Historically, microfinance institutions (MFIs) and their stakeholders have shown a tolerance for the risks of operating in challenging environments as they perform their mission of delivering financial services to poor or low-income clients excluded from the mainstream financial system. Some of the risks associated with microfinance are arguably mitigated by the resilience and sound credit quality of the underlying assets – microloans to the working poor. However, as balance sheets of the MFIs have grown, and as events have demonstrated the vulnerabilities of the sector, the importance of a more robust risk management approach has been brought into focus. The microfinance sector’s growing reliance on private capital is likely to bring increasing attention to the risks that MFIs are exposed to and the means of managing them.

What would it take for mainstream investors to fully embrace microfinance as an asset class? Can political risk insurance (PRI) play a role in improving the risk profile of microfinance investments so that more investors can buy into this asset class? The microfinance industry has shown a significant capacity for innovation. Political risk underwriters have similarly demonstrated an ability to respond to changing marketplace needs and opportunities. The time appears ripe for a productive conversation between microfinance investors and political risk insurers to better unlock funding for this dynamic market.

The commercialization and scaling-up of microfinance

Over the past 30 years, microfinance has proven to be an effective way to promote economic and social development by providing inclusive financial services for the working poor. What started as a few philanthropic projects in Bolivia, Bangladesh and other countries in the early 1970s is now an estimated US $35 billion industry comprised of some 10,000 MFIs which provide a wide range of financial services, including credit, savings, remittances, payment services, and health and life insurance to more than 150 million clients worldwide. While these numbers are growing rapidly, they pale in comparison to the sector’s potential. According to Standard & Poor’s (S&P), there are about 1.5 billion poor people who are potentially eligible for loans or other microfinance services, representing a total potential market of more than US $300 billion. While there are many small microfinance operations, the majority of microfinance borrowers and assets are concentrated in approximately 150 leading or “top-tier” MFIs.

Over the past decade, the microfinance industry has been transforming from donor-funded development projects managed by international NGOs to commercially viable and often locally regulated financial institutions, with international capital markets an increasingly important source of financing for the industry’s growth.

Two primary categories of players have emerged in leading the flow of commercial funds to microfinance: international financial institutions (IFIs) and development finance institutions (DFIs), as well as microfinance investment vehicles (MIVs) that attract funds in large measure from socially responsible investors, a growing contingent of private sector investments. According to the Consultative Group to Assist the Poor (CGAP), a leading policy and research center dedicated to advancing financial access for the world’s poor through microfinance, investments in microfinance by international public and private sector investors more than tripled between 2004 and 2007, totaling US $6.7 billion in 2007. Market participants forecast a further increase in microfinance investments of around US $20 billion by 2015. There are more than 90 MIVs, half of which have been created during the past five years. Moreover, as reported by Credit Suisse, total investments by institutional and individual investors (US $3.7 billion) exceeded total investments by IFIs and DFIs (US $3 billion) for the first time in 2007. According to Symbiotics (a Swiss investment brokerage firm) in Luxembourg alone, a popular domicile for MIVs, there were 21 MIVs as of December 31, 2008, boasting total assets of US $2.38 billion (a staggering growth of 800 percent since December 2005). Clearly, scale has arrived in microfinance funding.

Recently, in response to the global financial crisis and refinancing challenges experienced by MFIs, IFIs led the way in establishing the Microfinance Enhancement Facility, a short- to medium-term fund of up to US $500 million, with initial contributions of US $150 million from IFC and US $130 million from KfW. The facility is expected to provide funding to up to 200 MFIs, in up to 40 countries, including 20 of the world’s poorest countries.

On the commercial banking front, major players have entered the market, underwriting and investing in deals for the microfinance sector, including Deutsche Bank, Morgan Stanley, Citi, Credit Suisse, Standard Chartered, JP Morgan and HSBC, as well as emerging markets private equity investors such as Sequoia, Blackstone, Carlyle and others. And no wonder. The credit risk associated with microfinance projects is relatively small. According to Deutsche Bank, MFIs historically reported repayment rates exceeding 97 percent. And the industry is reliably reported to enjoy returns on assets of 3 to 5 percent and returns on equity of 20 to 30 percent. At a time when most of traditional asset classes demonstrate negative returns, microfinance is showing resilience and positive returns.

While the global financial crisis has made some commercial lenders more cautious, and many MFIs have had difficulty raising capital in 2008, commercial investors have exhibited an abundant appetite for equity investments in microfinance. For example, Developing World Markets has recently closed its DWM Microfinance Equity Fund I with a commitment of US $82 million from four large institutional investors, including two large pension funds: Netherlands- based APG (All Pension Group), a European pension asset manager, and New York-based TIAA-CREF. According to a recent study by JP Morgan and CGAP, by the end of 2008, there were 24 specialized equity funds dedicated to microfinance, totaling US $1.5 billion under management.

