New Partnerships for Innovation in Microfinance_2

10 J.D. von Pischke Finance innovates in three ways: reducing transaction costs, lengthening term structures and refining valuation processes. The nature of the challenges posed by these three ways and the social benefits they produce deserves explanation: • Reducing transaction costs – the admission tickets to financial markets – is the first mode of innovation in finance. At the retail level these costs include the transaction costs of savers, intermediaries and borrowers. These costs are often major constraints at the small end of the market. However, they can be dealt with in a number of ways. For example, highly successful co-operatives and group credit arrangements may pass many of these costs on to borrowers, who in fact believe that these costs are benefits – benefits from being involved in new activities that make a difference in their lives. Commercial financial institutions probing the frontier may attract clients by assuming greater costs, but in ways that lower clients’ costs relative to the next best alternative, which is often informal finance. This formula relies on market-based pricing and economies of scale and scope that make it possible for formal institutions to cover the greater costs of dealing at the bottom end of the market. Transaction costs play a large role in defining financial market segments. • The second way in which financial markets innovate is by lengthening term structure.1 Longer term structures denote confidence and produce accumula-tions of long-term funds that can be applied to useful projects of all sorts that take a long time to generate income. (To borrow from Stuart Rutherford (2000), a long normal yield curve is society’s “usefully large lump sum.”) Lengthening term structure is the most difficult mode of innovation because finance is delicately tuned to, and often has little power over, the larger determinants of term structure – confidence, moods and how society generally views the future. Information and incentives have a large role to play. But when crises occur and term structure collapses, finance is often blamed, sometimes rightly so. However, term structures lengthen as confidence grows, assisted by good contracts that protect creditors’ rights, and when projected rates of inflation are stable. Microfinance investment funds lengthen term structures in microfinance. These two forms of financial innovation are well-trod paths – the new quickly becomes routine and sometimes boring, but always important. The third is of a different order with transcendental features that are created by what sellers of financial contracts think they are buying. 1 Loosely put, term structure is defined by the most distant maturities available oncredit-instruments, and by the volume of credit and the interest rates prevailingondifferent maturities, from the present into the future. Term structure isusually plottedfor government securities on a yield curve that is normally steeper in theverynearterm and relatively flat in the long term. New Partnerships for Sustainability and Outreach 11 • The third way in which finance innovates is by refining valuation processes – which are determined by views of risk. Finance creates value by pricing contracts, based on estimations of risk and confidence. When the foundation of this process changes with better information and constructive incentives, opportunities arise for introducing new ways of managing and quantifying risk. How else did Muhammad Yunus make it possible through Grameen Bank to monetise the promises of very poor women who had never before held a coin or banknote in their hand? Broad leaps occur as valuation processes are refined. In credit markets the key variable is “what are you lending against?” In equity markets the question is “what are you buying?” In contingent contract markets the concern is “what is being guaranteed?” Credit scoring, explored in this volume, is a dramatic example of a refinement of valuation in credit markets. These three modes of innovation in finance will be used relentlessly to do what fi-nance can do, which is to transfer purchasing power from lower yielding to higher yielding activities; to expand, across time, the range of choices governing savings, asset accumulation and investment; and to improve risk management in economic activities. An important example is the increasing involvement in microfinance by venture capital/private equity investors, and from other segments of capital markets. A related trend is based on a proliferation of support systems that include technol-ogy, information and risk management systems, funding/refinancing vehicles, fidu-ciary norms and institutions, ratings, and credit scoring. Microfinance will continue to be driven by donors and public sector investors, but less so as integration into capital markets gathers steam. Donors and public sector investors continue to play an essential role in attracting private investors to microfinance through financial engineering, by pioneering new products, by pro-moting competition, by bolstering confidence through support for supervision and regulation, and by using their influence to reduce predation and corruption that stymies innovation in difficult markets. An exciting challenge that is receiving greatly increased interest is exit. How will donors reap their well-earned gains on their microfinance investments in ways that do not destabilise microfinance insti-tutions or weaken their mission? It seems reasonable to predict a smooth landing for efficient institutions. In summary, our innovative task is: • To create wealth where there is little wealth by using finance to facilitate productive activities at the bottom end of the market. Mission enhancement is essential for the realisation of this objective. • To create institutions that are structured to generate the information and the incentives to drive inefficiencies out of financial markets so that more people can be served with a greater choice of deals at better prices. 12 J.D. von Pischke • And, if justified by research results, to consider the feasibility of a global long-term savings guarantee mechanism that would to some degree protect poor people in non-OECD countries who save in instruments denominated in local currency. How might it be possible to insulate them from macroeconomic shocks or trends that unwind their efforts to save over their lifetimes so that they could realise their dream of a more secure future? References Adams, D.W, D.H. Graham and J.D. Von Pischke, eds. (1984) Undermining Rural Development with Cheap Credit. Boulder CO: Westview Press. Beck, T., A. Demirgüç-Kunt and R. Levine (2004) “Finance, Inequality, and Poverty: Cross-Country Evidence.” Working Paper 10979, National Bureau of Economic Research, Cambridge MA. Bornstein, D. (1996) The Price of a Dream: The Story of the Grameen Bank and the Idea that is Helping the Poor to Change their Lives. New York: Simon & Schuster. Fry, M.J. (1988, 1995) Money, Interest, and Banking in Economic Development. Baltimore and London: The Johns Hopkins University Press. Gonzalez-Vega, C. (1998) “Do Financial Institutions Have a Role in Assisting the Poor?” in Kimenyi, M.S., R.C. Wieland and J.D. 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Wallace, E. (2004) “EBRD’s Micro and Small Enterprise Lending Programmes: Downscaling Commercial Banks and Starting Greenfield Banks,” in I. Matthäus-Maier and J.D. von Pischke, eds., The Development of the Financial Sector in Southeast Europe: Innovative Approaches in Volatile Environments. Berlin: Springer. WDR (1989) World Development Report. New York, Oxford University Press for The World Bank. CHAPTER 2: Raising MFI Equity Through Microfinance Investment Funds Patrick Goodman Consultant Introduction Microfinance institutions (MFIs) are increasingly addressing the traditional finan-cial market to fund their continued growth and to better serve their clients. In its early days, the microfinance sector was essentially driven by non-profit organisa-tions and official development agencies. Over the last few years, these institutions, together with a few new entrants in the sector, have set up an increasing number of investment structures to fund MFIs. Common usage in the microfinance industry is “microfinance investment fund” as the generic term to identify all corporate investment structures (such as holding companies for example) which have been set up to provide equity and/or debt financing to MFIs, with investors acting as shareholders or as lenders.1 This paper builds upon a study prepared by the author on microfinance invest-ment funds (MFIFs) for the 2004 KfW Financial Sector Development Symposium held in Berlin in November 2004. This initial study presented an overview of mi-crofinance investment funds with their main features and characteristics. This paper focuses on those investment funds which invest all or a part of their assets in the equity capital of MFIs. A number of investment structures were initially created as vehicles to provide funding to development initiatives, such as MFIs. Oikocredit was for example established in the Netherlands in 1975 to make development-oriented investments in church-related institutions. It was only in the mid-1990s that the first commer-cially focused investment structures emerged, targeting MFIs such as Profund, launched in 1995. The original promoters of these investment vehicles were de-velopment agencies and non-profit organisations. All these initiatives had a com- 1 Donor institutions such as foundations and NGOs would not qualify as structures set up for an investment purpose. Development agencies are also not considered as investment funds as their structure and mission extend far beyond those of such vehicles. ... - tailieumienphi.vn