Liquidity Before Solvency: A Guide for Microfinance Investors in the Time of COVID-19
The COVID-19 pandemic has generated a real sense of crisis in inclusive finance, surpassing even the reaction to the 2008 financial crash a decade ago. And particularly among investors, the topic of highest concern is the looming crisis in liquidity for financial institutions.
For microfinance institutions (MFIs) in many countries, the combined effects of the pandemic and its economic impact will lead to high levels of non-performing loans (NPLs), as clients struggle to make their scheduled payments. During past crises, the typical impact on MFIs has been a period of retrenchment. Much of this is likely to be repeated: With slowing trade and economic activity, fewer loans will be made and portfolios will shrink. The combined effect of credit losses from the NPLs and a shrinking portfolio will put serious pressure on equity capital, quite possibly threatening MFIs with outright insolvency, and ultimately, losses to investors.
But a financial institution can simultaneously be insolvent and still liquid, and in a crisis, preserving MFIs’ liquidity must take precedence over maintaining their solvency. To understand why, it’s important to explore the two concepts, and how they’re likely to impact MFIs and their investors as the current crisis progresses.
The Role of Maturing Debt in Illiquidity
At heart, there are three channels to illiquidity. In the current crisis, perhaps the most immediate is from deposit-taking institutions that will face drawdowns by depositors tapping their savings to cope with the effects of the pandemic. An equally immediate challenge is that faced by MFIs operating under full lockdowns and even government-mandated moratoriums on loan repayment – without cash inflows from their loan portfolios, they will exhaust their existing cash and liquid assets and will be unable to pay their staff, effectively forcing them to massively curtail operations. Both of these situations present major challenges that can and must be addressed, but it’s the third source of illiquidity – maturing debt – whose scale presents arguably the largest risk. Fortunately, however, it’s also the easiest to fix.
The average maturity of credit that foreign investors provide to MFIs is 22 months (local bank debt is probably similar). What that means is that approximately every six months, more than a quarter of all MFI debt must be repaid. When times are good, most creditors simply issue new loans to replace those that have matured, thus keeping the system going. But in a time of crisis, this rapid turnover of funding provides a perfect opportunity for investors to temporarily exit – collecting the maturing debt but then waiting for the market situation to stabilize before issuing new loans.
However, doing so will create a liquidity crisis for the MFIs. With less money coming in from their loan portfolios, even a single investor exit may be enough to force MFIs into deep cost cutting, laying off staff that are key to maintaining their all-important customer relationships during the crisis – and also critical for restarting operations once the pandemic is past. Indeed, it risks transforming a time-limited (albeit serious) downturn into a long-term crisis, and undermining the MFIs’ ability to serve clients during a time of great need. That doesn’t sound at all like responsible investing.
A Moratorium on Investor Debt Repayments
This challenge is nothing new. Social investors have been dusting off lessons from the financial crisis a decade ago, to help them devise a fair approach to workouts and restructurings. The problem is that a workable approach requires investor coordination – and that implies a prisoner’s dilemma. If the investor whose loan is due in May extends the term, only to watch the investor with a June date proceed with the repayment, they’ll have been played for a fool. Extensions have to be agreed to, and typically, they must be agreed to unanimously. That’s no easy task – especially when there are a dozen investors involved.
But the global nature of the pandemic also presents a simpler solution. A critical mass of social and development investors should issue a public memorandum recognizing the crucial role that liquidity must play in the current crisis, and committing to a six-month repayment moratorium on their debt. The memorandum should moreover waive any cross-default and related provisions, which would have the effect of ignoring any default by MFIs to investors who demand repayment during the moratorium, even if those investors never signed onto the memorandum itself (hat tip to Tim Ogden for that idea). In effect, the memorandum would implicitly encourage financial services providers to strategically default to investors who choose not to take part in this moratorium. Because of that, it would be ideal if rating agencies were to sign on to the memorandum as well, and commit to excluding such strategic defaults from rating updates.
