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3iG

International Interfaith Investment Group

APRIL 2010

RUPERT MELSOM

Analysis of the Microfinance Sector Faith Institutions and Impact Investing

Recommendations

"Rupert Melsom's analysis of the microfinance market for the faith community's investment managers is a must-read for leaders throughout the development sector. His recommendation to invest in deposit schemes, to counter volatility of commercial funding and to increase local sustainability, demonstrates the depth of his analysis of the sector and his understanding of sustainable solutions that are required in the developing world."

Rev Séamus Finn OMI, executive board member of 3iG, is a consultant to a number of investment committees in his own institution, the Oblates of Mary Immaculate 1, and for other religious congregations.

"Rupert's microfinance investor paper gives Faith investors food for thought on how to allocate their impact investment funds best. Parties with a primary aim to alleviate poverty should take note of the strategic changes in the funding of the microfinance sector in order to achieve their goals effectively."

Fanny Ruighaver, Manager Institutional Investors, Oikocredit 2

"3iG is delighted to offer the Faith community this microfinance review as part of the series of impact investing papers. By combining 13 years of finance sector expertise with a passion for business development in emerging markets, Rupert has provided a remarkable account of the strategic challenges that face the industry and its investors. We are very pleased to share with you the strategic insights and in-depth knowledge to better achieve one's impact investing charter goals."

Katinka van Cranenburgh, Secretary General, 3iG ­ International Interfaith Investment Group 3

"At Five Talents we recognise the positive effects of deposit schemes in Africa. It is with great pleasure to see that Rupert's microfinance report for 3iG identifies the importance of local funding. Although many different deposit schemes are operating in different cultures, the common feature is that they all provide sustainable and locally expandable solutions for poverty alleviation. Based on Rupert's strong finance and business development background this report helps the investor in the development to assess the strategic direction of the industry."

Tom Sanderson, UK Director, Five Talents 4

The Oblates are a Roman Catholic religious congregation with members in 65 countries and a long history of Faith Consistent Investing. Oikocredit is one of the world's largest sources of private funding to the microfinance sector. 33 iG is a non-profit, multi-faith philanthropic foundation, whose mission is to contribute to a just and sustainable society through responsible investment in a spirit of genuine interfaith dialogue and co-operation. 4 Five Talents is the microfinance development initiative of the worldwide Anglican Church. The church provides a ready made infrastructure ­ a physical presence of people and premises at the heart of even the remotest communities.

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Foreword

3iG is proud to present the first report from the series of Faith Institutions and Impact Investing. Impact investments are investments that explicitly aim to respond to social or environmental challenges while generating financial returns. The first report is dedicated to microfinance and faith institutions. Historically, religious institutions have been at the forefront of the microfinance market ­ offering small loans to the poor in the undeveloped world ­ resulting in positive social impact and community development, as well as generating financial returns. Many of the currently existing microfinance institutions have their origins in the faith communities. This report defines microfinance and the microfinance industry's present parameters, highlighting both risks and trends in a comprehensive approach. In addition, the report makes recommendations about the different ways that faith institutions can participate in the changing reality. Whilst the report is primarily written for religious institutional investors, one should not underestimate the cascade effect that the initiatives of religious institutions have on their members and the civil society. While faith institutions may struggle to invest part of their portfolio in microfinance, the exemplary role of a church, synagogue or temple might have a significant influence on its members. Individual religious investors may often be less hesitant to change the mix of their portfolios and therefore microfinance can readily be considered as a potential alternative. Follow-up reports on clean technology, sustainable agriculture and other types of impact investment are envisaged to be published by 3iG in the upcoming years to complete the series on Faith Institutions and Impact Investing. By doing so, 3iG hopes to capitalize more religious money into the impact investment market. I hope you enjoy reading this report and find it valuable.

Katinka C. Van Cranenburgh Secretary General 3iG

Disclaimer: 3iG is not responsible for any investment decisions made by religious investors. All best practises mentioned in this report are based on a qualitative selection. 3iG does not necessarily promote one above others but just showcases them as examples of faith institutions' investing with impact.

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Acknowledgements

This research has been conducted for 3iG as part of an MBA project at Ashridge Business School in the UK. The detail of this document would not have been achievable without Katinka van Cranenburgh's support and vast network within the faith and microfinance investor community. I would like to thank her for her contribution. There are also a number of people I would like to thank at Ashridge Business School. Eve Poole has provided much direction and input regarding faiths and their relationship with usury and investments. Furthermore a token of appreciation should go to Erik Heinen of Oikocredit and Tom Sanderson of the UK based Christian charity Five Talents. By giving up their time from daily activities they shared important sector expertise, experiences and insights. Their offer to provide such wealth of experience with fellow faith institution investors and microfinance institutions, benefits the industry and the people for who poverty remains a daily reality. Rupert Melsom April 2010

©copyright International Interfaith Investment Group 3iG, 2010

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Executive summary

Microfinance has proven to be a valuable tool in alleviating poverty. In the years from 2000 to 2009 the industry introduced more transparency through standardised reporting and benchmarking. The performance generally demonstrated to be healthy in the sense of risk/ return. The availability of comparable data, the performance track record and a general increase in loan origination volumes led to an increased interest from commercial investors. Historically the microfinance sector has been predominantly funded by non-commercial investors, such as faith institutions and NGOs. The entrance of an increasing number of commercial investors has led to an increase in competition, particularly for funding of well performing microfinance institutions. Commercial investors are driven by profitability, therefore tend to compete for the most lucrative investments first and then move down the value curve. Non-commercial investors are driven by (sustainable) investment to alleviate poverty, opposed to purely profitability. The entrance of commercial investors is forcing non-commercial investors to make choices to protect their investment portfolios and charter objectives by learning from, and competing with, commercial investors. If no active management is undertaken, they risk having to scale down their investments, or even exit the microfinance market, which is contrary to their poverty alleviation objectives. Non-commercial investors, who have funded a diverse portfolio of high and low margin microfinance institutions, find that the balance of their investment portfolio is shifting to the low margin end. Due to the loss of high margin investment areas, the portfolio returns are reduced and cannot be redeployed in support of more socially orientated low margin investments. In other words, although an increase in commercial investment is beneficial for the high margin market, it has an adverse effect on the less profitable part of the microfinance market. Commercially it makes sense to cease profit redeployment to lower yielding investments; therefore profits are repatriated to commercial investors by means of dividend or redeployed in other high margin areas. As an effect the non-commercial investor has less high margin returns to cross-subsidise its low margin section of the portfolio. Leaving the most socially in need, subject to rising funding costs an overall lack of funding availability. The commercialisation of the sector has resulted in a number of positive trends, but also some undesirable effects. · Commercialinvestorshaveaccesstocapitalmarkets.Thisprovidesrelativelyshort term capital at a competitive price. Therefore local microfinance borrowers have access to lower interest rates. Although this seems beneficial, there is another side to the coin. Short term capital markets funding is more volatile than long term funding. Market conditions such as in 2007-08 result in a reduction of available funding to local microfinance institutions. This means that local borrowers suddenly have no access to loans and slip back into poverty again. Such confrontation of basic needs funded by market dynamics is reduced by non-commercial investors who continue to provide long term capital at sub-market rates, but their reach is limited.

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· Theentranceofthecommercialinvestorshasresultedinaprofessionalizationof the industry. Loan origination procedures and reporting standards are introduced. The microfinance institutions tend to be forced to adhere to international quality standards in order to pitch for any commercial funding. This has a positive effect on their efficiency. · Thecommercialisationoftheindustryhasincreasedtheleveloffinancialservices expertise. The need for other financial services has also been evaluated, resulting in an increase of insurance, trade finance and depositing services. · Theconvergenceofmobiletelephonyandfinancialservicesisfaraheadofthe developed world. It is foreseeable that telecom operators could be a key player in microfinance. If consumer credit score trends in the developed world are to be taken into account, then telecom operators are probably the best positioned to register financial services transactions. Commercial investors of microfinance are taking such trend parallels with the Western financial services market into account when investing in microfinance institutions. The value in this industry is far greater than simply the interest margin on microfinance loans.

Any commercial investments are likely to result in the profits being repatriated to their (mainly Western) shareholders. In which case, it is uncertain that any proceeds shall be redeployed in the developing world. Local communities would benefit most from keeping an equity stake in their microfinance institutions. This would most likely be in the form of a co-operative (like the German Sparkassen and British Building Societies). Any (future) value generation due to interest margin, consumer credit data and product cross-sell opportunity would be returned to the microfinance client (member of cooperative) upon an acquisition or de-mutualisation of their entity. It is quite possible that the emerging markets would see a consolidation of microfinance institutions within the next 10 to 20 years. This would be driven by internal cost cutting and efficiency generation as well as the desire of financial firms to get a greater retail distribution network. One should not forget that today's microfinance clients are tomorrow's banking and insurance clients. Commercial investors, such as private equity funds could benefit from launching and acquiring local microfinance institutions, in order to build up a substantial retail distribution network. The client data and relationship network could be of substantial value in markets where there is practically no consumer, credit or even census data. Their exit strategy would be to sell to a strategic buyer, such as a financial services, telecoms or retail company. Faith institutions should be aware of these trends and consider whether local borrowers benefit from the entrance of commercial investors in the long term. Faith investment charters regarding microfinance might require a review in order to align investment policies with the changing (more commercialised) market. Faith institutions may also wish to consider whether strategic long term equity5 opposed to debt investments or the launch of local co-operative and / or deposit funded schemes provide a more sustainable and beneficial solution for alleviating poverty.

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Lastly, it might be beneficial to take into account whether faith institutions should pool their resources and knowledge in order to protect and grow their market share whilst safeguarding the true drivers of microfinance ­ to alleviate world poverty. Otherwise they might find that this sector is "lost" to commercial investors and global poverty is not actually eradicated.

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It is important to stress the long term nature of equity investments, as marginally profitable microfinance institutions might seem a less attractive investment to the equity investor, whereas for a debt investor it might have been acceptable. There are examples in the industry whereby microfinance institutions have become much more short term oriented in order to deliver shareholder value. Venture capital inspired incentive schemes like carried interests are not necessarily aligned to the social drivers of non-commercial investors. Hence long term strategic stakes are to be considered, whereas short term horizons should probably be reviewed only with significant diligence.

