Microfinance Evolution To Sme Lending In South Asia

THE

MICROFINANCE

EVOLUTION TOWARD MSME LENDING

Lessons from Pakistan Kirsten Weiss

The Microfinance Evolution Toward MSME Lending: Lessons from Pakistan Published in Pakistan in February 2008 by ShoreBank International Ltd. (SBI) under the USAID-funded Widening Harmonized Access to Microfinance (WHAM) project.

Authored by Kirsten Weiss Reviewed by Gregory Chen, Laila Velji, Tabinda Jaffery Design and Layout by Sumaira Sagheer Printed at PanGraphics (Pvt.) Limited, Pakistan Copyright © 2008 ShoreBank International Ltd. 2230 S Michigan Ave, Ste 200, Chicago, IL 60616 USA Tel: +1.312.881.5800, Fax: +1.312.881.5801, www.sbksbi.com All rights reserved. For further information, contact Kirsten Weiss at [email protected]

The views expressed in this document are those of the author and do not necessarily reflect the views and policies of ShoreBank International Ltd. (SBI) or the donors who have funded the study. SBI does not guarantee the accuracy of the data included in this document and accepts no responsibility for any outcome of their use.

THE

MICROFINANCE

EVOLUTION TOWARD MSME LENDING

Lessons from Pakistan By KIRSTEN WEISS

Acronyms FMFB First MicroFinanceBank GNI Gross National Income (using the Atlas method) MFB Microfinance Bank MFI Microfinance Institution MSME Micro, Small and Medium Enterprise PMN Pakistan Microfinance Network ROA Return on Assets ROE Return on Equity Rs. Rupees (at time of publication, the exchange rate was roughly Rs. 60 = $1) SBI ShoreBank International SBP State Bank of Pakistan USAID United States Agency for International Development WHAM Widening Harmonized Access to Microfinance

The USAID-funded Widening Harmonized Access to Microfinance Program (WHAM), which began in May 2005, is a three-year project which seeks to stimulate lending to the “missing middle” of Pakistan's micro, small and medium enterprises (MSMEs). One factor in urban poverty in Pakistan is lack of access to capital for individuals who live slightly above the traditional poverty threshold for microfinance, but remain below income levels supported by the traditional commercial finance sector – small businesses which require funds in the $500 - $50,000 range. Evaluating the rationale for this type of lending, alongside its effectiveness and impact as an economic development tool, is a critical element of the project.

ShoreBank International (SBI) is an international financial advisory and solutions consulting firm with its roots in ShoreBank Corporation, the largest and oldest community development bank in the United States. Among its activities, SBI assists MFIs with long-term financial modeling, developing and implementing performance-monitoring tools, new product development, establishing policies and procedures, and pricing and profitability modeling for small enterprise lending.

Kirsten Weiss is a Senior Consultant with ShoreBank International. She is a small enterprise and microfinance specialist with over 12 years of international experience managing and supporting the development of micro, small and medium-sized enterprises. Her background includes microfinance, microleasing, grant management, coaching, product development for MFIs, and institution capacity building and training in transitional economies of Southeast Asia and the former Soviet Union. She has extensive experience working within microfinance apex institutions. Her US experience includes five years with the private sector in accounting and marketing. Ms. Weiss has an MBA in International Management from Thunderbird, the Global School of Management.

Table of Contents Executive Summary

01

1. The Evolution of Microfinance in Pakistan

02

2. Defining Small Enterprise Lending

03

3. Why Do MFIs Up-scale?

04

Demand Drivers

04

Competitive Drivers

04

Financial Drivers

05

4. How Is the Market Accessed?

07

Know Your Market

07

Select an Appropriate Methodology

08

Align Human Resources

10

5. Development Impact

12

Developing the Economy

12

Expanding, Rather Than Diluting, the Mission

12

6. The Future of Small Enterprise Lending and Lessons for Donors

14

Works Cited

15

“There are no shortcuts in evolution.” Louis D. Brandeis

Executive Summary As small enterprise lending grows in Pakistan, this paper considers why MFIs are adding it to their portfolios, how MFIs are reaching this market, and what the impacts are at the MFI and development level. Pakistani MFIs are evolving into more demand-driven entities, and because of this, three imperatives are attracting them into the Micro Small and Medium Enterprise (MSME) market: 1. Demand Drivers: The small enterprise lending market has been largely ignored by the formal financial sector and small enterprises are frequently found in the same districts where MFIs operate, creating a tantalizing market opportunity. 2. Competitive Drivers: Though the microfinance market is still relatively untapped, competition for the same types of clients in the same parts of the country has been fierce, driving some MFIs to diversify the breadth of their product offerings to new market segments. 3. Financial Drivers: The larger loan size with its attendant higher receipts per loan is expected to help organizations drive stronger bottom line financial performance. However, profitability is largely dependent on efficiencies, such as tight geographic targeting of clients, a strong screening program, and decentralized approval procedures. Another important issue that MFIs have encountered relates to how these small enterprises are accessed: which market to target, and which methodology and loan officers to use. The key to successful market penetration is a strong understanding of the market, which includes identifying a segment which is large enough to be profitable and similar enough to be organized into a useful marketing group. Segmentation also requires understanding which features of the loan product the segment cares about most when making the buying decision, and marketing the product accordingly. Next, the lending methodology must account for the additional risk of larger loan sizes and fewer social guarantees, while remaining cost efficient for the MFI. A $500 loan should not undergo the same underwriting process as a $500,000 bank loan. The decision as to whether to introduce specialized small enterprise lending officers or utilize existing microfinance lending officers balancing multiple portfolios can have dramatic repercussions. While there is no “right” answer, the human resources strategy must be carefully plotted. Finally, this paper refutes the idea that small enterprise lending in Pakistan has resulted in “mission drift” or a diversion of resources from poverty lending. Data suggests that entering the small enterprise market does not divert resources from traditional microfinance, and small enterprise lending may in fact have a positive impact on jobs creation and other development indicators.

