Microleasing - A means for scaling up microfinance?

Content

1 Introduction

2 Major Trends affecting Microfinance
2.1 The Millennium Declaration
2.2 The Bottom of the Pyramid (BoP)
2.3 The Role of Innovation at the BoP

3 The current State of Microfinance

4 Leasing and its Development Impact
4.1 The History of Leasing
4.2 The Evolution of Leasing in Developed Markets
4.3 Potential for Leasing as a Development Tool

5 Microleasing: The Logical Consequence?
5.1 Characteristics of Leasing
5.1.1 Introduction
5.1.2 Types of leasing
5.1.3 Types of risk and risk mitigation strategies
5.1.4 The range of leased items
5.1.5 The client perspective
5.1.6 Provider perspective
5.2 The Leasing Environment
5.2.1 Potential leasing clients
5.2.2 Existing and potential leasing providers
5.2.3 Regulatory and legal situation
5.2.4 Accounting and taxation
5.2.5 Repossession
5.2.6 Rural Leasing and subsidies
5.3 Distinctive Features of Regular, SME and Micro- Leasing & Lending

6 Sample Cases
6.1 Introduction and Relevance to this Paper
6.2 Background
6.3 Value Chain Analysis
6.3.1 Product ranges and target groups
6.3.2 Terms and conditions
6.3.3 Selection, approval and purchasing processes
6.3.4 Repossession, remarketing and residual value management
6.4 Success factors and institutional performance
6.5 Conclusions and Outlook

7 Strategic Implications on Scaling Up Microfinance
7.1 Why MFIs should scale up
7.2 How MFIs should scale up
7.3 Final remarks

8 Bibliography

List of tables

Table 1: Microfinance providers and customers

Table 2: Combined loans and savings accounts (in thousands) in worldwide microfinance

Table 3: The world market of external funding as of 2006

Table 4: How leasing aids domestic development

Table 5: Overview of key risks in loans, finance lease and operating lease

Table 6: MF & ML client strata

Table 7:“Transformation lending” is a potential niche for leasing providers:

Table 8: Leasing provider in developing countries

Table 9: Grameen and INDES leasing conditions

Table 10: Grameen and INDES leasing workflows

List of figures

Exhibit 1: Microfinance targets at the working poor without access to traditional banking services

Exhibit 2: Microfinance coverage in selected regions

Exhibit 3: The spectrum of financial service providers

Exhibit 4: Leasing markets

Exhibit 5: Mobile asset leasing share of overall domestic investment

Exhibit 6: The standard lease operation

Exhibit 7: Sample net present value analysis from a formal client’s point of view

Exhibit 8: Lease payment calculation

Abbreviations and Acronyms

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1 Introduction

Leasing as a means for scaling up microfinance is a relatively new and untapped topic. A lot of information about regular leasing in developed countries is available. In addition, some projects on leasing in developing countries have been successfully carried out. The International Finance Corporation (IFC), for example, successfully pioneered in entering the South Korean market and from there India, Pakistan, Turkey, and Russia. Surprisingly, information on leasing at the very micro-level of such economies is rare.

In times of commercialization and product diversification among microfinance institutions, insurance and remittance services as well as savings products have gained much attention. Leasing still is underdeveloped in that respect. This paper aims at the analysis of leasing in microfinance institutions and its potential to increase and upgrade the institution itself as well as its customers. As there clearly is a shortage of research and data in that field, the author will present the most recent literature available, including the state of microfinance and leasing in developing countries. Due to the lack of academic and practical information, this paper can not contain a complete analysis of all aspects of microleasing. It rather discusses the main features of microleasing with respect to the success factors of microinsurance, microcredit, microsaving and other products already introduced in microfinance institutions. The author will highlight the major opportunities and threats to the microleasing business that are likely to be faced by its stakeholders. The distinctive features of more advanced countries on the one hand and less developed and informal economies on the other hand will be part of the paper, as well.

The thesis divided into six parts. The first part is about the environment of microfinance and three major trends that had and still have a significant impact on its development. The second part analyzes today’s microfinance industry and its stakeholders. Once the structures and characteristics of microfinance in general are explained, the focus is shifted to leasing and its development impact. Part three highlights the evolution of leasing in developed markets as well as the conclusions for today’s developing world. It is complemented with the in-depth analysis of leasing in part four which provides an insight into the features of microleasing in comparison with regular leasing. The sample cases in part five illustrate two approaches to microleasing in practice. In addition, the implications for the process of scaling up clients and the microfinance institution at the same time are covered. Insights are gained from the two very different organizations giving hints on elements for replication in other microfinance institutions. Both, the practice- and the theory-based clues are finalized in the last part giving practical advice in the form of an introduction into strategic and operational challenges for the development of microleasing within the microfinance context.

