CHAPTER 2 THE ISLAMIC MICROFINANCE APPROACH TOWARD POVERTY
2.4. Sustainability and Dilemmas of Microfinance
Sustainability has been an emerging issue in discussions about the development of microfinance schemes. The issue arises since subsidy-based microfinance failed to sustain the mission of alleviating rural agricultural poverty. Researchers have attempted to develop a new microfinance paradigm that could be sustainable (Robinson 1995) and,
equally important, to address how to measure the sustainability of the model (Yaron and Benjamin 2002).
‘Sustainability’ means ‘perpetuity’ (Navajas et al. 2002) and it reflects a long-term perspective. By definition, sustainability is the capacity of microfinance institutions or programs to provide services over the long term and maintain healthy growth without external financial support, including subsidies, grants and concessional funds that can be accessed by the institution at lower prices or below the market rate (Ledgerwood 1999). In other words, sustainable microfinance should be commercially profitable.
Rosenberg et al. (2009) argue that, theoretically, microfinance could achieve sustainability by providing financial services that generate revenue in excess of costs.
Accordingly, to generate the income, microfinance institutions should charge interest rates and associated fees to clients who borrowing money at a sufficient level to cover the cost of lending and other operational expenses, such as cost of mobilizing savings and deposits from public, and other commercial funds, administrative costs and losses due to bad loans.
According to Ledgerwood (1999), the commercial interest rate is a leading determinant to sustain microfinance operations, and in this regard the client should be able pay the price for the loan. In the Islamic microfinance system, sustainability is determined by the proportion of PLS between the financier and the client, and the mark-up price (Obaidullah 2008). However, as previously discussed, charging a commercial interest rate could undermine the mission of microfinance to alleviate poverty (Woller et al.
1999), because higher interest rates are a huge burden for poor borrowers who, naturally, only earn limited incomes, and in many cases their incomes are insufficient to support their living. Thus, this view opposes the practice of commercial microfinance, with its imperative of financial sustainability, because it perpetuates the incidence of poverty (Khandker 1998).
Interestingly, empirical studies demonstrate that the vast majority of microfinance institutions set interest rates above the commercial bank rate (Rosenberg et al. 2009).
The underlying explanations to justify the higher rates are: First, the high cost of the fund. As revealed in several studies, for example Meyer and Nagarayan (2006), many microfinance providers are not self-funded because of limited capacity to mobilize
public savings and deposits. Instead, they rely upon commercial borrowing from local banks and international investors that are expensive sources of funds. The high cost of funds will accordingly be directly converted into higher a lending rate (Hamada 2010).
Secondly, another leading determinant is the higher overhead cost to process loan applications and to perform monitoring of the microcredit portfolio, compared to portfolios of larger loans. Third, it is worth noting that the typical return of microenterprises is slightly higher than the return for larger enterprises, which makes it more acceptable for the borrowers to pay higher interest rates in return for repeat access to bigger credit advances.
Sustainability is driven by loan quality (Ledgerwood 1999). The basic indicator of microcredit performance is to what extent the client regularly repays the loan within the agreed schedule. Late payment of instalments leads to loan default that affects the income stream and possibly becomes a loss if the loan quality deteriorates into bad debt.
Thus, clearly inadequate income creates financial turbulence and is eventually unable to sustain the operation. To maintain the performance of the loan portfolio, many commercial microfinance programs employ sophisticated loan collection and monitoring systems, including requiring collateral from the borrowers to secure the loss from loan default.
As mentioned in the previous discussion, the nature of microfinance operation involves relatively high overhead costs compared to the banking sector, thus efficiency is another marker of sustainability. In the study of microfinance in Lombok, Indonesia, Budastra (2003) summarizes three categories of efficiency that are associated with microfinance sustainability: first, a lower transaction cost (operational efficiency), second, effective credit allocation (allocation efficiency) and third, competitiveness (dynamic efficiency).
Moreover, in practice, a microfinance institution should embrace the concept of simplicity (Robinson 2002) through streamlining procedures and organisation, faster decision making, maintaining high productivity and continuous innovation.
The formulation of sustainability in microfinance has been discussed for many years, for example, Yaron and Benjamin (2002) suggest that sustainability is a subsidy dependence index which measures the amount of financial (quantifiable) subsidies received against interest earned by microfinance institutions.
More recently, there have been several methodologies developed to measure the soundness of microfinance institutions, and each method has its own specific standards and objectives. Arsyad (2006) summarizes four methodologies of microfinance assessment, for instances the ACCION-CAMEL uses capital, assets quality, management, earning and liquidity indicators to assess microfinance performance. The MICRORATE model emphasizes key risk areas such as lending operations and portfolio quality, organisation and management information system, and financial performance. The M-CRIL focuses on 30 indicators covering three main areas:
organisational and governance aspects, managerial and resource strength, and financial performance. The GIRAFE (Planet Rating) scrutinizes 26 indicators grouped under governance, information and management tools, risk analysis and control, efficiency and profitability. In addition, the Microfinance Information Exchange (MIX) of the Consultative Group to Assist the Poorest (CGAP) employs a peer assessment model by using various types of financial ratios of microfinance institutions that have reported for at least four consecutive years (MIX 2009).
A specific model to examine the sustainability of cooperative institution was developed by the World Council of Credit Unions (WOCCU). The PEARLS monitoring system incorporates 45 financial ratios that encompass protection, effective financial structure, asset quality, rates of return and costs, liquidity and signs of growth (Richardson 2002).
Furthermore, in Indonesia, assessment of the BMT sector is formally carried out by the MENEGKOP-UKM, the provincial or local cooperative department, based on government regulation No. 91/2004, and a method of measurement similar to the CAMEL model (MENEGKOP-UKM 2008).
In the early stages of development of the microfinance sector, the sustainability concept is perceived as a pathway of the microfinance institution to be financial viable; from being heavily dependent on external assistance, it then gradually becomes partially subsidized until it reaches a stage of healthy performance (Rhyne and Otero 1994).
Recently, the sustainable framework has been developed into two categories (Ledgerwood 1999). First, operational self-sufficiency (OSS), which can be achieved if earned income surpasses operating expenses. In other words, the OSS indicator determines to what extent the microfinance institution earns profit. Thus, a positive OSS ratio suggests the institution has successfully reached an initial stage of sustainability;
conversely, a negative OSS ratio is a sign of unsustainable operations that eventually would reduce the equity in order to cover operating losses.
The second category is financial self-sufficiency (FSS), which is a broader measure than OSS as it includes inflation and subsidy factors. FSS demonstrates that a microfinance operation is profitable and is able to maintain the value of equity, that is, it is fully sustainable. This study uses this concept in examining the performance of Islamic microfinance. (The formulation of the calculation is explained in Chapter 3.)