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Table of Contents

1. 2. 2.1. 2.2. 2.3. 2.4. 3. 3.1. 3.2. 3.2.1. 3.2.2. 3.2.3. 3.2.4. 3.3. 4. 4.1. 4.1.1. 5. 5.1. 5.2. 5.3. 5.4. 6. 6.1. 6.2. 6.3. 6.4. 6.5. 7. 8. Introduction Microfinance What is microfinance? For who is microfinance suitable? Who are the providers of microfinance? Who are the key funders of microfinance? Background information on the microfinance market and parties Microfinance market Parties offering microfinance services Microfinance Investment Vehicles ("MIVs") Microfinance Institutions ("MFIs") Peer-to-peer lenders Service providers Types of borrowers to lend to Background to the risks associated with investing in microfinance Risks of microfinance investments Risk levels by microfinance investment type Current microfinance trends Local funding through deposit schemes Increase in commercial investors taking equity stakes in MFIs The emergence of short term capital markets funding Effect of above market trends on faith investors' market share Recommendations Invest in microfinance Offer deposit schemes Lobby for regulation to safeguard minimum poverty alleviation Compete with commercial investors and acquire equity stakes in MFIs Regulate long term investor commitment References Glossary 10 12 13 14 15 16 17 18 22 22 23 24 27 28 29 30 31 33 34 35 36 37 39 40 41 42 43 44 45 47

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Executive summary

Appendices Appendix I Case studies of faith related microfinance business cases

Default risk (FiveTalents)

49 50

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Why deposit schemes improve lending opportunities and resolve social disputes (FiveTalents) 51

Understanding at grassroots level (ECLOF) Microfinance initiatives can involve state of the art technologies (ECLOF) Conducting sufficient due diligence and investment selection criteria (Oikocredit) The implementation of ancillary services and the effect on obtaining funding

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Appendix II

Overview of largest global and African MFI's

57 61 62 63

Appendix III Examples of Microfinance Investment Funds (MIVs) Appendix IV What is Impact Investing Appendix V Types of microfinance risks

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1. Introduction

This report looks at the investment opportunities and trends in the microfinance sector. Microfinance is one of the Impact Investment areas that provides sustainable improvements for relieving poverty. Microfinance, in its original form, provides people living in poverty access to very small amounts of credit to invest in (micro-) enterprise in order to climb out of poverty. Historically the financial services sector did not serve this market as it was considered not commercially viable. As the market matured, it became more commoditised and actual returns demonstrated commercial viability. The research explains the difference between narrow and broad definitions of microfinance and details the different service providers that operate in the sector as well as the target market. For readers new to the industry, there is background information on the market and the risks associated with the investment class. The global poverty market is touched upon to gauge the size and compilation of the potential microfinance market. Some of the key microfinance investors and local microfinance organisations are named. This offers newcomers to the industry, the possibility to research potential partners further and get a better understanding of where and how they operate in the business column. The key element of the research is the identification of the key industry trends and their potential effect on faith institutions' investment charter objectives. The trends deal with faith institutions' financial as well as non-financial drivers (such as eradication of global poverty). A number of recommendations are made based on the market requirements, investment risks, faith institutions' commercial and non-commercial drivers and industry trends. The key message from the recommendations is that faith institutions should take note of the commercialisation of the sector as it has an adverse effect to their commercial and non-commercial investment charter objectives. They may wish to consider: · takingnoteoftheprofessionalrigour,basedonincreasedtransparency,efficiency and corporate governance that commercial investors introduced; · bundlingtheirinvestorresourcestoinfluencethedirectionandspeedofpoverty alleviation; · makingtheirvoicemoreactivelyheardinordertobenefitthepoorestintheworld by safe guarding acceptable investment methodology regulation over full free market commercialism.

The findings upon which the key message and proposed considerations are founded are related to the market trends that are having an adverse effect on faith institutions' (non-) financial investment returns. · 1.Thepotentiallosstocommercialinvestorsofvaluablemarketshareatthehigh margin end of the microfinance market. This is due to commercial investors' cherry picking of the more profitable investments from the market. Priority of

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investment objectives are not aligned between commercial and non-commercial investors. Commercial investors are driven first by profit and secondly by social return, whereas for non-commercial investors the priorities are vice-versa. In addition the volume of commercial investment to the sector increased due to low yields in Western markets in the years preceding the 2007-08 market correction. A search for higher returns was found in emerging markets. In addition to margin drivers, social and sustainable investments have become more acceptable amongst the private investment community. This is possibly due to the Western public's ove rindulgence of the early "noughties" (2000-2007), which has resulted in increased interest in social returns. The faith institutions' loss of the well yielding parts of the microfinance market to commercial investors, could reduce the overall level of investment to lower margin opportunities. It is particularly those areas that are most in need of microfinance investment. · 2.Theeffectofvolatileshorttermfundingonlongtermpovertyalleviation.The entrance of commercial investors grew the overall market, but also increased cost of capital volatility due to the reliance on short term funding. One should take into consideration that the volatility of short term funding may have a more negative effect on poverty alleviation in declining markets than long term funding.

As faith institution investors tend to be asset rich, they generally hold long term funds and are not (as) reliant on capital markets as commercial investors. They serve the microfinance market sustainably, irrespective of economic trends. As we saw in 2007-08, commercial investors (needed to) retract from funding in declining markets. As a result, borrowers, in the process of rising out of poverty, are denied funding and slip back into poverty. However, commercial investors have helped alleviate poverty substantially. The influx of capital has increased the reach of microfinance hugely and the lower cost of capital has helped many local borrowers rise from poverty more quickly. In addition, commercial investors have enhanced corporate governance, transparency and standardised investor reporting and operating procedures. This has made many microfinance institutions more efficient and effective. The topic of this paper is to share current and potential industry trends, so that faith institutions can consider how best to achieve their financial and non-financial investment charter objectives. Based on the recommendations provided, it also aims to initiate an inter-faith discussion on the following topic: Considering that in the emerging markets, contrary to in the developed world, there is no minimum social security in place: Should faith institutions use their influence in the industry, to safeguard availability of sustainable poverty alleviation methodologies ­ like funding liquidity for microfinance, or let capitalism driven markets operate freely across the entire spectrum of the market?

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2. Microfinance

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2.1. What is microfinance?

Microfinance is often associated with lending money to the poor. As the interest in microfinance has expanded, so has the extent of the definition. According to one of the UK's largest microfinance charities it has a broad definition:

"Microfinance is the provision of a broad range of financial services and products such as credit, savings and insurance designed to assist poor people who lack access to financial services in the mainstream banking sector to develop their small businesses, save their earnings, and guard against risks" .

(Opportunity International, 2009) Most local microfinance operators, also known as microfinance institutions ("MFIs"), have started with one element: providing small loans to local entrepreneurs. In this paper the more narrow "microcredit" definition is adopted:

"Microcredit refers to very small loans for unsalaried borrowers with little or no collateral, provided by legally registered institutions" .

(Microfinance Gateway, 2009) Irrespective of the adoption of the broad or narrow definition of microfinance, the services have the aim to alleviate poverty in a sustainable way for the local population. By providing access to financial services the poor can break the poverty cycle and achieve an improved business return as source of income. Based on the poverty alleviation driver, microfinance has strong roots in the faith community. Faiths have applied social investment for many years and have been at the forefront of investing in microfinance initiatives. The United Nations designated 2005 as the year of microcredit. Its objectives included promotion of the industry, public awareness and inclusive financial sectors. The increased visibility of microfinance had a strong effect on the increase of funding for the sector. The increased awareness and endorsement by the UN of microfinance as a tool to alleviate poverty has a positive effect on the industry.

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2.2. For who is microfinance suitable?

Microfinance loans generally serve unsalaried workers and entrepreneurs who live in poverty. In line with the microfinance background of this paper, poverty is defined as:

Poverty is a condition in which people lack satisfactory material resources (food, shelter, clothing, housing), are unable to access basic services (health, education, water, sanitation), and are constrained in their ability to exercise rights, share power and lend their voices to the institutions and processes which affect the social, economic and political environments in which they live and work. (Vandenberg, 2006)

Many new borrowers of microfinance loans live in poverty. Whether this means they live off more or less than the much cited "$1 per day" is not relevant. The core issue is that they do not have access to (financial) means to lift them to a minimum living standard that is deemed acceptable by more fortunate people, predominantly living in the Western world. By providing access to financial products an improvement of living standards can be reached. According to Jonathan Morduch's 2002 working paper on "Analysis of the Effects of Microfinance on Poverty Reduction", there is...:

...ample evidence to support the positive impact of microfinance on poverty reduction as it relates to fully six out of seven of the Millennium Goals. In particular, there is overwhelming evidence substantiating a beneficial effect on income smoothing and increases to income. There is less evidence to support a positive impact on health, nutritional status and increases to primary schooling attendance. Nevertheless, the evidence that does exist is largely positive." (Morduch, 2002)

Morduch concludes further that "microfinance, if used under the right conditions, fits the needs for a broad selection of the population". However, microfinance lending practices are not suitable for the poorest of the poor ­ the destitute. Condition for a loan is a reasonable likelihood that the borrower repays capital plus interest6. This requires a prospect of (regular) income. Microfinance tends to be offered to the "top end" of the poor; people with access to shelter, clothing, regular food and income. The destitute are defined as people who do not have a stable source of income and who require shelter, clothing, access to regular food and medical care. The destitute must rely on aid and charity to improve their living standards. SKS Foundation, the non-profit arm of SKS Microfinance (SKS Foundation, 2009), is a good example of an aid provider distinguishing between potential microfinance borrowers and the destitute. Its aim is to serve the destitute in a way to lift them to microfinance eligibility status. It does this by providing an 18 month training program in India to help economic, health and social development areas. By providing an asset (like a cow or a goat) the destitute train how to get a stable income and become independent. At the end of the 18 month program they should have moved out of the poorest of the poor category and be eligible for microfinance.

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Capital plus interest or for Sharia loans the repayment amount

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2.3. Who are the providers of microfinance?

Microfinance loans to borrowers are generally provided by MFIs. MFIs range from single, voluntary staffed locations, to global, professionally staffed operations. Some MFIs rely on direct donations from individuals, foundations, faith institutions and NGOs. Such donations are used to provide lending capital, whereas interest received often contributes to cover defaults and ongoing operating expenses. Other than through donation, many MFIs are funded commercially through debt or equity participations from commercial investors, faiths institutions and NGOs. As local growth potential is high, MFIs funded solely by faith institutions and NGOs may seek 3rd party commercial funding to expand. Additional funding boosts their ability to grow their loan portfolio and alleviate more people from poverty. Any attracted (debt) funding must however, be repaid. This is either done through refinancing or by winding down the loan portfolio. Commercial MFIs sometimes have a social charter, but lend "sustainably". In essence this means lending commercially, to retain continuity of operations. The commerciality brings more pressure to return an acceptable margin and parties tend to operate in a structured business like and efficient way. Training, financial reporting and collection procedures tend to be centrally prescribed, as investors maintain those as minimum quality requirements. When capital is available in the capital markets or through the participation in investment funds, then credit lines are made available to MFIs. In which case, the MFI can continue to make loans available to local borrowers.

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2.4. Who are the key funders of microfinance?

MFIs are either funded though donation, debt or equity. Funding is available from commercial and non-commercial (e.g. faith and NGO) investors. With the launch of peer-topeer lending platforms, MFI funding is also sourced directly from private investors. Commercial and non-commercial investors tend to launch funds, also known as microfinance investment vehicles ("MIVs"). MIVs either have access to long term investor capital (faith institutions, NGOs and asset managers), or short term investor capital (capital markets). Investors either lend money to a fund (i.e. debt) or buy a unit or share in the fund (i.e. equity participation). Capital raised by the fund is invested in MFIs according to predefined terms (investment charter) and the fund manager's investment decisions. There are various alternatives to investment funds: ·InvestorscaninvestinanMFIonabi-lateralbasis.Thismeansthattheysource and manage their investments in-house. Various faith institutions and NGOs conduct their investments this way, as they might have a sister organisation that operates locally. The downside is that one might be the only investor in such MFI, which makes the MFI very reliant on the funder. Furthermore there is no risk diversification such as investing in funds. ·Securitisation.Thisworksinasimilarwayasamortgagebackedsecuritisation. With (very) short term funding a portfolio is built up and then subsequently refinanced for the mid-term by means of a securitisation structure. In essence, the forecast loan portfolio receivables are bought by a separate legal entity. The periodic cash flow receivables (capital and interest from local borrowers) are used to pay interest and repayments to the investors. The investor group is tranched into low risk and high risk investors. The low risk investors have first access to any receivables, but receive a low interest rate for their investment. The high risk investors have last access to the receivables, but receive a high interest rate. If defaults are higher than expected the high risk investors will probably lose out, but if defaults are less than expected their risk taking yields them a high return. ·Peer-to-peerlending.Thismethodisdesignedtocutoutany"middle-men",i.e. MIVs. Consumers and institutional investors can become a member of a lending platform that matches borrower loan requests with available investment funds. This method is generally used by consumers, whereby screened MFIs upload a borrowing request. The consumer can then bid for (a part of) the loan. The cheapest interest rates then form part of the winning bid and the funds are allocated to the borrower. The peer-to-peer lending platform manages all allocation of funds and receivables as well as the investor administration. The screened MFI manages the local financial reporting and collections and receives a fee for this that forms part of the grossing up of the interest rate actually provided to the borrower. MyC4.com and Kiva.org are examples of peer-to-peer lending platforms. In the next chapter an overview of the microfinance market is given. As part of that a more detailed account is provided of the above types of microfinance funders.