The detailed structure of this paper

Microfinance (MF) is not an isolated line of business. It is not even sure whether it is the cause or the consequence of upgraded economic conditions. Some even argue MF is nothing but a symptom of a weak financial system because seemingly social ties are the only means of ensuring the timely repayment of debt (See Prahalad 2005, p. 64). For that reason, microfinance has to justify its existence with the improvement of poor entrepreneurs’ living standards through the upgrade of their business. Therefore, microfinance must be assessed in the context of all major economic trends affecting its development.

This paper starts with the description of the Millennium Development Goals initiative. Micro finance was found to play a crucial role in it and plans have been made on how to utilize its opportunities for development in virtually every developing country in the world.

Micro leasing as a part of microfinance, in that respect, is even more dependent on overall legal and economic conditions because of its role as a mediator between its clients on the one side and the production sectors or trade partners on the other side. For that reason, the markets at the so-called bottom of the pyramid are described with respect to financial and entrepreneurial potential, in the second chapter. As an outlook, the outstanding opportunities deriving from information and communication technologies (ICT) are described and illustrated. ICT has made the world flat (Friedman 2006, p. 497) and offers whole new ways of tackling micro-level problems that leasing providers are likely to face in the developing world.

In the following part, the history of microfinance and its major drivers are introduced. They lead to the current state of microfinance being subdivided into different networks. These, in turn, are categorized according to their philosophy and operational design. A critical view on those issues is given at the end of the chapter.

That is followed by a presentation of the leasing history and the basic principles and models in leasing. The emergence of such services in developed countries gives an overview of what can be achieved within an enabling environment that facilitates the investment in leasing. Success factors, opportunities, and risks to the developed markets will be scrutinized in their applicability for emerging and underdeveloped economies. Ultimately, the gaps that leasing is eligible to fill are shown and the potential for the development of an entire economy is evaluated. This part of the paper serves as a kind of future oriented justification for the investment in leasing because it explicitly refers to similar developments in the history of industrialized countries, thus giving hints on the impact leasing could have in developing countries.

The fourth part “Microleasing: The logical consequence?” begins with a definition of microleasing. Subsequently, the different types of leasing that seem to be viable in early development stages of market economies are presented as well as the risk related to them and the items that could be leased.

After all, the demand for leasing strongly depends on the clients’ and providers’ preference for that type of financing. Under which circumstances each party may or may not favour leasing is discussed in the remainder of this part of the paper. Tax issues, accounting, the legal and regulatory environment, economic conditions and the status of the financial system are among the parameters that could have a significant impact on the demand and supply situation. A closer look will be taken at the special needs in a rural context and the role of subsidies. It is finalized with a conclusive comparison between regular, SME, and micro-leasing.

After that, two case studies serve as practical evidence of the potential of leasing under favourable circumstances as described in the chapters above. The first case is about the Chilean INDES Leasing company. It is a for-profit organization with a strong institutional backing from a successful microfinance institution, the government, and international investors. In contrast, the Grameen Bank, a NGO being among the largest microfinance and microleasing providers in the world, follows a socially driven path. Both institutions are thoroughly examined for distinctive and common features. Based on the evaluation of their performance, conclusions are drawn with respect to the future prospects of both organizations.

The sixth part is a final statement on what has been found out in the previous parts and chapters. It covers operational and strategic implications on how to achieve an upgraded microfinance institution.

2 Major Trends affecting Microfinance

Microfinance is an approach to delivering financial services to poor people. The services target at increasing the income capacity of households and micro-entrepreneurs. Such customers tend not to have the requirements that are necessary in traditional banking such as collateral.

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Exhibit 1: Microfinance targets at the working poor without access to traditional banking services

Therefore, microfinance is focusing less on traditional banking principles but rather on innovative approaches. In the ‘welfarist approach’ that dominated the last century self-help groups or similar entities commonly evaluated and monitored projects to be financed. The principles of trust and social control took over the risk mitigation function of collateral in traditional banking. However, in recent years, the upcoming commercialization and investment demand by commercial players have changed the playing field. The ‘financial systems approach’ is more targeting at improving the soundness of the microfinance institutions in order to make them sustainable. The shift in paradigm is reflected by the changes within the famous Grameen Bank in Bangladesh. The Nobel Peace Prize winning institution has become Grameen II in order to reflecting the shift towards commercialization. Group funds (common savings accounts) and group responsibility have been substituted by individual loan schemes and accountability.

The requirements in financing larger projects over a long time have long been a matter of credit history. Incremental credit schemes allowed for gradually increasing loan amounts only after the successful repayment of preceding loans. This is where leasing could play a crucial role. Its potential for scaling up microfinance will be analyzed in the remainder of this paper.

