Four Challenges for Shifting from MFI to SME Finance
As microfinance institutions (MFIs) have grown over the years and become more professional, some have begun to move into the small and medium enterprise (SME) segment. Many see this gradual transition to SME finance as a natural shift, as the MFIs follow their customers’ development/journey.
In fact, this shift has been driven mainly by concerns to keep the best customers in a fiercely competitive market, expand business and lower operational costs. Although portfolio growth improved the financial performance of some MFIs in the short term, profitability fell in the medium term (owing to lower margins and a higher risk of default). In hindsight, these institutions realized they overestimated their capacities to serve the SME segment.
Microcred, a digital finance company founded in 2005, has developed MFIs in Africa and China and currently has operations in nine African countries. Its current outstanding loan portfolio totals EUR 400 million for 600,000 customers with a 30-day portfolio at risk of 2% and an annual growth rate of 50%. During African Microfinance Week, Ruben Dieudonné, Chief Executive Officer of Microcred Africa, talked about the transition to SME finance, “We waited for the MFIs to establish themselves before launching SME products. But our mature subsidiaries – Madagascar, Senegal and Côte d’Ivoire – naturally moved into SME finance after just a few years of operations.” Finance for this segment represents over 40% of the total portfolio in volume and 4% in number of loans.
At the same time, the inclusive finance sector is seeing the emergence of new SME finance institutions targeting the “missing middle” SMEs. While African economies have experienced steady growth for some 15 years, powered by the private sector and SMEs in particular, access to finance for SMEs is still a real problem. A World Bank study reveals that just 10% of SMEs have access to finance, whereas they account for over 90% of private business in Africa.
COFINA, a network of financial institutions working to finance SMEs, was set up in 2014 to address this situation. The institution operates in Senegal, Guinea, Mali, Gabon, Côte d’Ivoire and Congo, serving over 75,000 customers for an outstanding loan balance of EUR 100 million and a 30-day portfolio at risk of approximately 3%.
With their launch into the SME segment, both COFINA and MicroCred have faced a number of challenges which have prompted them to adjust their organizational and operational set-ups.
Challenge #1: Analyze the risk
Information asymmetry between entrepreneurs and financial institutions is often a problem. Analysis of the credit application is complicated by lack of knowledge of the business, its market and its cost structure. As Jean-Luc Konan, Director of the COFINA network, put it, “You need to have as accurate an idea as possible of the client’s solvency, and for that you need to be in a position to understand the market and the business perfectly. You have to be able to combine local knowledge with accounting knowledge.”
Microcred already knew most of their SME customers, as they had previously borrowed smaller sums. However, Ruben Dieudonné of Microcred also highlighted the importance of truly understanding the client’s business and its environment from the very beginning of the relationship. What often happens, he pointed out, is that in the first six to twelve months of a new SME loan, financial institutions have the impression of understanding their clients’ market well enough, and since portfolio risk rates remain low, they don’t put much effort into developing a deeper understanding. But then after about a year, that honeymoon period ends, defaults rise and the institutions start to feel the effects of not having paid enough attention to getting to know their customers. Ruben Dieudonné warned that institutions must get "to know their clients well" from the beginning because afterwards it is usually too late.
To overcome this issue, some institutions work in partnership with business support organizations that help entrepreneurs draw up their business plan and gain access to finance.
Challenge #2: Adjust the model to the environment
Unlike microcredit, where cash flow is the main consideration when evaluating loan applications, SME loans call for an analysis of balance sheet and debt capacity. They require a skilled, dedicated operational team conversant in the requirements of “Know Your Customer and “Know Your Colleagues,” as SME finance calls for sound knowledge of the customer. MFIs often do not have this type of risk analysis expertise, so the current tendency is to advise institutions to set up SME units operating separately from traditional microfinance activities.
This is precisely what Microcred set out to do with its MFIs that moved into SME finance. However, the institution had to reconsider this approach when it realized that clients were unhappy about their loans being transferred away from the microfinance loan officers that they already knew, to be handled by the new SME unit. The institution now tends to incorporate the SME line into the microfinance business with integrated risk management: “As our 250 microfinance loan officers were unable to process this type of finance, we asked their supervisors to appraise the SME credit applications. This meant the agents could retain their portfolios and attend to customer support,” explained Ruben Dieudonné.
So there is no one-size-fits-all approach, other than adjusting to the environment and adopting a decentralized model where needed.
Challenge #3: Customize methodology and guarantees
According to Jean-Luc Konan, an estimated 65% of financial institutions that move into SME finance adopt inappropriate methodologies. One of the pitfalls to avoid is offering classic banking or microfinance products. Unlike microfinance, where products can be more standardized, SME finance calls for a more nuanced product design with suitable guarantees, due to its higher loan amounts and greater credit risk. Over a certain threshold, microfinance moves into the realm of finance, meaning that institutions can no longer rely on classic solidarity group guarantees or social collateral, as these types of security are generally too low or impossible to enforce in the event of a dispute. Instead, they must develop more formalized guarantees and security for their loans.
Challenge #4: Customer support
The other point to bear in mind is ongoing support for the financed SMEs. Both MFIs and classic banks, ill-equipped for customer support, often do without. The MFIs have too many small loans outstanding to be able to provide full customer support. And the larger banks consider it outside their remit, preferring to rely on substantial collateral. Microcred and COFINA have both adopted a strong client-centric approach to their business. This position has paid off to date, with both institutions reporting a highly satisfactory customer retention rate.
A financial institution that promotes long-term customer/loan officer relations, regular visits, loan management advisory services and building borrower proficiency manages its own default risk better and bolsters the financed SME’s longevity.