Economic growth and the strength of the banking system might have prompted a slow decline of the microfinance segment that has been raising a population

‘The MFI business model is over,” opined David Van, a Cambodian investment expert, recently.

He felt that in a couple of years, the market is likely to consolidate as microfinance institutions move into commercial banking to do consumer loans.

Additionally, the 18 per cent cap on interest rate on MFIs by the National Bank of Cambodia (NBC) in 2017 has become an “impediment” to operating cost.

“The market has been consolidating in the last few years with commercial banks acquiring MFIs as they [the latter] became cash tight.

“The economic slowdown has [also] compounded an increase in risky loans,” he said, just as 26-year-old Prasac Microfinance Institution Plc announced its full acquisition by New York-listed KB Financial Group Inc last month.

The largest MFI in the Kingdom in terms of total asset value at $3.6 billion, Prasac is the latest financial institution to be bought up by a foreign bank in recent years.

Bearing its French acronym, which stands for Programme de Rehabilitation etd’Appui au SecteurAgricole du Cambodge, Prasac grew from an EU project that funded rural agriculture programmes in 1995 to assume its current market position, after renouncing 90 per cent of its equity to foreign shareholders in 2008.

Prasac, which is among six institutions that is licenced to accept deposits from customers, is among a vast number of locally-incorporated financial institutions that are backed by overseas parties now.

External interest in the MFI sector, featuring 79 companies to date, has been steady.

In 2019, Singapore-based PhillipCapital Group’s Cambodian unit PhillipBank merged with Kredit MFI Plc to form commercial bank Phillip Bank Plc, boasting total assets valued around $641 million, as at end-December, 2020.

Not long after, former MFI Hattha Kaksekar Ltd joined the commercial bank ranks to become Hattha Bank Plc.

As of December 31, 2020, NBC data showed that nearly 78 per cent of the paid-up capital in MFIs or some $700 million was financed by foreign shareholders.

Annual Supervision Report 2020, National Bank of Cambodia

Like properties on a Monopoly board game, these financial institutions, which reported a cumulative net profit of $234.2 million last year, remain enticing to investors, particularly microfinance deposit-taking institutions (MDIs).

The reason being, MDIs have large distribution networks, a big customer base and a return on equity (ROE) that is “fairly attractive”, Stephen Higgins, co-founder and managing partner of Mekong Strategic Partners Co Ltd, explained.

“[They] have the cost efficiencies to remain profitable and move up into larger average loan sizes where the interest rate cap is less relevant [whereas] the smaller MFIs serve the bottom end of the market and are mostly struggling,” said Higgins, who was CEO of ANZ Royal Bank between 2008 and 2012.

The commercial bank was renamed J Trust Royal Bank Ltd following Japanese conglomerate J Trust Co Ltd’s 55 per cent acquisition of Australia & New Zealand Banking Group Ltd’s stake in the bank in 2019.

The number of banking and financial institutions in Cambodia, including 47 commercial banks and 12 specialised banks, has been confounding, particularly when nearly 70 per cent of the population remains unbanked.

The central bank has increased capital conservation buffer a few times in the past 15 years, the last in 2018, possibly with the objective of rightsizing the sector.

However, as most of the institutions have large foreign shareholding or parents who are able to shore up capital, the outcome was less spirted than anticipated.

Nevertheless, some shapeshifting in the MFI sector is expected soon.

As at end-December 2020, total assets in the sector stood at $8.5 billion, with growth backed by shareholders’ equity that grew 34.1 per cent to $1.9 billion and $3.6 billion deposits, gaining 18.8 per cent.

The total value of the assets, however, dipped from 35.9 trillion riel ($8.8 billion) in 2019 following the migration of Hattha Bank, and the Phillip-Kredit merger.

“If you look at the 10 biggest financial institutions, half are MDIs, and they already look like fully fledged retail banks. The only thing they’re really missing is a relationship with the card schemes like Visa, and the SWIFT network.

“Looking ahead, in five years, I would expect most of these MDIs to become commercial banks,” Higgins observed.

Turn away from small borrowers

The MFI sector in Cambodia has often been depicted as a modern day Shylock, the heartless moneylender from Shakespeare’s Merchant of Venice, for allegedly demanding repayments from over-leveraged rural households that take out loans to service existing ones.

It is also not common that borrowers end up with higher fees than the interest rate, as MFIs add on non-interest fees, such as commission, to offset the interest income loss.

An International Monetary Fund (IMF) working paper, Impact of Interest Rate Cap on Financial Inclusion in Cambodia, released in April 2021 stated that loan-related commission fees had tripled on average across all MFIs.

The authors – NBC assistant governor Chea Serey, NBC banking supervision deputy director-general Heng Bomakara and IMF economist Dyna Heng – found that the number of borrowers declined after the ceiling rate was introduced in 2017 but total micro loans continued to increase.

“Some MFIs have turned away from small borrowers and shifted toward larger ones. The impact of the cap on the number of borrowers has varied across financial institutions, depending on operation costs, funding costs, and segment of clients served,” they said.

While the revelation was astounding, Serey and her co-authors offered policy alternatives to the interest rate cap that could help protect borrowers from excessive interest rates and limit the negative impact of the cap.

This could include enhancing the borrower protection framework, fostering healthy competition, and promoting efficiency of the microfinance industry.

“Encouraging orderly consolidation of the microfinance industry may also help improve efficiency by reducing overhead costs and operation expenses,” they wrote.

