MICROBANKING BULLETIN - Microfinance Information Exchange

APPENDICEScurrent year’s inflation rate, which results in inflationadjustment income, offsetting to some degree theexpense generated by adjusting equity. 16 On thebalance sheet, this inflation adjustment results in areordering of equity accounts: profits areredistributed between real profit and the nominalprofits required to maintain the real value of equity.MFIs that borrow from banks or mobilize savingshave an actual interest expense, which is anoperating cost. In comparison, similar MFIs thatlend only their equity have no interest expense andtherefore have lower operating costs. If an MFIfocuses on sustainability and the maintenance of itscapital/asset ratio, it must increase the size of itsequity in nominal terms to continue to make thesame value of loans in real (inflation-adjusted)terms. Inflation increases the cost of tangible itemsover time, so that a borrower needs more money topurchase them. MFIs that want to maintain theirsupport to clients must therefore offer larger loans.Employees’ salaries go up with inflation, so theaverage loan balance and portfolio must increase tocompensate, assuming no increase in interestmargin. Therefore, a program that funds its loanswith its equity must maintain the real value of thatequity, and pass along the cost of doing so to theclient. This expectation implies MFIs should “pay”interest rates that include the inflation-adjustmentexpense as a cost of funds, even if this cost is notactually paid to anyone outside the institution.Some countries with high or volatile levels ofinflation require businesses to use inflation-basedaccounting on their audited financial statements.We use this same technique in the Bulletin. Ofcourse, we understand that in countries where highor volatile inflation is a new experience, MFIs mayfind it difficult to pass on the full cost of inflation toclients. We are not recommending policy; rather,we are trying to provide a common analyticalframework that compares real financialperformance meaningfully.SubsidiesWe adjust participating organizations’ financialstatements for the effect of subsidies byrepresenting the MFI as it would look on anunsubsidized basis. We do not intend to suggestwhether MFIs should or should not be subsidized.Rather, this adjustment permits the Bulletin to seehow each MFI would look without subsidies forcomparative purposes. Most of the participatingMFIs indicate a desire to grow beyond the16 In fact, an institution that holds fixed assets equal to its equityavoids the cost of inflation that affects MFIs, which hold much oftheir equity in financial form.limitations imposed by subsidized funding. Thesubsidy adjustment permits an MFI to judgewhether it is on track toward such an outcome. Afocus on sustainable expansion suggests thatsubsidies should be used to enhance financialreturns. The subsidy adjustment simply indicatesthe extent to which the subsidy is being passed onto clients through lower interest rates or whether itis building the MFI’s capital base for furtherexpansion.The Bulletin adjusts for three types of subsidies: (1)a cost-of-funds subsidy from loans at below-marketrates, (2) current-year cash donations to fundportfolio and cover expenses, and (3) in-kindsubsidies, such as rent-free office space or theservices of personnel who are not paid by the MFIand thus not reflected on its income statement.Additionally, for multipurpose institutions, TheMicroBanking Bulletin attempts to isolate theperformance of the financial services program,removing the effect of any cross subsidization.The cost-of-funds adjustment reflects the impact ofsoft loans on the financial performance of theinstitution. The Bulletin calculates the differencebetween what the MFI actually paid in interest on itssubsidized liabilities and the deposit rate for eachcountry. 17 This difference represents the value ofthe subsidy, which we treat as an additionalfinancial expense. We apply this subsidy to thoseloans to the MFI that are priced at less than 75percent of prevailing market (deposit) rates. Thedecreased profit is offset by generating an“accumulated subsidy adjustment” account on thebalance sheet.If the MFI passes on the interest rate subsidy to itsclients through a lower final rate of interest, thisadjustment may result in an operating loss. If theMFI does not pass on this subsidy, but instead usesit to increase its equity base, the adjustmentindicates the amount of the institution’s profits thatwere attributable to the subsidy rather thanoperations.Loan Loss ProvisioningFinally, we apply standardized policies for loan lossprovisioning and write-off. MFIs vary tremendously17 Data for shadow interest rates are obtained from line 60l of theInternational Financial Statistics, IMF, various years. Thedeposit rate is used because it is a published benchmark in mostcountries. Sound arguments can be made for use of differentshadow interest rates. NGOs that wish to borrow from bankswould face interest significantly higher than the deposit rate. Alicensed MFI, on the other hand, might mobilize savings at alower financial cost than the deposit rate, but reserverequirements and administrative costs would drive up the actualcost of such liabilities.56 MICROBANKING BULLETIN, SEPTEMBER 2000