Expanding Access to Financial Services in Malawi Kiendel Burritt UNCDF Senior Technical Advisor Foreword | Executive Summary Download pdf version of entire book (2.82 mg)

Executive Summary

The primary financial service needs of people are shared across income groups. They include accessing liquidity, having a safe place to store money, transferring money electronically to and from family members and creditors, and finding ways to decrease risk.[1] Correspondingly, microfinance includes the provisioning of a broad range of financial services including loans, deposit services, insurance, payment services and money transfers. While governments have long pursued the goal of financial sector deepening2 to support economic growth, the microfinance industry, focused on markets that have been excluded from formal financial systems, has emphasized the dual and mutually reinforcing objective of financial inclusion, or financial sector broadening. Financial inclusion means making available at an affordable price a wide range of financial services to meet people’s diverse financial service needs, particularly poor, low-income and vulnerable households and micro and small enterprises, including “household firms” 3. In Malawi, 65% of the population lives below the poverty line, with the rural poor being particularly vulnerable. Malawians seek safe savings facilities, payment services, and access to credit and insurance to build assets, increase income, reduce vulnerability, and maintain consumption for food and other services during lean periods.

Many potential markets have been excluded from formal financial sectors for a variety of reasons. Reasons range from legitimate ones, including high transaction costs for both clients and institutions and inadequate technologies in financial markets to manage client and institutional risk, to illegitimate ones, including irrational biases against certain market segments and government policies and donor programmes that undermine financial sector development. Addressing market exclusion in rural areas and agricultural markets has heightened challenges, particularly in Malawi where the economy is highly dependent on a narrow productive base.

Most agricultural markets, often defined by different segments of the agricultural value chain (input suppliers, producers, traders, processors, exporters) lack access to needed financial services, not just the least affluent. In Malawi, as in many countries, formal financial institutions concentrate services in urban areas and town centers. Services concentrate in these areas despite that 86% of the population lives in rural areas, and that agriculture directly employs more than 80% of the labor force, accounts for 54% of GDP (including agricultural distribution) and 90% of exports. Developing financial products and technologies to serve agricultural and rural markets, including smallholder producers and small traders, also requires the development of more complex financial technologies, for example, insurance and derivative products, that can potentially serve all segments of the agricultural value chain from farmer to exporter to reduce risk.

This report assesses the achievements and challenges for microfinance service delivery in Malawi, with particular attention to rural and agricultural markets. It identifies key elements that influence the development of Malawi’s financial system, and provides some recommendations and opportunities for investors, donors, government and private sector entities to support the development of an inclusive financial system. Recommendations focus on getting key policies right, promoting innovation in financial markets, supporting the integration of fragmented markets along the agricultural value chain, promoting transparency and accuracy in institutional performance reporting, and most critically providing financial and technical support to financial institutions that have the appropriate operating and governance structures to intermediate savings in rural areas, where the most challenging but greatest potential markets exist. This report also defines basic microfinance concepts and refers the reader to internet links and other resources to deepen their understanding of microfinance and relevant issues. The reader is invited to use these resources as a basis to challenge and/or deepen some of the conclusions presented in this report and advance the dialogue on inclusive financial systems in Malawi.

Once isolated from the wider financial system, microfinance initiatives in many countries have shifted from shallow programmes designed to win political favour or implement development policies (for example in agriculture) to the development of commercially viable institutions that comprise an important element of the financial system. Globally, microfinance services are provided by a range of institutions including (but not limited to) NGOs, mainstream commercial banks, specialized microfinance banks, non-banking financial institutions and credit unions. To serve massive unmet demand, institutions that provide micro financial services must be integrated with capital and financial markets to tap the financing required to serve growing numbers of clients.

The broader policy and macroeconomic environment enables or hinders the development of microfinance services. Evidence from successfully transformed economies (from centrally-planned to market-oriented) demonstrates that macroeconomic and sector reforms must precede efforts to build financial systems, particularly rural financial systems. Financial sector deepening in Malawi will depend on the Government of Malawi adhering to policies of fiscal and monetary stability, meaning reductions in government spending to further reduce inflation, stabilize the Malawi kwacha and reduce real rates of interest. The Government of Malawi appears to have made advances towards meeting fiscal objectives, having met key budgetary targets under the Staff Monitored Programme in 2004, and having proposed a 2004/5 budget that should reduce government domestic borrowing.

