The Economics of Microsavings: High-yield loans as the lynchpin of deposit-driven microfinance

Financial Access Initiative, 6-13 February 2012

I have a confession to make.  When I began composing this blog, I approached it with a fairly simple hypothesis:  Microfinance institutions (MFIs) that engage in large-scale deposit taking must likewise grow their loan portfolios.  After all, deposits are a source of funding with high operational cost that must be appropriately offset by growing revenue, and only microfinance portfolios provide yields high enough to achieve that.  And because many poor families have a higher demand for savings services than for credit, the resulting over-liquidity could push MFIs into unsustainable portfolio growth, eventually leading to the very credit bubbles that microsavings advocates are trying to avoid.

It seems a reasonable enough hypothesis, and sufficiently controversial to be interesting.  Trouble is, it’s not true.  Reality turns out to be more complicated.  

Small savings, large costs

Microsavings is expensive.  This is both intuitive to those familiar with microfinance operating costs, and is also borne out by the data.  Simply put, microsavings faces the same dilemma as microcredit – using a high-touch process to handle low-value accounts.

True, without the need for client evaluation, the degree of staff involvement in microsavings can be less than in microcredit, and the staff required is less costly (collectors are cheaper than loan officers).  However, the frequency of transactions is not necessarily lower, and for some products (with daily collections, for example) can even be higher than for most microcredit.  Savings also presents increased scope for cost reduction through technology, including ATMs and various types of mobile banking.  Still, no amount of technological innovation can replace the fact that the clientele served by MFIs operates in a cash-based economy, making costly cash-handling transactions unavoidable.  As a result, there is simply no opportunity in any foreseeable future for MFIs to adopt the kind of technology-supported economies of scale enjoyed by developed-country banks.

Ok, so we know it’s higher than for banks, but what exactly is the cost of microsavings?  Some studies have examined the issue.  A study of Latin American MFIs by the Inter-American Development Bank (IADB) found the average operating cost of microsavings accounts (<$100 average balance) to be in the range of 250-300% of the account value.  In other words, such accounts cost several times more to operate than the amount of funding they actually bring in. And this isn’t some handful of portfolio outliers either.  Such small saver accounts comprise 75% of total savings accounts in the 61 MFIs studied.  At the same time, they provide less than 3% of the total savings collected.

Microsavings as a service

It is readily apparent from these numbers that microsavings serve a purpose entirely separate from funding.  And this is not only the case with the Latin American MFIs studied by IADB – similar patterns can be seen in MFIs in Indonesia, Africa, and elsewhere.  Such accounts are also relatively active, with the IADB study finding an average of 1.7 transactions per month, while maintaining an average outstanding balance of only $12.   Unfortunately, data on transaction volume is not provided, but it is reasonable to assume that the amount of funds rotated through these accounts far exceeds the outstanding balance.  This assumption is consistent with Portfolios of the Poor, which found that poor families tend to be especially active users of financial vehicles, pushing through far higher transaction volumes than their average daily balance might imply.

The image created by these numbers suggests that it is more appropriate to view microsavings as a service than a funding source.  But if funding isn’t the objective, then what is?  Well, for one thing, providing microsavings has significant social returns, at least for those organizations that operate with a double-bottom line objective.  It can also contribute to financial returns as well.  One recent CGAP study examined two MFIs with large microsavings portfolios and found their small savers to be a profitable segment.  The CGAP study did not contradict the findings of the IADB study, since it also found that the operating cost of small accounts exceeded the total value of the accounts themselves.  Instead, it argued that the provision of small savings should be regarded as part of a suite of financial services offered to poor clients, and then evaluated the overall profitability of the clients themselves.

These clients are indeed profitable. Portfolios and other studies have demonstrated that poor savers are willing to pay for savings services through transaction fees or negative interest.  Thus, it shouldn’t be a surprise that microsavings accounts can generate significant transaction fees, accounting for as much as 1/3rd of total client profitability at one MFI evaluated by CGAP.  Nevertheless, the greater source of revenue still comes from lending.  In the CGAP study, loans to microsavings clients were responsible for over half of the total revenue received from those individuals.  And although not all savers were active borrowers at any given time (75% in one MFI, but only 15% in another), the yield generated from those who borrowed was substantial enough that, combined with fees from savings and other services (insurance, transfers, etc.), this client segment returned a profit margin of 26% and 58% at the two MFIs studied.