01

02

1. The Evolution of Microfinance in Pakistan Pakistan's microfinance industry has been undergoing a gradual evolution. In its initial stages, the industry was dominated by NGOs which provided integrated microfinance and social services, with missions that did not focus upon sustainability or outreach. Gradually, NGOs began separating their microfinance and social programs, enabling a better understanding of cost structures and sustainability. However, by 1996 Pakistan only had 40,000 microfinance borrowers. That same year, the first specialized microfinance NGO, Kashf, started up in Pakistan. Sustainable, scalable microfinance had begun. Microfinance Institutions (MFIs) began the evolution into demand-driven entities focusing on the unbanked rather than limiting their target market to the poorest of the poor. In 2007, the number of active microfinance clients in Pakistan crossed the 1.4 million borrower threshold, with the number of borrowers roughly doubling between 2005 and 2007. This sharp upward trend reflects Pakistan's massive investment in microfinance during the first half of the decade as well as its new focus upon sustainable, scalable lending. Because of its recent expansion, Pakistan's microfinance industry can still be considered in its adolescent stages; though microfinance activities have existed in Pakistan

“Donors such as USAID, which supported innovations, played a significant role in the evolution to MSME lending.”

for decades, it has only been within the past five years that the industry has hit its stride. Within this context, in 2005, the United States Agency for International Development (USAID), identified a gap in lending – what they came to call the “missing middle”. This gap consisted of entrepreneurs with businesses and lending needs too large for MFIs but too small for banks to serve. To finance growth, this group of entrepreneurs was forced to rely upon savings, loans from family and friends, or supplier credit, the latter which verges on

Tabinda Jaffrey, CEO, Asasah

the usurious. In order to facilitate financing to this “missing middle” USAID designed the Widening Harmonized Access to Microfinance (WHAM) project, managed by ShoreBank International, with the goal of stimulating lending in the Rs. 30,000 - 3,000,000 ($500 – 50,000) range. SBI decided only to work with MFIs which could make small enterprise loans without diverting resources from their traditional microfinance lending, and which had a demand imperative to enter the small enterprise market. Over 25,000 of these small enterprise loans were made by MFIs involved in the WHAM project, making a significant addition to Pakistan's microfinance evolution – the drive by MFIs to become MSME lenders. Today, some Pakistani MFIs are tapping into the “small” enterprise portion of the SME market. Will they continue to expand their services in the future? If Pakistan follows the trajectories of its South Asian neighbors, perhaps.

2. Defining Small Enterprise Lending Several MFIs in Pakistan are “up-scaling”, stretching past their traditional microenterprise market to lend to small enterprises. But what are these small enterprises? And what exactly constitutes a small enterprise loan? For that matter, what is a traditional microenterprise loan? In Pakistan, the bulk of MFIs' traditional group lending utilizes groups of 15-25 people, mainly women, delivering average loans of Rs. 12,122 ($202) per person (Pakistan Microfinance Network (PMN), MicroWATCH Issue 5). In contrast to these microentrepreneurs, the United States Agency for International Development (USAID) has identified a small enterprise market unserved by formal financial institutions in Pakistan, and including firms with credit needs ranging from Rs. 30,000 to 3,000,000 ($500 - $50,000). Then what exactly is small enterprise lending? Individual lending is one possible proxy for it, under the assumption that individual loans are larger sized and aimed at larger businesses, as is typical in other countries. As of September, 2007, MFIs reporting to the PMN had over 91,000 individual loan borrowers (PMN, MicroWATCH Issue 5). However, the average loan size for these borrowers was reported at only Rs. 24,869 (PMN, MicroWATCH Issue 5), a number larger than Pakistan's traditional microlending but still falling beneath the identified range of Rs. 30,000 – 3,000,000. Still, this is an average so while individual loans may not represent a perfect proxy for small enterprise lending, they can give us an idea of the direction the market is trending. What about Pakistan's microfinance banks? Are they involved in small enterprise lending? Some, such as Tameer Microfinance Bank, specialize in it. However, Pakistani microfinance banks are capped by prudential regulation to loans of Rs. 150,000 ($2,500)1 – within the identified range but only reaching into its lower tier. To date, the development of this small enterprise lending market has been lead primarily by MFIs such as Asasah (with average small enterprise loans of Rs. 36,495), Kashf Foundation, Tameer Microfinance Bank and FirstMicroFinance Bank.2 Pakistan's microfinance industry has self-defined small enterprise lending as consisting of loans between Rs. 35,000 – 100,000 ($580 – 1666) and consisting of both individual lending and Latin American-style solidarity group lending (Table 1). Table 1: MFIs' Small Enterprise, “Standard”, and Consumption Lending in Pakistan