The microfinance industry and its investment bankers (Deutsche Bank, Developing World Markets, BlueOrchard and Symbiotics among others) are demonstrating an increasing sophistication in structuring capital markets transactions as a means to mobilize large sums of capital. Over the past five years, the microfinance industry has seen groundbreaking capital markets transactions, including bonds, securitizations and IPOs.

According to S&P’s earlier estimates, securitization volumes in microfinance could reach between US $1 billion-$3 billion annually over the next decade. Because of the impact of unrelated sub-prime mortgage collateralized debt obligations (CDOs), the microfinance CDO market has been quiet since the landmark US $110 million microfinance collateralized loan obligation (CLO) arranged by BlueOrchard and Morgan Stanley and rated by S&P in May of 2007. Microfinance CLOs are poised for return in force when market conditions improve.

Nevertheless, the industry is vulnerable to the current credit crisis, with rising borrowing costs, shortening maturities and heightened lender sensitivity to risk, including foreign exchange risk. While funding from IFIs and DFIs is likely to remain stable and even grow in response to the crisis, foreign aid budgets are under pressure, some previously active banks are withdrawing from the microfinance business, and refinancing of existing debt is becoming a pressing concern for MFIs.

Microfinance is no stranger to political risks

The global financial turmoil also means that MFIs will face increasing risks as a result of the deteriorating political environment in some of the countries in which they operate. The industry has already seen a number of clashes between MFIs and governments that resulted in losses to MFIs or their complete closure. According to Microfinance Information eXchange, 2006 was a crisis year for MFIs in Uzbekistan (notably those affiliated with foreign international NGOs, which accounted for over 50 percent of the total microfinance portfolio in the country), when the government enacted new laws to regulate the operation of non-bank lending institutions. These laws required MFIs that were operating as NGOs to restructure into for-profit entities, which is normally a fairly involved process, or face penalties or forced closure. However, no grace period was provided for MFIs to do so and no clear procedures were set for registering under the new laws. Concurrently, the government pursued tax audits of several MFIs. In the end, three of the US-affiliated institutions were forced to close down their operations as a result of crippling back-taxes and penalties imposed by the government. Most of the other MFIs had to suspend their lending operations for more than six months until new procedures for registration under the new statutory structure were adopted.

Populist governments have also cracked down on MFIs in Ecuador, Nicaragua and India. The Economist reported on the most notorious of these cases, which took place in India in 2006, where local government officials in the state of Andhra Pradesh shut down 50 branch offices of four MFIs, imprisoned their loan officers, seized and destroyed their records and encouraged clients not to repay their loans. This controversial dispute lasted for about six months, resulting in MFIs’ agreement with the provincial government to cap interest rates. Such conflicts could emerge in other countries due to competition between state-run and private MFIs, and for other political reasons.

Microfinance operations also appear to be particularly vulnerable to episodes of political violence, with civil wars, cross-border conflicts and local disturbances causing the interruption or termination of operations and/or the destruction of assets in such places as Liberia, Eritrea, Bosnia, Nepal, Sri Lanka and Bolivia. The recent military confrontation in Georgia did not have a lasting negative impact on MFIs and their portfolios in the affected regions, but it certainly served as a reminder of political and security vulnerabilities in the Caucasus. And currency transfer delays or blockages, such as investors of all categories have encountered in places like Argentina and Venezuela in recent years, strike all sectors, microfinance not excluded. These kinds of loss events that MFIs have suffered are precisely those that political risk insurers are prepared to deal with.

PRI to the rescue?

So far, public sector political risk insurers have taken the initiative in recognizing and responding to the microfinance sector’s coverage needs. The Overseas Private Investment Corporation (OPIC) is developing coverage that includes, in addition to traditional expropriation, political violence and currency inconvertibility protection, coverage against sovereign imposition of interest rate caps and business interruption coverage against losses arising from political violence-caused defaults by downstream borrowers. OPIC is also working on a master policy form geared to MIV exposures to global microfinance operations.

The Multilateral Investment Guarantee Agency (MIGA) has not tailored products for microfinance investments, but it has provided coverage to a number of relatively small microfinance transactions. Export Development Canada (EDC) provided tailored political risk coverage to Développement international Desjardins (DID), a global leader in microfinance consulting and technical services. The policy extended expropriation, political violence, and currency inconvertibility coverage for DID assets in 21 emerging countries, including several high-risk markets.

