Emerging markets and micro-finance are hot topics at the moment. Whether it is micro-finance in Mexico, Brazil, India, Pakistan or Indonesia, the sector is definitely growing. All the major consulting firms from McKinsey, the Boston Consulting Group to Bain have tried to break into this sector. As expected, McKinsey has been heavily involved in micro-finance work and has undertaken some of the work significant and landmark projects. This posting is based on a series of discussions we have had with several McKinsey consultants working on a micro-finance project in Latin America. We follow them through a real engagement and see how they tackled the study. The McKinsey consultants interviewed spoke off the record and where not authorized to speak about the engagement.
The country setting for this engagement is a power house among emerging economies. It is usually mentioned in the same breath as Brazil, India, China, Russia, Turkey and Indonesia. A vibrant commercial sector has seen many consultants and consulting firms enter the market. A new president and more open trade policies saw a steep increase in the per capita GDP of the country. It was becoming awash with wealth and this excess liquidity was causing an equally steep rise in the domestic inflation rate. However, this did not bother the élite of the country.
Specifically, why doesn’t the federal government offer similar loans but at more favorable rates?
It did bother the rest of the population who toiled below the poverty line. Like its peer emerging markets, Brazil, Russia, China, India, Philippines, Indonesia and Turkey, this country was saddled with a massive population which does not take part in the formal economy. This large group of the population, comprising tens of millions of people, are usually descendants of the indigenous Indian population, are poorly educated and work in a shadow economy. Life is tough for them. To ease their burden, the government has created many agencies whose sole purpose is to use federal deposits to improve their access to home loans, micro-loans for businesses, emergency loans and other financial facilities. The market is so big that private players have created highly profitable and highly automated processes to offer micro-loans at steep interest rates and incredibly high profit. Mainly due to their success, private players have come in for their fair share of criticism. The federal government has also come under enormous pressure to do more. Specifically, why doesn’t the federal government offer similar loans but at more favorable rates?
That’s where McKinsey comes in. The federal agency responsible for providing micro-loans to entrepreneurs and small businesses wanted to ramp up its efforts. It wanted to offer more loans to customers and at better rates. Of the funding available to the agency, about 80% was not distributed. There were two schools of thought to explain this.
• One was that the absorptive capacity of the market was just not large enough.
• The other was that with the correct distribution channels more loans could be provided.
The Governor General of the agency was enamored with the idea of setting up agency-owned-and-managed offices in the rural areas to improve loan distribution. The middlemen, independent financial providers (IFP’s), who now distributed these loan’s where up in arms. This would create direct competition and eat into their business. It was also a key issue since owning IFP’s were highly lucrative and some of the country’s most influential and wealthy families both directly and indirectly controlled IFP licenses. McKinsey’s mandate was to:
• Determine the financial health of the federal agency.
• Determine the best way to increase the disbursement of funds.
The McKinsey engagement team consisted of 5 members and were a mix of consultants from the USA and Latin American offices. A micro-loan specialist from one of the Asian offices was also assigned to the team. The study was carried out over a 9 week period.
Setting up the McKinsey Financial Engagement
Everyone we interviewed agreed this was a very challenging engagement. In many ways, the most challenging engagements they had ever been on. These were the reasons cited:
• The scope of work was significant. The team needed to spend much time determining the boundaries of the project and understanding how to structure the problem statement.
• Data collection was difficult. Government agencies in emerging markets are not particularly good at collecting and checking data. This was no exception.
• The team was required to do some fairly complex data analyses and modelling. For one, they needed to project growth in different sectors of the economy, estimate the number of small and medium sized business and estimate the number of entrepreneurs who need funding.
• They needed to determine the economics of the channels to distribute funding and estimate the impact on the agency’s overall finances.
• Finally, they needed to model in the different products available to entrepreneurs: equity offerings, loans, credit grants.
• The sector was steeped in conventional wisdom generated from NGO’s and other western funded studies. They would need to use these as guides, but expect extensive criticism when their recommendations were presented.
The McKinsey team made the following decisions in structuring the study:
• The engagement team would focus the majority of their effort on assessing the channels, and particularly the Governor Generals wish to open up agency-owned-and-managed offices. This would be compared against the option of finding other ways to work with the IFP’s, or serve the clients directly with a new retail network of branches.
• The economics of the channels would need to be determined. This would be one focus on the engagement.
• The size, evolution and nature of the micro, medium and small entrepreneurial market would need to be determined. This was the target market and would need to be estimated.
