Preliminary Analysis of an Institutional Crisis in Microfinance

This summary was prepared by Michael Chu, Carlos Castello, Craig Churchill and Tim Nourse..

I. Introduction

Over the past year, Finansol, a regulated microfinancial intermediary in Colombia and an affiliate of ACCION International, experienced a crisis that caused a severe deterioration of portfolio quality. ACCION felt compelled to intervene in this crisis for two reasons. First, 40,000 microentrepreneurs and their families depend on the financial services provided by Finansol. Second, Finansol represents a model of microfinance that ACCION believes is essential to unlock resources for the large scale provision of microfinancial services: the transformation of an economically viable non-governmental organization (NGO) into a regulated financial institution. If Finansol was allowed to go under, as it appeared destined to do, it would have been a disaster for the microentrepreneurs of Bogot and a major set back for microfinance.

With the assistance and collaboration from both the private and non-profit sectors, ACCION developed and implemented a recovery plan. New management is now on board, portfolio quality has improved, and new investors have recapitalized the institution, with more to follow.

To share this experience for the benefit of the field of microfinance, ACCION hosted a symposium entitled Corposol/Finansol: A Preliminary Analysis of an Institutional Crisis in Microfinance on September 9, 1996 in Washington DC. The three objectives of the symposium were 1) to analyze the origins of the Corposol/Finansol crisis; 2) to explain the recapitalization package recently completed for Finansol; and most importantly, 3) to identify lessons that emerge from this experience. Presentations by Michael Chu, the President and CEO of ACCION International, Carlos Castello, ACCION's Vice President for Latin American Operations, and Maria Eugenia Iglesias, the new President of Finansol, were followed by an informal question and answer period.
II. Corposol/Finansol's Institutional History

A. Origins

Finansol emerged from Actuar Bogot (hereafter referred to as Corposol), an NGO founded by influential local business persons with ACCION's support to provide services to microentrepreneurs in Colombia's informal sector. From its start in 1987, Corposol was noteworthy. It grew at an unprecedented rate, providing integrated training and access to credit to more than 3,000 clients in 1989, and escalating to nearly 25,000 active borrowers at the end of 1992. Corposol was also one of the first microlending institutions to initiate its lending activities by obtaining lines of credit from commercial banks, initially through the personal guarantees of the founders, and afterwards through guarantees from ACCION's Bridge Fund and FUNDES. However, these different sources of capital were insufficient to sustain the institution's rapid growth. By 1992, Corposol began to explore ways to tap directly into financial markets by forming a regulated financial intermediary.

After examining the feasibility of a number of options, Corposol decided that a commercial finance company (CFC) was the preferred type of regulated financial institution. Not only would Corposol avoid raising the large minimum capital requirement (US$13.7 at that time) to create a bank along the lines of BancoSol, but it could purchase an existing CFC license and begin operations immediately. In October 1993, with 71% of the shares, Corposol became the controlling owner of a CFC which was renamed Finansol. Joining Corposol as minority shareholders were ACCION International, Calmeadow, FUNDES, a local development bank and private individuals.

B. Deterioration

Finansol inherited a loan portfolio of excellent quality, a proven lending methodology (i.e. short term, working capital loans and sequential step lending), large volumes and consistent operational profitability. Nevertheless, a number of factors quickly led to the deterioration of Finansol's financial position.

In the first place, the relationship between Corposol and Finansol was structurally flawed. Corposol, the NGO, retained the credit extension staff while Finansol, the financial institution, served only as a booking and financing agent. Since most of Corposol's operating revenues were generated by training fees charged concurrently with loan disbursement, this created an incentive to disburse and a disregard for collection. In addition, except during the first few months, Finansol was managed by a long-time associate and subordinate of Corposol's President. Together, these factors left Finansol without the ability to control loan placement, nor the will to conduct independent action.

Secondly, Corposol became overly ambitious. Buoyed by its previous success, the management of Corposol set out to provide completely new services and expand quickly at the same time. Due to their entangled relationship, Finansol was dragged along as Corposol launched three new untested microfinance projects: Mercasol, a chain of retail outlets for microentrepreneurs to purchase supplies with credit lines; Agrosol, a rural credit program with larger borrower groups and different repayment schedules than the urban program; and Construsol, a home improvement loan scheme. In some cases, Corposol allowed two or three different loan products per client.

The results were dismal. The new products were largely unsuccessful; the management information system could not keep up with product diversification; and the institution lacked appropriate staff training for the new products. In order to stop the monthly P&L hemorrhage caused by provisioning for deteriorating loans, management launched a massive refinancing of the portfolio, that included lengthening loan terms and rescheduling bad debts. This provided brief cosmetic relief at the huge cost of hiding and worsening their asset quality, and undermining the ACCION methodology. At the same time, loan officers came under intense pressure to increase loan volumes to generate revenue for Corposol, disregarding the past concern for credit quality.

