New approaches to microlending should be tested through pilot projects before being introduced on a large scale, according to an audit by OED.* Between 1990 and 1993, the World Bank financed a project aimed at making funds widely available to cottage enterprises and developing a viable guarantee system for lending to microenterprises in the Philippines. Designed at a time when very few Bank-supported microlending projects existed anywhere else, the operation did not include a pilot project and tried to break new ground by finding substitutes for collateral through mutual guarantee associations, which grouped potential borrowers and provided guarantees for loans made to their members.
Although microlending is much needed in the Philippines, where the informal sector is very important to the economy, the project met a series of difficulties. Commercial banks were uninterested in lending to the guarantee associations, and the procedures for establishing the associations were complicated and expensive. The project was complex and could not rely on prior experience in guarantee association schemes. It also did not make extensive use of an existing network of rural banks, and intentionally opted to work through accredited financial institutions. The project was unsuccessful, but it did provide valuable lessons for the rapidly growing practice of microlending in developing countries.
Cottage firms in the Philippines have almost no access to bank credit because most of their owners do not have real estate titles they can use as collateral besides their homes, which are already mortgaged. What collateral these family-run businesses do have usually consists of small machines that can be easily moved and are difficult to value or repossess. As a result, banks are generally unwilling to provide credit to microenterprises.
The World Bank in 1991 supported a project aimed at boosting the microenterprise sector in the Philippines by developing a system of loan guarantees for retail lending to cottage industries, and by providing funds countrywide to a significant number of women entrepreneurs, who make up the majority of micro-enterprise owners. It also aimed at increasing both capacity and interest of the financial system in providing loans to cottage enterprises, especially in the countryside.
The microlending operation in the Philippines attempted to create a new substitute for collateral by developing mutual guarantee associations (MGAs). The associations would group potential borrowers with something in common, such as professional or family relationships, or geographical proximity, and issue guarantees to banks on their members’ behalf. The MGA concept had been tried only among high-income professions in western Europe, and not in a developing country. The Philippines project also differed from others in that it did not plan to use an existing network of rural commercial banks, relying instead on individual banks and lending institutions.
The $15 million project was approved in May 1989. It was designed specifically for the informal sector, which in the Philippines is very important to the economy. The MGA concept appeared to fit well with the country’s social environment, which values community activities very highly. The project, however, ran into a series of obstacles, the most serious of which turned out to be the lack of previous experience with MGAs. The MGA concept for lending to cottage industries in the Philippines was entirely the Bank’s idea, and ran counter to an analysis by the country’s National Economic Development Agency.
The project had a poor outcome. Few financial institutions were willing to lend to MGAs and few MGAs were successfully established.
From 1990 to October 1993, when the project was closed one year ahead of schedule, only 39 MGAs had been legally established, compared to an initial target of 60. Today, 21 MGAs still legally exist, but only 12 are operating. Ten of these are considered institutionally strong and likely to remain active in the long term, but many have suffered since their very start from a lack of trained administrators. During the project, the targeted size of each MGA was reduced from 60 to 40 members. Today, each MGA has an average of 35 members.
Commercial banks did not consider MGAs attractive clients: difficulties in obtaining adequate information from borrowers resulted in high processing costs, while onlending arrangements made the interest margins too low. Furthermore, commercial banks in general seem uninterested in lending to small-scale enterprises, which are able to borrow from a number of subsidized schemes.
In the end, most banks agreed to lend only to those enterprises they felt had growth potential, and on condition that the proposed intermediation margin be attractive and that borrowers make deposits. In 1993, loans approved to MGA members totaled only 72.8 million pesos (about $2.5 million) with individual loans averaging between $2,700 and $2,900.
Another problem was that bankers did not know their prospective MGA clients, who in many cases lived far away. An individual contribution of 10,000 pesos ($400) to an MGA allowed members to become eligible for a credit of up to 90,000 pesos ($3,600). But commercial banks considered this figure too high for new and unfamiliar borrowers. (Even with a maximum contribution of 30,000 pesos, only 47 percent of an individual loan was covered by MGA guarantees.) Furthermore, many MGAs were in remote areas and relatively far from the banks they were trying to borrow from.
The MGAs themselves had their own problems. The administrative process of creating MGAs was cumbersome and more expensive than had been anticipated. For example, MGAs had to register with the securities and exchange commission (SEC); separate agreements were needed for matching loan funds, guarantee agreements, registration with SEC, memorandums of understanding, registration of individuals, preparation of financial statements, and notarization of documents. As a result, some MGAs were set up artificially just to meet deadlines, with reduced sizes and members often having little in common with one another.
The project also had problems with information dissemination. In spite of the staff’s promotional efforts, many potential borrowers believed the loans included some form of subsidy and were under the impression that repayment conditions would be flexible.
The main lesson of the project is that an untested approach for lending to microenterprises should not be adopted on a national scale without first trying a pilot operation, allowing the borrower and the Bank to test the feasibility of the scheme. Moreover, the views of the borrower on what can and cannot work should be taken carefully into consideration in the planning stage.
If MGAs are to be adopted successfully in developing countries, they need to be carefully tailored to specific conditions during project preparation and testing. The lessons learned from the experience in the Philippines highlight some of these issues:
• Project design should remain simple and allow easy access to credit, particularly where there is poor information and limited banking technology. Regulations governing MGAs should not be too expensive or burdensome.
• To make their clients more attractive to commercial banks, microfinancing projects based on MGAs may need to set up a small matching fund facility so they can guarantee a higher percentage of each loan.
• Lenders and borrowers should be located in the same area, to reduce travel times and allow long-term personal contacts to develop.
• Promotional efforts should clearly explain the commercial aspects of the plan to borrowers, and more intensive dialogue with the government and implementing agencies is needed during project preparation.
• MGAs may require temporary subsidies for seed capital and to help cover initial expenses in the first years of operation.
• MGAs need to select participants carefully: borrowers with good business development potential; rural banks and credit unions who know their customers; and well-trained MGA leaders, preferably with a higher education and a successful business.
*Performance audit report:“Philippines: Cottage Enterprise Finance Project,” by Nicolas Mathieu, Report No. 15834, July 24, 1996. Available to Bank executive directors and staff from the Internal Documents Unit and from regional information service centers. Précis written by Stefano Petrucci.