1. Read the BancoSol case from the casebook and respond to the following questions:

1. What are the characteristics of BancoSol as an institution?
2. Who are its clients?
3. What are its main products?

2.Briefly provide a critical assessment of the following:

1. Country Risk
2. Mission Risk
3. Strategy and Economics
4. Growth of the institution
5. Risk management
6. Compensation

3.Securitization:

1. What is Securitization
2. Does BancoSol need securitization?

4.What should Citibank do with regards to the proposed transaction?

BancoSol

BY DAVID BEIM* AND SALVATORE BOMMARITO

ABSTRACT In 1997 Citibank lending officer Susan Murphy encountered an atypical loan application that proposed the securitization of a portfolio of small loans from Bolivia, a poor South American country. In performing due diligence, she was charged with deciding whether her company could take on the associated risk.

Introduction

Susan Murphy had been a Citibank lending officer for eight years, but had never seen a loan application quite like this one. It was true that many bank assetsincluding mortgages, car loans, and consumer receivableshad been securitized in recent years, and that this practice had spread from the United States to a number of other countries. But here she was looking at a special-purpose vehicle that proposed to securitize a portfolio of very small loans from some of the poorest people in one of the poorest countries on the face of the earth. Could this possibly make economic sense? The bank offering the transaction was Banco Solidario S.A. of Bolivia (BancoSol).

It had only been formed in 1992, yet by 1997 its 85,000 borrowers represented nearly 30% of the customers serviced by the entire Bolivian banking system. It seemed to defy economies of scale: despite having an average loan size of only $828, BancoSol appeared to be one of the most profitable banks in South America; for 1997 it reported an average return on assets of 2.7%, a return on average equity of 33%, and an equity base equal to 13.1% of assets. Furthermore, its nonperforming loans were only 2.1% of its gross loans. By way of comparison, the FDIC reported that for 1997, US commercial banks had on average a return of assets of 1.2%, a return on equity of 14.7%, an equity base equal to 7.6% of assets, and nonperforming loans to individuals equal to 2.5% of gross loans to individuals. Murphy shook her head. What could be wrong here? She reached for her yellow pad, ready to draw up a list of questions, concerns, and problems that might be lurking beneath these almost unbelievable numbers. Even if all of this were true, why would BancoSol be securitizing assets? Why wouldn't the bank just apply for a corporate loan? This application was going to require more due diligence than most.

Bolivia in 1997

Bolivia is a landlocked country in the high Andes with a land size about three times that of Germany, but its GDP in 1997 was about one-quarter that of Rhode Island's. With a population of 7.5 million and per capita GDP of about $1000, Bolivia was the poorest country in South America. About half of the population was Amerindian, and about 30% of the population was illiterate. Life expectancy in rural areas was about 55 years. Bolivia's political history was stormy, with more than 200 coups since the country was founded in 1825. The Bolivian economy is heavily oriented toward natural resource extraction, principally of tin and zinc as well as petroleum and natural gas. In addition, there is some agriculture; among other products, Bolivia is a significant grower of coca leaves. Low savings and investments have long held back economic growth. Bolivia was massively over indebted during the global banking crisis of the 1980s; the price of bank loans to Bolivia sank to a low of 6% of face value by 1987.

Despite these disadvantages and problems, Bolivia has often been ahead of other South American countries in reforming its economy. Heavily statist for many years, Bolivia suffered a hyperinflation in the 1980s, with the annual change in the consumer price index rising to a crest of 11,750% in 1985. After that experience, before any other country in the region except Chile, Bolivia turned its back on statism and embraced free markets and global trade. With the support of most political parties and numerous other countries, Bolivia managed to get its debt and currency under control by the 1990s. In 1993 Gonzalo Sanchez de Lozada was elected president. He had been a minister in the 1985 reform government, and now embarked on a further round of economic reform and democratization. Political reforms shifted more power to local governments. A creative form of privatization was introduced in which the highest bidder would win 50% of the shares of major state-owned entities plus full management control, while the other 50% of shares would be divided among all adult Bolivians, held in trust for a new private pension system. The results of these changes are shown in Exhibit 1. Financial repression, with negative real interest rates and very low liquidity, had prevailed into the mid-1980s, but financial development subsequently improved steadily. The 1985 reforms brought inflation down to the 8%-12% range and stabilized GDP per capita, but did not result in rapid economic growth. The post-1993 reforms brought real GDP growth into the 2%-4% range. Still, it seemed to many that this growth did little or nothing to improve the lives of the poorest half of the population.

BancoSol

Banco Sol's history began in 1986 with the founding of the Fundacion para la Promocion y Desarrollo de la Microempresa (PRODEM), a nonprofit foundation dedicated to microenterprise development. PRODEM determined that it would start its first major project in Bolivia. Accion International (Accion), a US-based nonprofit organization, shared its financial expertise and field experience, and prominent leaders of the Bolivian business community provided leadership to the project. PRODEM used Accion's solidarity group lending method, in which the group members cross-guarantee each other's loans in lieu of collateral to provide capital for small-scale production and commercial activities. PRODEM encountered financial and institutional constraints as it attempted to meet the explosive demand for its services.