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3. Background information on the microfinance market and parties

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3.1. Microfinance market

World Bank affiliate CGAP8, publishes a global progress indicator detailing barrier levels to traditional banking. The CGAP 2009 Financial Access Report has benchmarked financial services against those of the developed world. Policy makers and regulators in 139 countries have identified global indicators that demonstrate the barriers of traditional banking. Such restrictions result in only the wealthiest people having access to financial services. People in emerging markets hold only one quarter of deposits and loans compared to people in developed countries. Hence the poor have no significant tools to invest in their economies.

Least bank loans per capita. SubSaharan Africa most underserved

Note: Estimates for countries that did not report the number of accounts in commercial banks were generated from a statistical model that uses income per capita and various features of the financial system--such as the number of bank branches per 100,000 adults and the value of deposits per adult--to predict the number of commercial bank accounts. Where the number of accounts in nonbanks was not reported, an attempt was made to fill in data from other sources. The estimates for bank and nonbank categories were summed by country to estimate the total number of deposit accounts in each country. See the methodology appendix for more details. Source: Financial Access database.

Figure 1. The number of bank loans per 1,000 adults is correlated with economic development Source: (CGAP - Consultative Group to Assist the Poor / World Bank, 2009)

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Consultative Group to Assist the Poor

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UN Millennium Development Goals aim to half the number of people living on less than $1 per day by 2015. Although the percentage of the population living on $1.25 per day has declined (see figure 2.), the region most in need, sub-Saharan Africa (see figure 3.), has not benefitted as much as other regions. This is possibly due to: ·managingmicrofinanceinmoreruralsub-SaharanAfricaisrelativelymore expensive than e.g. in more urbanised Eastern Europe; ·allocationof(Western)fixedcostsispercentagewisehigher,duetothelower average loan size; ·fundallocationtosub-SaharanAfricaisthelowestpercentagewise.

Share of population living on less than $1.25 a day (%) 80 60 40 20 0 1981 1984 1987 1990 1993 1996 1999 2002 2005

Figure 2. Poverty rates have begun to fall Source: (DiLeo, 2009)

Sub-Sahara Africa South Asia East Asia & Pacific Latin America & Caribbean Middle East & North America Europe & Central Asia

This supports reasoning for longer term CSR driven investors to look at Africa.

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Share of population living on less than $1.25 a day, estimates extrapolated to 2005.

Largest percentage of population (>50%) living on less than $1.25 per day. Hence the greatest need.

Figure 3. The percentage of population living on less than $1.25 per day Source: (World Bank, 2010)

Of the Microfinance Investment Vehicles (MIVs) only holding companies invest significantly in Africa and Middle East. Holding companies are generally entities that invest equity and provide expertise to start-up MFIs. The investments are often funded by organisation's own means. Such investments are usually subject to a long term buy and hold strategy, i.e. not actively (nor easily) traded. It is possible that various charities, NGO's and faith institutions use such investment type specifically for greenfield MFI operations in Africa. NGO's and faith investors also use Blended Value funds to make social (and typically less than market performing) debt and equity investments.

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An alternative to holding companies is a fund based structure as mentioned in the previous chapter. In such structures the fund manager is generally under pressure to achieve a target return. This could be the reason that fund structured MIVs tend to seek investment opportunities in more mature and profitable microfinance geographies, such as Eastern Europe, Central Asia and Latin America (see figure 4 below). Microfinance Portfolio, Main regions

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

All MIV's Registered Mutual Funds

Commercial Investment Funds

Only holding company MIV's are major investors in Africa.

Structured Finance Vehicles actively managed

Structured Finance Vehicles passively managed

Blended Value Funds

Holding Companies

Private Equity Funds

Eastern Europe & Central Asia

Latin America

Asia

Africa & Middle East

Other

Figure 4. Geographic allocation of funds by MIV type Source: (DiLeo, 2009)

It is difficult to gage the extent the emerging markets are underserved regarding financial services. Market size estimates range from USD 50bn (DiLeo, 2009) to USD300bn9 (Bochatay, 2009), whereas total MIV investments are estimated at $10.4bn (DiLeo, 2009).

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Based on 1.5bn people (population on less than $2 per day and working), and multiplied by a conservative9 average loan size of $200

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3.2. Parties offering microfinance services

Of 500 million active microfinance clients, 150m have credit, 300m saving and 50m insurance products. Geographically the client group is split 70% in Asia, 20% Latin America and 10% in other geographies (Bochatay, 2009). The substantial sub-Sahara African market is therefore largely underserved. The microfinance market can be split into various direct and indirect investors:

3.2.1. Microfinance Investment Vehicles ("MIVs")

There were 91 MIVs in the world as at 31-12-2008. Top five MIVs held a 52% market share and represented a total of USD 5.4bn of assets under management (as at 31-12-2007) (DiLeo, 2009). The top five MIVs were: ·ProCreditHolding ·BlueOrchardFinance ·CreditSuisseMFFundManagementCompany­responsibility ·Oikocredit ·OppenheimAssetManagementServices(EFSE) (DiLeo, 2009). ProCredit Holding is a German based company that has built up 22 banks/organisations in Middle and South America, Eastern Europe and Africa. It is a social sustainability orientated organisation, but believes that commercial terms have to be adhered to as well. Key shareholders and funders are: IPC, KfW, FMO, IFC, TIAA-CREF, DOEN foundation and the Omidyar-Tufts Microfinance Fund (founder of eBay). Blue Orchard Finance is a Swiss based commercial microfinance investor. Through the launch of investment funds and equity participations they attract capital, which is lent to, or invested in, MFIs. Credit Suisse and Oppenheim are global financial services players. They follow a social sustainability driven investment charter for the fund and business unit mentioned, but also aim to work on commercial terms. Oikocredit is the only faith related (ecumenical) MIV in the top five. They drive a social sustainability investment charter, aiming in particular at underserved MFIs (smaller and more rural-based MFIs) with a clear social mission as well as financial sustainability. Their loan pricing policy is set as the higher of a. Local market price; and b. Internally calculated cost price. Not all investors might be aware that the loan pricing is at market standard.

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DiLeo et al. have defined six key groupings of MIVs depending on: ·thewaythefundsinvestinMFIs(provisionofdebt,equity,guaranteesora mixture), ·thedriversofthefund(socialdevelopmentorcommercialdrivers),or ·theownershipofthefund(mutualorshareholderstructure). An overview of these main types of funds and names of some of the key players are listed in Appendix III.

3.2.2. Microfinance Institutions ("MFIs")

There are about 10,000 MFIs world-wide (Bochatay, 2009). The MIVs' main challenge as a fund manager is to identify the right MFI to invest in. For MFIs on the other hand, it is often a challenge to know which MIV could be interested in their way of operating, their corporate/NGO values and beliefs. The required skill set at an MFI is wide as one might be teaching an illiterate client money and repayment concepts one day and negotiating financial and legal terms with investors and lawyers the next. Many not-for-profit organisations are related to certain focus areas, values and beliefs. This can be a certain region or village, an ethnicity or a faith. Some institutions have a policy that they lend only for proposals that meet certain borrowing criteria (white listed sectors such as agriculture and handicraft, or do not lend to blacklisted sectors such as tobacco, arms and child labour). Further acceptance criteria can involve alignment of the borrower's faith with that of the provider of credit; certain faith institutions provide loans only to borrowers, who share the faith of the institution (Steve, 2009). Fortunately there are also faith institutions who lend indiscriminately. As MFIs are the organisations on the ground, they have the local infrastructure and resources to train people and monitor loan proposals and collections. As many MFIs are linked to NGO's they work with frequently changing Western volunteers and local employees. The commercial success of an MFI is often determined by the quality of the training, monitoring and procedures the organisation has in place. It is essential to run the MFI in a professional way to maximise efficient use of capital. Since the entrance of specialist data providers, such as MixMarket in 2002, comparison of the performance of MFIs has become easier. In addition specialist MFI rating agencies have launched that monitor the MFIs. MIVs rely more and more on external views when allocating investment funds to MFIs. In Appendix II global and Africa focused data tables are listed, detailing the 15 largest MFIs, their portfolios and performance. The data presented is typically what a MIV fund manager would form investment decisions on. As a (potential) microfinance investor, it is advisable to analyse the presented data, as this is what one is actually investing in directly

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or indirectly. Understanding of the performance measures is also helpful to verify the fund manager's decisions and asset allocation. As indicated there are thousands of MFIs. Some are funded exclusively; others operate through donation and/or multiple funding lines. For a better understanding of the activities of MFIs one could review information from prominent global organisations that operate own or partner with third party local MFIs. Examples of such global organisations are FINCA, Grameen, Opportunity International, Shared-interest, Women's World Banking and ACCION.

3.2.3. Peer-to-peer lenders

Peer-to-peer ("P2P") lenders are parties who provide a matching facility to investors and MFIs/borrowers. Although the name might suggest a form of lending, they do not take any lending risk. An online broker infrastructure is provided to match investors directly with microfinance borrowers or MFI's and take a commission for doing so. Different P2P players operate differently: MyC4.com is a Danish based co-operative company that provides a service to African entrepreneurs to submit a preset application form with their borrowing requirements and capital allocation reason. Members of MyC4.com submit bids for a loan proposal, detailing capital amount and interest rate. The most competitive bids get selected and the "winning" lenders form part of a syndicate to the respective borrower. Each investor receives their pro-rata share of interest and repayment and MyC4.com takes care of the investor administration. Any defaults are also split pro-rata the investor capital contributions. Upon repayment of the loan the investor receives their capital back and can choose to re-invest in a new loan proposal. Since launch, over 16,000 investors have lent almost Euro 10.5m. According to user experiences on blogs, MyC4 is not fully transparent in calculating the interest rate. Users are confronted with local withholding taxes and (deemed) unreasonable exchange rates as all loans are made in local currency. However, the latter is disclosed clearly and investors simply have to price such risks and rates in, if they want to invest in different jurisdictions with little traded local currencies. It is not believed that MyC4 is making any gain/loss on the currency risk; simply small loan sizes have less favourable exchange rates. Such risks also occur for MIV investors, although with such fund structures the FX exposure is pooled and swapped on a total portfolio basis. MyC4 has encountered some unfortunate MFI selection choices, which has resulted in high default rates in the past (Costa, 2009). Despite some negative blogs and press, MyC4 is probably one of the best organised and presented P2P service providers. They are also leading from a social and sustainability point of view as the entity is a co-operative. Kiva.org is a non-profit US based P2P provider that operates in a similar way to MyC4, except that the "philanthropic" lenders (usually people in the global north) do not receive any interest on their loan. It also has pre-selected MFIs who upload the entrepreneur's

