Microfinance: Was there a crisis?

FILES: A woman who collects recyclable materials pulls her loaded cart in Phnom Penh on May 24, 2021. Photo: AFP

Scrapping the sector would spell disaster

Looking at the news these days, one may get the impression that in the microfinance sector not only is everything under control but that prospects are bright. Others pretend not to worry because in a few years, microfinance will no longer be of much relevance for Cambodia. The author disagrees with both assumptions. Neither is everything under control nor is microfinance an outgoing model.

Let us recall the facts: The microfinance sector, as the banking sector in general, has witnessed a massive rise in credit defaults as a consequence of the economic disruption caused by COVID, or in other words, we have seen many business owners and many families in severe trouble. The numbers amount to more than half a million people adversely affected. A massive debt restructuring of up to 20% took place in the sector, supported by the National Bank, to find ways to defuse their financial problems. Given the limited previous expertise that Cambodian authorities and the banking sector had with an external shock of that magnitude, one must say that the acute crisis has been managed rather well. The restructuring on the whole was successful, though not in every case and not for everyone.

At this stage, we should all recall two things: First, the present stability is the hard-gained result of a long series of measures taken by the National Bank to stabilize the microfinance sector. Second, the criticism by civil rights organizations has not stopped. So it seems reasonable to further discuss the following aspects:

First, what is the relevance of microfinance for Cambodia?  The microfinance sector – with microcredit as its core product – will be pivotal for the economic recovery of small businesses. Many of them will be in need of external capital to reassume full level of business activity. Business owners in all likelihood will not have enough money to invest in stock, materials or new equipment as savings have largely been eaten up during the past year of the pandemic. Recently collected preliminary data seem to indicate that even in times of crisis, roughly three quarters of microfinance credit is for business activities. So there is a strong case in favor of strengthening, not abandoning microfinance.

Second, did the crisis just reveal a large number of individual cases of non-compliance or did it reveal faults of the system as a whole? If so, can those systemic problems be addressed?

Civil society organizations have during the crisis reiterated their position that the microfinance sector was applying irresponsible lending practices, provoking credit failure and forcing land sales to pay back outstanding debt. They called on international investors (that lend money to microfinance institutions so that they can on-lend to Cambodian businesses) to stop supporting the Cambodian microfinance sector. While the author takes this criticism very seriously, he does not agree with some of the analysis and conclusions:

Discontinuing microfinance in Cambodia would be a disaster for the post-crisis recovery of small businesses. Also, it seems unlikely that any credit institution would deliberately provoke credit failures. It just doesn’t make sense because it means losing money. Unless, and now it gets tricky, [and civil society organizations may have a point]: Despite the individual bank’s interest in maintaining a healthy credit portfolio, the performance of the sector as a whole may produce adverse effects and unhealthy lending practices. Still, stopping the business activity of international lenders is certainly no solution for that problem, not least because it would only increase the leverage for credit sharks. Rather, what the sector does need is a review of the regulatory framework and compliance monitoring to address shortcomings of the past to make sure the root causes of the crisis are addressed.

From the author’s perspective the practical challenges center around three core issues: 

First, all microlenders should base their credit decisions for individual loans on a thorough cash-flow analysis of the client and his/her household. This means to investigate if there is enough liquidity available at any point of time to pay the instalments. In other words, a credit decision should be based on a solid cash-flow analysis, not on the value of the available collateral.

At the same time, simply prohibiting to use land as collateral, as demanded by some CSOs, is not helpful: In all developed market economies, real estate as collateral is of great relevance for the credit system. What Cambodia needs is a regulation in place that does not create incentives to force land sales or eventually take land or other assets away from clients.

Second, regulation should aim at having an incentive scheme in the lending process of microfinance institutions in place that balances risk-taking and portfolio growth with healthy credit decisions. For instance – as it is already the case for MFIs – bonus payments of loan officers should be closely tied to the quality of the loan book they have originated, not to the number or volume of new loans. Knowledge building in the institutions needs to be supported. Furthermore, any management bonus should be linked to quality and institution building in the medium term and not only to present profits as this leads to decisions that focus on a short time horizon. It is also worth noting that the risk of irresponsible recovery practices is sometimes not through formal channels: For example, undue pressure from a loan officer to repay may push a client to sell land, regardless of whether that land was placed as collateral. Even with good incentive schemes and sound regulation, irresponsible lending can still occur. This is why supervision by the MFIs themselves and the regulator is key.

Third, Cambodia’s MFI sector needs an increased transparency of credit conditions to protect customers against credit they cannot afford. An interest rate cap doesn’t do the trick. Experience shows that lenders are likely to invent and charge fees associated with the credit, which makes it much more difficult to understand the complete cost of credit – particularly in light of limited financial literacy. And apart from that, those few readers of this article who hold a degree in economics will hopefully agree that in economic history, price regulation has almost never worked.

Finally, with regard to overcoming the crisis and ensuring a solid future, the author would like to underline the important role of civil society organizations: It was the call by those 108 organizations that triggered subsequent multiple action as the COVID crisis loomed large, stabilizing the situation of hundred thousands of debtors and their families as well as creating the framework for stabilizing the banking system. Civil society organizations have put the spotlight on to cases where taking credit has not been to the benefit of customers. What still remains to be investigated is if these cases are isolated events or if they reveal a widespread continuous systemic problem.

Cambodia has one of the world’s highest rates of microfinance indebtedness. This is an indicator for a low level of credit literacy.  For a sound microfinance system, high credit literacy is just as important as a good regulatory framework. This is a field where the participation of civil society organizations is essential for success.

In conclusion, all relevant actors, including bankers, authorities and civil society organizations     should undertake a joint effort, analyzing and using  all available data, to discuss and refine existing credit regulations, and set up a system that ensures compliance, including a joint effort to strengthen credit literacy. As a contribution from the German side to this complex discussion and now that the pandemic is under control, an on-the-ground survey to assess the impact of microfinance in Cambodia will start in early 2022.

The author is well aware that the discussion he is suggesting will not be an easy one. However, it is in the interest of hundreds of thousands of present and future small lenders to undertake a joint effort towards a sustainable healthy microfinance sector.

Christian Berger is German Ambassador to the Kingdom of Cambodia

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