Although it was able to access Bolivian banks for financing, PRODEM quickly reached the limit of its debt capacity under local banking regulations. At that point, PRODEM began a three-year process to transfer its operations to a newly chartered full-service bank for the poorBancoSol. BancoSol began functioning as a bank in 1992, with $3 million of start-up capital from PRODEM and 13 other shareholders, including Bolivian banks and private investors, the Inter-American Investment Corporation, Accin International, the Rockefeller Foundation, and the Calmeadow Foundation. While the shift from nonprofit organization to profit-seeking bank was made because of capital needs, it also brought intangible advantages. Bolivian bank charters were not easy to obtain; BancoSol's charter was granted primarily because of the quality of its shareholders. The charter itself then became an imprimatur of quality. Furthermore, scrutiny by the Superintendency of Banks and Financial Institutions and the providers of market capital indicated stronger monitoring than occurred in most nonprofit organizations.

Almost all developing countries have some form of informal capital markets. These may include pawnbrokers, moneylenders, or local cooperative organizations, which provide capital to needy people who have no access to borrowing from banks or to formal capital market institutions. In some countries, extended families with their own businesses form a network of capital flows, whereby those who are more successful advance funds to those starting out with business ventures. Informal capital markets can prosper despite the poverty of their clientele because lenders and borrowers know each other very well and are part of a social fabric that would be damaged by any default. Microfinance organizations are an attempt to formalize these informal networks without destroying their inherent character. Throughout the 1990s, local governments and eleemosynary organizations provided substantial funding for the microfinance industry; several billion dollars of such loans were outstanding by the late 1990s. Governments in developing countries as well as poor areas in developed countries viewed microfinancing as an attractive alternative to government welfare. The financial performance of such organizations, of which BancoSol is an example, was often surprisingly good. It has been estimated that microfinance organizations were growing globally at a rate of about 30% per year in the late 1990s.

Lending Operations

BancoSol's strategy was based upon group lending. Potential customers had to band together into groups of three or more and jointly sign for a loan. These minicooperatives were known as solidarity groups. The group would pressure each individual member to perform according to his or her agreements. Peer pressure and the shame associated with failure substituted for formal collection procedures. Although the clients of BancoSol were poor, they were by no means the poorest Bolivians. They were all engaged in some type of business that had existed for at least a year before they applied for a loan. Exhibit 2 shows the results of a 1995 survey of borrowers' characteristics. Sixty-three percent of those surveyed worked primarily in trade, and 83% of the bank's loans were for trade activities. These statistics do not necessarily indicate that borrowers preferred to be engaged in trade; BancoSol's clients were required to make frequent repayments, and people who worked in trade could more easily meet their obligations than those who worked in other areas. In addition, 78% of BancoSol's customers were women, and many women worked in trade. Women also seemed particularly effective at forming solidarity groups; pattern has been observed in other microfinance settings, including the urban United States. Requiring frequent repayments was central to BancoSol's lending policy. The bank did not attempt to screen and monitor its clients in the usual way (i.e., by gathering information about their businesses).

Rather, its lending was based on making a series of short-term loans rather than one long-term loan. Borrowers started with small loans requiring weekly payments and over time were given larger, longer-term loans requiring less-frequent repayments. Any failure by an individual to make a paymentby even one dayhad immediate consequences, setting back the group's progress up this ladder. The sequence of possible loans from BancoSol in 1995 is shown in Exhibit 3. Initial loans were as small as $62; long-term BancoSol customers were granted loans as high as $25,000. BancoSol made a few small loans in bolivianos (the currency of Bolivia), but by the end of 1997 almost all loans (97% by value) were denominated in US dollars at fixed rates of interest. Since the bank's funding was also denominated in US dollars, as were 92% of its deposits, this protected the bank from foreign exchange risk. This also created less foreign exchange risk for borrowers than would first appear, since a significant portion of Bolivian commerce was "dollarized," i.e., Bolivian transactions were often conducted in US dollars. Most BancoSol loans were unsecured, since the borrowers had little of value to pledge and the philosophy of collection was to rely on close relationships rather than legal obligations.

BancoSol representatives were located very close to their customers; bank officers would visit clients frequently to review payments on existing loans, discuss any late payments, and consider customers' future needs. This mode of operation was costly, but less so than attempting to obtain true information about the clients' businesses, and the operating cost was offset by the high interest rates that BancoSol could charge. The bank had other advantages: an excellent management team and computer systems capable of handling substantially larger volumes of loans. The head of BancoSol was a former Citibank employee born in Bolivia who had developed an enviable reputation for his modern management practices, even though he was involved in microfinance. Much of the PRODEM staff had transferred to BancoSol in 1992, bringing with them a strong sense of mission to help the poor and a warm, almost familial culture. New employees had been added rapidly as the bank grew (see Exhibit 4). With so many new employees and new branches, however, it became harder to maintain the unique culture of the bank. BancoSol's early success attracted competition, and while that created challenges, in a nonprofit setting competition might be considered as evidence of mission success rather than as a problem. PRODEM continued its own microfinance operations. A private, regulated nonbank financial institution, Caja de Ahorro y Prestamo Los Andes, entered the field, as did two other nonprofit organizations, Centro de Fomento a Iniciativas Economicas (FIE) and Fundacion SARTAWI. Exhibit 2 suggests a high degree of customer satisfaction at BancoSol, but any profits the bank was making from quasi-monopoly rents were vanishing by the late 1990s.