2.1 The Millennium Declaration

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On September 18, 2000 the General Assembly of the United Nations adopted a resolution named A/55/L.2. This resolution has become increasingly popular under the name “United Nations Millennium Declaration”. It serves as the UN’s guideline and pathway to the millennium development goals (United Nations General Assembly 2000, p. 1). Among the variety of goals to be achieved by the year 2015 the eight cornerstones displayed at the left side are outstanding. Microfinance was found to be one of the most promising means in order to achieve at least some of these major goals.

The impact of access to financial services received even more recognition as the 2005 International Year of Microcredit was launched by the United Nations Organization and its Development Program UNDP. The head of UNDP at that time and subsequent Deputy Secretary-General Mark Malloch Brown said that “microfinance is much more than simply an income generation tool. By directly empowering poor people, particularly women, it has become one of the key driving mechanisms towards meeting the Millennium Development Goals, specifically the overreaching target of halving extreme poverty and hunger by 2015” (UN Department of Public Information 2004, p. 2).

The recent publicity is a result of a long-term development. The essence of microfinance can be traced back at least to the 18th century as loan funds in Ireland were channelled to self help groups. In Germany, predecessors of today’s savings banks emerged at that time. Based on their experience and with other institutions like Raiffeisen’s credit associations and credit cooperatives invented by Schulze-Delitzsch, Germany managed to overcome poverty among millions of people during the industrialization period of the 19th century.

However, the term microfinance itself, or rather Micro credit, refers to what started in the 1950s in many developing countries. “The crucial problem for such countries is to achieve sustained growth, not to smooth short term fluctuations”. (Friedman 1973, p. 39) Sustainable growth at a large scale was recognized as being essential to a nation’s development hand in hand with a low-inflation policy. Traditional down-to-earth industries were found to be the key to growth rather than government subsidized prestige projects (See Friedman 1973, p. 43). And access to financing in order to increase and improve production in this sector is the key in triggering development.

Exhibit 2: Microfinance coverage in selected regions

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Source: Daley-Harris 2002, p. 231

Informal microfinance without broad-based development impact has been in place in most of the countries. For example, there have been “tandas” in Mexico and “arisan” groups in Indonesia as kinds of neighbourhood savings and credit clubs since the 19th century.

The situation changed in the 1950s as agriculture was heavily promoted by governmental programs and funds. On the one hand, credit was available in rural areas at affordable yet subsidized interest rates. On the other hand, the existing though ‘fragile’ loan providers in these areas were pushed out of the market. In the 1970s, projects were initiated to support women and their micro businesses in Bangladesh and Indonesia.

That constituted a shift away from supply driven and subsidized approaches toward tailored and demand driven loan products with a significant leverage effect on the society. Today, the Grameen Bank and Bank Rakyat Indonesia (BRI) are some of the best-known MFIs in the world.

Women were no more neglected by formal banks but considered being reliable customers. At that time it became evident that mobilizing savings could help reducing dependence on government and donor funds (See Schneider 1997, p. 43-44). Self help groups emerged rapidly with the support of countless NGOs and linkage programs ensured the inclusion of these groups in the financial markets.

Exhibit 3: The spectrum of financial service providers^[1]

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Source: Helms 2006, p. 36

On the way to achieving the goals stated in the Millennium Declaration, microfinance has proved to have grown to a potent measure in reaching the millennium goals. Especially the impact on women can help improving the overall living conditions of families. Medication, food, education, communication, transportation can become affordable or at least be financed through additional sources of income.

Therefore, the challenge is expanding the outreach to poor but economically active people and increasing the efficiency of MFIs in order to become or remain sustainable. Microfinance has to be integrated in a country’s overall financial architecture which in turn is integrated in an overall development strategy (See Ledgerwood/White 2006, p. 21ff.).

2.2 The Bottom of the Pyramid (BoP)

The Millennium Development Goals are designed to reduce the number of destitute and poor people. There is a lot of discussion whether and to what extend microfinance institutions (MFI) can help reaching these poor people at affordable cost, be self-sustainable, and not adding a debt burden on these families at the same time (See Daley-Harris 2005, p. 11). Whatever the result, the potential target group is an estimated four billion people living on less than $2 per day adjusted for PPP (Prahalad 2005, p. 3ff.). The number of four billion implies a heterogeneous socio-economic composition of people from all over the world and with manifold backgrounds. However, there are some similarities in terms of poverty-specific problems.