High real rates of interest and an uncertain future remain a major impediment to economic growth in Malawi. These conditions create disincentives for bank lending to the private sector (in June 2003 net lending to the government was more than double that to the private sector; in 2004 net lending to government was projected at nearly three times lending to the private sector), discourages the entrance of new financial service suppliers (particularly those seeking foreign finance), the entrance of new players in the agricultural value chain (traders, input suppliers, etc.) and makes it difficult, if not impossible, for smallholder producers and other players in the agricultural value chain to generate adequate margins. This creates a vicious cycle in which the high cost of inputs, including credit, hinders improvements in the quality and efficiency of production and trade, depressing margins even more.

While the government recognizes that sustainable access to affordable finance is a critical pillar in the Malawi Poverty Reduction Strategy, the absence of broad-based market solutions to supply products and services including inputs, credit, transport, etc. has resulted in donor and government-affiliated projects that provide “credit” with limited expectation of repayment to transfer cash and inputs to households to meet non-financial, welfare objectives (e.g., food security). This approach threatens the development of long-term market-based solutions that have the potential to create sustainable access to finance. It is continual access to services, not one-time injections, that allow people to grow their asset base and reap the poverty alleviation-related benefits that access to finance provides. Careful coordination and sequencing of grant and credit programmes is important to preserve a strong credit culture and to ensure that the greatest number of people can be reached with public resources. Dialogue across sectors that generates coordinated policies and programmes that complement each other to meet financial sector, agricultural development, social policy, and economic growth objectives is critical. Some effective examples of cross-sectoral and multi-donor collaboration, for example the National Action Group (NAG) and the Health SWAP, may offer lessons on how to support an effective cross-sectoral dialogue and coordinated action.

Innovation in products and delivery channels creates value for both suppliers and clients, driving the finance frontier outwards4. Significant disincentives however exist for companies to invest resources required for research and development (R&D) since innovations can be easily adopted by competitors who benefit from new technologies without having to absorb the R&D costs, including the costs of failed attempts to innovate. Donors and/or governments may have a role to play in supporting R&D investments in financial markets.

The Reserve Bank of Malawi, has installed a state-of-the-art switching network (MALSWITCH) to support the national payments systems and smart card technologies. With a reliable communications infrastructure and the presence of Point of Sale (POS) or Automatic Teller Machines (ATMs), the switching system may offer a promising platform for electronic banking services that enables new delivery channels and product development opportunities. The opportunities for electronic banking to deepen and broaden financial sectors however will depend on the development of cost effective business models that support electronic banking applications.

In Malawi, few instruments exist that enable producers, financial institutions, traders, marketing boards, and exporters to manage the price and production risk associated with agriculture. Growing the financial system – thus people’s ability to save, take on loans, make payments, hedge risk and transfer money -- will depend on the development of financial instruments that enable risk sharing and pooling at all levels of the agricultural value chain. In Malawi, however, there are limited incentives for speculators to take on heightened risk with the potential for high returns given the relatively consistent trend of declining tobacco prices. The development of insurance and other products that enable Malawi to pool and transfer risks in national and international markets is another area where donors and governments may have a role to play supporting innovation, particularly for agricultural markets.

Estimating demand for financial services is an imprecise exercise. This study estimates demand for microfinance loans in Malawi at between 300,000 and 760,000 clients. Generally, the method for estimating demand assumes a fixed proportion of the population that can repay credit. Wary of this method, one industry expert likens this method to a magic trick -- “ [the estimator] figures out a reasonable average loan size, estimates the number of borrowers, multiplies by the magic percentage, and presto!” Recognizing the limitations of this method, estimates provided are merely meant to demonstrate that even assuming very limited debt capacity, the potential market is still sizable. Higher end estimates peg loan demand at more than four times the current supply of microcredit. Meeting even limited “effective” demand would nearly double the size of private sector credit in the economy. A more useful way of understanding demand and supply for financial services however is to consider the “frontier of finance” approach, explored below.

