The microfinance paradox: Costs do not go down as sector expands to include more Jordanians; taxation does not help
Microfinance in Jordan provides tens of thousands of jobs and can potentially benefit millions of Jordanians still, according to representatives of the sector in the previous article of this two-piece series on the microfinance paradox, which you can find published in Monday’s edition.
Although growing remarkably, at 10 per cent in 2017, the sector accounts for no more than 1 per cent of the country’s overall banking and finance sector’s credit facilities in 2017, according to the Central Bank of Jordan (CBJ).
Microfinance institutions (MFIs) are non-profit enterprises seeking to building economic capacity in “undeserved locations” (see part 1), beyond urban centres, and further the implementation of CBJ’s financial inclusion strategy.
However, MFIs still face various challenges that negatively affect the overall outcome and benefit of the sector’s operations.
On one hand, there is the issue of the unregulated microfinance sector, whose predatory practices are hurting both the borrower and the sector as an industry. No one government institution has agreed to take responsibility for it; neither the Ministry of Industry, Trade and Supply nor the Central Bank.
On the other, there are structural issues within the formal sector itself, affecting sectoral profitability and sustainability.
“In 2018, the microfinance sector had more than 300,000 active clients across the Kingdom,” Ziad Rifai, vice chairman of the Jordan Microfinance Network, Tanmeyah; former 12-year director of Tamweelcom; and CEO of Ethmar, Jordan’s first Islamic microfinance enterprise, told The Jordan Times.
Most of those are in the governorates, approximately 70 per cent, CBJ data show.
Against all the odds, Rifai and other sector officials have underlined in part one of the microfinance paradox, that the formal sector seems to be doing a good job keeping itself in check.
Tanmeyah’s leading portfolio in Maan grew at a remarkable 22 per cent by the end of the third quarter of 2018. The portfolio of active borrows grew 26 per cent, with a portfolio-at-risk (PAR) rate of no more than 0.4 per cent, the network’s figures show.
The second greatest growth was in Mafraq, at 18 per cent, with an active borrower’s portfolio growth rate of 13 per cent and a clean PAR; that is “no bad debt”.
The quality of the Portfolio is a major concern for MFIs, Tanmeyah Executive Director Saleem Nammari said.
So far, PAR30 (inactive and unpaid loans for more than 30 days) and written off debts do not comprise more than 1.8 per cent and 0.34 per cent of the network’s overall portfolio, respectively, he underscored.
In terms of impact, formal MFIs have helped create more than 80,000 jobs through more than 1.3 million beneficiaries across Jordan, Nammari said.
Shafea Kayed, a former microfinance credit officer at Cairo Amman Bank, said: “These microcredit facilities are the lifeline of some small businesses and families, whose members are unemployed or whose salaries are below elegibility criteria,” and this is where it gets a little tricky.
Microfinance enterprises borrow money in bulk from the major commercial banks, as well as donors, at rates lower than the market interest rate, Kayed highlighted, but not significantly so, Rifai and Nammari contended.
The interest rates at which they eventually lend out the money are much higher than the banks’, Kayed said.
“True, our rates are higher. But that is only because we borrow from commercial banks at a slightly discounted rate, at best. In general, the bank’s 9 per cent is our ground zero; our baseline. We do not borrow at ‘interbank rates’,” Nammari argued.
Banks, however, borrow from each other at significantly lower costs. The interest rate on loans by one commercial bank to another is called the “interbank rate”, which is dramatically lower than the market interest rate.
According to economist Mazen Marji, banks have diverse investment portfolios, and billions in deposits to move around. MFIs do not, Nammari responded.
Banks and MFIs operate on very different premises, Marji added.
“While both are financial institutions, the prior has massive investment portfolios and diverse streams of revenue. Meanwhile, MFIs get their money mostly from commercial bank loans, in addition to the occasional grant or donation,” he said.
“The only way for microfinance enterprises to grow their capital, in order to sustain operations and expand to reach more Jordanians and achieve their ‘developmental’ objectives, is to profit from the single and sole profit generating operation; loans,” Marji explained.
Meanwhile, the most pressing internal issues facing the sector are taxation and short-sighted regulatory policies, Nammari and Rifai concur.
Myopia or faith in the market
For the industry as a whole, there is little regulation to keep the lending processes in check or lower the costs of capital, unlike for commercial banks.
“The Central Bank of Jordan does not impose limits on bad debt ratios for MFIs, but based on best practice [benchmarks], there are standard acceptable, recommended limits for these ratios,” the CBJ told The Jordan Times.