Loan size Purpose of loan Collateral Installments Loan term

Small Group and Individual Loans

Large Group (Traditional) Microfinance

PKR 35,000 – PKR 100,000 (US$ 580 - US$ 1,700)

PKR 1,000 – PKR 35,000 (US$ 17 - US$ 580)

Working capital, livestock loan. More emphasis on personal guarantee/s

Enterprise loan, refinancing loan, consumption loan Large group guarantee

Fixed and equal monthly

Fortnightly or monthly

12 months

10 - 18 months

(Burki and Shah, 11-12) 1

03

Current limits on microenterprise loan size are set by the State Bank of Pakistan at Rs. 150,000, however, microfinance NGOs are not covered by these restrictions. 2 The predominant service for small enterprises remains credit. First MicroFinanceBank is a full service bank and does provide some checking, deposit and fund transfer services to its clientele. Other organizations may in time add noncredit services for small enterprises as well, but these services remain underdeveloped as a whole.

04

3. Why Do MFIs Up-scale? Lending to the very poor remains a priority for Pakistani MFIs, yet some have expanded their mandate to finance micro and small enterprises. Donors such as USAID have no doubt provided added impetus for MFIs to introduce new products reaching these markets. However, were MFIs not demand-driven, donor funds and technical assistance would have little long term affect. Rather, demand-driven MFIs are drawn to this new market by three key considerations: client demand, competition, and improved financial performance.

Demand Drivers As the microfinance philosophy evolved from a focus on charity to scalability and sustainability, Pakistani MFIs became more conscious of market demand. As Shahid Maqsood from Kashf tells it: “Mr. Greg Chen of the WHAM project and Kashf's CEO Roshaneh Zafar were walking through the old city of Lahore. Mr. Chen pointed to some small shops in the bazaar. 'Where do these people get financing from?' he asked. 'Let's find out,' Roshaneh responded. As they proceeded to interview the shop owners, it became clear to Roshaneh that this was a potential market for Kashf that deserved further research.”

Case Study: Demand drives innovation Asasah, an MFI based in Lahore, discovered that some of its traditional microloan clients had much higher borrowing needs and repayment capacity than the MFI's existing microloans served. These borrowers confessed in interviews that the traditional microloans they had taken in the past had been too small to be useful, and had not been used for business purposes but only as a foothold into the Asasah system. This was seen as a testament to the need for larger loan sizes; the traditional Asasah microloans had twelve month loan cycles and required monthly meetings – a significant commitment for someone who couldn't really utilize the loan. Small enterprise lending represents an opportunity for MFIs to expand their market without having to invest in new branches. Potential small enterprise borrowers are situated in many of the same areas where MFIs provide traditional microloans. Because of the MFIs' knowledge of these areas and their existing facilities within them, there are incentives and efficiencies to servicing these small enterprises. Small enterprise lending, therefore, is frequently begun by MFIs in urban or peri-urban areas where both micro and small enterprises are located. Indeed, Lahore is a classic example of this, with Asasah, Kashf, First MicroFinanceBank, and Tameer Microfinance Bank all introducing small enterprise lending products there.

Competitive Drivers In Pakistan, despite total microfinance market penetration estimated at a lowly 4.68%3, there remains intense competition in certain urban areas for traditional microcredit clients. This is particularly evident in the city of Lahore, which has twelve MFIs with offices in overlapping “territories.” 3

Members of the Pakistan Microfinance Network reported 1.37 million borrowers. However there are nearly 30 million people beneath the poverty line. (Pakistan Microfinance Network, MicroWATCH Issue 5).

This overlap is reflective of the traditional “bazaar” marketing model. Bazaars attract large numbers of clients to a small area for similar types of goods. Stall owners selling similar or even identical goods (e.g. spices) then compete for these clients, whose vast numbers guarantee that sales will be made. The model is in a sense a substitute for advertising and market segmentation. However, while many Pakistani MFIs have similar or identical products, competing to sell spices in a bazaar is a far cry from competing to sell microloans; a spice seller doesn't have Is the spice bazaar a good marketing model for MFIs?

to get the spices back, plus interest. In the case of Lahore, the “bazaar model” of tightly clustered MFI branches has led to clients taking loans from multiple MFIs at the same time, and to the rise of microcredit “wholesalers” to facilitate this practice (Burki & Shah, 2007). This unhealthy market competition has been an added incentive for MFIs in hotly contested urban areas to quest for new market segments within their existing geographies by adding credit products for small enterprises; it's more cost effective in the near-term to expand from an existing location than to open up a new one.