The supply of microcredit as of end 2004 is estimated at approximately 230,000 loans. While a range of institutional types exist with the potential to reach different market niches, government owned institutions and government affiliated programmes remain the dominant suppliers, accounting for more than 63% of estimated borrowers and 80% of savings services. Supply and demand estimates indicate a relatively high proportion of met demand, but may be misleading. Given that few microfinance operations demonstrate potential for financial viability now, it is unlikely that a significant percentage of loans will be available on a sustainable basis. From the demand side, given the high level of client exits5 in Malawi (probably more than 50%), a significant percentage of those currently receiving loans do not represent sustained demand.

A more useful way of understanding demand for and supply of financial services is to consider the dynamic aspect of markets. Through innovation, new financial technologies, ways of structuring deals, means of creating confidence, and appropriate incentives, suppliers can engage new clients and market segments, and create both debt and savings capacity. Debt and savings capacity is also enhanced by improvements in productivity in the agricultural sector, improvements in legal frameworks that enable titling of assets and more efficient arbitration, and macroeconomic improvements. A change in any of these variables changes the number of potential clients that are drawn into the financial system. Considering demand for services beyond debt including savings, payment services, money transfers and insurance, demand for financial services seems infinite, and supply limited. Only 3% of the population accesses deposit services now.

Developing an inclusive financial system will require strengthening current players and potentially, supporting the entrance of new players. Currently there are no microfinance operations in Malawi that are fully financially viable (though institutions that have microfinance lines of business may be profitable due to heavy investments in government treasuries.) The absence of retailers that can provide liquid savings accounts, efficiently intermediate savings and provide “one-stop” shops for clients is a glaring absence in Malawi’s financial landscape, particularly in rural areas. Parastatals with their relatively large branch networks and significant knowledge of rural markets, may provide the only potential platform for rural financial service delivery for the majority. However, they will require extensive operational and financial restructuring to realize potential. Malawi Rural Finance Corporation and Malawi Savings Bank are currently receiving support under the World Bank Privatization and Utility Reform Project (PURP) to restructure their operations to prepare for eventual private sector participation in their ownership. Absent significant changes in governance, operational and financial restructuring and capacity upgrades from this process, donors and investors may consider supporting a new, scalable financial institution that can effectively serve rural markets. Seeking results over relatively short-term periods, reluctant to affiliate with government-linked institutions, or simply fed-up with investment in non-performing institutions, some donors and development finance institutions (DFIs) with deep pockets have chosen to walk away from the complex and time-consuming task of transforming parastatals or supporting new, formal financial institutions. Instead, large sums of money have been earmarked to develop community managed savings and credit groups. While these can add a valuable element to a country’s financial system, especially where no financial infrastructure exits, there utility is limited. Informal systems cannot provide the range and depth of services nor the consistency of services required by rural populations. While the task of establishing a formal intermediary in rural areas seems daunting, donors and DFIs with deep pockets should consider investments anew.

Microfinance institutions have made notable achievements in recent years. Many institutions have recovered from the portfolio crises of the early 2000s; operators have attempted to reprice services to eliminate overt subsidies; suppliers have worked to reduce transaction costs by linking with producer and farmer associations and supporting group based lending technologies. However despite these achievements, operators have identified important challenges that remain, and that for the most part are shared across the industry. Operators continue to seek ways to reduce transaction costs for both suppliers and clients, including innovative means to move service points closer to clients. Non-bank operators seek ways to make their success less dependent on the use of commercial banks infrastructure by seeking alternative channels through which to process transactions. Operators seek ways to meet the challenges that HIV/AIDS poses to both clients and staff. With start-up capital exhausted, operators seek access to financing to implement ambitious growth strategies necessary to realize financial viability.

