risk and the ability to compare the creditworthiness of various instruments, we believe that our efforts will provide both clear standards for disclosure and financial accounting and outcomes that MFIs can use to enhance their ability to attract donor and other noncapital market investment. Moreover, MFIs themselves will be able to use the feedback provided to benchmark themselves against their peers and to map their progress toward best practices in their industry. This could be especially useful for second- and third-tier MFIs as they work toward improving their reporting systems and management capabilities. The development of a larger, more robust group of intermediaries that can absorb available capital is a key long-term goal of the microfinance industry. Finally, central governments can also use these familiar tools when evaluating regulatory reform designed to facilitate access to local capital markets.
Ratings and related credit assessment reports will provide all stakeholders with an improved understanding of an MFI's credit risk profile, challenges, and strengths.
What other efforts has Standard & Poor's undertaken to support the participation of MFIs in the capital markets?
As the world's foremost provider of credit ratings, Standard & Poor's has used its expertise to provide thought leadership in the microfinance arena. As noted above, Standard & Poor's first step was the creation of a working group consisting of analysts and representatives from organizations with long experience in the MFI industry. The purpose of the working group was to produce a report outlining recommendations for a comprehensive rating methodology for the microfinance industry. The report, entitled "Report of the Microfinance Rating Methodology Working Group," was published in June 2007 (RatingsDirect, June 19, 2007; also see "MFI Rating Methodology," RatingsDirect, June 19, 2007.) As the next step, Standard & Poor's will leverage off the findings of the working group and its long experience in rating financial institutions to develop microfinance credit rating criteria and an industry-specific ranking system. Once reviewed and approved internally, the criteria and ranking scale will be made public, in accordance with Standard & Poor's policy.
What are the criteria for selecting the 10 MFIs for the pilot program?
Standard & Poor's aim is to gather as broad a group as possible in selecting the 10 MFIs from throughout the Latin American and Caribbean region. Some of the key factors that will be considered include diversification by size of portfolio, geography, and type of institution, and a cross-section of some of the major microfinance networks. Standard and Poor's will select these MFIs and engage in the rating process independently.
What is the time line for the IADB project, and when will the first results be available?
The execution period for the project is 18 months. The pilot ratings project will begin immediately. Standard & Poor's will follow its standard practices and conduct a full evaluation of those MFIs selected for participation. Once each rating process is complete, Standard & Poor's will publish a full analysis of all publicly released ratings. Upon completion of the 10 ratings, Standard & Poor's will prepare a detailed public report discussing the findings of the pilot ratings project. The report will describe and analyze discerned patterns of strengths and weaknesses and broad trends observed among MFIs and discuss any other issues that could help raise awareness of the development needs of the industry as they relate to creditworthiness. Standard & Poor's will use its extensive distribution channels to broadly disseminate the report to global and domestic capital markets players and to the microfinance sector
Will Standard & Poor's global microfinance ratings scale and criteria be extended to other institutions following the initial pilot ratings project?
Standard & Poor's expects that the transparency and standardization provided by a pool of globally accepted credit ratings and benchmarks will facilitate the more active participation of mainstream investors and, thus, lead to better financing terms for MFIs. As a result, we anticipate that more MFIs will use global ratings to attract capital. Standard & Poor's will make its microfinance rating criteria public and work with interested MFIs throughout the world to provide ratings.
What is your approach to evaluating the credit risk of MFIs? Do you anticipate that your criteria will differ from that used to assign ratings to other financial institutions?
Standard & Poor's will use its financial institutions rating criteria as a starting point in evaluating the credit risk of MFIs. The analysis will include a review of all the standard indicators of creditworthiness for financial institutions, including economic and industry risk; management and strategy; ownership and governance; financial reporting; operational, enterprise, and market risk and management; funding/liquidity; and capitalization.