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borrowing request. But opposed to investors bidding for loans, they simply allocate a loan amount (minimum $25). It is in essence almost a donation, which upon repayment of the loan, is returned to the lender for withdrawal (but with a request for it to be donated in full to Kiva, for re-lending by Kiva itself). Although Kiva is one of the largest P2P providers and is endorsed by many respectable foundations and MIVs, it has had some negative press (Microfinance Gateway, 2008). This was based on the procedure that Kiva goes through when allocating funds through MFIs. The investor is led to believe that they are investing in a certain entrepreneur and business case, whereas in reality the MFI receives the funds from Kiva and can allocate accordingly to current business propositions. Kiva now clearly states on its website that the MFIs pre-lend to the borrowers and then submit funding requests to Kiva lenders. Hence the Peer-to-peer ("P2P") lenders are parties who provide a matching facility to investors and MFIs/borrowers. Although the name might suggest a form of lending, they do not take any lending risk. An online broker infrastructure is provided to match investors directly with microfinance borrowers or MFI's and take a commission for doing so. Different P2P players operate differently: MyC4.com is a Danish based co-operative company that provides a service to African entrepreneurs to submit a preset application form with their borrowing requirements and capital allocation reason. Members of MyC4.com submit bids for a loan proposal, detailing capital amount and interest rate. The most competitive bids get selected and the "winning" lenders form part of a syndicate to the respective borrower. Each investor receives their pro-rata share of interest and repayment and MyC4.com takes care of the investor administration. Any defaults are also split pro-rata the investor capital contributions. Upon repayment of the loan the investor receives their capital back and can choose to re-invest in a new loan proposal. Since launch, over 16,000 investors have lent almost Euro 10.5m. According to user experiences on blogs, MyC4 is not fully transparent in calculating the interest rate. Users are confronted with local withholding taxes and (deemed) unreasonable exchange rates as all loans are made in local currency. However, the latter is disclosed clearly and investors simply have to price such risks and rates in, if they want to invest in different jurisdictions with little traded local currencies. It is not believed that MyC4 is making any gain/loss on the currency risk; simply small loan sizes have less favourable exchange rates. Such risks also occur for MIV investors, although with such fund structures the FX exposure is pooled and swapped on a total portfolio basis. MyC4 has encountered some unfortunate MFI selection choices, which has resulted in high default rates in the past (Costa, 2009). Despite some negative blogs and press, MyC4 is probably one of the best organised and presented P2P service providers. They are also leading from a social and sustainability point of view as the entity is a co-operative. Kiva.org is a non-profit US based P2P provider that operates in a similar way to MyC4, except that the "philanthropic" lenders (usually people in the global north) do not receive any interest on their loan. It also has pre-selected MFIs who upload the entrepreneur's borrowing request. But opposed to investors bidding for loans, they simply allocate a loan

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amount (minimum $25). It is in essence almost a donation, which upon repayment of the loan, is returned to the lender for withdrawal (but with a request for it to be donated in full to Kiva, for re-lending by Kiva itself). Although Kiva is one of the largest P2P providers and is endorsed by many respectable foundations and MIVs, it has had some negative press (Microfinance Gateway, 2008). This was based on the procedure that Kiva goes through when allocating funds through MFIs. The investor is led to believe that they are investing in a certain entrepreneur and business case, whereas in reality the MFI receives the funds from Kiva and can allocate accordingly to current business propositions. Kiva now clearly states on its website that the MFIs pre-lend to the borrowers and then submit funding requests to Kiva lenders. Hence the perception of a lender funding a specific borrower is somewhat reduced. In November 2009, four years after its trading practices started, Kiva exceeded a cumulative loan origination value of $100m. Throughout the four years they had brought together 573,000 lenders and 239,000 local entrepreneurs. (Techcrunch, 2009) MicroPlace is a for-profit P2P provider in the US. It was bought by eBay in 2008, a year after its launch. This platform does not provide access to local borrowers, but to MIVs and MFIs. The investor can choose what MFIs they would like to lend money to, or participate by subscribing to a MIV equity offering or investment fund. The MIV then loans the funds on to the MFI under their own conditions. Two MIVs that use MicroPlace to offer their funds to consumers are Calvert and Oikocredit. This is a convenient way to tap the individual investor market (opposed to institutional investors and members (e.g. churches with Oikocredit). MicroPlace investors receive a return of about 1.25% - 3% p.a., but is only accessible for US citizens. The average loan term is 27 months, in comparison to Kiva's average loan term of approximately 10 months. The difference is that one invests in multiple loans, whereas with Kiva funds are returned at the end of each local loan. (Microfinance Gateway, 2008) Veecus is a French based limited liability company that operates in a similar way to Kiva. One lends the money for 0% interest, but the MFI is the counterparty and takes any default risk. The funds are allocated to individual borrowers that the investor has selected. Veecus makes a return by receiving a one-off new investor fee and a kick-back from MFIs for bringing in loans (the cost of which is obviously added to the borrower's rate). OptINnow is a platform run by Opportunity International. It operates from a donation perspective opposed to an investor lending platform.

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3.2.4. Service providers

Service providers are in principle all other parties who provide ancillary services to microfinance clients, MFIs, MIVs and investors. Examples are: ·specialistMFIratingagencies(e.g.PlanetFinance); ·MFIdatacollectorswhoofferperformancereportsandstatistics (e.g. mixmarket.org); ·researchproviders(e.g.CGAP,MicrocapitalandMicrofinance-gateway) ·tradebodiesofprofessionals(e.g.intheUKMicrofinanceAssociationand MicrofinanceClubUK) ·advisoryserviceproviderslikeconsultancies(M2iandGFA) ·otherssuchassupportingacademic,government,aid,accountancy,legaland faith organisations With the sector becoming more mature and the increased interest of commercial investors, the need for service providers has increased. It is difficult to collect and generate timely and comparable data as the sector is relatively young, fragmented and subject to many different local disclosure laws and regulations. The research houses and rating agencies rely on local MFIs to process data in a predetermined way. Key challenges obtaining data are often local as MFIs are staffed by volunteers and local loan officers. They might be unaware of the context and importance of certain Q&A's. Communication and distances are also contributors. Data is often logged by hand and then typed up when back at the MFI base. If information is unclear or missing, it might be a week/month before the loan officer can visit a specific region again.

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3.3. Types of borrowers to lend to

When one thinks of microfinance borrowers, one often thinks of individuals. In reality many loans are made to groups of borrowers, cooperatives, companies and schools. Individual borrowers: The Grameen model is generally adopted when dealing with individuals: a group of (5-20) individuals present themselves as borrower group and enrol on financial training. Each individual is responsible for interest and repayments of any group member loan. This creates a high degree of social control and low default rates. It also creates a high degree of transparency and due diligence of new lending proposals. Cooperatives: Cooperatives are businesses in which the workers and/or other stakeholders have an equity share. Examples are microfinance loans to agrarian businesses, whereby the workers receive a profit share or a local bank/MFI, whereby the borrowers and depositors have an equity share, based on the custom they contribute (like Sparkassen in Germany and Building Societies in the UK). Company loans: Typical examples are loans to exporters of fair trade goods and SME's ("small and medium sized enterprises"). Loans to very small companies (drink or telecom booths) are usually structured as a loan to an individual. Schools: Loans to schools are often made by charities opposed to by commercial microfinance investors. However, with the increase in sustainability benchmarks, ever more MFIs need to measure and demonstrate what social benefits their operations are delivering t o local communities. This has resulted in an increase in social projects by MFIs as it influences their chances to attract funding. Funders might wish to reconsider whether MFIs are best positioned and skilled to launch and deliver on social projects (like schools and medical care).

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4. Background to the risks associated with investing in microfinance

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4.1. Risks of microfinance investments

In the West we are used to warnings related to financial products. "Shares can go up or down", "Do not invest more than you can lose", "Your home might be at risk if you do not keep up mortgage payments", etc, etc. Unlike financial services companies, the microfinance market is lightly regulated and if regulated done so according to many different standards and jurisdictions. Although most investors are institutional, hence of professional nature, there are also consumers that seek to invest or donate. Irrespective of one's experience in investment markets, it is wise to take note of the encountered risks when investing through certain investment vehicles.

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4.1.1. Risks of microfinance investments

The main risks can be categorised into six areas: Default, Currency, Operational, Financial, Political and Environmental risks. Each of these risks is explained in Appendix V. Although investors need to take all above risks into consideration, they are generally of different significance based on the type of investment made. Below an attempt has been made to categorise the six risks by investment type: Type of investment: Providing debt to MIVs Risk Grade LOW

·MFIorborrowerdefaultriskisgenerallylowasportfoliosarediversifiedandthe risk is taken by the MIV ·CurrencyriskisalsolowasloanstendtobemadeinWesterncurrencyandtheMIV hedges this risk when investing in an MFI ·OperationalandfinancialriskofMFIsisalsolow,asthecorebusinessofanMIV is to validate the quality of MFIs and run their own investment practice in a transparent and financially sound way ·Politicalandenvironmentalrisksarelow-mediumasMFIsarealwayssubjectto such risks, which can have a devastating effect on their operations (can wipe out an entire MFI at any moment in time and is usually not insurable). The MIV should diversify the portfolio of MFIs geographically to minimize this risk ·KeyriskisbankruptcyoftheMIVduetooverexposuretocertainMFIs(toolittle diversification), whereby bad performance of the MFIs are so significant that they jeopardise the overall performance of the MIV MEDIUM-LOW

Providing equity to MIVs (or investing in MIV funds)

·MFIorborrowerdefaultriskislow-mediumasitispassedontotheinvestor ·Currencyriskisalsolow-mediumasthereisapossibilitytohedgecurrencyriskat fund level. Any cost of the hedging or currency exposure is carried by the investor ·OperationalandfinancialriskofMFIsislow,asthecorebusinessofaMIVisto manage the investment fund and selection of financially sound MFIs (see above) ·PoliticalandenvironmentalrisksaremediumasMFIsarealwayssubjecttosuch risks (see above). The investor carries the risks encountered for the MFIs that were invested through the fund, opposed to all MFI investments of the whole MIV (less diversification) ·KeyriskisbankruptcyofthefundduetooverexposuretocertainMFIs(toolittle diversification), whereby bad performance of the MFIs are so significant that they jeopardise the overall performance of the fund

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Type of investment: Investing in self selected MFIs

Risk Grade HIGH-LOW

· ependingonthelevelofdiversificationandscaleoftheinvestor'sfundsitcanbe D high, medium or low risk. If one is to invest in one or a handful of MFIs only, then the lack of diversification would result in a high risk and probably a high operating expense scenario. Scale increases diversification and reduces risk and possibly also operating expenses ·Similardefault,currency,operational/financialandpolitical/environmentalrisks as above HIGH-MEDIUM

Investing in own MFI / charitable organisations:

·Similarriskdiversificationissueasabove ·Similardefault,currency,operational/financialandpolitical/environmentalrisks as above ·Whenoneownsthelocalorganisationthatsharesbeliefsandsocialinvestment policies, it does make the direction of the operations easier. However addressing non-performance (especially financial) is often quite difficult. A clear set of financial targets should be set out as should efficient operation procedures. Just because the cost of capital is low (e.g. donations) and the cause is charitable does not mean that should not achieve to utilise funds as efficiently as possible MEDIUM

Investing in the provision of loan guarantees

Loan guarantees are provided in combination with (bank) loans from third parties. They represent a "first loss" piece, which means that the first (e.g. 10% of) defaults are taken by the provider of the guarantee. In return a financial reward for the loan (like an insurance premium) is received ·Similarriskdiversificationissueasabove.Loanguaranteesareinsurancelike, whereby the rule of numbers is crucial (hence scale and high diversification level) ·Similardefault,currency,operational/financialandpolitical/environmentalrisks as above Peer-to-peer lending HIGH-MEDIUM

·Diversificationisinprinciplelowastheinvestorselectseachinvestment ·OnedoesnotalwayshaveinsightintowhichborrowerrequestsMFIsputforward on the P2P platforms and which they fund themselves through funding arrangements from MIVs ·P2PplayersdocarryoutduediligenceandauditMFIs,likeanyotherMIV.The actually tend to have a positive effect on the information provision, hence management and procedures of the MFI operations ·Investorsareexposedtodefault,currencyandpolitical/environmentalrisks,but that is what they receive a return for. Individual loan currency exposure is not to be hedged viably.