CBJ by-laws stipulate that MFIs set maximum debt burden ratio ceilings for borrowers and outline a clear mechanism for rescheduling non-performing loans, among other issues, including specific procedures to deal with defaulters with humanitarian conditions and emergency financial difficulties.
Also, the central bank does not set a ceiling for MFI interest rates. As for the costs of borrowing from commercial banks, it is deemed to be an internal issue between MFIs and their lenders; the banks, primarily.
As a result, MFIs issue loans at 18-20 per cent interest, Nammari confirmed.
But donors do not care to involve themselves in the details of the process.
Against calls to regulate at least this aspect of the sector’s operations, donors believe that less regulation is better.
“The market will eventually regulate itself,” a senior official with an international donor organisation, who asked to remain unnamed, told The Jordan Times.
“You have to allow the market to function… it’s the great paradox of microfinance; yes, borrowers are being charged higher rates, but the banks are not making more money. And we have to think about the flipside of that coin. These MFIs operate at these rates so that they can also pay back the loans they took to finance their clients’ needs. One thing to note here is that the central bank fully regulates all [formal] MFIs,” he noted.
Notably, MFIs are “very, very expensive to run”, the source added.
“The costs go even higher as they branch out to more remote, smaller locations. They are not really making big profits. It is just that the operating costs of giving very small loans end up being very high,” the official said.
International donors fund several MFIs in Jordan, including Tamweelcom and the Microfund for Women.
The funding for Tamweelcom’s outreach programme was “not tied to their rates of interests or costs of borrowing, but to the specific, geographic and demographic areas of operation and specific fields of development”.
In an attempt to cut costs, Tamweelcom got together with its donors and decided to launch the microfinance bus.
It worked, to an extent, asserted the executive.
But despite the cut in costs, the bus had no bearing on Tamweelcom’s interest rates; they remain ultimately high, because the costs of borrowing were not getting lower.
According to Nammari, the margin attained was used to cover more operational costs and finance further expansion.
In the end, these MFIs are non-profit, the international donor reiterated.
The Jordanian dinar interbank offered rate, commonly referred to as JODIBOR, overnight (O/N) has stood at 3.59 per cent since April 2018, with the short-term rate by June 2018 standing at 6.031 per cent.
The CBJ’s prime interest rate stands at 4.75 per cent.
Of course, the longer the duration of the loan, the higher the offering rate.
Eventually, MFI lenders have to factor in changes in the interbank rate and the prime interest in accordance with the CBJ’s index rates that follow changes in the US federal funds rate.
This is only one side of it.
Banks also need to factor in their own capital costs into the lending rate equation, said Adli Qandah, director of the Association of Banks in Jordan (ABJ).
According to Fadi Mashharawi, head of the ABJ’s research department, banks have two main expenses, when it comes to capital costs.
“One is the direct cost of capital, mainly interest payable on deposits; the banks’ prime source of capital. The second is the cost of borrowing from other banks. That said, banks operate their capital resources by investing and issuing loans. In many instances, banks borrow from other banks and the central bank to fund these operations,” he said.
The remainder of the banks’ operational costs, including wages and other expenses, as well as profits, are taken out of the interest rate margin — the difference — between the costs of capital and the lending rate, Mashharawi said.
In 2017, this margin stood at around 3.24 per cent, an ABJ study showed.
Overall, the interest rate ends up rising from an O/N rate of 3.59 per cent to around 9 per cent, CBJ figures show.
When speaking about margins though, the same goes for MFIs, sector representatives say.
At such rates, MFIs have to add an additional 10-12 per cent to cover operational and other expenses and make profit.
More so, there is the risk factor to consider.
MFIs look to make their profits from the salvageable loans they give to mitigate the risks of bad debt, in order to cover their expenses and the costs of financing, from what the source at the donor agency told The Jordan Times.
When applicants seek out loans from commercial banks to finance their start-ups, businesses or even personal affairs, their applications undergo meticulous profitability and feasibility assessments, Kayed argued.
MFIs do not have that luxury. They have to play the odds, which statistically work out to their favour, he added.
“Their entire business model is based on the mitigation of risk by operating at high interest rates to make good debt far more profitable. Many of our potential clients were lost to these companies, as they do not require the same guarantees we did, at the bank,” Kayed noted.
Bearing in mind that MFIs do not borrow money at prime or interbank rates, as Nammari pointed out, nor have other sources of capital or income, it sounds reasonable lending money at 18-20 per cent, since nearly half of it goes to covering baseline costs.
How else will it sustain its operations, let alone make enough profit to expand them, experts argue.