However, as part of the analysis, the special characteristics of the microfinance sector will also be taken into account, such as the high volume of small loans and rapid turnover; relative newness; range of lending methodologies to meet the unique capacity of clients; and variety of ownership modules. The overall rating will use the traditional global rating similar to that used for ratings assigned to financial institutions and corporations worldwide. Mainstream capital market investors are familiar with this scale, and through it they will be able to compare the risk embedded in an MFI's transaction with other investment options.
In addition, Standard & Poor's plans to develop a more-specialized, MFI-focused rating scale to allow for finer distinctions of credit quality among MFIs across the world that may fall within the same global rating category.
What role can securitization play as a funding source for MFIs?
Securitization can provide an alternative source of funding for MFIs, be it in the form of a loan funded through a collateralized loan obligation (CLO) or the financing of an MFI's own loan portfolio. While MFIs issued a handful of securitizations over the past five years (predominantly CLOs but also some portfolio transactions), ratings were only assigned to these transactions within the past two years. While Standard & Poor's doesn't believe that the volume of microfinance securitizations will ever grow astronomically, or that securitization is an appropriate funding source for all MFIs, a core of maybe 1%-2% of MFIs (tiers one and two) may participate in securitizations in the future. One benefit of securitization is that it instills global best practices among MFIs and MIV managers.
These transactions will be compared on a global basis, thereby allowing investors to obtain a view of MFI securitization risk compared to that of Brazilian, Russian, Turkish, or U.K. portfolio securitizations (asset- or mortgage-backed securities) or CLOs. In addition, the increased focus will emphasize the need for transparency and reliable data as well as provide a trickle-down effect of increased investor interest to tier 2 or 3 MFIs that are at earlier stages of development or have a different corporate structure than the top 100 to 200 MFIs. Standard & Poor's transaction pipeline has a number of requests for microfinance securitizations ratings. If actualized, these transactions will go a long way toward developing primary and secondary markets for the microfinance sector.
Standard & Poor's rated a groundbreaking microfinance CLO last year. How does Standard & Poor's rate such a transaction?
BlueOrchard S.A's BlueOrchard Loans for Development S.A. was the first publicly rated microfinance CLO. Its capital structure was composed of senior ('AA' rated), mezzanine ('BBB' rated), subordinated (not rated), and equity components (not rated). The underlying loans collateralizing the notes consisted of unsecured loans to 20 MFIs or their affiliates in 12 developing countries (Azerbaijan, Bosnia, Cambodia, Colombia, Georgia, Kenya, Mongolia, Montenegro, Nicaragua, Peru, Russia, and Serbia). The loans were fixed-rate maturing in five years and denominated in U.S. dollars, euros, Peruvian neuvo soles, Colombian pesos, Mongolian tugriks and Russian rubles.
The ratings process focused on the credit enhancement provided through the subordination of cash flows to the respective classes and on the credit quality of the underlying obligors, in this transaction through credit estimates performed by Standard & Poor's on each of the MFIs. In addition, the process also focused on the transaction's cash flow structure, which was subjected to various stress scenarios requested by Standard & Poor's; the collateral manager's/servicer's (BlueOrchard) experience in the microfinance industry; how currency and interest rate risk was covered via the swaps provided by Morgan Stanley & Co. International; the use of the reserve fund (equaling 1% of the initial note balance) to cover shortfalls in the priority of payments; and the issuer's bankruptcy remoteness at closing.
In rating this transaction, Standard & Poor's relied on the analytical skills of its financial institutions team to perform credit estimates on all the MFIs and the structured finance team to adapt standard CLO credit analysis with other factors specific to microfinance and emerging markets. This was coupled with supporting legal analysis.
Related Articles
Press release announcing the Pilot ProjectWorking Group Report, "Special Report: Microfinance: Taking Root In The Global Capital Markets," RatingsDirect, June 19, 2007.
"Presale: BlueOrchard Loans for Development S.A. (Compartment 1)," RatingsDirect, May 3, 2007.
Project Manager Nelun Wijeyeratne contributed to this report.
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