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5. Current microfinance trends

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5.1. Local funding through deposit schemes

A successful and sustainable funding methodology is that of attracting local deposits. Intuitively one would consider that people living in poverty have no savings, but quite the contrary is true. Lack of banking services has resulted in many people holding cash for e.g. medical emergencies and family member funerals. Holding cash is a significant risk due to criminality. It is not uncommon to pay deposit takers to take care of one's (non-interest bearing) cash. In the developed world it is standard practice to receive interest on deposited funds. In emerging markets people often pay to have their funds safe guarded. This creates an interesting commercial business opportunity as deposited funds can be lent out as microfinance loans. Deposit schemes are not only commercially interesting from an interest margin point of view. From a default risk perspective on microfinance loans, they are also interesting. Local communities have started using terms like "hot money" and "cold money" to distinguish between microfinance funding from local sources (hot) and developed world sources (cold). The incentive to repay any loan financed locally (hot money) is higher than one financed with cold money. A default on a hot money loan might lead to one's neighbour or village elder knocking on one's door. The deposit scheme trend is also important as it contributes to a sustainable long term source of funding for microfinance loans. Funding through local deposits makes borrowers less reliant on external funding. This means they are less likely to attract volatile capital markets funding. The local community also remains shareholder of the local microfinance lending entity, which means that any profits are redeployed locally.

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5.2. Increase in commercial investors taking equity stakes in MFIs

In the run up to the credit crunch of 2007-08 MFIs streamlined their operations by implementing standardised procedures and reporting. Due to the decline in the capital markets most MFIs found it difficult secure refinancing of their portfolios, let alone meet local borrower demand. With markets recovering private equity investors are returning to seek out "bargains" in the microfinance investment arena. The MFIs that have survived are likely to have sound operating standards and healthy loan portfolios. If one is to apply the same key valuation drivers to microfinance operations in emerging markets to those of financial services companies in the developed world, then one can conclude that the opportunity value is much more than simply the return on the loan portfolio. Financial firms in the developed world build up client portfolios and information on their clients. The ownership of the client and their purchase behaviour, gives the firm the opportunity to cross-sell more products. The consumer credit data and purchase behaviour is valuable in itself. Some firms choose to sell this data to third parties in the form of leads. In emerging markets there is very little data on consumer purchase behaviour. Most countries don't even have basic census data. Investors that own and monitor client portfolios should consider the value, as microfinance clients of today, shall be bank clients of tomorrow. Private equity investors could benefit substantially by taking equity shares in MFIs with the aim to achieve a substantial retail distribution network. The exit would be to sell such network to a financial services company or retail/telecoms company offering financial services and other cross-sell opportunities. With regard to this point, faith institution investors may consider two elements: ·whethertoletcommercialinvestorscreamoffthetopoftheMFImarket,asthe loss of the well yielding MFIs shall jeopardise the sustainability of their overall investment portfolio; and ·whetherlettingprivateequityinvestorstakingequitystakesinMFIsismore beneficial to local communities in the long term, than offering local communities the services and earn-out opportunities in the form of co-operative structures. The crux of the above is whether any future profits to third party investors are repatriated to the existing shareholders or redeployed in local communities in order to speed up poverty alleviation. Furthermore, to what extent are investments in MFIs purely related to commercial financial services vs. alleviation of poverty and provision of basic human needs?

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5.3. The emergence of short term capital markets funding

Commercial investors' initial entrance to the market introduced standardisation of operating procedures and reporting. This brought a greater transparency and improved corporate governance. The microfinance market was booming and poverty alleviation was ramping up. Due to the economic downturn in 2007-08, underperforming MFIs were confronted with difficulty to attract funding. Commercial investors became more selective in funding and extending credit lines to MFIs throughout 2008-09. Although the positive of the initial increased investor appetite was largely welcomed, nobody expected the backlash of them leaving so abruptly. Having funded the industry due to the low cost of capital from the debt capital markets, the MFIs found themselves having to turn down credit requests from local borrowers. Undoubtedly some of those borrowers had been teased with escaping poverty by the provision of previous loans, only to be dropped back into poverty due to the combination of market conditions and the way MFIs had sourced funding. Although the microfinance market benefits from increased competition in the short run, it can have a damaging effect in the long term. Commercial investors tend to have access to relatively short term capital markets funding (less than 5 years), whereas true sustainability comes from cash rich non-commercial investors, who can bridge market downturns. One should take into consideration that, unlike in the developed world, microfinance based financial services are a substitute for a non-existent social welfare system. Taking something away that one has previously enjoyed is much more painful than missing the same level of service when one has never experienced it. Let alone, when it involves basic human needs11. Short term based capital markets funding contributes an undesirable volatility that can jeopardise the sustainable provision of basic human needs. In order to counter this, the microfinance industry should consider only long term funding commitments (20-30 years) to be acceptable, thereby safeguarding sustainability of serving (the lower end of) the industry.

This issue has not been highlighted much in the press. Possibly as it encompasses multiple facets of the microfinance and financial services industries and because the entrance of short term funded investors has highlighted and expanded the success of microfinance. The volatility and liquidity issues of short term funding are however particularly negative, possibly even immoral. One could compare it with a donor physically offering food to a nation subject to starvation and then before they could consume it taking it away again. According to today's moral standards, such behaviour would be widely deemed cruel and unjust.

11

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5.4. Effect of above market trends on faith investors' market share

Based on Porter's Five forces framework (Porter, 1979) and a PESTEL analysis the potential shift in market positioning of investors is summarised in a directional policy matrix (Robinson, 1978).

Threat of new entrants (High risk) · High due to low capital markets funding · High due to funder appetite for Impact Investments

Suppliers (High risk) Faith Investment Funds are long term. Whereas capital markets funds are cheaper, but short term and more volatile

Internal rivalry Current market places shall undergo significant changes due to new entrants and commercialisation

Customers (Low risk) Demand > Supply

Source: (Porter, 1979)

Threat of substitute (Medium risk) · Low as charity donations are stable · High if local deposit schemes become the new funding mechanism

PEST(EL) analysis

Factor Political Economic Socio-cultural Impact Regulatory landscape is increasingly transparent and homogeneous Demand > Supply and recent downturn exposed difference professionality amongst MFIs Microfinance becoming more known and accepted locally. Initiatives by locals also increasing Increased transparency, which resulted in efficiency and lower rates Increased wealth has a negative effect on environment Microfinance is locally and internationally Response Acceleration of commercial investors as entry barriers decrease Private equity firms funding and acquiring financial sector retail operations Sector must be educated (people & MFI staff) on concept of profit. Otherwise it will turn into a hard lesson when commercial investors have control of the sector Has made sector more attractive, calculable, hence investable. Entry barriers have reduced None, as global wealth parity has higher importance Legal costs declining. Entry barriers reduced Impact Investing: Microfinance

Technological Environmental Legal

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Based on above five forces and PEST(EL) analyses, one can demonstrate the proposed market trend in Robinson's Directional Policy Matrix (Robinson, 1978). This tool is normally used for corporations seeking to identify which businesses they wish to invest in, continue operating or dispose of. The reason it has been used is that from the perspective of the end borrower, it does not matter where the funds originate from. Therefore both investor groups are serving the same market. If commercial investors gain market share due to creaming off the well performing MFIs, then Faith investors shall have to give up the best parts of their market share.

High

Aim and milk this business

Market attractiveness

Commercial investors

Protect this business

Faith investors

Low

Get out of this business Low Strength vs. Competition High

Source: Internal analysis based on (Robinson, 1978) framework. Direction and length of arrows is indicative only Above trends indicate that poverty alleviation shall re-enter a cycle of commercial investment, probably fuelled by relatively cheap short term funding. Commercial investors are also better positioned as they have better access to financial services expertise than noncommercial investors (faith institutions and NGOs). If the faith investor community does not utilise its influence over the sector, then no change in regulation shall take place. This shall result in no / low entry barriers for any new investors and microfinance shall be funded subject to free markets. Although the majority of the investor community supports capitalism and free markets, one might wish to model the effects it could have on the low end of the microfinance borrower community. Low entry barriers means that poverty alleviation shall become more difficult for those most in need, as non-commercial investors shall have a less wide reach. This is due to the fact that any marginally profitable business shall be lost to commercial investors opposed to the proceeds being utilised to off-set any unprofitable investments.

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6. Recommendations

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6.1. Invest in microfinance

The overall recommendation is for faith institutions to enter into, or continue to invest in, microfinance. It has proven to be successful financially and socially. Socially has been interpreted in the sense that it alleviates poverty in a sustainable way and meets most of the Millennium Development Goals. According to their risk appetite and investment charter, faith institutions may consider investing their own funds in any of the six types of microfinance investments as detailed on pages 31 to 32. Investment required: Investor risk: Borrower risk: Return potential: Social return: Low - High Medium Low Low ­ High depends on investment type High

Secondly faith institutions may consider offering their members access to a ring-fenced P2P investment platform, which has the possibility to filter on their own faith compliant values and beliefs. This could be part of offering members access to predefined Impact Investing products (shares, indices, commercial debt, options, etc) that are compliant with the values, beliefs and/or investment charter of one's faith. Investment required: Investor risk: Borrower risk: Return potential: Social return: Low (in kind only. P2P player to invest) n/a Low n/a High, as with zero own investment more capital is invested in poverty alleviation

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6.2. Offer deposit schemes

Deposit schemes provide local sustainable long term sources of capital. The only cost of lending is the local cost of capital (which is low) plus the operating expenses. Faith institutions are recommended to enter this market to provide a long term and sustainable micro-credit solutions that also benefit local communities upon any earn-out in the future. It also helps faith investors losing market share to commercial investors. Faith investors could earn a percentage of the profit as a management fee, which could be used towards other poverty alleviation schemes. Such fee income is achievable without any significant investment as microfinance loan capital would be provided through deposits. Investment required: Investor risk: Borrower risk: Return potential: Social return: Low Low Low High, based on investment size High

Investment required: Low (in kind only. P2P player to invest) Investor risk: n/a Borrower risk: Low Return potential: n/a Social return: High, as with zero own investment more capital is invested in poverty alleviation

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6.3. Lobby for regulation to safeguard minimum poverty alleviation

If commercial investors only seek to invest in the profitable side of microfinance, then non-commercial investors are driven out of the market. The result is that the size of the non-profitable investment portfolio shall shrink as it is not funded by the proceeds of the profitable side. Faith institutions are recommended to lobby for regulation that ensures certain levels of commercial profits be redeployed to non-profitable poverty alleviation schemes. Examples are: ·commercialinvestorswhoseektooperateinmajorcitiesonly,duetolowercost basis, are forced to either diversify to rural areas or contribute part of their profits to funding rural MFIs. Although cost of capital shall increase for borrowers in the profitable parts of microfinance, it is likely that it is still lower than rates offered by existing loan sharks; ·segregationofmicrofinanceservicestargetedtoprovidebasichumanneedsvs. commercial needs. Investors in the former category are regulated to redeploy any profits above a certain threshold in non-profitable microfinance investments, as it should be considered a surrogate social welfare system. For the latter group rules of the free market economy apply. Investment required: Investor risk: Borrower risk: Return potential: Social return: Low (in kind only) n/a n/a n/a High, safeguards poverty alleviation

As UN Secretary General Mr Ban-Ki-moon stated at the ARC and UNDP organised Windsor Castle event in November 2009:

"You [faith institutions] are the third largest category of investors in the world (...). Your potential impact is enormous."

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6.4. Compete with commercial investors and acquire equity stakes in MFIs

Commercial investors' initial entrance to the market introduced standardisation of operating procedures and reporting. This brought a greater transparency and improved corporate governance. The microfinance market was booming and poverty alleviation was ramping up. Due to the economic downturn in 2007-08, underperforming MFIs were confronted with difficulty to attract funding. Commercial investors became more selective in funding and extending credit lines to MFIs throughout 2008-09. Although the positive of the initial increased investor appetite was largely welcomed, nobody expected the backlash of them leaving so abruptly. Having funded the industry due to the low cost of capital from the debt capital markets, the MFIs found themselves having to turn down credit requests from local borrowers. Undoubtedly some of those borrowers had been teased with escaping poverty by the provision of previous loans, only to be dropped back into poverty due to the combination of market conditions and the way MFIs had sourced funding. Although the microfinance market benefits from increased competition in the short run, it can have a damaging effect in the long term. Commercial investors tend to have access to relatively short term capital markets funding (less than 5 years), whereas true sustainability comes from cash rich non-commercial investors, who can bridge market downturns. One should take into consideration that, unlike in the developed world, microfinance based financial services are a substitute for a non-existent social welfare system. Taking something away that one has previously enjoyed is much more painful than missing the same level of service when one has never experienced it. Let alone, when it involves basic human needs. Short term based capital markets funding contributes an undesirable volatility that can jeopardise the sustainable provision of basic human needs. In order to counter this, the microfinance industry should consider only long term funding commitments (20-30 years) to be acceptable, thereby safeguarding sustainability of serving (the lower end of) the industry.