Financial Drivers Small enterprises require larger loans than microenterprises and because of this, MFIs concerned with sustainability and scalability anticipate that small enterprise lending will be more profitable than traditional microlending. Globally the profit margins, return on assets (ROA), and return on equity (ROE) are indeed significantly higher for MFIs making larger, individual loans (see Table 2, below). Little wonder that the expectation of profitability compels many to enter, particularly when combined with the risk reduction that accompanies portfolio diversification.

Table 2: Global Microfinance Performance by Methodology Average Outstanding Balance

Average Outstanding Balance/GNI per capita

ROA

Financial Sustainability

Profit Margin

Real Gross Portfolio Yield

Loans per loan officer

Operating Expenses/ Loan Portfolio

PAR90

Individual

$1,087

57.1%

1.3%

110%

9.5%

19.6%

190

14.9%

1.8%

Individual and Group Loans

$347

41.2%

.4%

104%

3.9%

24.3%

234

23.9%

1.6%

Group loans

$122

15.8%

-.2%

102%

1.9%

20.8%

234

24.9%

.6%

(MicroBanking Bulletin, 2006)

But is this sort of lending more profitable in Pakistan? Pakistan's 2006 average outstanding balance/GNI per capita for individual loans is 49%4, compared to 57.1% globally (see Table 2, above). While this puts individual loan sizes in Pakistan a bit on the low side in terms of GNI, the smaller number is likely a positive thing. MFIs globally have found that “step crediting” – starting first time borrowers with a small loan and increasing the size in later 4

Using the average outstanding balance as of December 31, 2006 from the PMN's MicroWATCH, Issue 3, Quarter 1, pg. 6 and the Atlas method of computing GNI, which removes some of the exchange rate volatility and is used to calculate GNI in the MicroBanking Bulletin. Using the purchasing power parity methodology, GNI per capita for 2006 was $2,500.

05

06 terms – is just as effective a risk reducer for individual lending as for group lending. Since individual lending is still relatively new in Pakistan, it makes sense for the loan sizes to be smaller. But there is likely still room for growth in loan sizes, and this should improve profitability. Assuming the average “traditional” Pakistani group loan consists of around 20 women per group, with each borrower receiving on average Rs. 12,000 ($200), one arrives at a total loan of Rs. 240,000 per group. In order for an individual small enterprise loan to be more profitable, it would either have to be larger (over Rs. 240,000), more efficient to deliver, or have a higher interest rate. As the average individual loan in Pakistan was Rs. 24,869 ($414) in 2007, they are certainly not larger than a traditional group's loan. That leaves higher interest rates and higher efficiencies, if individual lending is to be profitable. Globally, individual lending profitability gains do not tend to be achieved by higher interest rates. Yields on individual loans worldwide tend to be less than those for group lending (see Table 2) and Pakistani MFIs charge the same or lower interest rates for their “up-scaled” loans. Small enterprises tend to be more sensitive to price than traditional microborrowers, exerting downward pressure on prices. With prices for up-scaled loans the same or lower than those for traditional microfinance, this leaves efficiency as the profitability driver. Efficiency is an issue as important in small enterprise lending as it is for traditional microlending, if not more so. In Pakistan and elsewhere, MFIs have found that utilizing strong screening procedures and monthly repayments, targeting geographic clusters of clients, and maintaining a streamlined, decentralized approval process can all greatly reduce costs while maintaining portfolio quality.

Screening reduces cost and risk Screening may seem like just an extra step in the process, but that extra fifteen minutes with a client can save hours of waste. A simple, one page form can be used at first contact to screen out unsuitable clients before the MFI spends too much time on underwriting. But what of portfolio quality? Small enterprise lending by MFIs – whether in a small solidarity group or as an individual loan – does not appear to generate significantly higher delinquency or write-off rates. Looking again at the global statistics, portfolio at risk and write-off ratios are higher for large individual loans compared to solidarity loans – 1.4% to .3% (MicroBanking Bulletin, 2006) but remain well within acceptable norms. However, MFIs should not assume their existing loan methodologies will enable them to achieve such sound portfolios. Risks are different for up-scaled loans, and they must be managed differently than group loans, if MFIs are to maintain strong repayment rates in these portfolios.

“Marketing to individual borrowers is entirely different and more intensive than marketing traditional group loans. In group loans, the loan officer introduces the product to 3-4 people, who then go out and do the marketing for us to generate a group. In individual lending, the loan officer must go door-to-door in markets, bazaars and the streets, selling the loan one-on-one.” Shahid Maqsood, Kashf Foundation.