One of the key reasons for this segment’s profitability is that the loan sizes of microsavings clients exceeded their outstanding savings balances by a factor of 70 or more.  Thus, a saver with a deposit balance of $6 might take out a loan of $450, the latter being largely in line with the MFI’s overall loan portfolio.  When compared with the larger loan amount, the high operating cost devoted to managing the savings account – about $42 from the IADB study – looks far more manageable.  That is because the loan yield is high enough to cover both the loan and savings costs, as well as the costs of non-borrowing savers.

High yield loans: the lynchpin of deposit-driven microfinance

That raises a question: if small savers are indeed profitable without providing significant funding, then where does the funding of deposit-driven MFIs come from?  The answer takes us back to the IADB study, which found that the bulk of deposit funding came not from savings accounts, but from time deposits, which sport a far higher average balance.  Among Bolivian MFIs, half of all deposits mobilized came from accounts greater than $50,000 (both savings and time deposits), even though such accounts comprised just 0.4% of all deposit accounts.  Clearly, deposit-driven MFIs are raising their money from a very different customer segment than the one targeted by microsavings.

For such accounts, operating costs are essentially negligible.  Instead, the cost driver in their case is interest expense.  And it is here that we see the other side of the deposit-driven model.  Consider for a moment who is depositing $100,000 sums in a country like Bolivia.  At a minimum, it has to be an upper middle class household or business.  Now, why should such a client go to an institution associated with the poor?  With rare exceptions, it is not out of a sense of social solidarity.  It could be better service, since at an MFI, clients don’t need to bring in a million dollars to be treated like the “big fish.”  Anecdotes from the field suggest that this is indeed part of the motivation, though if it were only that, surely smart banks could find a way to improve their customer service to retain such clients.

Unfortunately for the banks, the MFIs have an advantage that they cannot match:  a high-yield portfolio.  Even in the most competitive markets, microcredit portfolio yields remain substantially above those of banks.  And this allows MFIs to offer significantly higher rates on large deposits.  A recent look at MiBanco’s website shows an interesting advertisement:  a 7.1% rate on 3-year time deposits.  The closest bank competitor offers 5%; most are below 3%.[1]

Apparently, such rate differentials are high enough to attract wealthy customers away from banks.  Yet for MFIs, even a 7.1% rate (in local currency) is an excellent deal, and it is cheaper than nearly all foreign loans.  The fact that these customers are attracted by high rates is also useful for another reason:  it makes funding easy to adjust as needed.  Thus, an MFI seeking to slow down its funding inflows can simply decrease the interest rate on deposits to see a near-immediate effect.  Indeed, large deposits allow significantly more precision and sensitivity to funding needs than working with large-ticket debt, such as from MIVs, local capital markets, and the like.  The ability to control funding also extends to maturity – for example, a shift into shorter-term funding only requires increasing the rate offered for short-term deposits and decreasing for longer-term deposits.

With a good regulatory regime and a high-yield portfolio, a deposit-funded MFI can find itself quite comfortably situated, compared to those that don’t collect deposits.

Concluding thoughts

As I had confessed in the beginning, I began researching this blog with a hypothesis that a shift into microsavings could cause excessive liquidity, which would bring us back to the saturated microcredit markets we’re trying to avoid.  So what is it about the economics of microsavings that proves the notion wrong?

First, because it generates minimal funding, microsavings alone cannot result in over-liquidity.  Second, the ability to adjust interest rates charged to the actual funders – wealthy local households – allows MFIs to closely tailor funding to the needs of their portfolio growth.  Funding by large deposits allows greater flexibility for MFIs seeking to better attune their funding to changing loan portfolio needs.

This is a significant departure from the push-factor of institutional funders trying to place their funds – whether needed or not – with high-performing MFIs.  After all, the majority of crisis-affected microfinance markets (India, Pakistan, Bosnia, Morocco, and Nicaragua) featured excessive inflows of institutional funding, whether from local banks or foreign lenders.  While deposit-driven MFIs are not immune from credit bubbles (see Nigeria for a notable exception), their funding model is less likely to generate the kind of excess liquidity that we have seen elsewhere.

[1] Retrieved 5 Dec 2011.

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