Funding Sources

Although BancoSol's original funding sources were primarily eleemosynary, the bank status it acquired in 1992 enabled it to offer deposits to its customers and friends. By the end of 1997 the bank had about $70 million of liabilities, consisting primarily of $48 million of deposits and $14 million of local bank loans (see Exhibit 5). Furthermore, the bank was rapidly developing a performance record better than that of normal commercial banks, so it appeared that fully commercial financing could soon be feasible. The bank had been able to sell two issues of two-year bonds. In both cases, 50% of the principal payment was guaranteed by USAID, the US government's foreign aid agency. The first issue, for US $3 million, was sold to local Bolivian investors in March 1996. The second, for $3 million, was sold in two parts, $2 million to the Corporacion Andina de Fomento, a regional development agency based in Caracas, and $1 million to local Bolivian investors. However, the extreme illiquidity of the bank's assets was a source of concern. All banks tend to borrow short-term and lend long-term, but in developed economies, bank loans are often syndicated and traded. This is feasible because information about the borrowers is widely disseminated. Furthermore, large classes of standardized bank assets such as home mortgages, automobile loans, and credit card receivables are routinely securitizedthat is, pooled into special-purpose vehicles and funded by securities representing various claims on the pool. All of these developments make a modern bank less vulnerable to sudden depositor demands, since assets can readily be sold as needed.

the class of bank assets that have never been securitized, however, are small company loans. Though numerous banks have attempted this, the fundamental obstacle is the difficulty in standardizing the underlying assets. Standardized home mortgages and automobile loans require certain measurable loan-to-value ratios. Standardized credit card receivables are based on confirmable income and demographic statistics. But each small business tends to be unique. Securitization of small business loans in developed capital markets has failed because of the difficulty of observing or confirming the real underlying risks. If this cannot be done, purchasers of securitized claims who are unable to independently check the quality of a bank's loans will worry about adverse selection, i.e., the likelihood that banks will sell their weakest loans and keep their best ones. Might securitization contribute to BancoSol's liquidity? Certainly the bank planned to continue its very rapid rate of growth (see Exhibit 6). If it could sell assets, BancoSol might be able to have much larger volume of business with its small capital base. It could become, in effect, an originator and packager of microfinance loans rather than a permanent holder of them. Reading the offering document, Murphy wondered if this could really work. How might BancoSol change in character if this were to occur? Could BancoSol continue growing at such a very rapid rate without having serious problems?

The Proposed Transaction The proposed transaction is diagrammed below: $10 million Collateral $8 million Revolving Credit $9 million Revolving Credit (plus guarantee) $1 million Equity Infusion Accin and two other investors would establish a special-purpose finance company called ABA, capitalizing it with $1 million of equity and an $8 million line of credit from a lender such as Citibank. ABA would extend a $9 million revolving credit to BancoSol secured by a $10 million portfolio of qualified loans. While the criteria for loan qualification had yet to be developed, a successful history of loan repayment would probably be the most useful. In addition, BancoSol would offer a general corporate guarantee of repayment of the $9 million revolving credit from ABA. The equity investors would be Crown Capital (80%) and Twin Capital (20%). Twin Capital would also provide ABA with managerial services, for an annual fee of $25,000. The interest spread earned by ABA would be divided as follows: 72% to Crown Capital, 18% to Twin Capital, and 10% to Accin. If ABA's interest spread turned out to be 2%, Crown Capital would earn a 16% rate of return and Twin Capital would earn a 26% rate of return (including the management fee) over five years. If the spread were 3%, these returns would rise to 25% and 36%, respectively. ABA would arrange to have loan documents drafted by US counsel in cooperation with Bolivian counsel. The revolving credit would protect BancoSol from possibly unreliable sources of short-term capital and enable it to grow its portfolio with confidence of funding.

The pricing of the bank's loan to ABA would fully reflect market rates and the risks involved. From Accin's point of view, the proposed transaction had value as a potential model. Could a connection be made between microfinancebased on the most traditional forms of village-level trustand a thoroughly modern technique such as securitization? If so, a model might be created to flow private capital to private enterprise in emerging markets in a wholly new way. Citibank traditionally handled transactions such as this within its public responsibility group, which accepted higher risk transactions for charitable reasons. But this proposal was something new: BancoSol was asking to be treated as a commercial entity. The model would have its maximum effect only if it could credibly pay full market interest rates. Furthermore, the equity investors in ABA would have to receive market rates of return if the model were to prove itself viable. From Citibank's point of view, the presence of a $1 million equity cushion in ABA, plus the $1 million of overcollateralization, provided additional elements of security. In addition, BancoSol offered its general corporate guarantee to ABA's obligations, so that concerns about adverse selection could be minimized. Still, there was a great deal for Citibank to worry about. Murphy's list of questions and concerns was rapidly growing longer.