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Microfinance’s downward spiral

Ever since venture capital (VC) started flowing into Pakistan, the local ecosystem has seen polarising debates on whether the companies being built are sustainable, given their generally questionable unit economics.

From unbelievably high losses to calls for investigating lax corporate governance mechanisms, the space receives a high dose of flak, both fair and unfair, that may be disproportionate to the underlying scale.

But there’s another sector that’s going through a somewhat similar situation that has avoided scrutiny for the most part — exceptions include a few reports in the press here and there.

Pakistan’s microfinance banking has been undergoing its share of troubles in the last few years with a scale of losses that could, to an extent, rival VC-backed businesses and their capital revenue issues.

According to the State Bank’s Financial Stability Report, microfinance banks cumulatively posted a red bottom line for the fourth year straight. The post-tax loss of the sector reached Rs17.2 billion in 2022, significantly worsening from Rs8.08bn in 2021.

While the regulator conveniently blames it on the “lingering effects of Covid-19” and subsequent macro deterioration and floods, the sector’s woes began much earlier in 2019.

The number of loss-making institutions increased to six in 2022 from four in 2021. For quite a while now, some of the more notable players have been relying on the largesse of their sponsors for capital injections to continue operations — not too dissimilar to the VC-backed businesses.

The share of outstanding loans at interest rates of 25pc or more reached 77pc of the total by December, much higher than the earlier 51pc in June 2022

Similarly, the total capital to risk-weighted assets continued its downward trajectory for the fourth consecutive year, declining to 10.9 per cent in 2022 from 18.3pc in 2021. This is lower than the minimum mandated capital adequacy ratio for microfinance banks set at 15pc. The tier-one capital position has also posted a similar trend, falling to just 8.1pc.

While the sector only accounts for 2.2pc of the overall banking deposits, it still holds outsize importance due to the strong market penetration. As of 2022, there were 90.8 million microfinance bank accounts, of which 5.3m were borrowers with outstanding loans of Rs361.7bn.

Many of them have traditionally lacked access to credit and undergone serious financial stress since the onset of Covid-19 and the subsequent macroeconomic stresses of the last few years, affecting their repayment ability. As a result, the sector’s gross non-performing loans ratio rose to 6.7pc in 2022, from 5.2pc the year before.

This shouldn’t be too surprising, given the sharp recalibration in monetary policy over the last two years. One way to look at its impact is that the share of outstanding loans at interest rates of 25pc or more reached 77pc of the total by December, much higher than an earlier 51pc in June 2022.

Similarly, 15pc of all credit was at 36pc or a higher price, compared to 5pc in the period under review. Remember, the benchmark Karachi Interbank Offer Rate between these two dates rose by a relatively modest 184 basis points.

Meanwhile, the sector remains under pressure from two fronts simultaneously: first, the provisioning and bad debts written off jumped by 40.1pc to Rs22.8bn in 2022.

Second, the growth in admin expenses, in particular, considerably accelerated to 33.6pc, reaching Rs70.8bn. For context, the corresponding increase in net interest plus non-markup income was relatively slower at 19pc.

Though the sector’s health and ability to survive without constant backing from sponsors has been questionable for a while, the cracks are visibly widening now.

Even the International Monetary Fund felt compelled to take notice in its latest report on Pakistan, “We will also continue our efforts to tackle the pockets of vulnerability in the microfinance bank sector, which has been severely affected by the floods, among others by asking the owners for time-bound recapitalisation plans to address existing capital shortfalls and by otherwise ensuring the orderly market exit of non-viable institutions.”

Now the question is, what will the regulator do about it? If the two private commercial banks with capital issues are to serve as an example, it may be a while before any serious action is taken regarding the microfinance institutions. Especially considering how these entities help push the financial inclusion targets, particularly those relating to account opening.

Published in Dawn, The Business and Finance Weekly, July 31st, 2023



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