Microfinance and COVID-19: Is Insolvency on the Horizon?

This blog post is also available in Arabic, French and Spanish on the FinDev Gateway.

Crises in the financial sector tend to come suddenly and often to the surprise of many, but there are usually warning signs that can be spotted by careful observers. Back in June, we wrote about early results from the CGAP Global Pulse Survey of Microfinance Institutions (MFIs) showing that clouds were gathering above the microfinance sector but had not yet caused a storm. That’s still the case, but with more data now and more time to analyze the data, we’re in a better position to zoom in on those gathering clouds. In this post, we’ll focus on one of the main risks to MFI solvency: a decline in portfolio quality. We see sharp increases in nonperforming and restructured loans during the early months of the pandemic, but we also see strong capitalization mitigating the risk of insolvency for most MFIs.

A rise in portfolio at risk in the early months of the pandemic

PAR30 (loans in arrears for over 30 days) is the most common indicator of how an MFI’s portfolio is performing, and we see some warning signs emerging in our survey. The chart below shows a 41 percent increase in PAR30 at the outset of the crisis compared to a prepandemic baseline from June 2019. However, it’s important to note that at least part of the increase is likely due to declining portfolio growth. A growing portfolio can mask underlying weakness. When growth stops or reverses, PAR levels increase, and that’s one likely driver of the April/May spike.

The decrease in PAR30 from May 15 to 31 may be due to noise in our sample, or it could be a sign of stabilization. We’ll know more about the trend after subsequent rounds of our survey. (You can keep an eye on them through our results dashboard.)
 

PAR30 at the outset of COVID-19 pandemic (simple average)

That’s the picture at the global level, but of course, not all MFIs are affected equally. There are nuances — pockets of strength and weakness — that underlie the averages. The two most salient relationships we have observed so far are with respect to an MFI’s size and the region in which it is located.

At the global level, small MFIs have PAR30 levels nearly twice as high as those of larger MFIs. We looked for other relationships like this at the global level and found some promising leads among variables including an MFI’s emphasis on gender, regulatory status and level of digitization. But these variables themselves were highly correlated with MFI scale, which we believe is more likely to be the primary influence. We will continue looking into these relationships and share findings as they emerge.
 

PAR30 by MFI size (simple average)

At the regional level, we have larger samples in Sub-Saharan Africa (SSA) (where PAR30 levels are higher than the global simple average) and Latin America and Caribbean (LAC) (where levels are below average). Given the modest number of responses we have from other regions, we should not take those figures to be conclusive.
 

PAR30 by region (simple average)

Loan restructuring and moratoria add to the uncertainty

PAR30 levels do not solve the portfolio quality puzzle by themselves. Write-offs also are important to consider, but given their lagging nature (only 10 percent of MFIs said they had started writing off loans due to the pandemic), we are setting them aside for now.

More significant in the case of the pandemic are the loans that have been restructured, including those restructured as a result of COVID-19 moratoria on principal and interest that have been mandated by governments or voluntarily provided by MFIs.

Our data show extremely high levels of restructured loans. We can add those restructured loans to PAR30 to arrive at a figure we can call “troubled portfolio,” which reached nearly 50 percent among our respondents by the end of May 2020. These troubled portfolios are the gathering clouds in our analogy. We see them at a distance, but whether they will cause a storm and how much damage that storm would inflict depends on several factors. The uncertainty is especially pronounced among the loans that are subject to moratoria; we simply do not know how those loans will perform.
 

Troubled portfolio globally

When it comes to the regional breakdown of troubled portfolios, we again have larger samples in SSA and LAC (as of April 2020), where we see restructured portfolios in the 15 percent range. The MFIs in South and Southeast Asia (SSA) and Middle East and North Africa (MENA) regions had much higher restructured levels. But, again, the small samples in those regions should temper any conclusions we may be tempted to draw.
 

Troubled portfolio by region

High capitalization offers a line of defense

A critical line of defense between an MFI and insolvency is equity, which can absorb unexpected loan losses (beyond what is already accounted for through expected losses and provisions). Fortunately, the MFI sector benefits from relatively high levels of capitalization. At a global level, the MFIs we used for the analysis below had higher levels of equity than troubled portfolio.
 