4. How Is the Market Accessed? Globally, only 10-30% of traditional microenterprise borrowers appear capable of graduating to larger, small enterprise loans (Delliens, 14). While microloans have appeared to increase income levels and household consumption (Qureshi, 26), few microentrepreneurs have the management or financial capacity to significantly expand their enterprises. This is in part due to low literacy, which prohibits management planning (Qureshi, 22), in part to a habitual reliance on cheap labor rather than mechanization, and in part to the fact that microloans are fungible, frequently going to support household expenses. Thus, one of the first lessons of developing a small enterprise portfolio is that few existing clients will graduate to larger loans and this in turn changes the market the MFI is attempting to access. When Kashf, for example, segmented its small enterprise product, the MFI concluded that fewer than 10% of its current borrowers would “graduate” to the small enterprise product. Therefore, in order to significantly enter the small enterprise market MFIs must reach out to new borrowers, who don't have prior credit histories with the MFI. But with the traditional microfinance underwriting process dependent upon group solidarity dynamics and “step crediting,”5 how can MFIs identify and safely lend to business owners without prior credit histories?

Know Your Market To effectively manage the addition of small enterprises to the loan portfolio, clients within the small enterprise market must be clearly identified. Experience in Pakistan has shown that small enterprises with credit needs in the range of Rs. 30,000 – 100,000 ($500 – 1,666) can be effectively financed through either small solidarity groups or individual lending approaches. This knowledge, however, does not spell success in the small enterprise market. Loan size is only one aspect of segmentation, and frequently the least important. To achieve scale and profitability, MFIs must know more. It is tempting to assume that the small enterprise market of loans between Rs. 30,000 – 100,000 constitutes a single segment. It doesn't. And yet it is by loan size that MFIs most frequently define their markets. In Pakistan, small enterprise “loan sizes, especially for new clients, are pre-determined and not always responsive to business needs.” (Qureshi, 1). If MFIs are to provide value to clients, they must provide a loan size the client can utilize not one based on pre-defined ranges. Why do so many MFIs fall into this trap? Because it's easy, and because MFIs are frequently directed by their social mission and/or by State Bank regulations to cap their loan sizes. The small enterprise loan range of Rs. 30,000 – 100,000 identified by USAID only represents loan sizes not currently available through formal financial institutions to businesses in Pakistan – it does not represent a segment of borrowers. Within that range of loan sizes, there exist multiple segments with differing needs and concerns regarding product features besides loan size, such as price, speed of delivery, and point of access. Which segments the MFI decides to target within this loan range will affect the marketing, price, product, place and promotion – of the product. Asasah, for example, initially 5

“Step crediting” describes the process of starting borrowers with small loans and the promise of larger future loans if the initial loans are repaid on time. This is a key driver of high repayment rates in microfinance.

07

08 identified small retail shops and manufacturers as customers for its small enterprise product. The mindset and attitudes of these small business owners differed so significantly from that of Asasah's traditional microborrowers, however, that the MFI's loan officers found it difficult to sell the benefits of its small enterprise loans. The MFI then realized that it

Effective segmentation entails: Easy identification by staff of clients within the new segment. A clear fit between the market segment, the methodology, and the product

features, demonstrated by high client retention rates. Developing standardized but flexible products capable of serving multiple segments. Segmentation does not mean developing multiple products for each segment it means understanding what different segments want and how to communicate with them. was neglecting another market segment within the same loan size range which they already had strong experience serving – home-based businesses managed by women with a “traditional microfinance” mindset. Asasah had to discard its initial understanding of small enterprises as small shops and manufacturers located outside the household to successfully develop its portfolio. Only by determining which types of small enterprises Asasah really had the best strategic fit with, was the MFI able to make progress in the market. As far as a general profile of this market goes, clients tend to be most frequently traders, followed by manufacturers (Qureshi, 12-20). The vast majority are sole proprietorships, with the remainder unregistered family partnerships. Loans tend to be used for working capital; investments in plant and equipment are limited by the loan sizes on offer. Nearly half of small A Small Enterprise Borrower?

enterprise borrowers are illiterate or semi-literate, likely a driving force towards them starting their own businesses as formal employment opportunities for this group are few (ibid). However, while these definitions may provide a helpful starting point, they still require further refining by the individual MFI. Through segmentation and targeting client needs, not only can MFIs better serve their clients but they can also differentiate themselves from each other.

Select an Appropriate Methodology Large Group, Small Group, or Individual Lending: As loan sizes increase there is a downward pressure on group size, leading eventually to a switch to individual lending. This occurs for the simple reason that group borrowers become less willing to guarantee each other's loans as the loans get larger. But what to do without group solidarity? Unable or unwilling to take collateral, Pakistani MFIs involved in individual lending to small enterprises have typically buttressed this missing group solidarity through guarantors – another form of social pressure – rather than requiring collateral. However, as Asasah and First MicroFinanceBank have proved, small groups do work up to a certain threshold, which is determined both by market segment and by loan size. Today, Pakistan's emerging small enterprise lending methodologies range from small groups to pure individual loans.