First of all, in order to highlight the relevance of the Bottom of the Pyramid (BoP) it is useful to understand the dimension of purchasing power in developing economies. Especially the BRIC countries have to be put in focus (See Smith 2006, p. 73). They represent a population of about 2.7 billion compared to the European Union with 487 and the United States with 298 million people (See The CIA World Fact Book 12006). By way of comparison, these markets are still considered having a rather low purchasing power. However, the purchasing power adjusted GDP of the BRIC countries combined is estimated at more than $17 trillion compared to the $13 trillion of the European Union or United States, respectively (The CIA World Fact Book 22006).

But the purchasing power is trapped for a high portion of people. A comparison of the costs of basic goods and services reveals a so-called poverty premium. The interest rate for a credit in a Mumbai (India) shanty town varies from 600 to 1,000 per cent per year. In the nearby district Warden Road the cost for borrowing money only equals 12 to 18 per cent. The poverty premium is a price raised 50-fold. Drinking water can be purchased at a cost of $1.12 and $0.03, respectively - a 37-fold price increase. Even phone calls and medication are 1.8 and 10 times more expensive for poor people within the city of Mumbai (Prahalad/Hammond 2002, p. 8). The main reasons are a lack of information and education among the customers as well as a monopolist informal sector.

Poor people are less likely regarded as being customers than their rich counterparts. “The greatest harm they [MNCs] might have done to the poor is to ignore them altogether” (Prahalad 2005, p. 5) and not to bring fair competition to shanty towns. There are exceptions, however, to that statement as Unilever has proved with its Indian subsidiary Hindustan Lever Ltd. (Prahalad 2005, p. 207 ff).

It is one side of the coin to be poor because of high prices. The other side of the coin is remaining poor because of a lack of opportunities in climbing up the social and economic ladder. There are countless approaches on how to explain poverty. As this paper aims at the integration of leasing as another commercial tool into the microfinance system, the author will only stick to the most daunting problems in the economic development.

Besides the poverty premium as explained above there is another “poverty trap” phenomenon: untapped capital.

Registering or expanding an enterprise, purchasing a house or land are common procedures in developed countries. When Peruvian economist Hernando de Soto, founder and president of the Institute for Liberty and Democracy^[2], and his team conducted a study about the bureaucracy and the lack of formal property in different developing countries, he found disillusioning results. It took his partners 289 days at a cost of $1,231 to register a single-person business. That amount equals 31 times the minimum wage in Peru (See de Soto 2001, p. 18). In a number of other countries and samples this result was validated. The team gathered information about real estate prices in Cairo, Lima, Manila, Mexico City, and Port-au-Prince in order to calculate the hidden wealth. In all cases real estate (the most obvious property) was not registered to a large extent. On the contrary, the overall value of the real estate e.g. in Egypt is estimated $240 billion or 30 times the value of all shares on the Cairo Stock Exchange. In Peru, the extra-legal property is estimated to be $74 billion - about 14 times the FDI ever invested in that country (See de Soto 2001, p. 32). The Institute for Liberty and Democracy estimates the overall value of rural and urban real estate in developing countries being more than nine trillion US Dollar (See de Soto 2001, p. 33). Mobilizing this untapped capital is essential in promoting money based trade rather than barter trade with its practical limitations for these countries. Furthermore, the capital is urgently required for participating in the globalizing world trade and financial transactions.

One promising way of tackling such problems in BoP markets evidentially is information and communication technology (ICT). The digital divide has turned into the opposite - “The world is flat” or “Globalization 3.0” as Thomas L. Friedman (See Friedman 2006) coined it. The activation of untapped capital and the integration of a developing economy into the global trade could not be achieved without the ICT.

2.3 The Role of Innovation at the BoP

“The purpose of a business is to create a customer. Innovation and marketing are the prime tasks.” (Drucker 2002, p. 37)

Innovation in ICT as well as business approaches improves private and public services. It triggers economic development and must be part of any entry strategy to BoP markets.

Especially in rural areas innovation in ICT is an essential way of connecting people. For instance, the problem of high transaction costs in public services can be tackled with ICT approaches, thus boosting the economic system, as described above. Leasing companies depend on public services such as registration of commodities.

As a first example, the people in the Indian state Andhra Pradesh were used to bribery, nepotism, humiliation, and long queues. That has changed with Internet kiosks installed by the government and a comprehensive eGovernance project. Internet based systems allowed the citizens for birth certificate applications, school registrations, paying bills, and registering property. The processes became transparent, safer, and much faster. Despite initial problems with suspicious citizens and new forms of corruption, the project turned out to be a success and will be further supported. A watchdog was deployed to make sure no mission drift occurs in the future (See Prahalad 2005, pp. 85-98).

Second, private sector involvement and innovative business approaches have upgraded and changed the way business is conducted at the BoP.