Thirdly, management made poor decisions in response to banking regulations. In 1994, the Colombian government attempted to control inflation by limiting the asset growth of regulated financial institutions to 2.2% per month - an extremely low figure considering that annual inflation was in excess of 20%. Finansol was immediately affected, but as an NGO, Corposol was not. It became expedient for Corposol to retain a portion of the loans to permit the combined portfolio to grow at a faster rate than the regulated system. Thus began a practice of shifting portfolios between the institutions that lacked transparency and misrepresented their financial position.

Thus, the combination of a flawed structure, overly ambitious policies, and poor decision-making led to the worsening of Corposol/ Finansol's financial position. The loan portfolio deteriorated; the credit methodology was weakened; and neither ACCION nor the Superintendency were able to get a clear picture of the situation.

III. The Turnaround

A. Discovery

Although ACCION and the other outside directors sensed these problems, they found it difficult to analyze and tackle these issues effectively. By presenting its new projects and later reporting on them, its attractive opportunities, shifting assets between the two institutions, and assuring critics that it was dealing with the problematic signs, Corposol was able to delay effective review of its operations. In addition, a clean audit by a big six accounting firm bolstered its case.

In May 1995, after eight months of delays, ACCION prevailed upon Corposol to perform a CAMEL evaluation of the entire microlending operation. The results, reported in July, identified worrisome trends, but because the CAMEL was restricted to a period ending December 31, 1994, it did not capture the true magnitude of the deterioration. However, the CAMEL was instrumental in effectively articulating the concerns of the outside Board Directors and launching the move for change. After the resignation of Finansol's President in September 1995, a totally open appraisal of the institutions occurred.

B. Solution

In October 1995, Finansol obtained the services of Luis Fernando Tob\n, a prominent banking consultant formerly with Citibank, to analyze the operations and design a corrective plan. The turnaround plan rested on a conceptually simple solution: a rigorous and uncompromising return to the basics. Finansol regained control over its loan portfolio by terminating new product offerings, returning to the basic loan model, severing most arrangements with Corposol and taking management responsibility for the credit extension staff. In addition, Finansol implemented a comprehensive plan to reduce costs, improve reporting and budgeting, and focus on quality hiring, training and evaluation. In March 1996, Maria Eugenia Iglesias, a former colleague of Tob\n's at Citibank with extensive local and international experience, was hired as the new President of Finansol.

To track the progress of the turnaround, the portfolio was split into a "New Bank" containing loans since October 1995, and an "Old Bank" with the portfolio of the past. The trend of the New Bank's performance indicators have been similar to other ACCION programs, indicating the efficacy of the new policies. Finansol is also eliminating non-productive assets that at one point comprised a significant portion of all assets, and effected a capital increase of $2 million to cover loan losses. The problem was correctly diagnosed, a highly competent management took corrective measures, and the affected portfolio, although significantly worse than in the past, was no longer at the disaster stage.

C. Regulatory Context

Although the operational problems were diagnosed and the cures already implemented, the regulatory framework presented another set of challenges for Finansol. Since Colombian banking rules mandate the gradual provisioning of delinquent loans, the effect of writing off the Old Bank's debts flowed regularly through Finansol's books for the first nine months of 1996. During this period, the monthly losses caused an erosion of Finansol's net worth to the extent that it violated the Superintendency's standard that a regulated financial institution may not lose more than 50% of its starting net worth in a given fiscal year. This "thin red line" was crossed in May 1996, creating a situation where the Superintendency could have intervened.

The potential ramifications of intervention are significant. This could have sent a signal to the market that Finansol was entering a crisis situation, rather than coming out of one. Not only could this have caused Finansol's collapse due to a lack of market confidence, but it would have had a serious effect on the broader Colombian financial market as well since Finansol issued paper amounting to approximately $30 million at that time. Accordingly, averting this crisis was of the utmost concern. Intense efforts to launch a recapitalization plan were quickly initiated to forestall intervention.

