Mainstream and social media has recently been awash with horror stories of the predatory practices of loan sharks – many citing stories of high-interest rates and exploitation of poor borrowers.
On the face of it, it would seem that the criticism is correct. How can charging such exuberant rates from a person in need be anything but exploitation? So Profit went out to understand the issue and the astronomical figures involved.
The sector says there is more to that figure than just plain profit and greed.
The microfinance sector, over the past decade, has emerged as a primary lender to the financially underserved segment of society. However, as the sector grew, it came into the public eye and has since been scrutinised for practices that raise questions over its ultimate goal.
A key player in the sector is microfinance banks (MFB) which are involved in approximately 75% of the country’s microfinance lending. Yet, some of these banks have a questionable approach when it comes to their operations, which are led by a fragile business model.
A constant criticism of these banks has been their relatively high-interest rates. They charge anywhere from 35%- 40% a year for lending out the money.
Kabeer Naqvi, President & CEO of U Microfinance Bank, says he understands why there is criticism, but that there is a need to understand the MFB model and the costs involved. There is the cost of borrower verification, setting up branches in remote areas where microfinancing is needed more, among other costs. Then there is the cost of compliance with banking and finance laws.
“This adds to the cost especially when you take into account the small loan ticket size,” Naqvi tells Profit.
The reality of the matter is that the average loan size of these banks stood at around Rs60,000 as per a Pakistan Credit Rating Agency (PACRA) report published in 2021. Therefore, the advantages of economies of scale are missing in the sector.
As per, “The How & the Why of Microfinance Lending Rates”, a study conducted by Pakistan Microfinance Network in 2019, operational costs comprised around 22% of the average gross loan portfolio for the overall microfinance sector including Non-Banking Microfinance Companies. Additionally, the cost of funds for these institutions is also high as they have to offer premium rates in order to compete with conventional alternatives for attracting depositors.
“Yet, with a 35%-plus interest rate, we have a margin of only around 4-5% and that is not accounting for the adverse impact of calamities like locusts or the recent floods which significantly increase the default ratio in the sector,” Kabeer says.
Kabeer stated, “Recently, the sector has been subjected to a lot of criticism and cited as predatory lenders. The fact is that MFBs cater to a segment of society that, for the longest of time, was left at the mercy of local loan sharks who would charge exuberant interest rates of more than 100% and had tyrannical methods of recovery.”
“The need for a bank in the segment stems from the fact that the NGO model is not scalable. As long as you are not able to raise money from the affluent to lend to the excluded segment, there is no way that eight million people could have been served.”
Are MFBs sustainable?
Not long ago, the sector was pleading for regulatory relaxation to the SBP after the pandemic shook its foundations – and there was more criticism for the sector. With so many apparent issues involved, the question remains if the MFB model is sustainable or viable, and how can these issues be addressed.
“When Covid hit, the most vulnerable socio-economic sector was unfortunately our borrowers. The industry’s communication with SBP, which later came out in the media, was taken out of context. The figures we presented were representative of the worst-case scenario. It was an exercise to understand the magnitude of the challenge at hand. Yet, the SBP was very accommodating as it allowed the industry to reschedule loans and other relaxations were also provided.”
As per sources, the microfinance department of SBP has asked the banks to provide for earlier rescheduled loans, specifically that portfolio for which the interest has ballooned to levels of the principal amount.
“I cannot comment on other banks, but U Bank’s rescheduled portfolio is down from Rs12 billion in 2021 to Rs3 billion up till now. Further, we are the only bank in the country, scheduled or micro, that has implemented IFRS-9 and accelerated provisioning on loans. Therefore, the SBP was able to draw comfort from our portfolio quality,” Kabeer explained.
Despite the troubles, U Bank’s head honcho presents an optimistic outlook for the industry: “As far as the sustainability of the model is concerned, the sector has ventured into high ticket value financing like a Rs3 million housing loan or a tractor loan. When the disbursements of these products will pick pace, the interest yield will inevitably reduce. If the sector maintains the right balance between micro-consumer lending, MSME lending and high-ticket lending, you would witness a turnaround in the next few years.”
The case of U Bank
U Bank is operating like a commercial bank. It has invested more in securities than it has lent and it has substantial borrowings, almost five to nine times the borrowing of other MFBs in the sector. Further, the effective tax rate for the bank was around 16%, the lowest in the past five years.
Kabeer told Profit, “The reason why U Bank’s balance sheet mix looks like an anomaly in the sector is purely a strategic one. Conventional microfinance lending is an extremely risky business, and coupled with our aggressive growth strategy of expanding branch operations, we needed to hedge the risk. That is primarily what drove our investing spree.”
“Further, our effective tax rate went down as the bank had carried tax losses that we decided to realise and the fact that taxation on treasury investment is only 15% half of the corporate tax rates also explains the effective tax rate.”
U Bank, through U Paisa, has a stake in the Mobile Financial Services segment like other telco-backed banks. However, when the pandemic started, the SBP issued a circular instructing banks to abolish Inter Bank Fund Transfer charges to promote digital payments. This was one of the main earning points for Mobile Financial Service Operators. Coupled with the market opening up to FinTechs and Commercial Banks venturing into the digital banking space, existing players are now challenged for the dominance of Pakistan’s mobile banking market.
“U Bank’s strategy for growth is a bit different. To summarise what we are trying to achieve, we need to look at where the resources are being invested. The bank now has six verticals; Rural Retail, Urban Retail, Islamic Banking, Corporate Finance/Investments, Corporate & MSME and Digital Banking,” Kabeer elaborated.
“On the digital front, we are aiming to leverage our existing customer base and shift it to digital accounts completely. Our AI-enabled application UBot and banking software Temenos Infinity will help us make that shift. So essentially, whosoever opens an account at the U Bank branch will be opening a digital Level 2 account.”
“This will serve as our pathway to venture into full-fledged digital banking space without entangling ourselves in the complexities of a digital bank license,” he added.
As per SBP’s Strategic Plan for Islamic Banking Industry 2021-25, “The plan identifies improving liquidity management by inspiring the industry to develop innovative products to cater to unserved/underserved sectors and regions. This will also enable the industry to achieve the target of 10% and 8% share of its private sector financing to SMEs and Agriculture, respectively by 2025.”
“Islamic Banking has a huge potential in the country as the population resonates with the idea. U Bank has also ventured into this sphere and we are expanding. In the next few months, the bank will be inaugurating around 30 Islamic Banking branches which will focus on lending rather than parking money in Sukuks.”
However, the primary driver of growth in the country’s Islamic banking segment has been Meezan Bank which is likely to take any new entrant heads on.
While the MFBs have their share of liquidity issues, some commercial banks are not that well off either. The government, in the Memorandum of Economic and Financial Policies, earlier last month, stated, “We remain closely engaged with two undercapitalised private banks and are committed to ensuring compliance with the minimum capital requirements.”
“I am very clear that MFBs need to be operated like banks rather than just loan shops. The banks must invest, lend and raise funds, and work on product innovation. We recently converted U Bank’s Tier-2 capital into Tier-1 and also issued preference shares. All this was for growth financing that is necessary to compete as a challenger retail bank, especially when the total assets are fast approaching a figure of Rs150 billion which in no way is micro and is comparable in size to some small commercial banks,” Kabeer reaffirmed.