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6.5. Regulate long term investor commitment

Poverty alleviation shall undoubtedly re-enter a cycle of competitive capital markets funding. As in the years from 2007 to date, availability of capital can be volatile. As long as there is no social plan to cover minimum welfare in developing markets, it is recommended that investors commit to long term funding only. They should de-link their source of funding from the capital markets in order to remove any recurrence of funding constraints as caused by the credit crunch of 2007-08. As this is not aligned with the free market economy and the use of competition to determine the most efficient cost of capital, it can only be achieved through regulation within the industry. The case shall be difficult to argue as with markets improving people tend to easily forget past damage caused. Faith institutions may wish to lobby that for the section of the microfinance market that actually provides poverty alleviation (provision of basic human needs) only revolving long term capital may be used. For all other microfinance areas that contribute to wealth improvement relating to non-basic human needs, free market economy conditions may apply, i.e. full commercialisation. Investment required: Investor risk: Borrower risk: Return potential: Social return: None (in kind only) Unchanged Much lower High, creation of entry barriers High, due to less volatility

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7. References

Bochatay, C. L. (2009, October 23). Presentation ESADE Net Impact event. Barcelona, Spain: Esade. Centre for the Study of Financial Innovation. (2009). Microfinance Banana Skins 2009: Confronting crisis and change. UK: Centre for the Study of Financial Innovation. CGAP - Consultative Group to Assist the Poor / World Bank. (2009). Financial Access Report 2009 - Measuring Access to Financial Services around the World. Washington DC: CGAP. Costa, D. (2009, March 20). Microfinance Lending Platforms. Retrieved November 20, 2009, from www.myKRO.org: http://www.mykro.org/ microfinance-lending-platforms/ DiLeo, P. a. (2009, April 15). Filestore Presentations (Microfinance Investment Funds). Retrieved October 20, 2009, from MicrofinanceClubUK.org: http://www.mfclubuk.org/ index.php?option=com_remository&Itemid=78&func=fileinfo&id=21 ECLOF. (2009). Ghana: Little known animal with a promising future. Retrieved November 23, 2009, from ECLOF, Ecumenical Microfinance For Human Development: http://www.eclof.org/index_UK.php?p=nh&idj=4&idArt=7 Microfinance Gateway. (2008, April 07). Open up your virtual wallet. Retrieved November 19, 2009, from Microfinance Gateway: http://www.microfinancegateway.org/p/site/m//template.rc/1.26.9154?page1=print Microfinance Gateway. (2009, October 19). What is microfinance. Retrieved October 19, 2009, from Microfinancegateway.org: http://www.microfinancegateway.org/p/site/m/template.rc/1.26.9183/ MixMarket.org. (2009, October 29). Microfinance institutions. Retrieved October 29, 2009, from mixmarket.org: http://www.mixmarket.org/mfi/indicators/flatstore _ mfi_mfdb_data.mix_diamonds__c%2Cbalance_sheet_usd.gross_loan_portfolio %2Cproducts_and_clients.total_borrowers/2007?order=balance_sheet_usd_gross_loan_ portfolio&sort=desc Morduch, J. (2002). Analysis of the Effects of Microfinance on Poverty Reduction. New York: NYU Wagner - Working Paper No. 1014.

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Oikocredit. (2009). Annual Report 2008. Amersfoort, Netherlands: Internal publication. Opportunity International. (2009, October 19). Microfinance FAQs. Retrieved October 19, 2009, from Opportunity.org.uk: http://www.opportunity.org.uk/Page.php?id=2 Rosta, J. (2009, September). US Banker - Tools & Data - Trickle Down Effect. Retrieved October 29, 2009, from US Banker: http://www.americanbanker.com/usb_issues/119_9/trickle-down-effect-1001271-1.html SKS Foundation. (2009, October 29). About SKS Foundation | Mission and Goals. Retrieved October 29, 2009, from SKS Foundation: http://www.sksfoundation.org/payments/Background.aspx Steve, B. (2009). The Role of Faith/Spirituality in Microfinance. 2009 Pacific Northwest Microfinance Conference May 9, 2009. Seattle: Seattle Pacific University / VisionFund/ World Vision. Techcrunch. (2009, 11 01). http://techcrunch.com/2009/11/01/. Retrieved 02 23, 2010, from Techcrunch.com: http://techcrunch.com/2009/11/01/four-years-after-foundingkiva-hits-100-million-in-microloans/ The ECLOF Magazine. (2009, July (issue 41)). Solar power helps children do their homework. New Horizons , 5. Vandenberg, P. (2006). Poverty reduction through small enterprises. Geneva: International Labour Office. World Bank. (2010, 1 27). Online Atlas of the Millenium Development Goals. Retrieved 1 27, 2010, from Worldbank.org: http://devdata.worldbank.org/atlas-mdg/ World Bank, edited by Catherine Marshall. (2007). Development and Faith: Where Mind, Heart, and Soul Work Together. Washington DC: World Bank. Yale Entrepreneurial Institute (Composer). (2009). Podcast: The Development of SKS Foundation's Microfinance Profram for the Ultra Poor in India. [A. Shah, Performer] New Haven, Connecticut, U.S.A. Zaman, H. (n.d.). World Bank Policy Research Working Paper 3398, September 2004.

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8. Glossary

Blended value funds Blended value funds offer below market returns to socially-focused investors and provide a mix of debt and equity finance to MFIs. These funds are generally managed by not-for-profit organizations. CGAP Consultative Group to Assist the Poor. "An independent policy and research centre dedicated to advancing financial access for the world's poor. It is supported by over 30 development agencies and private foundations who share a common mission to alleviate poverty. Housed at the World Bank, CGAP provides market intelligence, promotes standards, develops innovative solutions and offers advisory services to governments, microfinance providers, donors, and investors." Source: www.CGAP.org, About Us Page. Commercial investment funds Commercial fixed income investment funds seek a close to money market return from fixed income investments. As private investments companies they are not subject to UCI regulations. Currency risk, Default risk, Environmental risk, Financial risk See appendix V. Greenfield operations Greenfields are new launched start-ups. Opposed to existing operations. Holding companies Holding companies provide mainly equity finance and technical assistance to start-up microfinance banks. They usually hold a predominant stake in their investees and are generally accessible by private invitation only. Holdings of MFIs These companies provide equity finance and technical assistance to Greenfield MFIs. They usually hold a majority stake in their investees. Impact Investing Appendix IV. MFI Microfinance Institution. An organisation that operates locally and provides microfinance services to its client base. Micro-credit See Microfinance (narrow definition). Microfinance (broad definition) "Microfinance is the provision of a broad range of financial services and products such as credit, savings and insurance designed to assist poor people who lack access to financial services in the mainstream banking sector to develop their small businesses, save their earnings, and guard against risks". Source: (Opportunity International, 2009).

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Microfinance (narrow definition) "Microcredit refers to very small loans for unsalaried borrowers with little or no collateral, provided by legally registered institutions". Source: (Microfinance Gateway, 2009). MIV Microfinance Investment Vehicle. An investor in MFIs. Operational risk, Political risk See appendix V. Private equity funds Private equity funds provide mainly equity finance and seek a market return with a long time horizon. Most funds are driven by commercial organizations with a strong development emphasis. Private equity funds include venture capital and private equity firms providing equity capital to MFIs. Registered fixed income mutual funds Mutual funds regulated and supervised by a market authority. Registered mutual funds Registered mutual funds seek a close to money market return primarily from fixed income investments. They publish their NAV on a monthly basis and are regulated by market authorities (undertakings for collective investment regulations). Socially focused funds Provide debt, guarantee, or equity finance to MFIs. They invest in smaller MFIs and in frontier markets. These funds are generally managed by not-for-profit organizations and cooperatives. Structured finance vehicles (actively managed) Structured finance vehicles actively managed offer different risk and return classes to microfinance investors. The pool of assets is actively managed and includes mainly fixed income investments. Structured finance vehicles (passively managed) Structured finance vehicles passively managed offer a range of asset-backed securities with different risk and return profiles to microfinance investors. Generally classified as CDOs, the assets only include a static pool of fixed income investments (pool of loans to MFIs). Structured finance vehicles/dynamic asset allocation These vehicles issue two or three tiers of liability but only the senior debt is rated. They invest mainly in fixed income in large MFIs. Structured finance vehicles/static asset allocation - CDOs Generally classified as CDOs, these vehicles also issue two or three tiers of liability but their assets include only a static set of loans to large MFIs (promissory notes). Unregistered fixed income investment funds Private investment companies offering fixed income products to MFIs. These funds are not supervised by a market authority.

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Appendices

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Appendix I Case studies of faith related microfinance business cases

Default risk (Five Talents) Default risk is one of the key risks for investors. Tom Sanderson of the UK charity Five Talents identified a difference in default rates based on the level of community involvement in the microfinance model. He referred to the concept of "hot" and "cold" money (see below) giving the examples of Five Talents' microfinance programmes In Kenya and Southern Sudan. Due to funding requirements and the needs of the community, the programmes in those two places are based on deposit schemes. In Africa (in contrast to the West) people are accustomed to either pay for or have a pro bono deposit scheme. Interest receipts on deposits are not expected. This could be due to the inconvenience and cost of holding funds. For example people tend to hide their savings in order to reduce the chance of losing funds when robbed. In some schemes, people have their funds collected every day and the capital sum returned at the end of each month. In this way, depositors not only secure the safety of their takings, they also get to use the capital sum for a major purchase. Something that would otherwise be unlikely as it would have been spent on day-to-day expenses. The local bank that Five Talents has funded in Southern Sudan is a community-led project with, at the time of writing, 450 customers after just over one year in operation. Each customer can join by depositing funds. The deposit is actually a non-interest bearing share in the bank. Hence the customer is actually a shareholder (similar to a cooperative). For each $5 equivalent, one acquires one share in the bank. Once one has acquired seven shares, one becomes eligible for borrowing funds at 5% interest. Any interest made on the loans, minus operating expenses, is paid out to the shareholders in the form of a dividend at the end of each year. By providing a safe place to store funds the community bank becomes a significant entity to all. Interestingly it has brought local tribes together and general conflicts have been resolved in amicable ways. The driver is that many different people from different tribes have all had their money at stake in the same bank, so they could not rule with an iron fist, as they might risk the whole (co-bank-shareholder) community not approving the pay-out of their funds. This social control has benefited the stability of the region. The second interesting feature is that of reduction of default risk. Having received many funds from the local community, there is the ability to provide loans. As all accounting is very transparent, people know the source of the funds. Hot money is money that people have had to earn themselves and have subsequently deposited and cold money is money

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from Western organisations. The social control and incentive to repay co-community member funds is much higher than to that of anonymous third party Western funders. So default rates for hot money have tended to be lower than for cold money. Investors in microfinance, who wish to lend money to help people out of poverty, might have to consider a counter-intuitive move for the sector to be successful. This would be to facilitate local deposit schemes like those operated by Five Talents that can themselves provide loans, as opposed to providing loans to communities directly.