• Finally, the team would need to assemble a set of benchmarks and best-practices from around the world.
The team decided early on to conduct a field visit to understand the nature of the market, meet the recipients of the funding and view the challenges faced on a daily basis. The microfinance market is different in every country and it was important to understand the local issues before the analyses was framed.
The field agents would not change their schedule but would go through a typical day.
The field visits would take place over two days and in two separate cities. They would spend the day with field agents from four different IFP’s. One day would be spent in the sprawling capital city to understand the challenges of serving an urban market and the second day would be in the outskirts of the second largest city. Here they would focus on rural and peri-urban customers. The field agents would not change their schedule but would go through a typical day.
Day 1 started at 7am when the team set out for their first field visit. The capital city is a sprawling urban mess noted for the smog, heat and ridiculous backlogs. The team had several goals in mind when they planned the field visits:
• Assess the challenges with managing a field office and the challenges faced by field officers in collecting outstanding loans.
• Conduct a day-in-the-life study of the field officers and the managers in the field offices.
• Estimate the potential gaps and bottlenecks in the process.
• Map the key processes in the field and in the office to replicate the operations in the financial model.
The team spent the morning visiting three borrowers who had not made their monthly repayments. The field agents normally travelled on scooters while the consultants followed them in the smallest car they could rent. The field agents carried mobile debit and credit card machines to process transactions. All transactions were electronically recorded and processed in real-time. The first client was not home. The field agent mentioned that the client typically tried to hide when she knew a field agent was visiting. They had phoned a day before to book the meeting. This was not the first time she had missed a meeting.
When the client declined to present these, the field agents threatened her with having her interest rates hiked, the funds taken straight out of her bank account, her property seized or a combination of all three.
By quizzing her neighbors, the field agent determined she was in a pool hall a few blocks down the road. The field agents went to the pool hall and questioned the client about her missed payments. They offered to process the transaction right there using either her debit or credit card. When the client declined to present these, the field agents threatened her with having her interest rates hiked, the funds taken straight out of her bank account, her property seized or a combination of all three.
All of this trouble for a $250 dollar loan, with an interest rate of 86%, to open a home-based clothing design studio.
This pattern continued throughout the rest of the day. Clients avoided the field agents when they did not have their monthly payments and the field agents threatened or harassed them.
All of this trouble for a $250 dollar loan, with an interest rate of 86%, to open a home-based clothing design studio.
At the field office itself, things did not run as smoothly. All processes to collect and process payments were automated. Processes to verify claims, payments and record agreements where less than perfect. The office had no documentation to collect complaints. Borrowers had to send their complaint along with their contact information via a drop box at the office. If the information needed to process the complaint was missing, and borrowers were largely illiterate and not aware of what this information could be, the complaint form was discarded.
Notices and guidelines outlining consumer’s financial and legal rights were not to be found anywhere. The law states they should be prominently displayed. Very little advice and counselling were provided to new clients as they signed up. It was also worrying to note that the interest rate charged was never explicitly mentioned to the client unless they asked for the information.
Day two was more of the same but with a twist. The IFP serving the rural areas did invest as much money in automating its processes. The field agents visited fewer clients in the day and seemed less worried about collections and more worried about the borrowers businesses. They were forceful in getting to clients but did not demand payment or threaten any clients. They did not have automated credit and debit card machines. In one case, they offered to take a client to an automated-banking-machine to transfer an outstanding payment. They had to drive very long distances to reach customers and then drive around a little more to find them.
Offices were not automated and poorly sign-posted. No consumer or credit information was provided. Some information was printed in English although every single person in the town spoke Spanish. Records were poorly kept and often lost. There was no central archiving and each field office was responsible for its own document storage.
Financial Study Structure
The team worked very long hours on this engagement; they typically got in between 7:30am and 8am and left the office around 10pm. Initial hypotheses focused the team on understanding the case for the federal agency setting up its own offices in the field. This was loosely termed a “retail structure”. The team structured this part of the analyses around the following questions:
• Why should a retail structure be developed?
• Did a retail structure help the agency’s financial performance?
• Did it enable the agency’s government mandate?
• Was it possible for the agency to develop a retail structure?
• If it was not possible, what was the agency’s are other options?
• If it was possible, how should it be done?
To answer these questions, they needed to understand the following:
• What were the federal government’s mandated expectations of the agency?
• Was it explicitly social, explicitly financial or a hybrid?
• Was the federal government willing to accept the outcome of successfully pursuing the mandate?
• Should the agency target viable parts of the market or leave that to the private sector.