This approach has two major advantages. First, it obviates the need for unanimous agreement among investors negotiating a debt restructuring, and it allows investors to buy time to draft bespoke restructuring agreements for those investees that will ultimately require them. In the meantime, the blanket moratorium allows a speedy response to a crisis that will in one way or another affect nearly every financial institution in nearly every country – a global solution to a global problem.
There are, of course, some legal downsides to a debt default. But so what? Tackling a crisis requires breaking rules – in case of emergency you DO need to break that glass. An MFI that refuses to make a scheduled debt payment might plausibly see a legal challenge, but how many courts will take that case up in the middle of a pandemic? By the time the case really does come to court – assuming the aggrieved party will even pursue it – there will be many opportunities to settle. In the meantime, it will buy the institution crucial months of extra liquidity that may literally mean the difference between survival and bankruptcy. And should the institution not survive anyway, the legal proceedings will be moot. Whatever the outcome, one thing is clear: A credible threat of strategic default is crucial to avoiding the typical investor race for the exits that we have seen during so many crises before, with each trying to get their money out before the gates are shut.
Adopting a Crisis Mentality: Liquidity Before Solvency
But what about solvency? Ultimately, it’s insolvency, not illiquidity that results in investor losses, so shouldn’t that be their primary concern? To understand why liquidity must come before solvency, it’s worth unpacking the difference between the two. Illiquidity means quite literally having no cash – you can’t pay your staff; you can’t pay a customer when she comes to withdraw her savings. Insolvency is a more esoteric concept. Think of an institution’s assets as a loaf of bread, with different investors getting their slices in order of priority: Depositors come first, then creditors, then shareholders get whatever remains. If credit losses shrink the loaf into a state of insolvency, there is nothing left for the shareholders after depositors and creditors get their slices, and usually creditors won’t get everything they’re owed either. But again, so what?
Investors and other stakeholders need to recognize that this is a crisis, and act accordingly. Say an MFI operates as an insolvent entity for a while – maybe the pandemic runs its course, people get back to work, trade restarts, clients start repaying their loans, and those paper losses disappear as quickly as loans can be reclassified as current. But what if it doesn’t – what if major parts of the MFI’s portfolio must ultimately be written off, and the losses become permanent? Well, the financial institution will need to restructure its debts, with some being written down, and some converted to equity. In one manner or another, the institution will go through a resolution, or in the worst case scenario, it will be wound down and liquidated, with shareholders wiped out and creditors taking major losses. But that’s all in the future – a future that at this stage is impossible to predict for any particular institution. So until then, MFIs must focus on liquidity – the actual cash they need to maintain operations – and let concerns about insolvency wait their due turn. In a crisis, liquidity must come before solvency.
But what about regulators? Won’t central banks shut down institutions that breach capital requirements or even become insolvent? Maybe. But in the middle of a pandemic, most central banks will avoid pouring gasoline onto the fire. Some have already proactively loosened prudential norms with respect to capital, recognition of non-performing loans, provisioning requirements and the like. And those that haven’t are just as likely to create the same effect through delayed action and quiet forbearance. After all, can you imagine shutting down a deposit-taking institution in the midst of a pandemic – creating panicked lines in front of ATMs and branches that limit entry to a handful of customers at a time due to social distancing requirements? It’s a regulator’s nightmare! As with investors, so with regulators – the response is the same: In a crisis, liquidity must come before solvency.
The suggestions here – encouraging credit default and regulatory non-compliance – would get laughed out of the room in normal times. But these are not normal times – and these are serious actions that have been successfully tested in past crises.
Finally, there is the question of investor losses. And here too, focusing on liquidity before solvency is the better course. The value of financial institutions – especially in microfinance – is tied to their ability to continue operations. If reduced liquidity means cutting staff and winding down operations, it will ensure the very losses that investors are trying to avoid. At best, a lucky few will get their money out – leaving the rest holding a largely empty bag. It’s a classic case of selling distressed assets in a panicked market – the seller is assured of maximum loss, while those who take the longer view have far better financial prospects. In a time of crisis, focusing on liquidity will help investors minimize their losses too.
So take heed investors, remember these counter-intuitive lessons, and go forward. You will be rewarded not only with better financial outcomes, but better social ones too.
Photo courtesy of PublicDomainPictures.
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