D. Recapitalization

Working with IFI (Instituto de Fomento Industrial), Colombia's second-story development bank, ProFund, Citibank-Colombia and others, ACCION led a full recapitalization plan in July 1996. The plan had two goals: 1) to sever the relationship between Corposol and Finansol; and 2) to raise enough capital to meet the capital requirements of the Superintendency and to provide for future growth. The first goal was achieved when Corposol surrendered its majority stockholder position through a debt for equity swap with its banks to whom those shares were pledged. Although the timing was complicated by the intricacies of Colombian corporate law, this swap was effected by the end of August. The second goal was achieved when the new investors purchased $3.5 million of equity in Finansol. To raise additional capital, Citibank-Colombia is placing shares for $4 to 7 million on the Colombian market in September and October 1996. This represents the first time that a premier bank has become an investor in a microfinance institution and provided investment banking services in the commercial placement of shares.

With its difficulties nearly solved, Finansol's future looks bright. It has a proven presence in a potential market of 1.2 million clients. When it resumes lending operations in the near future, it is projected that Finansol will be able to turn around its finances by the end of 1997 and become solidly profitable in 1998.

IV. Lessons Learned

Although the narrative leading up to and through the crisis at Corposol/Finansol is interesting, it is more important to share with the microfinance community the lessons learned from these events. These can be drawn by examining the institutional characteristics that allowed the crisis to occur, the role of ACCION in monitoring and eventually helping to rectify the situation, and the implications for MFIs in the event of a serious crisis.

A. Institutional Characteristics

The institutional relationship between ACCION and Corposol/Finansol must be taken into account. Typically, ACCION has co-founded institutions in its Network with local partners drawn from the leaders of the private business sector. While working intensely to establish new microfinance operations, ACCION does not involve itself directly on the Board of local organizations in order to promote the full involvement, and the attendant strong sense of ownership, of its local partners. ACCION believes that the development of these deep roots is an essential ingredient in the Network's success in reaching both economic self-sufficiency and scale. As a result, in the Colombian case, ACCION was on the Board of Finansol as an investor, but not on the Board of Corposol. Thus there was little opportunity to influence Corposol's diversification into untested activities.

This aggravated a governance issue that arises from having an NGO parent as the majority shareholder of a regulated microfinance institution. While the problem is not impossible to resolve (as the example of BancoSol suggests), an NGO parent nevertheless establishes a controlling party which is not inherently bound to the same standards of economic performance or fiscal prudence that may be reasonably expected in the business sector. In fact, some may argue that the NGO's own mission is to assume greater risk precisely in order to accomplish its vision.

Because of this possible tension, in the best cases the NGO parent must consciously guard that, in dealing with its regulated microfinance subsidiary, it sets fiscal standards appropriate to the financial sector, even if these are not applicable to its other activities. In the worst cases, the lack of normal shareholders at the NGO parent may translate into a disregard for economic performance that influences how it runs the MFI. Unfortunately, this was the case in Colombia where, in pursuit of its own aims and the maximization of its own income to cover operating deficits of its new initiatives, Corposol pushed for the expansion of services and the explosion of clients at Finansol.

The lack of management autonomy at Finansol, for reasons previously noted, aggravated this state of affairs. But even if there had been a will to oppose Corposol's initiatives, the structural relationship between the institutions ═ěhere Corposol retained all the credit extension and supervision capabilities═ěould have made it difficult to intercede.

One direct result of this structural flaw was the dramatic distortion of the lending methodology. Under pressure from Corposol to increase clients, the credit officers allowed larger loans for longer terms, without the credit history from sequential lending. Even worse, management allowed loans to be refinanced to circumvent the provisioning requirements, solving a short term problem, but creating the conditions for the future crisis. These resulting problems underline the fact that microfinance institutions cannot relax standards under pressure to increase services or the client base.

Given the CAMEL's importance in mobilizing the Board of Finansol, it is clear that the application of such a global analytical review even a few months earlier may have made a significant difference. This underscores the conclusion that an effective quality control instrument, applied on a regular basis by professionals with microfinance experience, is one of the best safeguards against the kind of institutional deterioration seen at Corposol/ Finansol. In addition, the importance of such specialized reviews is heightened by the realization that neither external audits by prestigious accounting firms, nor the supervision of banking regulators, is sufficient assurance that an alarm system will be tripped, either at all (in the case of the faulty audit) or early enough (in the case of the Superintendency of Banks).

B. The Role of ACCION

In examining the role of ACCION, the first fundamental question is why the perception of the true magnitude of the problem was delayed. A variety of factors contributed to this: local management that, in the best cases, suffered from an excess of salesmanship and, in the worst cases, intentionally provided faulty information; a clean external audit by the local office of a Big Six accounting firm; an institutional structure that for a variety of reasons lacked transparency and made comprehensive analysis difficult; and the persuasive power of a highly successful prior track record. However, perhaps the most damaging was ACCION's own reluctance to accept the depth of the Finansol crisis.