In Nicaragua, Financiera Calpiá unions offer combined credit and savings products designed to smooth the seasonal income of farmers. A similar product offered by the Bolivian MFI Caja los Andes tailors the loan disbursement and repayment to the expected harvest periods (See Buchenau 2003, p.5ff). In Bangladesh, a pilot project is started with another flexible loan product. Customers pay the interest up front and repay within the agreed period as they wish. The loan amount can be increased as clients have repaid the preceding contract as agreed. In Brazil, the rural customers of SICREDI can save and borrow money in combination with crop insurance. Moreover, 173 Central American credit unions have launched IRnet, an international remittance network connected to the US (See Evans/Ford 2003, p. 11ff). The NGO Technoserve has helped developing a credit scheme based on the harvest of farmers in Ghana. The MFI offers credit against the collateralized crop enabling the farmers to pay urgent cash-needs and stock their products until prices are more favourable than in the main harvest time. Later - in the off-season - the yields are used to repay the loan (See The World Bank Rural Sector Board 2003, p. 36). In India people can deposit money into their account in manned telephone booths whereas in South Africa the bank dispenses cash through armoured trucks to their customers. There are countless ideas that proved to sustain the microfinance movement.

A recent idea that gained attention in the press is the concept presented at www.kiva.org where individuals can invest money in a project that is attended by a partner MFI in a developing country. The projects are presented directly by the micro-entrepreneurs who apply for the money. There is no interest charged on the one hand and no certainty to be repaid on the other hand, other than the MFI-customer credit history suggests.

The examples above illustrate innovative thinking in terms of products and procedures. In addition, innovation in ICT facilitates the flexibility of such institutions.

The Bolivian bank Prodem FFP provides most of its services through sophisticated ATMs. They recognize fingerprints instead of PINs and offer verbal guidance through the processes in different languages and with different colour codes with respect to illiterate customers. The use of smart cards also saved costs as the ATMs are only connected to the internet once or twice a day. The machines are purchased for $18,000 which is less than half the price of common ATMs because of the fact that Prodem decided to offer a limited range of high quality products. For example, the denomination of cash is limited to a few amounts (Hernandez/Mugica 2003, p. 1ff). There are even more examples like the Interactive Voice Response (IVR) technology in a Peruvian rural bank, handheld computers for bank officers in Venezuela, Mexico, India, and Dominican Republic and there are automated credit scoring systems at BancoSol (Bolivia), Mibanco (Peru), Women’s World Banking (Dominican Republic and Colombia), and Unibanka in Latvia.

The Digital Dividend Project Clearinghouse (www.digitaldividend.org) aims at collecting best practice solution, shares intelligence, and provides background information on these issues (Prahalad/Hammond 2002, p. 10).

The variety of operational and technological innovation from BoP markets can be a competitive advantage over Western companies. The Indian chemical company Reliance, Brazil’s manufacturer of small aircrafts Embraer, the Turkish full-service trade conglomerate Koc, Cemex from Mexico, and Orascom from Egypt are only some examples of upcoming blue chips from emerging or developing countries. They survived and grew in a hostile environment and gained valuable insights on how to serve BoP customers.

3 The current State of Microfinance

Today, there are more than 30 microfinance networks representing a large share of all MFIs. These networks and their business models are competing for several reasons.

1. They have different approaches to the lending procedure. Whether the loan is disbursed to a group or toward individuals is a fundamental question. The Grameen Bank model, for example, has been following the group lending path in the 1990s whereas ProCredit has promoted the individual responsibility loan in its network’s MFIs.
2. Whether or not to offer market price interest rates is another critical point. Some MFI-networks do not see the point in making money with the poor. Their view is that the development goals of microfinance can only be achieved through capped and subsidized interest rates below market prices.
3. The term outreach as a central success factor of MFIs is defined differently, as well. For some financial service providers it is important to serve the customers without access to finance. Others focus on serving the poor only and some even exclude all people but the very poorest from their activities. The tools for measuring poverty in that respect are subject to arguments within the development community.
4. Product portfolios vary from credit only to a comprehensive range of services like deposits, insurance, and remittances.
5. Another question in microfinance is whether to separate the financial services from other development activities. It determines whether to take action in conjunction with educational, health care, religious, and other development efforts or to stick to the core business only.

The largest networks are ACCION, Opportunity International, ProCredit, FINCA, Women’s World Banking, and Grameen with its Grameen foundation to replicate the business model in other parts of the world (See CGAP 2004).

Some of these networks are exclusively comprised of NGOs and their members and financed accordingly; some have managed to attract donor funds. Recently, commercial bank involvement also increased. ACCION and ProCredit are probably the most recognized networks among international banks. Their co-operation efforts will be further introduced at the end of this chapter.