Levels of Financial Analysis: Traditional solidarity lending methodologies do not adequately manage the risk inherent in larger loan sizes. Every borrower has a limit when it comes to the size of the loan installment they can consistently repay. This makes the assessment of debt capacity a crucial element of small enterprise lending. Capacity analysis can, however, be a challenge for microfinance lenders steeped in large group lending methodologies that focus more on poverty assessments (i.e. ensuring the borrowers are “poor enough” to qualify) rather than an assessment of the borrower's ability to repay. Individual lending tends to rely more heavily upon financial analysis than small group lending, though both incorporate some level of financial analysis. MFIs might at first be tempted to adopt commercial bank-style financial analysis; however, the reality is that in Pakistan it is difficult if not impossible to accurately obtain this sort of financial data from these target businesses, a fact loan officers can be quick to ascertain. Once loan officers lose faith in the process, believing they are only “going through the motions” and collecting useless data, the temptation to fill out the MFI's loan forms with false data or to neglect cross-checks of the data can prove irresistible. MFIs should, therefore, decide how much financial analysis is realistic, usable, and efficient for loans under Rs. 100,000 ($1,166). For example, attempting to value fixed assets for inclusion in the balance sheet is of little use if loan officers are incapable of assessing the asset with any degree of accuracy. Further, an MFI's clients, by definition, tend to have few fixed assets of any value. Lack of assets is why they are clients, and should not be a barrier to accessing credit. On the other hand, a valuation of the client's inventory – a type of current asset – can be feasible and useful. Many, if not most, borrowers will use the loan for inventory purchases, and understanding how much the loan will increase existing inventory can go a long way towards capacity assessment. Table 3: A Comparison of Methodologies Advantages

Disadvantages

Large group

No external guarantors required Extensive loan officer time required Works well in rural areas Less marketable in urban areas Attractive to female borrowers Unattractive to male borrowers Borrowers carry burden of risk analysis

Small group

Larger loan sizes than large group Works better in urban areas where

clients have less of a social network Underwriting simpler than individual loans

Individual loans

Most palatable to male borrowers Works better in urban areas where

clients have less of a social network

Fewer repayment meetings required Largest loan sizes Greater flexibility for clients

Extensive loan officer time required to

both manage groups and conduct additional analysis Loan officers need some analytical skills

Loan officers need analytical skills Different risk profile than group loans Requires more intensive marketing

Globally, most MFIs avoid developing pro-forma financial statements over the life of the proposed small enterprise loan due to the costs involved and to the difficulty obtaining reliable data. Instead, they analyze whether the borrower could pay the proposed loan today (Churchill, 1999). For up-scaling loans utilizing small solidarity groups (e.g. of 3-5 borrowers), some MFIs reduce the analysis to a simple cash flow statement alongside a few easy ratios which can be calculated with some degree of accuracy, (e.g. inventory turnover, average collection period, or current ratio) or even to a quick comparison of inventory to 09

loan size.

10 In the end, there is no single “correct” methodology – it will vary by target market and the MFI's capacity, creating a continuum whereby loan sizes increase alongside financial analysis as group size decreases (see Figure 1). However, the borrower's character as an element of underwriting is never neglected, and neither should it be. Figure 1: Methodology and Level of Financial Analysis

Methodology Individual

Loan Size per borrower

Small Solidarity Group

Large Group

Poverty Assessment

Minimal Financial Analysis

Moderate Financial Analysis

Level of Financial Analysis

Align Human Resources Human resources can become a contentious issue when small enterprise lending is introduced in an MFI. It should not be assumed that a “traditional” microcredit loan officer will automatically be successful in small-group or individual lending, which require a

“The mindset of the loan officers had to be changed.” Inshan Ali, COO, First MicroFinanceBank

different kind of analysis and sales approach. Therefore, a key question when adding small enterprise lending is whether or not to allow “traditional” microfinance lenders to manage the new small enterprise product. There are pros and cons to either approach. Specialization: Advocates for developing a specialized small enterprise staff and/or department note the difficulties in transitioning existing staff members, who will likely require extensive training in capacity analysis. A common response to such a transition, and one observed by this author in Pakistan and elsewhere, is for loan officers to strenuously resist the collection of additional data. Uncomfortable with the extra calculations and convinced that small enterprise repayment is as character-driven as it is in traditional group lending, loan officers then fill in loan applications with numbers invented by the loan officer that will qualify the borrower for a disbursement. This mindless form-filling can only be countered by staff that is comfortable with real analysis, e.g. who understands when numbers provided by the client don't make sense and is able to formulate strong follow-up questions and to evaluate the answers. Additionally, traditional microfinance staff given the extra task of penetrating the small enterprise market may find it difficult to understand how to identify and sell to the new segments. A Pakistani male trader who manages a small shop has a far different mentality than an impoverished woman making ends meet by working from home embroidering dupattas. Women tend to be more willing to “put up with” the onerous rules, pledges, and meetings that group lending requires, alongside the sometimes paternalistic attitude of the loan officers who lead these meetings. The average Pakistani male shop owner may require a less dogmatic and more egalitarian approach. Not all loan officers are able to make this attitudinal change.