Private political risk insurers have tended to view the sector as involving transactions too small to merit their attention. Certainly, many microfinance investors would not offer exposures of a size that would interest private political risk insurers. But with the increasing scale of investment activities per country and worldwide (through ordinary growth or consolidation) and the large sums they are moving cross-border, there should be attractive opportunities for political risk insurers. Global policies for MIVs and MFI networks or holding companies with substantial worldwide exposures would yield lower premium unit costs for those investors and provide economies of scale and spread of risk for underwriters.

Public agencies may offer lower cost protection and possibly more generous conditions, but microfinance investors who intend to approach public agency underwriters like OPIC and MIGA need to be alert to their policy criteria and, in particular, their mandate to underwrite new but not existing exposures. MIVs and other lenders to MFIs may find that private insurers will have greater flexibility and freedom from eligibility and other constraining policy criteria. In any case, the growth and potential size of the market should provide ample opportunities for both public and private insurers.

Political risk insurers, once convinced of the opportunities, have shown an admirable capacity to create products and coverage terms tailored to a variety of sectors, instruments, and needs. Some years past, few would have anticipated that the market would have well-fashioned policies for capital markets issues, coverages that dealt with the special circumstances of project financing, regulated industries, and oil production sharing agreements, or non-honoring coverage that would respond to Basel II compliance issues. In all instances, the PRI market provided tailored coverages that were instrumental in managing political risks and in augmenting the flow of funds to which those risks were an obstacle. For investors, the key to obtaining the proper protection is to recognize that PRI is not traditional insurance but a financial instrument for managing risks that requires both expert financial, legal and insurance assistance as well as the close attention of company management.

PRI has played an important role in facilitating increased capital flows to emerging markets in sectors comparable to microfinance: commercial banking, financial services and capital markets. For example, in 2007, MIGA issued US $10.2 million in coverage to the First Kazakh Securitization Company, B.V. for a securitization of residential mortgage loans in Kazakhstan. MIGA covered a portion of interest payments on the mortgage portfolio against transfer and convertibility restrictions and expropriation. MIGA’s coverage was instrumental in securing an increase in Fitch’s rating for the $141 million transaction to A- (above the country ceiling of BBB+).

In addition to encouraging equity investment in MFIs, the coverages offered by political risk insurers (currency inconvertibility, political violence and expropriation, including arbitral award defaults) can be used to protect senior lenders and to encourage them to offer longer tenors as well as achieve higher credit ratings for structured capital markets transactions.

There is ample precedent for believing that the right approach by microfinance investors will elicit from political risk insurers a product that deals effectively with the sector’s risks and that will lead to enhanced investment flows to the sector.

Whether coverage is sought from public or private insurers, the usual sound practices apply: a timely approach to the marketplace, a focus first on getting the best coverage rather than the (apparently) cheapest, a careful and complete laying out of the facts to the underwriter and well-advised negotiations to achieve the optimal and most appropriate coverage for the transaction(s) in question. As MFIs tend to grow, consolidate, graduate to more regulated status within the countries in which they operate and offer a greater diversity of financial products, it would be desirable for microfinance investors and lenders to anticipate those changes and to seek coverage flexible enough to keep pace with their evolving circumstances. Above all, investors in this sector need to reflect on the special political risks and concerns that confront them, and to work with their specialist advisers to see that their coverage is duly designed to address those matters. [Readers may wish to refer to our article in the September 2008 issue of this Newsletter, “Making a Claim: Readiness is All” for detailed suggestions regarding obtaining and maintaining PRI that will respond effectively to losses when they occur.]

The microfinance industry has funding needs that the marketplace may be willing to satisfy only if the risks can be rendered manageable. Political risk insurance has the capacity to help manage some of the most critical of those risks. It is time for the conversation between microfinance investors and political risk insurers to begin in earnest. ■


Tatyana A. Mikhailova, a coauthor of this article, is an attorney whose practice focuses on cross-border structured finance transactions, political risk insurance, microfinance and international arbitration. Prior to joining robert wray PLLC, Ms. Mikhailova served as in-house counsel with a major Washington, DC-based microfinance organization with operations in 23 countries. Her microfinance experience includes conducting legal feasibility studies for, and advising on, asset acquisition, greenfield projects, and transformations of non-profit entities into locally regulated banking and financial institutions in Eurasia. She has advised MFIs in negotiating numerous financing facilities with commercial and multinational lenders and also acted as legal counsel in complex litigation and expropriation matters.

The Microfinance practice at robert wray PLLC is led by Ms. Mikhailova, Felton (Mac) Johnston, and Geraldine R.S. Mataka. The RW microfinance team provides legal and related services in the areas of debt and equity financing, structured finance, transformation into regulated financial institutions, consolidation, litigation and arbitration. In its Political Risk Insurance practice the firm offers expert assistance to investors in connection with the negotiation of coverage, evaluation of coverage effectiveness, the pursuit of claims, and arbitration of disputed claims.