Troubled portfolio vs. equity (simple average)

Is that enough to weather the storm? It depends on how badly it hits. In an optimistic scenario, where only 20 percent of the troubled portfolio ends up being lost, the average balance sheet would remain strong, with an equity-to-assets ratio of 25 percent. Even in a catastrophic scenario, with an 80 percent loss, equity would be at 11 percent.

Regulatory intervention is a distinct but related risk. An equity-to-assets ratio of 12 percent may be sufficient for a company to survive economically, but the capital adequacy requirements imposed by regulators may be based on different ratios or definitions.
 

Solvency scenarios

One-third of MFIs face solvency stress

Again, these are global figures, and there are certainly pockets of vulnerability lurking behind these averages. The chart on the left below breaks down the global averages and shows that about a third of MFIs in this analysis have more troubled portfolio than equity. This finding coincides with the fact that about a third of MFIs have reported anticipating a solvency issue in the next six months. This third of MFIs are on the wrong side of the global average and were demonstrating signs of pressure on their solvency early in the pandemic. One thing we don’t know is whether the pandemic caused this weakness or whether that third of MFIs were already facing solvency challenges. We don’t have a prepandemic baseline for these figures from our survey, but an analysis of historic MIX data, like the one Daniel Rozas conducted for liquidity, could shed light on the issue.
 

Just as with PAR30, region and size appear to be significant drivers. Interestingly, it’s the medium-sized MFIs in our sample that seem to be experiencing the most solvency stress, as indicated by the chart below.
 

Distribution of troubled portfolio to equity ratio, by MFI size
(approximation as of 30 April 2020)

Given the higher PAR levels of small MFIs that we noted earlier, we might expect them to be under greater strain, but the chart below shows that they also have higher equity levels, which mitigates insolvency risk. Our data also show that smaller MFIs have lower levels of restructured portfolios. At the other end of the spectrum, larger MFIs have lower equity, but they also have much lower PAR30 levels. It’s the medium-sized MFIs that appear to be getting squeezed.
 

Equity to assets ratio, by MFI asset size

Given the limitations of our data, comparing the troubled portfolios with capital structures at a regional level requires a bit more effort and results in the more complex chart below (note the two vertical axes). What jumps out from this chart is the high troubled portfolio relative to the equity levels in SSA and MENA. We have fewer data points there so we shouldn’t take these figures as conclusive, but they do warrant further investigation. We have more data from LAC and SSA, and again, we see higher relative risk in Africa. But even there, the risk is still at the concerning level, not quite in alarming territory; even if half of the troubled portfolio is unrecoverable, the average SSA MFI in our survey would likely survive.
 

Troubled portfolio vs. equity

So is there a looming solvency crisis in the microfinance sector?

Warning signs were accumulating in May 2020, but a global crisis did not appear to be imminent. It’s impossible to say for certain, however, and we still have more questions than answers. Our analysis implies that loans subject to moratoria will not perform well once moratoria are lifted, but we don’t know if that will be the case. Global and regional averages mask higher vulnerability among some segments of the MFI ecosystem, and about a third of MFIs in our sample were already displaying signs of solvency stress in May. If the April and May rates of deterioration continue, we could get into global crisis territory soon. It’s also important to note that declining portfolio quality, which is the focus of this blog post, is not the only solvency risk for MFIs. For example, if reduced demand for loans or lower risk appetite among lenders ends up shrinking portfolios, MFIs may not be able to generate enough revenue to cover expenses.

Is this analysis useful?

We need your help In the coming weeks. We will have data as of the end of June 2020 and will post another update on how these trends are evolving soon after. However, the response rate for our survey has declined. If you find this information and analysis useful, please encourage all the MFIs in your network to complete the survey here. We’ve taken some steps to make the survey leaner and less frequent. Finally, we wish to thank all the MFIs who are participating in the survey and the other stakeholders who are encouraging them to do so. This is a collective effort, and we could not do it without you.