When Kashf designed its small enterprise loan product, therefore, it recruited bettereducated loan officers who had the skills required to mine and analyze its clients' financial information. The foundation plans to go a step further and transfer this loan portfolio and its staff to the new Kashf Bank in 2008, creating an even stronger delineation between the programs. Keeping It All Together: Other MFIs, such as First MicroFinanceBank and Asasah, enable their loan officers to make both traditional and small enterprise loans, eschewing specialization. This approach tends to be more successful when the existing loan officers have above average financial skills. Additionally, in Pakistan it is difficult for MFIs to hire staff which have a high level of financial skills and are willing to accept the salaries on offer, as well as to submit to the arduous field work required – a strong motivation to use existing staff. Retaining the same loan officers for both products can also mitigate potential morale problems. Sometimes creating two departments can set up an unhealthy competition

“If you move loan officers from large to small groups, they don't want to do the extra analysis. They're used to putting the analysis on the shoulders of the clients, used to relying upon one or two good people within the group to keep the group together. MFIs need a mix of old loan officers who understand the mission, and new loan officers who can bring new skills and mentor fellow staff.” Tabinda Jaffrey, CEO, Asasah

between the small enterprise lenders, who have more advanced analytical skills, and traditional microloan officers. It takes diligence and some finesse on the part of management to ensure such ruptures do not develop. Allowing traditional microloan officers to make small enterprise loans can also increase staff retention, providing the loan officers with new skill sets and diversifying their activities. Finally, creating separate small enterprise and microlending divisions can even further restrict the flow of “graduates” from the traditional large-group microloan program to the small enterprise portfolio. Loan officers in the traditional microfinance program may be unwilling to hand over a good client to the small enterprise unit if it results in a reduction in their own loan portfolio and any attendant portfolio bonuses. In its pilot test of the small enterprise product, Asasah used specialized small enterprise lending officers. However, it found that this limited growth. Therefore, after the test was complete, the MFI decided instead to simplify the small enterprise financial analysis so their existing credit staff could manage it without much additional training. Staffing Issues and Reaching Female Borrowers: A mission-related issue is how staffing choices affect the number of female borrowers. In Pakistan, it is much easier for female loan officers to reach female borrowers. As personal sales remains a key marketing element of both small enterprise and microlending, an MFI serious about including female small enterprise borrowers would be wise to evaluate its proportion of female to male loan officers.

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5. Development Impact The entry of MFIs into Pakistan's small enterprise market, which is starved for reasonably priced credit, is encouraging. But MFIs generally exist to achieve social and development goals. Does serving the small enterprise segment achieve these objectives? Many development institutions have begun to change their understanding of the impact of and reasons for introducing credit. There has been a shift from a sole focus on poverty alleviation and towards economic development as a whole, under the theory that “a rising tide lifts all boats.” Those who advocate for small enterprise lending argue that providing credit to small enterprises can have a larger economic impact than the provision of microcredit, arguing that small enterprises generate more employment. Are they correct?

Developing the Economy A recent study of Asasah’s small enterprise lending program indicated that while few borrowers were spurred towards high productivity growth due to their loans, firms expanded their sales and business income. “The most commonly reported use of loan proceeds was increase in inventory, and this helped increase business income by 1) increasing sales and 2) reducing input costs, primarily through quantity discounts and [the] ability to buy on cash. In keeping with the increase in sales and business income, employment also increased,” (Qureshi, 30). The firms in the sample also played a significant role in community development, providing goods and services which met the needs of the economically disadvantaged in their neighborhoods (Qureshi, 2-3). Though this study can by no means be considered the final word on the matter, it does support the argument that small enterprise lending is a viable means of economic development.

Expanding, Rather Than Diluting, the Mission Another concern about MFIs adding small enterprise lending is that it may lead to mission drift through a shift away from poverty-targeted lending. First MicroFinanceBank's Chief Operating Officer (COO), Inshan Ali Nawaz, argues that providing both small enterprise and traditional microfinance represents a holistic approach, enabling the bank to develop incomes in rural villages (traditional microfinance) and in the small rural towns that provide the villages with goods and services (small enterprise finance). Figure 2: Traditional microfinance continues to dominate in Pakistan

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Active Borrowers by Methodology - Pakistan 1400000 1200000 1000000 800000 600000

Group

400000

Individual

200000 0 3rdQ’06

6

4thQ’06

1stQ’07

2ndQ’07

3rdQ’07

Data compiled from the Pakistan Microfinance Network's MicroWATCH, Issues 2, 3 and 5.