Table 1: Microfinance providers and customers

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The outstanding criterion, however, is whether or not a network wants its MFIs to operate for financial profit or not for profit. It is a significant difference if a MFI is sustainable or profitable. Sustainable means that the MFI is covering operational costs - sometimes capital costs of donor funds are also included in this measure. Profitable MFIs, in turn, are covering operational costs as well as the cost for market based capital and strives to generate a profit margin. The reason for having different perspectives is reflected in the microfinance history. The state owned rural banks have not proved being successful in terms of development impact and repayment rates (See Helms 2006, p. 4). Therefore, uncollaterized loans were provided through NGOs from the 1970s on. The next generic step was involving commercial banks in the 1990s.

Table 2: Combined loans and savings accounts (in thousands) in worldwide microfinance

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Table 3: The world market of external funding as of 2006

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Today, investment funds, mezzanine capital, guarantee funds, and the largest banks in the world take their first steps into the microfinance business. The capital market based funding is, of course, available to profitable MFIs only, which have already achieved high levels of professionalism and are rated accordingly. These MFIs have applied commercial principles like increased cost recovery as well as operational and financial self-sufficiency and can now take deposits and source market based funds as a for-profit institution within the formal financial system (See Ledgerwood/White 2006, p. 27 Introduction).

The lines between commercial banks and microfinance institutions are increasingly blurring: Large commercial banks could enter emerging markets directly or through Microfinance Investment Vehicles^[3] (MIVs) or credit lines, or all of them at the same time. MIVs, in turn, source funds from International Financial Institutions as well (See Microrate 2006, p. 2ff). Even among commercial banks the reasons for investment in this business differ. Some merely fulfil their corporate citizenship requirements with respect to developing countries, other global players expect profitable outcomes based on experiences gained in these markets - but most of them follow both targets at the same time (See van der Putten et al. 2006, p. 49). Citigroup, for example, is present at the retail level in India (Citibank) and Mexico (Banamex). In addition, its wholesale activities can be found in more than 20 countries. Its internal microfinance department focuses on commercially oriented activities and delivers services such as loans, hedging, bond issuing, securitization etc. The Citigroup Foundation, on the other hand, focuses on philanthropic activities and technical assistance (See van der Putten et al. 2006, p. 57).

Furthermore, the ICICI Bank pilot in India shows that local players can be an important source of investment, too (See The Economist 2005). Other important projects on a global or international scale are the joint venture between the ACCION network and ABN AMRO, the Deutsche Bank microfinance fund, and the ResponsAbility initiative of Swiss banks. Commerzbank holds significant equity stakes in South-East and Eastern Europe in the purely commercially oriented ProCredit banks (See van der Putten et al. 2006, p. 55ff). The network of affordable remittance services as installed by the Bank of America (Mexico) and HSBC (Philippines) adds to the diversity of microfinance investment opportunities (See The Economits 2005).

With all the recently developed possibilities in commitment to this business - reliable information on the performance of MIVs and MFIs is only available for some rated^[4] and transparent institutions. First tier^[5] MFIs representing about two per cent of all MFIs gain a lot of attention from the investors as they fulfil the minimum requirements of the investors’ risk departments. The lower tier sphere is still facing difficulties in attracting external funds needed for expansion (See Dignity Fund 2006, p. 5-6). Donor funding is still required in order to kick-start organizations that aim at being profitable in the long run.

Critics of microfinance complain about a general lack in transparency of MFIs. The microfinance pioneer Grameen Bank was attacked for not publishing realistic repayment rates and confronted with the little progress made in Bangladesh in terms of poverty reduction (See Pearl/Philips 2001). In addition, loans are found to be used for consumption purposes instead of investment by the large number of non-entrepreneurial customers (See Dichter 2007, p. 8ff). The result is said to be a disability to boost economic development with microcredit as proposed by Grameen (See Jopson 2007) especially in rural areas. “Does the dominant role played by SMEs reflect poor enforcement of commercial contracts outside the neighbourhoods in which they operate?” (Prahalad 2005, p. 64) That question implies that MFIs are caused by a dysfunctional economic environment rather than its cure.

Whether these critical statements are relevant for private sector involvement in microleasing, as well, will be discussed in the following chapters.

4 Leasing and its Development Impact

4.1 The History of Leasing

What is called “leasing contract” today has a long history before the term itself was coined. Relicts were found in today’s territory of Iraq that suggest leasing arrangements in that region as early as 350 B.C. conducted by the Sumerian people. Idle land was leased by landlords to farmers for a fixed share of the harvest. In case oxen were let to them, as well, the risk was on the farmer’s side as long as he could have saved the animal/land from harm. In every other case the risk was with the lessor. The Babylonian king Hammurapi (1728 - 1686 B.C.) introduced these binding rules, therefore the very first leasing legislation (See Stromberg 2005, p. 6).