`Canaries to fly off’

Given that MFIs borrow at eight per cent with operating expenditure around five per cent, total operating costs can be in excess of 18 per cent.

Despite the “creative fees” that go beyond the interest rate cap, the “fat profit” days are over, said Van, a public-private partnership senior associate of Platform Impact Co Ltd.

“Foreign lenders were smart, having allegedly exploited the carry trade when the US dollar was near zero to lend at eight per cent. [That was] easily [a] 500 basis points’ spread.

“They knew that the music would stop sooner or later,” he remarked, quipping that the interest rate cap was a “signal for canaries to fly off the coal mine” then.

Consolidation is evolution

The underlying contention in the sector has always been its ballooning outstanding balance. Experts have in the past warned of an impending credit risk, particularly with the Covid-19 effects playing out in the background. Even more so when the loan restructure policy is lifted.

Last year, outstanding loans stood at 27.5 trillion riel ($6.7 billion) or around 18 per cent of the total outstanding loans of $37.7 billion, with banks making up the larger portion.

NBC data showed that 8.6 trillion riel ($2.1 billion) or 31.2 per cent of the total credit dispensed by MFIs comprised household loans, followed by trade and commerce at 5.8 trillion riel and agriculture (5.3 trillion riel).

Non-performing loan ratio came in at 1.8 per cent, up from 0.8 per cent in 2019.

Annual Supervision Report 2020, National Bank of Cambodia

A lot of the reason for the growth in the outstanding loan balance is meeting the needs of the under-served small and medium enterprise (SME) market, which has helped to drive up average loan size, Higgins said.

“These are $60,000 SME loans rather than $500 traditional MFI loans. Yes, they’ve [MFIs] also lent too much to poor households, driven by inappropriate incentive models, but that’s not why the average loan size has gone up so much,” he commented.

Once a majority shareholder of Prasac, Sri Lanka-based Lanka Orix Leasing Co (LOLC)’s Cambodian unit LOLC (Cambodia) Plc is the third largest MFI in terms of asset value after Amret Plc.

In a similar vein as Higgins, its CEO Sok Voeun said, “whether the moratorium is lifted or not, it has no material impact to credit risks [as] most of the clients have been able to fulfil their obligation according to the new repayment schedule.”

He also felt that consolidation is an evolution of the financial sector. “It basically means that the financial sector [or] financial provider in Cambodia is stronger.”

Turning to bond market?

For now, NBC has stayed the policy requirements to raise the capital conservation buffer and liquidity coverage ratio to 100 per cent to ensure liquidity into the market. This helped the banking and financial sector to remain buoyant.

However, it is yet to be seen if the institutions would experience problems when NBC reinstates the policies.

In the last three years, a few MFIs and banks have turned to the stock market to raise funds via equity and bond listings.

Five corporate bonds were listed on Cambodia Securities Exchange (CSX) while Acleda Bank Plc went public last year with its shares traded on the Main Board.

The bond issuers are wholly-owned by foreign shareholders while Cambodian parties have retained a majority stake in Acleda, which also began as an MFI in 1993.

When asked if US Federal Reserve rates could affect funding costs, given that most lending is in US dollar, Association of Banks in Cambodia chairman In Channy said the increase in US dollar interest rates were “a thing of the past”.

“It [has] not caused a significant impact on the cost of funds in Cambodia since the General Department of Taxation reduced the withholding tax for international borrowing last year,” added Channy, also Acleda president and group managing director.

LOLC’s Voeun too said the exchange rate fluctuation would generally prod MFIs to diversify sources of fund to support portfolio growth.

“But turning to the secondary market might require them to prepare for a long process,” he mentioned, indicating that it might not be a popular option.

That said, LOLC issued bonds that are listed on the CSX two years ago.

In any case, Voeun noted, the top 10 MFIs have been trying to lower its funding costs by saving with “digital and offshore loans” and increasing staff productivity to cushion the decline in profit due to interest rate cap.

For Higgins, the concern is not so much rising costs as most of the MFIs are “reasonably efficient”, but rather their ability to compete with competitors that have lower funding costs.

In particular, MDIs with a bank parent is able to deliver lower funding costs, he said. “[They] would be in a much stronger competitive position than those that don’t have that type of parent.”

Is the end is near?

The history of micro credits dates back to the early 1990s, following the end of the Khmer Rouge occupation. Acleda - the first MFI having started as a non-governmental organisation - and similar projects offered micro credits to rural communities to empower them through agriculture programmes or small business ventures.

In a vastly poor country then, the non-collateralised loans backed by the EU and UN helped communities to become self-sufficient. While this intention was noble, the notion of microfinancing likely waned as it shed its social enterprise ethos over the years.

In the long run, the business model of MFIs will be one to be reckoned as the economy grows and moves towards a high income nation.

While the top players consistently report net profit and total asset growth, many of the smaller ones might fold especially if the minimum capital requirement is raised further and if they continue to report losses.

As such, the possibility of the MFI sector riding into the sunset one day is not something Van of Platform Impact dismissed.

“I anticipated that long ago as [it’s] not sustainable and the market has been consolidating with more commercial banks acquiring them or turning into commercial bank,” he said.

Channy concurred, noting that the scenario is compelling as Cambodia rises to achieve higher middle-income status in the next 10 years.

“MFIs, one after another, especially those that have good corporate governance may either become commercial banks, acquired by commercial banks or [receive] investments [from] commercial shareholders in the near future . . . a few have already done so,” he said.