While operators have attempted to support new markets with new products, with some notable exceptions, they have achieved product imitation not innovation, often cannibalizing markets served by other suppliers resulting in limited value creation for either suppliers or clients. While portfolio management has improved, portfolio quality remains vulnerable. The implementation of information systems that can better support management’s quest to ensure portfolio quality, customer satisfaction, and profitability objectives remains an oft-expressed need. Many institutions suffer from weak governance and ownership structures. Companies Ltd by Guarantee seek transformation to shareholding companies with clear ownership structures and incentives for success. Parastatals require a governance overhaul to create effective checks and balances between management and Boards, and to force accountability.

Meeting capacity building needs will require technical support from a range of players including technical service providers with global knowledge and experience in key areas identified by financial institutions. Some successful strategies for accessing global knowledge and expertise have included temporary management contracts (for example, for turn-arounds), technical assistance contracts focused on specific issues or for general strategic support, exchange visits to institutions in other countries with similar operating environments or challenges, and training courses or programmes geared specifically to microfinance or regulation. The cost of international technical assistance can be high; institutions and their supporters should budget appropriately to access this technical support. In Malawi as in many countries, local markets for technical assistance for microfinance are thin. Developing industry infrastructure is required that builds local expertise in financial systems development including not only broad based technical assistance but also specialized firms like audit firms and rating agencies.

An efficient and functioning financial system requires long and short-term debt markets, sources of equity finance, and specialized institutions that can manage institutions’ associated financial risk. Financial institutions in Malawi have limited access to short-term debt markets (though interbank lending has increased in recent months), and almost no access to capital markets (long-term debt finance) and equity finance to develop stable and effective financial structures. There are few institutions that can provide insurance to underwrite portfolios, to manage price and production risks for agricultural markets, including derivatives, or even to provide micro insurance for clients (e.g., death, health, etc.). Developing the microfinance sector will require the emergence of new companies in Malawi or links to foreign companies that serve international markets to meet current deficiencies in the financial landscape.

Though the world of high finance may seems worlds away from the world of microloans, in fact, the development of more complex financial instruments will provide a foundation for the delivery of many kinds of microfinance services. For example, absent instruments that can manage and pool risk of agricultural markets, supply and demand for services for smallholders will remain limited. In some countries, where market failures mean key sectors remain underdeveloped, government has created Funds with appropriately designed incentives to stimulate sector development. Venture capital funds seeded with public funding may stimulate the establishment of new financial service companies, partnerships between financial institutions and technology companies, or the establishment of venture capital financing required to provide equity where stock markets remain inactive. In addition, brokers (public or private sector initiated) can play a useful role bridging information gaps (a key reason for market failure) that match institutions with potential sources of national and international equity and debt financing.

Generating client, donor and investor confidence requires transparency in financial reporting and the establishment of common performance benchmarks that enable comparisons across the industry. Confidence is a prerequisite to accessing new sources of financing, maintaining a stable client base, and achieving high levels of repayment. Non-repayment often results from client assumptions that programmes or institutions are short-lived; sustainable access to services remains the primary reason for high levels of repayment. Transparency also encourages competition that almost universally results in benefits to end users in terms of lower prices and better service. The Malawi Microfinance Network has begun collecting performance data, but the network and its members require support to generate accurate reporting compliant with international standards and to disseminate reporting information widely. Developing a common set of indicators requires the participation of a broad range of stakeholders. Stakeholders include government and lawmakers whose knowledge of the industry and its players will influence policies and legal and regulatory frameworks, and donors and investors responsible for enforcing standards and using information to make investment decisions.

A preliminary assessment of the legal and regulatory framework identifies no serious barriers to entry in the market for new financial service providers in Malawi or the establishment of microfinance operations. While there appears to be no pressing need to open a new regulatory space, several issues relevant to the legal and regulatory environment do require attention now:

• Operating under different legal frameworks, institutions do not have consistent oversight across the industry or are subject to different regulations that may provide competitive advantages to one class of institution over another. Consistent oversight, including required performance reporting under the industry’s various legal frameworks, or under one supervisory entity will encourage stronger client, member and investor confidence;
• Weak oversight of cooperatives that mobilize members’ savings, but fall outside of banking law, presents risks to the safety of members’ savings;
• Widely varying tax laws for different institutional types potentially creates an unlevel playing field; and
• Secondary legislation should be reviewed to ensure that there are no serious regulatory disincentives to establishing microfinance lines of business and that it enables supervisors to adequately monitor microfinance operators that mobilize deposits.

