Debt Financing – What do MFIs need to do to Attract Capital from Banks?

At a Sa-Dhan conference in Chennai last week entitled “Enhancing Resource Flow to the Microfinance Sector”, the part of the day I found most interesting was listening to private and public sector banks (e.g., ABN Amro, SIDBI, India Overseas Bank) discuss financing MFI debt. In an area such as microfinance, where MFIs have different goals (e.g., profit v. non-profit, social missions) defining criteria for lending to MFIs can be tricky. So, although this area may not be the most exciting topic, understanding how these private players evaluate MFIs can be helpful for those institutions looking to grow their business (and for interested observers, CGAP has some done some insightful work on foreign investment linked here).

Before going into how banks evaluate MFIs , it’s worth quickly reviewing debt financing. Debt financing refers to borrowing money from outside one's company (in this case the company would be an MFI, with the lender being a bank) under outlined conditions which centre around the interest rate and number of years the MFI would have to pay back the principal. Debt financing is similar to a mortgage for buying a house, with a certain interest rate and time horizon for paying back the principal amount of the loan. This is different from private equity, in which the investor would become a part-owner in the MFI. If you are still a little unclear, this description on DARE’s website could be useful.

Criteria for Investment in an MFI

Srinivas Bonam, a Vice President at ABN Amro Bank (a private bank), clearly outlined his company’s approach to lending to MFIs. First of all, ABN Amro views MFIs as institutions that the Bank lends “through” not “to”, which mean ABN Amro cares about the individual borrowers' experience, not only the MFI. From there, ABN Amro looks at the following stages of an MFI’s performance during evaluations:
Past – Track performance of the MFI (if possible)

Present – Ability to deploy funds effectively

Future – Where does the MFI plan to go? What is the MFI’s vision?

Indicators that ABN values and evaluates when thinking about providing capital to an MFI (in order of importance given during Srinivas’ presentation) follow below:

• Reputation
• Governance
• Transparency
• Portfolio quality
• Sound business model
• Strong internal models
• Profitability (if part of model)

SIDBI General Manager R.M. Nair added that third party audits increased credibility for MFI portfolio quality and repayment stats, and also mentioned the four key areas that SIDBI (a public sector bank that acts as a apex for small businesses) analyses during funding review: 1) Governance, 2) Mission, 3) Legal structure, and 4) Balance sheet.

With priority sector lending requirements (40% of a bank’s portfolio must go to areas outlined by the Reserve Bank of India such as agriculture, microfinance), banks need to find MFI partners to loan to. That said, as banks refine their evaluation techniques, MFIs will need to compete for such financing by meeting bank demands for transparency, and information on criterion such as those detailed above.