Why deposit schemes improve lending opportunities and resolve social disputes (Five Talents) In the case study on default risks (page 44), the positive impact from a deposit scheme was detailed. The default chance, as communicated by members of the local community, was much lower. Their own distinction between hot and cold money clarified their views. The provider of this cooperative scheme, UK charity Five Talents (an initiative of the Anglican Church), has managed to fund the launch of the local "village bank" in Southern Sudan. By overseeing and implementing clear governance and financial procedures, the bank now has 450 customers. The customers are from different tribes, faiths and communities. There is no gender policy and all are free to become a member of the bank. The administration of the deposits and loans is transparent to all. At the end of the year any profit is paid out to the depositors in the form of a dividend. The "deposits" are therefore actually equity shares as opposed to interest bearing debt products. As previously stated, peoples' financial involvement in such a scheme creates a more harmonious community. Any disputes within the community are more likely to be resolved amicably as individuals with money in the community bank have higher stakes at risk. The scheme also provides business training. By encouraging people to save their money to purchase assets that can help them out of poverty, they create the ability to build a sustainable family business. Seven $5 deposits make one eligible to apply for a loan. This ensures that the bank has the time to educate the community member on what responsibilities a loan involves and can review the person's ability to manage money (their saving diligence). Bank customers, who build up a sound financial deposit/loan track record, are observed to have better school enrolment rates for their children and better diet and health outcomes. One of Five Talents key focus points is to provide local jobs by employing and training local staff. In Sudan their local manager is Thomas Anei - formerly a child soldier who was forced to join the liberation army. He was rescued and given training at Five Talents' Economic Development Institute in Kenya in 2006. Having launched the first bank successfully in Wau district in 2007, Southern Sudan, his main task now is to replicate the village banking model in surrounding areas with the support of Five Talents.

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"One aspect of Five Talents that sets it apart from other microcredit enterprises is its effort to provide business training and one-on-one business counselling to loan recipients, thereby enabling them to pursue new and creative ways to use their skills and talents." (World Bank, edited by Catherine Marshall, 2007)

Understanding at grassroots level (ECLOF) Simply adopting a Western financial model in rural areas of the developing world is just not the way forward. It sounds so straight forward, but one would be surprised how many initiatives fail unnecessarily due to lack of local knowledge. A good example is of adoption of grassroots knowledge is from Geneva based ECLOF, the Ecumenical Microfinance For Human Development. In Ghana the meat consumption is 200,000 tons, of which 80% is imported. A small local animal called the grasscutter is high in nutrition and tops the country's favourite meat list. Furthermore it is also acceptable to Muslims, who do not eat rabbit and guinea pig. Due to a lack of breeding stock and the initial cost (equivalent to two goats), not many people farm the animals. A great shame as from an operational point of view, many people could farm them easily on small plots of land. ECLOF put one of their partners (HPI) in contact with the local farmer cooperative to create a loan and training scheme for breeders. According to the ECLOF business case: "... Heifer Project International [provided] small loans. Taye Ocansey began with just six wild grasscutters but, with assistance in the form of training and a small loan for a cage, today he has a stock of 350 animals." It proves that microfinance can be very successful on a small scale as long as one understands the local market and needs.

Microfinance initiatives can involve state of the art technologies (ECLOF) The following microfinance case was taken directly form ECLOF's July 2009 issue of their microfinance magazine. Solar power helps children do their homework Households helped: 17,000 Loan value: US $150,000 Region: Bolivia-wide Partner: Bolivian Government Project launched: November 2006 Useful website: www.idtr.gov.bo

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"Thanks to this loan we now have light and energy ­ and our children can do their homework in peace." Elisban Huisa, 32, who borrowed US $310 over 2 years. Solar power is ideal for Bolivia's farmers who live miles from the mains under dazzling blue skies. The alternative is reading by candlelight, or carrying a car battery into town to get it recharged for a fee. The Bolivian Government estimates that about 700,000 rural households are without power. So it has launched a campaign to install up to 17,000 solar panels all over Bolivia by 2012. ECLOF is helping the Bolivian government finance large numbers of solar panels. Under the programme, ECLOF lends the farmers money to buy solar panels, which act as security for the loan. So far, ANED has loaned 5000 rural farmers money for solar panels, across 7 out of 9 departments. Before the Infraestructura Descentralizada para la Transformacion Rural (IDTR) scheme, ANED lent farmers money individually for solar panels. A typical solar power system includes a 22-75 Watt panel that charges a battery while the sun shines. At night, the battery can power 3 compact fluorescent (energy-efficient) lights, a mobile phone charger, a radio and a TV." Source: (The ECLOF Magazine, 2009, July (issue 41))

Conducting sufficient due diligence and investment selection criteria (Oikocredit) Oikocredit is one of the largest faith related MIVs. The organisation has over Euro 365m in lendable funds (Oikocredit, 2009) and provides debt, equity, guaranteed loans, subordinated loans, convertible loans and credit lines to MFI's, local financial institutions, fair trade organisations and individual borrowers such as agricultural cooperatives and agribusinesses. The majority of their investments are debt related. Prior to any investment decision a thorough in-house due diligence is carried out. Oikocredit works globally and their local in-country staff carries out such fact finding missions. As with many MIVs and investors, Oikocredit asks potential borrowing businesses and investee companies for three years worth of audited financial statements. However, Oikocredit also accepts applications from start-up and young enterprises that have a shorter track record but have high social relevance for poor and disadvantaged people. The reason why the Oikocredit due diligence information is provided is because it gives a good indication of how thorough professional parties are. An application for a loan will result in a 15-20 page extensive analysis of the business plan, the company and the project. Key focus areas are the quality of the management, the viability of the company and project and whether the business objectives are in line with the values and beliefs that Oikocredit support.

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Overview of topics in an Oikocredit due diligence report: Applicant data Contacts, description of business, legal status, external view on management Project data Type, purpose of funding, beneficiaries, partnerships Project performance Payback time, DCF valuation, Return on Equity, Return on Assets Risk assessment The risk assessment is formularised based on the input from the entire due diligence report. This forms input for the pricing of the loan and that forms the drivers for the profitability of the project Risks evaluated are: Financial, Governance/supervision, Management, Market aspects and Production and Technology. Financial summary Loan and currency details, Terms of the loan, Pledged securities, Audit information Executive summary Summary of the borrower, loan purpose and loan proposal Applicant data General Background Information ·Economicindicatorsofthecountry ·Projectpartner'sbusinessinrelationtothegeographicalenvironment ·Missionandgeneralobjectives ·Productsandservicesoffered ·Marketposition ·Targetgroupsandclients ·Existingpartnerships Performance and track record to date ·Applicant'scapability ·Currentandfutureactivities ·Debtposition/loans ·Regularityofreportingupdates ·Capitalstructure ·Financialprojections Ownership and Governance ·Statusofshareholders/membershipstructure ·Boardandgovernanceroles ·LoanstoBoardmembersandstaff ·EffectivenessofBoard Management structure and experience ·Description ·Processes ·Managementsystems

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The Project Project description ·Purposeoftheproject ·Activitiesforwhichthefundingisintended ·Effectonenvironment ·Fundingstructure Funding requirements and sources of funding SWOT analysis Measurement against Oikocredit criteria Does the enterprise benefit poor and disadvantaged people? Are benefits widely distributed or doe just few organisers and investors reap the rewards? Is the larger community socially and economically further advanced due to this project? Is attention given to ecological impact (animal/plant welfare)? Is a cooperative structure used/possible? Are women as direct beneficiaries given preference with this project? Is the project economically viable and does it have appropriate management and technical leadership to become sustainable within a reasonable amount of time? Is there a clear need for foreign investment? Financial Analysis Recommendation Analysis (B/S, P&L, CF) and Equity valuation Legal analysis Values of securities Pledges of assets received Pledges of assets to other parties List of unpledged assets Legal assessment Loan details Terms and conditions Repayment schedule Interest calculation ·Externalcostofcapital ·Oikocreditcostcoverage ·Countryrisks ·Projectrisks ·Discountforsecurities ·Mark-upordiscountbasedonmarketsituation ·Discountforextraordinarydevelopmentrelevancy Financial forecasts P&L ­ Three year history P&L ­ Three year forecasts

Source: Summary of internal project approval documents. Redrafted with kind permission of Oikocredit (2009).

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The implementation of ancillary services and the effect on obtaining funding Within the investor community, parties have to demonstrate the achievement of their communicated objectives. MIVs, like Oikocredit have found that they need to demonstrate that the funds they provide actually reduce poverty and increase quality of life. In order to track social performance they have adopted third party indices (Social Performance Index) and launched an own index together with the Grameen Foundation (Progress out of Poverty Index). (Oikocredit, 2009) Although demonstration of improved social welfare is a good thing in principle, there is not necessarily a link between achieving it and who needs to provide the facilities to achieve it. MIV's can invest funds in an MFI who provide a financial service. If all goes well, then there will be outreach to microenterprises of people living below the poverty line. The increased activity and income will have a trickledown effect and other social services will become desirable and available within the community. This increases e.g. the PPI index and the MFI's attractiveness to MIV's. It does not necessarily mean that the MFI should embark on multiple loosely related social programs in order to try to increase the PPI performance. As the social performance tracking has become more transparent, MFIs have embarked on trying to provide ancillary services. A couple of examples of services are schooling, vaccinations, housing and links to medical treatment. Although it sounds good on the outset, there is also something to be said about sticking to what one does best. Hassan Zaman writes the following in his: "Conclusions from The Scaling-Up of Microfinance in Bangladesh: Determinants, Impact, and Lessons." A second lesson is that microcredit may be a more effective remedy against poverty and vulnerability if it is complemented with other interventions. These interventions may be particularly appropriate for the poorest households, which face the greatest risks of income fluctuations and have the greatest need for a range of financial and non-financial services. Moreover, while the provision of microcredit can enhance a woman's status in the eyes of other household members, social mobilization and legal education interventions in conjunction with credit are likely to have a more significant effect than credit alone. However this does not imply that microfinance institutions ought to provide these services. In many cases organizations may prefer to specialize in providing microfinance and facilitate linkages to providers of other non-credit interventions. (Zaman, 2004) So although the ancillary services do help from a social impact point of view, it seems as if MFIs are finding themselves in a situation to expand their mandate to demonstrate their social performance. It might be wise that the sector acknowledges the benefit of the transparent indices, but also puts the use of them into perspective.

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Appendix II Overview of largest global and African MFI's

Average loan balance per borrower (USD) Average deposit balance per depositor Yield on gross portfolio (nominal) Operating expense/ loan portfolio Portfolio at risk; 30 days Write-off ratio Personnel Number of active borrowers Total women borrowers Number of depositors

The world's top 15 MFIs based on loan portfolio size as at 31-12-2008 (based on data from 1078 MFIs)

Name

Country

Gross loan portfolio (USD)

3iG International Interfaith Investment Group

444 2.410 28.496 1.226 5.528 2.051 102 103 6.318 9.214 5.152 988 1.491 79 2.167 1.000 22 249 208 21,81% 24,66% 24,62% 23,31% 1.072 20,08% 2.288 16,01% 1.977 16,85% 7,36% 10,13% 12,22% 19,38% 9,24% 15,00% 13,66% 122 19,51% 10,87% 28 25,63% 3.023 30,78% 14,67% 2,85% 7,69% 3,67% 1,54% 1,07% 2,17% 8,57% 3,94% 4,44% 0,35% 1.919 26,91% 6,52% 7,38% 404 21,02% 13,26% 14,59% 18,59% 8,81% 3,00% 0,06% 0,40% 2,84% 3,64% 1,45% 0,00% 0,44% 0,73% 1,57% 1,65% 0,16% 0,52% 0,06% 733 21,11% 12,67% 13,64% 8,79% INCORRECT 6,92% 7,30% 0,82% 7.809 6.460 2.161 4.283 1.009 2.862 26.749 24.240 1.158 1.995 1.860 4.036 3.838 25.719 6.128 6.792.978 902.486 64.056 852.925 151.471 380.807 6.327.250 6.210.000 96.420 64.102 113.854 542.249 320.190 5.877.480 214.337 4.711.064 124.012 283.629 515.823 57.016 206.121 6.074.152 6.016.248 2.391.789 372.050

