The microfinance market: looking for a new balance

An overview of Russian microfinancers

  • Declining personal incomes will have a deterrent effect on the microfinance sector in the event of a prolonged economic downturn caused by falling oil prices and the risks associated with coronavirus.
  • The growth in the payday loans (PDL) segment is likely to slow down in the next 12 months amid regulatory restrictions and the need for market participants to rebuild their business models.
  • On the contrary, the portfolio growth in the segment of installments (IL) may accelerate due to the absence of major regulatory restrictions, and because PDL companies may consider the IL segment to be more beneficial and reformat their operations.
  • The prudential standards set forth for microfinance institutions (MFIs) remain quite liberal and most of them does not impact the sector significantly.
  • The capitalization of PDL companies will remain under pressure amid declining margins. Due to regulatory restrictions, PDL segment profitability in 9M 2019 approached the level of the IL segment, and in ACRA's opinion, this trend will persist.
  • Margins in the IL segment are more resistant to unexpected shocks. However, risks associated with insufficient reserve coverage of microloan portfolios will continue to put pressure on capital, especially given the relatively high leverage in the segment.
  • Significant concentration and lack of stable funding sources will continue to create refinancing risks. MFIs are generally funded by a limited range of legal entities and individuals.

Growth is slowing down amid stricter regulatory requirements

In the next 12 months, the MFI sector1 will adapt to the changes in the operating environment, which have largely affected the industry regulation. Key regulatory innovations are aimed at restraining market participants that follow the most aggressive business models and include: lower maximum payment that MFIs may require from a borrower (since January 1, 2020, the total of interest, penalties and other liabilities may not exceed 150% of the principal due from a borrower), daily interest rate capped to 1% since July 1, 2019, and the requirement to calculate the debt burden ratio (DBR) for each borrower since October 1, 2019. A decline in personal incomes in a case of a protracted economic downturn due to the collapse of oil prices and the risks of the further spread of coronavirus will, in ACRA's opinion, have a significant restraining effect on the quality of microloan portfolios and, as a result, on the capital adequacy of MFIs.

1 Hereinafter, MFIs include only those companies that issue microloans to individuals.

Figure 1. The current growth in the share of the PDL segment is likely to slow down in the next 12 months

Source: Bank of Russia

The aforementioned regulatory changes and expectations of their entry have already influenced the microfinance sector last year. According to the Bank of Russia, microloan portfolios grew by about 30% in 2019 compared to 50% in 2018. At the same time, in 2019, the increase in the PDL segment was significantly higher than in the IL segment, which, in ACRA's opinion, is associated with the strive of PDL companies to issue as much microloans as possible before the next reduction in the maximum amount of payments that may be due from a single borrower (starting from January 1, 2020). By the end of 2019, the PDL segment grew up by almost 40% (compared to 66% in 2018) and the IL segment went up by about 20% (against 40% in 2018), according to the Bank of Russia.

ACRA believes that over the next 12 months, the above regulatory restrictions will continue to affect the dynamics of the PDL segment. The Agency expects a further growth slowdown in 2020, as many PDL companies will be forced to significantly restructure their business models by tightening underwriting standards and reducing risk appetite. The need to transform business models is a direct result of more stringent regulatory requirements for the maximum amount of payments that an MFI may require from a single borrower, as well as the limitation imposed on the daily interest rate.

At the same time, ACRA does not exclude some acceleration in the growth rate of the IL segment in the next 12 months, given the absence of significant regulatory restrictions, as well as the possible refocus of PDL companies to the IL format, which will allow them to increase the volume of lending operations further as part of the new business model.

Other regulatory restrictions, in particular prudential standards for MFIs, remain quite liberal and do not have a significant impact on the sector, since most market participants comply with them easily. For example, the application of higher risk weights for borrowers with higher DBR as part of capital adequacy calculation is a significantly less effective regulatory tool compared to similar one in the banking sector. This, in turn, can push up the flow of clients from banks to MFIs.

Since the current prudential standards for MFIs, in ACRA's opinion, do not fully match the level of risks faced by sector companies, the Agency does not exclude their gradual tightening in the long term.

It is worth noting that the digitalization of the sector will continue, as well as efforts aimed at higher customer focus. Therefore, developed online sales channels will remain one of the main competitive advantages of the most successful MFIs in 2020, especially in the face of uncertainty associated with the coronavirus pandemic and the introduction of quarantine measures. According to the Bank of Russia, the share of microloans issued online has been steadily growing over the past three years, especially in the PDL segment.