The evidence from Pakistan and abroad supports this holistic delivery concept, as in most cases both the traditional microfinance and the small enterprise lending programs have grown in tandem (see Figure 2). The 2006 MicroBanking Bulletin data shows that globally, MFIs engaged in both solidarity and individual lending averaged outstanding loan balances of only $347, compared to $122 for MFIs engaged solely in solidarity lending (MicroBanking Bulletin, 2006) – the former are larger loans for sure, but still small enough to only be of interest to economically disadvantaged persons. In Pakistan, the average loan balance for MFIs remains only Rs. 13,018 (just over $200) (PMN, MicroWATCH, 6), in spite of the introduction of larger loan sizes. It appears that small enterprise lending has not resulted in mission drift when it comes to serving the poor. In fact, Pakistani MFIs such as Asasah have continued to “downscale” to consumption lending even as they take on small enterprise lending. However, small enterprise borrowers in Pakistan remain overwhelmingly men. This is because in Pakistan, women are less inclined to manage enterprises of any size outside the home, and as loan sizes move away from supporting the household and towards developing small businesses, they also move away from women (Figure 3). Figure 3: As loan sizes increase, female borrowers decrease.

Methodology Individual

Men Small Solidarity Group

Women Large Group

Poverty Assessment

Minimal Financial Analysis

Moderate Financial Analysis

Level of Financial Analysis

Kashf's original mission focused on providing support to women. Its individual lending product, however, targets primarily men. Kashf reconciled this apparent dissonance by extending its mandate to serve the unserved – both men and women. As small enterprise lending has grown alongside traditional microfinance, the ratio of active male to female microfinance borrowers has remained stable7. Expanding into MSME lending has not led to an abandonment of the mission.

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Data compiled from the Pakistan Microfinance Network's MicroWATCH, Issues 2, 3 and 5.

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6. The Future of Small Enterprise Lending and Lessons for Donors In Pakistan, poverty-focused lending has expanded alongside small enterprise lending because MFIs have made strategic decisions about their mission, capacity and portfolio allocations. These decisions can be considered strategic because the introduction of small enterprise lending affects an MFI's marketing and human resource strategies, financial performance, and development impact. For these reasons, up-scaling to include MSME is not for the faint of heart. It is little wonder that those MFIs that have added small enterprise lending are among the strongest in Pakistan – those that are the fastest growing and are at or on their way to self-sustainability. The evolution of Pakistani MFIs moving from microlenders to MSME lenders remains in its nascent stages, with MFIs only grazing the lower echelons of the small enterprise market. ShoreBank International, which is working with “up-scaling” MFIs through USAID's Widening Harmonized Access to Microfinance project, is confident that these efforts represent a natural evolution that will strengthen the industry and significantly contribute to Pakistan's economic development, as it has in other countries. In the meantime, Pakistan's small enterprise market has begun slowly, tentatively attracting other, formal, financial institutions. The National Bank of Pakistan has made loans as low as Rs. 150,000 through its new small enterprise lending program. If MFIs do not continue to provide value to small enterprises through competitive pricing, speed of service, etc, they may eventually be sidelined by more commercial competitors. Knowing the market and delivering the best and most efficient product possible will, therefore, become even more critical as Pakistani MFIs evolve to expand their outreach.

Lessons for Donors Technical assistance and financing can spur movement into the MSME market if: 1. MFIs have reached sustainability and scale with a core “traditional” microfinance product; 2. MFIs have the institutional capacity to implement the structural changes necessary, for example regarding staffing and efficiencies; and 3. There is a market imperative to becoming an MSME lender, for example a large potential client base. By following these three lessons, the MFIs which worked with WHAM are able to continue to expand their small enterprise lending beyond the life of the WHAM project.

Works Cited Ali Nawaz, Inshan. COO. First MicroFinanceBank. Interview: December 6, 2007. Islamabad, Pakistan. Burki, Hassan-Bano & Shah, Mehr. “The Dynamics of Microfinance Expansion in Lahore,” ShoreBank International Ltd. & Pakistan Microfinance Network, 2007. Churchill, Craig. Client-Focused Lending: The Art of Individual Lending. Calmeadow. Toronto: 1999. Dellien, Hans, Jill Burnett, Anna Gincherman, and Elizabeth Lynch. “Product Diversification in Microfinance: Introducing Individual Lending.” Women's World Banking. 2005:14. Jaffrey, Tabinda. Chief Executive Officer. Asasah. Interview: February 1, 2008. Lahore, Pakistan. Maqsood, Shahid. Head of Banking. Kashf Foundation. Interview: January, 31, 2008. Lahore, Pakistan. Microfinance Information Exchange, Inc. (MIX). “MicroBanking Bulletin: 2006 Benchmarks.” Washington, DC. 2006. Pakistan Microfinance Network. “MicroWATCH.” Issue 2, October December, 2006: 5. Pakistan Microfinance Network. “MicroWATCH.” Issue 3, January March, 2007: 6. Pakistan Microfinance Network. “MicroWATCH.” Issue 5, July September, 2007: 6. Pakistan Microfinance Network. “Pakistan Microfinance Review 2006: Shades of Growth.” Islamabad. 2007: 15. Qureshi, Uzma and Sarah Zaka. “Survival or Take-off: A Study of MSEs in the Lahore Small Business Finance Market.” Widening Harmonized Access to Microfinance. November, 2007: 1-30. World Bank, “Microfinance in Pakistan: Toward Financial Inclusion for the Poor”, 2006. World Bank, “World Development Indicators Database.” September, 2007: 2-3.

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