The $32-billion microfinance sector has been pounded by the worst economic slowdown since the Great Depression. Default rates at MFIs are rising, with many borrowers facing a harsh deterioration in economic health because of weak conditions in the developed countries. And growth has pulled back significantly, with MFIs hampered by the capital constraints endemic to the financial market meltdown.

"Far from being insulated from the economic mainstream as traditionally thought, microfinance could face a fall in growth and funding because of the global recession and declining investor confidence," according to Microfinance Banana Skins 2009, a report from British think tank CFSI that measures the risks facing the business.

Even so, no microfinance institutions have failed as of early August, observers say. Many MFIs have nimbly adjusted to these pressures, says Bob Anibale, global director of CitiMicrofinance. They have refocused on the needs of their customers and returned to local markets as the preferred source of funding. Meanwhile, multilateral institutions such as the Inter-American Development Bank and national agencies, such as the U.S. Overseas Private Investment Corp., have been willing to provide backstops for some troubled MFIs.

However, there's no doubt that the financial market crisis and recessionary conditions have taken a toll, according to this year's Banana Skins report. Of the top 10 risks now facing the microfinance sector, nine are directly or indirectly related to the economic meltdown, including the two biggest: credit risk and liquidity. The survey is based on interviews with more than 400 microfinance lenders, investors, regulators, and analysts in 82 countries.

"Fears about the impact of recession on loan portfolios, particularly the problem of overindebtedness, dominated the responses," the report states. "This marks a sharp turnaround from the earlier view that MF borrowers had a good repayment record." Increased competition between institutions and the erosion of lending standards are fueling the decline of loan quality. MFIs are less prepared to deal with risk and the danger of "institutional failure is seen to be high," the report warns. Responses were fairly consistent worldwide, aside from Africa, where microfinance participants are primarily focusing on management, staffing, and corporate governance issues. Even there, however, a "rising worry was the threat to funding and refinancing," says the report.

"MFIs were not asleep when it came to the liquidity issue--they were very much more aware than the commercial banks," Anibale believes. "Their concern moved up the list, but it was on the list," he says. Key concerns vary in degree from market to market. For example, liquidity is a less important issue in the biggest microfinance markets, such as India and Bangladesh, than cross-border funding problems. There are severe liquidity problems in the Balkans and central Europe, on the other hand.

Some observers downplay the risk of failures. Laurie Spengler, president of ShoreBank International Ltd., says that MFI borrower defaults are increasing "at roughly the same rate that we see defaults rising at the consumer level in OECD countries." But so far the microfinance sector has not seen defaults such as in the U.S. subprime mortgage market in 2007 and 2008. And most MFIs tend to continue working with borrowers who are in default to reschedule or restructure payments, resulting in fewer writeoffs than those experienced by traditional banks.

Microfinance continues to grow, although at a subdued pace. This is a welcome change, says Elizabeth Littlefield, director of CGAP, an independent think tank housed at the World Bank. "A lot of external investment fueled a very fast pace of expansion that outstripped institutions' financial and management capacity," she says. The withdrawal of liquidity has forced some MFIs to reduce costs and strengthen internal controls.

Some private-equity money is still in play, and it is mostly directed at pre-IPO institutions. The sector continues to depend on its core sources of funding, however: social-purpose funding from institutional investors, foundations, and personal investors.

MFIs have also adjusted to their clients' changing needs. Borrowers have been faced with rising food prices; now they are feeling the aftershocks of reduced demand in the developed countries, including layoffs and reduced wages. "With clients facing newly vulnerable conditions, MFIs are refinancing and restructuring loans," says Littlefield. And they are offering a wider array of financial services, expanding their focus from credit to deposits and insurance, and the integration of remittances, Anibale adds.

"Lending has slowed but not by as much as one would expect," according to Spengler, who attributes much of the increase in borrowers and portfolios in recent years to the rise of larger MFIs. "These institutions remain well capitalized, well managed and supported by donors and investors. I think the weakness in the market is more evident in the Tier 2 and Tier 3 MFIs that don't have the same access to resources," she says.

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