VBSP

Vietnam

3.017.866.034

21 3.257.563

BCSC

Colombia

2.175.015.562

KMB

Russia

1.825.328.324

Caja Popular Mexicana

Mexico

1.045.509.906

3.073.249 163.083 190.618 8.090.369 7.670.203 402.214 220.023 478.745 3.018.356 2.150.156 7.276.677 487.803

BancoEstado

Chile

837.324.690

MiBanco

Peru

781.214.013

BRAC

Bangladesh

647.938.718

Grameen Bank

Bangladesh

642.257.512

ProCredit Bank - KOS

Kosovo

609.193.056

ProCredit Bank - BGR

Bulgaria

590.607.143

ProCredit Bank Serbia

Serbia

586.610.658

Equity Bank

Kenya

535.813.060

Khan Bank

Mongolia

477.335.994

ASA

Bangladesh

466.081.486

ACLEDA

Cambodia

464.477.809

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Figure 5. World top 15 MFIs by Gross Loan Portfolio size. Source: (MixMarket.org, 2009)

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Africa's top 15 MFIs based on loan portfolio size as at 31-12-2008 (based on data from 216 MFIs)

Average loan balance per borrower (USD) Average deposit balance per depositor Yield on gross portfolio (nominal) Operating expense/ loan portfolio Portfolio at risk; 30 days Write-off ratio Personnel Number of active borrowers Total women borrowers Number of depositors

Name

Country

Gross loan portfolio (USD)

Equity Bank 706 499 219 1.633 314 1840 738 390 1.545 2.376 434 1.354 524 915 254 20,35% 33,15% 15,13% 15,17% 460 26,47% 23,68% 164 35,04% 19,84% 552 16,78% 11,55% 18,23% 2,26% 22,33% 2,46% 8,64% 178 14,62% 10,69% 0,01% 27,53% 14,23% 11,07% 22,34% 10,14% 3,00% 0,00% 0,00% 0,73% 3,83% 0,00% 2,82% 3,81% 1,42% 362 21,89% 0,197 6,11% 1,03% 153 11,06% 2,87% 1,78% 0,16% 246 31,04% 28,20% 4,60% 0,73% 1.256 1.887 730 949 1.744 827 1.017 914 634 953 851 77 18,98% 5,55% 1,35% 0,00% 2.590 138 78,48% 40,55% 10,11% 0,00% 3.414 19,21% 11,14% 3,74% 0,00% 2.073 472.339 638.616 710.576 92.675 464.622 73.354 177.869 326.766 70.534 38.696 208.010 58.578 138.514 70.646

Kenya

535.813.060

988

208

21,81%

19,38%

8,57%

1,65%

4.036

542.249

283.629 213.968 283371 425.006 18.522 113.674 22.140 93.960 108044 11138 11973 208.010 20573 82.411 16.446

3.018.356 1.129.000 1.085.780 729.378 261.437 362.343 587.538 252.629 208.010 125.314 321.416

Al Amana

Morocco

333.623.362

Capitec Bank

South Africa

318.429.249

ACSI

Ethiopia

155.668.558

Centenary Bank

Uganda

151.295.500

3iG International Interfaith Investment Group

DECSI

Ethiopia

145.826.452

CMS

Senegal

134.977.281

FBPMC

Morocco

131.213.350

Zakoura

Morocco

127.379.728

RCPB

Burkina Faso

108.955.730

CamCCUL

Cameroon

91.959.264

KWFT

Kenya

90.190.593

K-Rep

Kenya

79.293.150

FONDEP

Morocco

72.553.152

FUCEC Togo

Togo

64.647.178

Figure 6. Africa top 15 MFIs by Gross Loan Portfolio size. Source: (MixMarket.org, 2009)

Impact Investing: Microfinance

Below a description of the columns: Tables 5 and 6 provide useful statistics that can be adopted when analysing which MFIs to enter into business with. The figure should be read as follows: (see page 59)

58

Gross Loan Portfolio: Is the capital sum amount that is outstanding with borrowers. This would be the sum of the initial borrowing minus any loan repayments and then cumulated for all the borrowers of the portfolio. Equity Bank has lent out in total $535m to microfinance borrowers.

Average loan balance per borrower Each active microfinance borrower has a loan balance outstanding. Amount is as at reporting date. The average loan per borrower is calculated by dividing the Gross loan portfolio by the number of active borrowers (one but last column). $535,813,060 / 542,249 borrowers = an average loan size of $988 per borrower. Average deposit balance per depositor Each active microfinance depositor has a deposit balance outstanding. Amount is as at reporting date. Yield on Gross Portfolio (nominal) (%) Interest and Fees on Loan Portfolio/ Loan Portfolio, gross, average. This is the total charges that a borrower pays as a percentage of the capital loan sum and then averaged for the whole loan portfolio. This yield is nominal as it is not corrected for inflation. So on average a borrower with Equity Bank pays in total 21.81% on their loan. Operating Expense / loan portfolio This is the total of all operating expenses to run the business (excluding interest expense for the MFI to attract capital) as a percentage of the total loan portfolio. This gives an indication of the minimum cost base an MFI encounters and needs to recoup by adding it to the rate they offer to their borrowers. Alternatively over time they need to streamline and bring this down. For Equity bank the difference between the Yield on Gross Portfolio and Operating Expense/loan portfolio is only 2.43%. This should include their cost of capital and any margin they are making. This is excessively low, so they are probably making a loss. Portfolio at risk; 30 days The value of all loans outstanding that have one or more instalments of principal past due more than 30 days. This includes the entire unpaid principal balance, including both the past due and future instalments, but not accrued interest. It also includes loans that have been restructured or rescheduled. The percentage represents the total loan sums that are at risk (opposed to the amount in arrears) / portfolio loan sum, whereas it is often possible that the arrear is paid in due course and the client is back on track. Also, it is possible that in the case of a default a part of the loan is still recovered. Write-off ratio Amount of capital sum from loans that have actually been written off (cancelled) due to non-performance, divided by Loan Portfolio capital size. Within the sector a much quoted (hence acceptable) write-off ratio is 2.5%.

3iG International Interfaith Investment Group

Impact Investing: Microfinance

59

Personnel The number of personnel that work for the MFI. This field is useful to provide a good indication of the efficiency of the MFI. If one divided the loan portfolio size by the number of personnel, then one gets information on the level of capital provided per member of staff. E.g. Equity Bank: ($536m / 4,036 personnel = Av. Loan sum responsible for: $132,758). Alternatively one divides the number of borrowers by the number of personnel, then one gets the average number of borrowers per member of staff. E.g. the number of borrowers per employee is: (542,249 / 4,036 = 134). ·Oneshouldconsiderwhatmarginonemakesonthe$132k,asevery$132kincrease in capital lending should in principle provide enough margin to cover at least a new loan officer's salary. ·Oneshouldalsoconsiderwhetheritispossibleforaloanofficertomanageatleast 134 clients (134 is the average and there will be many support staff, which inflates the actual number of clients for the on-ground loan officers). ·Oneshouldalsotakeintoconsiderationthatcomparablefiguresareimportant.It is not possible to compare such ratios between rural and city based operations. Nor is it possible to compare ratios of Eastern Europe and African operations, as the average loan sizes are very different. Number of active borrowers Number of microfinance borrowers that have a loan that has not yet been fully repaid. Number of women borrowers Within microfinance sector there is a strong tendency to lend to women as they are deemed more successful in handling money and repayments (hence lower default/writeoff ratio). It is important to check how many women borrowers there are compared to the total number of borrowers in order to take a view on forecast default rates. Number of depositors The reason to include this column is to check whether the MFI provides deposit services. This is important as there are broadly two ways to fund a financial services business. Either one attracts deposits and uses them to lend out again in the form of borrowings, or one attracts funds from the capital markets (like loans from MIVs). If an MFI has deposit services, then one should dig deeper and find out how many funds they are attracting compared to how much they are lending out. The difference is their funding gap for which they might seek loans from MIVs.

3iG International Interfaith Investment Group

Impact Investing: Microfinance

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Appendix III Examples of Microfinance Investment Funds (MIVs)

What are the main types? Microfinance Development Funds · Oikocredit · Global Partnerships · Opportunity Transformation Investments Blended Value Microfinance Funds · Calvert Social Investment Foundation · Gray Ghost Microfinance Investment Fund Registered Mutual Microfinance Funds · ResponsAbility Global Microfinance Funds · SICAV Microfinance Leaders Fund · SNS International Microfinance Fund Commercial Microfinance Funds · LocFund · Impulse Microfinance Investment Fund Private Equity Funds · Bellwether Microfinance Fund · Antares Equity Participation Fund · Accion Investments in MF · Global Microfinance Equity Fund · Aavishkaar Goodwell India Microfinance Development Company · AfriCap Microfinance Fund Holding Companies · Pro Credit · Catalyst

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Impact Investing: Microfinance

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Appendix IV What is Impact Investing

Many well capitalised faith institutions seek to invest in funds that are aligned with their values and beliefs. To select such sustainable investment opportunities it is possible to screen companies positively or negatively (white listed and blacklisted companies or sectors). A more refined way to select the right investment is to invest in companies that top sustainability indices or ratings. However, with the incentives high to rank as high as possible in such league tables, the true social and sustainable nature of such companies is being clouded over by the well presented corporate policy and image. The term "greenwash" has been adopted to identify which (often large) companies manage to use their PR expertise to position themselves as high as possible up the sustainability league tables (and attract investors), without actually having equally matching true social and sustainable policies. Faith investors that seek alignment of their values and beliefs with their investment choices are required to carry out more in-depth analysis to identify true investment opportunities. Impact Investing requires investors to actively seek and monitor investments that are truly aligned with their social and sustainable investment charter. It encompasses to enter into active dialogue with the Board and stakeholders of investments and investment opportunities with regard to adopting and monitoring the desired values and beliefs.

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Impact Investing: Microfinance

62

Appendix V Types of microfinance risks

As with every investment there is a degree of uncertainty, for which one is remunerated a return. In the case of microfinance there are a number of uncertainties or risks. Most common risks are: 1. Default risk Default risk is the risk that counterparty cannot honour its commitments. This could be interest or any other form of cash flow (like with e.g. Sharia loans), but could also include the repayment of capital. Defaults can be incurred by the microfinance borrower or any affiliated party, such as an MFI or MIV. One party's default can have a knock-on effect that causes other parties to default. Grameen had a similar situation after significant floods in Bangladesh and communities had to refinance their loans as they would otherwise have defaulted due to lack of income. 2. Currency risk Currency risk is the risk of currency movements. An investor might report (and have access to funds) in a Western currency, but make a loan to an MFI in a local currency. Although the borrower makes scheduled payments, the value of the local currency might have changed in relation to the initial exchange rate (positive/negative). This will impact the return on investment in Western currency terms. 3. Operational risk Operational risk is normally associated with the day-to-day running of the MFI. This can be minimised by conducting thorough due diligence, choosing MFIs with experienced management teams and insisting on clear and tested lending and collection procedures. Operational risk also is affected by diversification and the level of local buy-in from communities. 4.Financial risk Financial risk is often associated with the corporate governance of an MFI opposed to that of a borrower. If due to mismanagement the financial administration is not auditable to a satisfactory standard, then levels of trust can deteriorate and the financial model implodes (from an investor and borrower point of view). 5.Political risk Political and regulatory risk are external risks that are generally difficult to price. Political relates to the political stability of a country or region and regulatory relates to the stability of regulatory procedures that MFIs and investors need to adhere to. If both are stable environments with little forecast changes, then the increase in price to cover such risk can be minimum.

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Impact Investing: Microfinance

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6. Environmental risk Environmental risk is the risk of encountering natural disasters. Examples are floods and draughts, often resulting in insufficient crops, clean water and hunger. Due to the lack of such basic human needs the market for ordinary services and produce declines. This results in a decline of the economy and peoples access to income.

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Impact Investing: Microfinance

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