MFIs' margins are still under pressure

ACRA expects that a decrease in margins and a probable increase in reserves for non-performing microloans will negatively affect the profitability of MFIs in the next 12 months. Companies will become more cautious in shaping their policies on capital adequacy, asset quality and underwriting standards amid stricter regulatory requirements and risks of worsening economic conditions.

Further analysis was conducted using a sample of top 31 MFIs that publish their financial statements composed in accordance with the Industry Accounting Standards (IAS). For a more correct analysis and comparison, all MFIs were grouped into PDL-focused and IL-focused. According to ACRA estimates, the total asset volume of MFIs under review is at least 50% of all sector assets, which ensures a sufficient representativeness of the sample.

The Agency notes that over the past 18 months, the level of capitalization of MFIs has remained unchanged. The PDL segment is characterized by a higher level of capitalization compared to the IL segment, which is a direct consequence of the riskier business model, which assumes significantly higher interest rates and loan losses.

Figure 2. The PDL segment shows higher capitalization* than the IL segment

* The ratio of total equity to assets.
Source: IAS financial statements published by MFIs

Amid regulatory pressure, the profitability of PDL companies for 9 months of 2019 approached the level of the IL segment, and, according to ACRA estimates, this trend will continue in the future. According to the Bank of Russia, in Q3 2019, the total margin of PDL loans dropped almost by a half to 350% p. a. compared to 506% in Q2 2019. Consequently, lost revenues significantly limit the ability of PDL companies to absorb losses, which will require significant adjustments to business models and underwriting standards in the long run. In the short term, lost interest returns may be compensated by the accumulated capitalization and the relatively high current level of coverage of microloans with reserves.

The profitability of the IL segment, in ACRA's opinion, is more resistant to unforeseeable shocks: interest income to average portfolio for a period is more than two times higher than the cost of risk2, while for PDL companies it is one and a half times higher. All other things being equal, this indicates the greater flexibility of IL companies, which have more opportunities to absorb unexpected credit losses with profits. However, the capitalization of the IL segment is pressured by the low level of coverage of microloans with reserves.

2 Total reserves divided by average portfolio for a period, taking into account annualization

Figure 3. Return on average assets** in the IL and PDL segments are coming closer

** The ratio of profit to average assets for a period, taking into account annualization.
Source: IAS financial statements published by MFIs

Figure 4. IL companies have higher capacity to absorb unexpected credit losses with profits

Source: IAS financial statements published by MFIs

Figure 5. Reserves ratio*** for portfolios of PDL companies is notably higher than in the IL segment

*** The ratio of impairment reserves to microloan portfolio.
Source: IAS financial statements published by MFIs

Additional pressure on capital will be due to deterioration in the quality of microloan portfolios in the event of a prolonged economic downturn accompanied by a decrease in household incomes.

The public domain, including the financial statements published by the companies under review, contains insufficient data to accurately determine the quality of microloan portfolios in the PDL and IL segments. The dynamics of changes in asset quality may be estimated indirectly by the ratio of interest received to accrued, which has been steadily declining over the past three years (see Fig. 6).

Figure 6. Ratio of interest received to accrued: the quality of microloan portfolios has been declining gradually since 2017

Source: IAS financial statements published by MFIs

Significant concentration and lack of sustainable funding sources will remain as risk factors

The majority of MFIs do not have access to reliable sources of long-term financing, and banks are reluctant to lend to them (with the exception of affiliated entities), which is one of the main obstacles to stable development. As a result, the primary sources of funding of MFIs are funds provided by a limited number of legal entities and individuals, which in turn leads to a concentration of liabilities. Until recently, there were grounds to believe that Russian investors’ interest in MFIs would grow in the long term because deposit rates in the banking market remained rather low. However, this development of events may be hindered by growing credit risk in the microfinance sector should the negative scenario be realized, which involves a continued and/or sharp economic downturn and a sustained weakening of the national currency accompanied by a growth in interest rates in Russia.

As for the IL segment, funding is mostly provided by legal entities, mainly small and medium-sized enterprises (SMEs), as well as banks, since the latter are affiliated with the largest market players. In addition, banks generally view IL companies as less risky and more predictable than PDL companies, and this helps simplify the relationship between financial institutions.

Figure 7. Funds of corporates (mostly SMEs) form the largest share of IL companies' liabilities

Source: IAS financial statements published by MFIs

Companies from the PDL segment rely mainly on equity to finance their operations. At the same time, in terms of the liabilities ACRA notes that since 2018 these companies have been changing their approach, with more focus on borrowings from legal entities. The overall funding profile of the segment is more diversified compared to that of the IL segment, given the significant share of funds from individuals.

Figure 8. Funding profile of PDL companies is becoming more diversified

Source: IAS financial statements published by MFIs

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