“Add to that the 3-per cent sales tax, even though we are non-profit. It does not make sense!” Nammari said.
Up until the end of 2018, MFIs absorbed the sales tax increment instead of making borrowers pay it. As of January 2019, MFIs have begun incorporating the sales tax into the lending rate.
“We took the punches for the borrowers for four year! How long can we keep doing that? Until the government reconsiders, we can no longer sustain additional taxation. The borrower has to, unfortunately,” he exclaimed.
In 2004, the Ministry of Finance decided to exempt MFIs from the sales tax imposed on finance institutions.
Later in 2014, the ministry lifted the exemptions, in accordance to decision number (12/11/1/20946), while lowering the sales tax for the entire finance sector to 3 per cent, so long as MFIs do not get any tax exemptions on their purchases.
Credit mediation companies are exempt from these taxes, unlike MFIs.
The Jordan Times tried to contact the Ministry of Finance, and they directed us to income and sales tax official Mousa Tarawneh.
When we finally got through to him, having sent him all related government decisions, Tarawneh did not comment.
Overall, the sector pays 28 per cent in revenue and income taxes, in addition to the 3-per cent sales tax.
Financial economist, Al Ghad columnist and head of the economics department Yousef Damra said: “A 3-per cent sales tax is high. It will reflect negatively on the sector.”
Higher taxation raises the cost of borrowing either for the MFI sector, their clients or both, he said.
As it stands now, it raises the costs for the borrower, according to Nammari.
“It damages the sector’s profitability. Non-profit or for-profit, any enterprise has to stay afloat in order for its operations to be sustainable. How else will it be able to do so without profit?” Damra exclaimed.
As a suggestion, he recommended that MFIs diversify their streams of revenues and develop more diverse capital sources.
On that, Damra and Nammari agreed only initially.
The latter believes that the financial and developmental authorities should get together to establish a more sustainable source of funding for MFIs, at much lower rates, and scrapp the sales tax.
Contrarily, Damra argued that MFIs should turn to other for-profit operations to develop their capital resources.
Meanwhile, the issue, according to Damra, is not only the interest rate.
He thinks that MFIs should focus more on developing loans for micro, small and medium-sized businesses to attain their developmental goals, instead of focusing on consumer microloans.
However, MFI officials say this is not a problem.
Market segmentation or exploitation?
“Consumer microloans comprise no more than 17 per cent of our portfolio in Q3-2018,” Nammari replied. “And who is to argue what falls under consumer loans and what doesn’t? In most instances, people resort to consumer loans to buy basic home appliances, like fridges and washing machines, and in many instances they use the washing machines to make money washing their neighbour’s clothes.”
More so, as a non-profit, the network aims to better the quality of life for citizens in remote areas, who do not have access to commercial banks, Nammari said.
“I say bettering the quality of life for Jordanians is as developmentally essential as building their business and productive capacities,” he noted.
Some 49 per cent of the sector’s credit facilities go to financing commercial operations, while 21 per cent go to home maintenance loans, Tanmeyah’s figures show.
Between what is considered a consumer loan and what is not, within the same category, and the other categories that directly finance developmental and economic capacity-building operations, “I say MFIs are on spot with their market segmentations,” Nammari said.
According to the unnamed executive, women enrolled with the women’s funds, as well as other programmes, receive a variety of courses to enable them to better plan and manage their affairs.
Despite some undesirable outcomes, donors insist it is an effective approach to development, in line with the Central Bank of Jordan’s strategies for financial inclusion.
“We can look to MFIs and their network to really push financial inclusion forward,” the unnamed executive underlined.
To his organisation, the operational and capital costs of the sector are all part of the big machine that serves a “developmental” purpose.
Speaking of development, Rifai insisted that turning to the many Islamic instruments of finance will not only further developmental efforts, but will also lay the foundation for a fairer microfinance sector.
“There are more than 15 tools of Islamic finance that we can utilise in microfinance today. The most widely used is the murabaha Islamic tool [a deferred-purchase financing tool], but it is also the most questionable,” Rifai elaborated.
Islamic financial institutions rely on it because it carries the lowest risk compared with other tools of Islamic finance, which sometimes renders it no different in terms of exploitation, “Sharia-wise”, than traditional credit instruments.
With more Islamic tools, the sector can greatly contribute to the betterment of society and lowering the risks of bad debt, Rifai concluded.
The sector is doing a fine job regulating itself in the areas left unchartered by the central bank’s regulations, Nammari added.
“There is a lot of area to cover and issues to address. We are working on it and we will get there,” he said.