Exhibit 4: Leasing markets

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Source: Euromoney Yearbooks 2006, p. 16ff.

The European roots of leasing can be traced back to the Greek culture about 350 years before Christ. The philosopher Aristotle said wealth comes from using an asset rather than owning it. Mines, ships, enterprises, and slaves were leased in that time (See Spittler 1992, p. 1). However, the first company in modern history applying that kind of arrangement under the name “leasing” was the Bell-Telephone-Company in the United States. In 1877, telephone sales activities were supported with the option to rent a phone rather than purchasing it. The captive finance department merely supported the core business in that case. The first financial institution focusing on leasing as the core activity was the San Francisco based United States Leasing Corporation in 1953. Its business model was replicated all over the Western world boosting the leasing industry in these countries (See Feinen 2002, p. 3). In the year 2004, overall leasing volumes amount to more than $550 billion globally representing a penetration of about 30 per cent in the US and 12.5 per cent in the OECD member states but significantly less (in a range of about 1-9 per cent) in developing countries as a share of commercial investment in fixed assets (See Nair et al. 2004, p. 23ff).

4.2 The Evolution of Leasing in Developed Markets

According to the figures above, Europe and North America account for more than 80 per cent of the global leasing market. The largest leasing region is Europe with an overall volume of €270 billion in new contracts or €600 billion outstandings in 2005, respectively. Leasing is used in all economic sectors and virtually every asset can be leased. The market is dominated by equipment leasing such as road transport vehicles and cars, ships, rail, planes, and industrial machinery. However, real estate leasing and hire purchasing are gaining importance through significant growth in the last decade (See Leaseurope 12006).

Especially the regulatory and tax environment has had an outstanding influence on the performance on these leasing industries. Therefore, legislation in all its facets in Europe and all over the world has facilitated or hampered different environments for leasing activities, consequently different acceptance of this kind of financing. Legal definitions, tax regulation, and the accounting standards in every economy can vary significantly making it impossible to come to a universal understanding of leasing. Basically, this paper will stick to the widely accepted definition according to the economic substance as to be explained later. It refers to the economic ownership rather than formal ownership over the item. Since the lessee bears most risk and mostly gains from opportunities relating to the asset, he will be regarded as the economic owner in that respect.

In the early stage of development, financial leasing has been more important than operational leasing and it still is in developing economies (See Fletcher et al. 2005, p. 2). Fully developed leasing markets have diversified into a number of the following leasing variations:

- Real estate leasing (Land and buildings are leased between two or three parties)
- Hire-Purchase (Ownership is gradually transferred from the lessor to the lessee as the instalments are being paid continuously)
- Sale and lease back (Gaining liquidity through selling an asset to a leasing company and then leasing it back - intangible assets can be the basis of such a financing, as well)
- Revolving leasing (After the duration of the lease term another contract follows up, often with an updated version of the property)
- Special leasing (Not fungible assets are leased in a customized big-ticket lease)
- Full-Service Leasing (Lessor offers a range of additional services complementary to the asset)
- Zero Leasing (Interest and administrative costs are cancelled in favour of sales promotion e.g. for a car producer)
- Cross-Border-Leasing (Leasing contracts across national borders with the intention to save taxes due to differing tax legislations of the two host countries)
- TRAC-Leasing (Terminal Rental Adjustment Clause is an open end leasing for trucks and other vehicles)
- Synthetic Leases (The asset does not occur in the balance of the lessee but in the accounts of a special-purpose entity owned by the lessee in order to save taxes)

All these and even more types of leasing could emerge because regulations faced by leasing providers are generally not as tough as for the banking institutions (See Feinen 2002, p. 6ff). For example, there is no leasing chapter in the civil law in Germany and Italy. In Russia leasing companies do not need an operating licence like a financial institution. In Austria the terms operating and financial leasing are not differentiated and in France one distinguishes between long term rental and financial leasing only (Leaseurope 22006).

Exhibit 5: Mobile asset leasing share of overall domestic investment

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Source: IKB Leasing-Gruppe 2007

Even the Basel II regulations do only apply for leasing companies fully consolidated in an international bank (Bundesbank 2004, p. 27). The risk adjusted equity layer is not required by law and the central bank or any other supervisory instance has no immediate power over stand-alone leasing providers. At the same time, leasing companies are allowed to participate in capital market re-financing through loans, funds, forfeiting, asset backed securities (ABS), asset backed commercial papers (ABCP), and certificates (See Feinen 2002, p. 75ff).