In 2005, the Reserve Bank of Malawi will review the legal and regulatory framework with an eye towards ensuring its conduciveness to supporting a stable and growing microfinance industry as it evolves. The Reserve Bank is also reviewing various aspects of the legal and regulatory framework for other parts of the financial sector (for example, for non-banking financial institutions). A review which looks at the impact of legal and regulatory frameworks on the development of the financial sector as a whole (including for example, the influence of reserve requirements on financial sector development) as opposed to separate industries within the sector, may be a logical next step.

While there may be no compelling reason to create a new legal and regulatory space for microfinance now, the sector will evolve requiring ongoing review of the framework over time. Driving the need for an evolving framework will be:

• the corporate and financial restructuring of parastatals and Companies Ltd. by Guarantee;
• the need for scalable institutions that can effectively intermediate savings;
• the emergence of new kinds of financial institutions to serve market gaps;
• the changing structure of the financial sector with the emergence of new players;
• the potential participation of new kinds of suppliers (for example, retailers) that use technology to offer financial services or that substitute new products for traditional financial services (e.g., stored value cards that operate like savings or lines of credit); and
• an expressed desire on the part of microfinance service suppliers to be recognized as legitimate players in the financial sector.

Supporting the ongoing acquisition of knowledge by regulators and lawmakers to evolve the legal and regulatory framework and to ensure a level playing field will be critical to promote microfinance industry development. In other countries, for example, in Tanzania and Uganda, the success of evolving legal and regulatory frameworks has been attributed to a high degree of information exchange among stakeholders within a specially created forum, not hastily developed laws.

The development and approval of the Malawi Microfinance Policy and Action Plan in 2002 as well as the prominent role that access to financial services plays in the MPRS are evidence of government’s interest in expanding access to financial services. The hard work of government and stakeholders to support policies and initiatives that promote an inclusive financial system however is just beginning. This year, the Government of Malawi established the MWK 5[*] Billion Malawi Rural Development Fund (MARDEF). Attention to the way the Fund is structured to create incentives for suppliers to effectively manage resources and borrowers to repay funds on time will be critical to its success. The visibility and size of the Fund (nearly 50% of total estimated microfinance loans now) creates significant opportunity to demonstrate sound practices to increase access to financial services, or conversely further weaken the sector and destroy any real opportunities for inclusive financial system development.

Recommendations to support the development of an inclusive financial system that serves a wide range of market segments including the poor, vulnerable and unbanked populations with diverse products are explored in the report. Key recommendations include:

• Providing appropriately structured incentives to support innovative products (e.g., insurance, savings, remittances, derivatives) and delivery channels (e.g., electronic card-based, physical, input suppliers) and institutions that can provide them is required. While the world of capital markets, equity finance and derivatives seems unrelated to microfinance, development at various levels in the financial system is required to support financial markets at the grass roots.
• The industry has realized important achievements in recent years, but capacity building needs remain. Key capacity building needs include corporate restructuring of parastatals, institutional transformation of Companies Ltd. by Guarantee to shareholding companies, development of state-of-the-art management information systems to support financial management for profitability and high portfolio quality, and product development, particularly for rural and agricultural markets.
• Reaching markets in rural areas requires the development of a scalable financial institution that can effectively intermediate savings. Government with their investors must decide whether the political and institutional potential exists to support radical transformation of parastatals or whether it requires building a new intermediary with an inventive business model that can serve rural markets.
• Radical changes to the legal and regulatory framework appear not to be required now, but supporting the acquisition of knowledge of the Reserve Bank of Malawi, the Ministries of Industry and Commerce, Agriculture and Finance will support the evolution of policies and frameworks over time.
• Supporting dialogue among stakeholders across sectors to meet the challenges of the industry as it evolves, and through an organized forum, is critical.
• An industry infrastructure (auditors, technical service providers, raters, practitioners network (Malawi Microfinance Network), etc.) that can support regulators as well as financial service providers will support professionalization and transparency in the sector and its ongoing development.