This failure at an early date to push for the ultimate implications of the various troublesome signs perceived by ACCION personnel at various levels was due to two major reasons. In the first place, Finansol had been widely held as a leading example of where ACCION believes the microfinance field must go to fulfill its promise: the insertion of successful programs into the capital markets. While Finansol's problems are due to deviations from ACCION's methodological model, and as such this crisis does not reflect on the conceptual framework of ACCION, there was nevertheless a heightened sense of symbolic visibility of Finansol which, in retrospect, clearly introduced elements of wishful thinking into ACCION's perceptions. Secondly, these blinders were further exacerbated by the importance of Finansol in the statistics of the Network, particularly in terms of microentrepreneurs reached. This experience has emphasized the importance of clarity of analysis, regardless of image or other non-operating considerations.

But even if an understanding of the depth of the crisis was delayed, what should ACCION have done differently? Clearly, ACCION should have made its confrontations with Corposol management more open and forceful. ACCION should not have contented itself with just stating its objections at the Finansol Board level while the company veered in directions it found disturbing. Serving on Boards always presents the dilemma of deciding which is more effective: vocal opposition at Board meetings or suggestions and recommendations to management in the corridors. In the case of Finansol, ACCION believes it should have confronted earlier the fact that, until the CAMEL, it was not being effective in either venue. In this regard, the ultimate lesson is that, for apex organizations to be truly effective, they must have the political will to put an organization's affiliation with the Network at stake when fundamental issues are concerned and when its effectiveness has severely diminished.

It is also important to analyze what ACCION did do, once the depth of the crises was communicated by Finansol's new management. ACCION immediately mobilized an internal team to lead a rescue effort while simultaneously alerting its international partners (FUNDES, Calmeadow and ProFund) and stakeholders (both actual and potential, such as the Inter-American Development Bank, USAID and the World Bank). The last several months of intense efforts illustrate several key lessons for ACCION as an apex organization. Firstly, at the vanguard, MFIs have become full-fledged participants of the financial sector. The ability to deal with crises in this context, with all its implications for functional and management expertise, is now a necessity. Secondly, such efforts require an inter-disciplinary team that combines both microfinance methodology and financial-business experience, preferably involving complex capital restructuring. Thirdly, in addition to quality, there must be the sufficient quantity. Fully two-thirds of ACCION's senior management team was directly involved in the Finansol crisis and the remaining third was redeployed in order to prevent other activities from being seriously impaired. Had this crisis occurred eighteen months ago, ACCION may not have been capable to field all the professional resources required. Fourthly, the assistance of other organizations in crafting a viable solution is critical, as demonstrated by the involvement of FUNDES, Calmeadow and ProFund.

C. Implications in the event of a MFI crisis

As successful microfinance institutions scale up and become regulated financial institutions, although the specific reasons may differ, it is inevitable that some of them will go through crises. In that event, some additional lessons may be applicable. The importance of management quality is foremost. In the entire restructuring process, the exceptional quality and experience of its current President, Maria Eugenia Iglesias, has been fundamental. Without a similar capability, none of the vital components of the proposed solution could have come together. The institutional changes required, the support of the ACCION Network and colleague institutions, the sustained confidence of the financial markets, the credibility with the Superintendency of Banks, and the involvement of new investors.

In addition, the time frame in which crises in open financial markets must be resolved is inconsistent with the response time of multilateral institutions. During the entire process, ACCION received strong encouragement and benefited from the advise of many international agencies interested in microfinance in Latin America. They clearly understood the severity of the crisis and the importance of the Finansol emergency for the nascent microfinance industry. However, there were only two months between the new management's report of the extent of the crisis in March and the crossing of the "thin red line" that opened the possibility of intervention by the Superintendent of Banks. The injection of the first round of new equity occurred three months later, at the outside limit of the Superintendent's flexibility. None of the multilateral institutions could act within those time limits.

This further emphasizes the importance of specialized financial investment funds such as ProFund. In practice, it was through ProFund that multilaterals could translate their strong support of microfinance into action in short order. Perhaps it is through similar vehicles, structured as independent units with professional investment management, that multilateral institutions can achieve the necessary reaction speeds to resolve microfinance emergencies.

Finally, the Finansol experience demonstrates the importance of a microfinance model that is based on economic viability and performance. Without a past experience as a profitable NGO, and a firm commitment in the future to serving the most fragile sectors of the community while producing sustained and attractive returns, it would have been impossible to consider attracting investors from the private sector, such as Citibank-Colombia and the potential buyers it will be mobilizing in the coming weeks. Paradoxically, it may have taken a major crisis for commercial investors, as opposed to socially-responsible investors, to assume a majority ownership of a microfinance institution.
Hari Srinivas -
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