• Which segment and sectors of the market should the agency target?
• Is the micro-loan market more within the agency’s mandate than the small-loan market?
• Is the food and restaurant sector more within the agency’s mandate than the fishing sector?
• Is the north of the country more within the agency’s mandate than the south of the country?
• Should the agency aim to work across the value chain or in segments of the value chain?
• What was the agency’s past performance, successes and challenges and what ability and capacity did this imply?
• What was the performance of the product portfolio?
• What was the return on equity?
• What was the size of the bad debt book? Was this a trend?
• What claim rate was needed to break-even? Could this be achieved?
• How were the IFP’s performing?
• Are they financially viable?
• Do they create jobs in the long-term?
• Could the agency do a better job if it replaced the IFPs?
• Is there any international precedent?
• How does the organization and governance structure match the intent of the business?
• How do other agencies balance between wealth creation and poverty alleviation?
• What is the best way to lend as much as possible, as cost effectively, and as quickly as possible?
• What is the best way reach the most right target audience through the most effective channels?
• What are the required technical and credit skills?
• What is the lending methodology appropriate for risk profiling the target market?
• How should the interest rate be set and used? (Focus on the latter)
Lesson’s Learned by the McKinsey Team
The McKinsey team members outlined the following challenges and lessons learned on the engagement:
• Given the size of the engagement and huge amounts of data, it was easy to get lost in significant and useless analyses. They overcame this challenge by scheduling disciplined sessions to structure the hypotheses and develop an analyses framework. Only when this was done, did they move on to the analyses.
When dealing with federal governments or any mandated federal agency, it is critical to go back to the original legislation governing the agency. You would be surprised how many people have never read the legislation and many misinterpret the agencies mandate.
• This was a fast-moving engagement with many moving parts. On a typical day new data or insights were developed which could change the direction of the engagement. The team held morning meetings every single day to share ideas. Without them, the team would have struggled to work effectively and it would have required substantial rework.
• When dealing with federal governments or any mandated federal agency, it is critical to go back to the original legislation governing the agency. You would be surprised how many people have never read the legislation and many misinterpret the agencies mandate.
• Federal governments are buffeted and pushed by many different priorities. It is difficult to know how their priorities will change over time. Therefore, never ever present the perfect solution by itself. There is no perfect solution. There is only a solution which works under certain conditions and to deliver certain outcomes. Always present a range of options and clearly explain the pros and cons of pursuing each option.
• Maintaining team morale is important on long and arduous engagements. This can easily be done through the type of engagement manager assigned to an engagement and how he manages the engagement. A manager genuinely interested in your development and well-being will make a world of difference.
• Do things correctly the first time. On tough engagements, there is no extra time. You can save yourself much stress by completing something correctly the first time around. There is just no time to do it again.
• Collecting information from the front line (field officers, clients and field office workers) presents a totally new layer to the story developed from top-down analyses. It is difficult to conduct any analyses and develop any meaningful recommendations without speaking to the frontline employees.
New ideas developed about micro-finance
The engagement team developed some new insights and idea about micro-finance. We list a few of them here:
• Agencies providing relatively low dollar value funding to entrepreneurs need to decide if they want to follow the “poverty alleviation” or “wealth creation” strategy. Both cannot be pursued at the same time given the agency’s mandate.
• Agencies which have not adhered to their mandate have consistently failed in the market.
• It’s possible in international markets with high population densities to reach the bulk of the target market in a timely and cost-effective way. Countries with low population densities or no major urban areas cannot reach the bulk of the population and need to segment the country by regions.
• Relatively fewer channels can be used to reach the entire target segment.
• It is essential that all credit provision is supported by training and technical support for the recipients.
• The interest rate offered always exceeds the prevailing market interest rates. This cannot be avoided. Too low-interest rates lead to “moral hazard”.
Key Findings for the Client
• The agency should not directly build, own and control the retail market.
• IFP’s providing loans below a certain size will never be viable.
• Unfortunately, these are the loan sizes the market can absorb and they are not viable. Other products will need to cross-subsidize them.
• Jobs are created only be spending significant amounts of capital and producing very low returns.
• Most products offered destroy value.
• The cost of serving micro-loans is too high and makes them uneconomical.
• The market does not have sufficient absorptive capacity given the current cost of providing the loans.
• To improve job creation, the number of sectors and regions served should be reduced.
• The IFP’s need to be restructured to target viable regions, products, loan sizes, sectors and products. They cannot chase the entire market.
• The legislation government the agency forces it to take actions which will make it unviable.