The obvious opportunities that derive from such regulations have been seized in many Western countries. The graph above illustrates the increasing importance of mobile asset-leasing in Germany, already one of the largest leasing markets worldwide and not equipped with a particular pro-leasing bias in regulations compared to other leasing markets in the developed world. From 1975 until 2006, the volume of new leasing deals per year increased from €2.86b to €54b representing the business line with the largest investment in the German economy, today (See BDL 2007).

On a global scale, the potential of leasing becomes evident, as well. Among the OECD countries, the leasing share in the investment in fixed assets is about 29 per cent. In the average developing country, the share is less than 16 per cent (Fletcher et al. 2005, p. 6).

4.3 Potential for Leasing as a Development Tool

In a 2003 economic survey, the World Bank found access to financing the second major constraint in the worldwide business environment. Especially for small firms it constitutes one of the major bottlenecks with more than 65 per cent of managers mentioning it. Other outstanding constraints such as high interest rates, lack of access to long term credit, collateral requirements, bank paperwork, and lack of credit information were predominantly mentioned in the developing regions of Latin America, MENA, CIS, CEE, and South Asia (See Batra et al. 2003, p. 34 ff).

Leasing can be a tool on the way to inclusive financial sectors for development. These include microcredit and all financial services available in developed economies (See United Nations 2006, p. 1). It means deepening the medium term financing activities for customers without an eligible asset base. Especially small and short-in-cash enterprises without credit history can increase their economic activity without additional collateral required and without harming the credit lines. It bears advantages for the lessor, as well. In countries without lien registers or with weak enforcement of the lessor’s right to repossess property in case of the debtor’s default, leasing can serve as a relatively secure means of lending as the ownership is accepted more readily. In general, risk can be managed more effectively and shifted to the one party which can cope with it (e.g. because of extensive experience in the re-marketing process). Leasing can help boosting production, growth, and employment because it fills a financing gap for micro-entrepreneurs and SMEs which are the backbone of every developing economy in terms of employment (See Fletcher 2005, p. 6). More advanced equipment can be imported from abroad. Technical knowledge and the expertise in how to use it can be adopted from foreign leasing providers, thus improving the productivity of the overall economy.

In rural areas, leasing might be the only available means of financing, thus economic development. If the leasing companies are not subject to interest ceilings as faced by banks, leasing has an outstanding advantage. Some governments in developing countries also have amended legislation for the compulsory disbursement of credit to disadvantaged and so far neglected groups such as small farmers and micro-entrepreneurs. Leasing usually does not have to follow these orders. That could help encouraging microleasing institutions (MLI) to tap rural markets, as well.

The higher costs for customers could be partially offset by lower down payments than in loan agreements and by the lower risk in case of legal disputes due to the clear property title of the asset. The significance of a sustainable rural financial institution for development is further increased by the fact that so far (MFIs’, Credit unions’, and commercial banks’) outreach and short term credit supply are not satisfactory (See Nair et al. 2004, p. 6).

With all the positive prospects connected to the development impacts associated with leasing, it should not be overestimated. Leasing is a means for financing fixed assets only. Current liabilities and working capital financing still depends on other sources such as loans. Therefore, leasing itself will hardly make a big difference at the micro-level of developing countries during the early and very small loan stage. It needs to be complemented with other development efforts. This is not just financial and economic development, but also social, health, education, governance, infrastructure, and many aspects more that take effect in the potential of leasing as a development tool.

The table below reviews the contributions leasing could make at different spheres of an underdeveloped economy with respect to each stakeholder fraction. It states how the effects and ‘side effects’ could be released.

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^[1] ROSCAs = rotating savings and credit associations; ASCAs = accumulating savings and credit associations; CVECAs = Caisses Villageoises d’Épargne et de Crédit Autogérées; FSAs = financial service associations; SHGs = self-help groups; NGOs = nongovernmental organizations; NBFI = nonbank financial institution

^[2] The institute co-operated with various developing countries’ governments in implementing property-titling schemes, e.g. in Russia, Peru, El Salvador, Haiti, Tanzania, Egypt and probably soon in Indonesia. De Soto was honoured with “The Economist Innovation Award” in 2006.

^[3] MIVs are intermediaries of any legal status channelling funds from investors to MFIs.

^[4] Rating agencies and market broadcasting is still underdeveloped in the microfinance industry. For example, Bank Dagang Bali is still presented as an interesting investment opportunity at www.mixmarket.org although being shut down by the central bank years ago

^[5] First tier MFIs are already successful and have a good reputation among investors, the tiers two, three, and four are less-known and not as successful and mostly unregulated/not transparent