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Managing Credit Risk in Microlending Operations

Guest post by: United Nations Capital Development Fund

Article Overview: One of the most important determinants of a successful microlending operation is the successful management of credit risk. Or, more simply, keeping loan delinquencies to an acceptable level.

Managing Credit Risk in Microlending Operations

By Steven A. Bernstein, Senior Advisor and Director, White House Initiative on African Mortgage Markets, United States Department of the Treasury*

One of the most important determinants of a successful microlending operation is the successful management of credit risk. Or, more simply, keeping loan delinquencies to an acceptable level. The need to keep a portfolio current is important for the obvious reason that an institution needs its loans to be repaid if it is to survive and thrive. On a higher, systemic level, maintaining low delinquencies is critical for minimizing moral hazard than can result in mass defaults across a financial system.

As the microfinance industry has evolved so have the methods for managing credit risk. Currently the trend is toward adopting more formal systems. At the same time, successful microlenders are tempering these formal systems with a customer service approach that meets the special needs of low-income and informal sector clients.

Determinants of Credit Risk
The basic components of credit risk are a borrower's willingness and ability to repay a loan. Ability to repay a loan is straight forward. It refers to a borrower having the financial resources to make a scheduled loan payment. It is most often measured by a borrower's income and financial obligations. In short, a borrower needs to be able to afford the scheduled payments on a loan. Unemployment and overspending are the primary contributors to a reduction in a borrower's ability to repay a loan.

A borrower may have the financial resources but be unwilling to continue to pay a loan. Determinants of a borrower's willingness to repay a loan are complex and determined by economic, legal and moral incentives. For example, empirical studies consistently show that the likelihood of default rises as the value of the asset decreases relative to the amount still owed on the loan. In other words, borrowers, at all income levels, do not want to keep paying for an asset that has little or no value. Legal systems and community pressure also contribute to a borrower's willingness to repay a loan.. If borrowers know that there will not be any consequences if they fail to repay a loan then the likelihood of default will increase.

Determination of a borrower's willingness and ability to repay a loan is critical if a microlender is to minimize credit risk. Furthermore, once a loan has been granted, it is critical that the microlender does everything possible to ensure that the borrower maintains the loan in good standing. There are three operational areas on which a microlender should focus to minimize credit risk. These include loan design, underwriting and loan servicing.

Loan Design
Appropriate loan design is critical for both a borrower and a lender. If a loan becomes too expensive then a borrower will be unable to repay the loan. On the other hand, the interest rate, at a minimum, should cover the lender's costs as a lender cannot sustain operations if it loses money on its loans. This balance between the affordability needs of borrowers and costs to lenders is not necessarily difficult to achieve if both sides have realistic expectations. While volumes can be written about this subject there are two important lessons that have been learned over the years:

1. Interest Rates Are Relative: Often well meaning people get upset over what appear to be usurious interest rates being charged by microlenders. For a legitimate lending operation to be sustainable it must cover operating costs, credit risk and funding costs. Sometimes these costs are high and the resulting interest rate is high. That said, what has been documented over the years is that households in most countries do not focus on the interest rate but rather focus on the payment. As long as they know what the payment will be, and can afford it, the interest rate is irrelevant.

2. Long Term Loans Need a Variable Interest Rate: Loans greater than five years present special issues for a lender. These kinds of loans, which are used for housing and the purchase of large assets, are difficult to offer as affordable fixed-rate products in many countries. The reason for this is largely macro economic instability. In the presence of inflation, a fixed rate loan will lose value and eventually cost more to fund than it earns. This means that the lender will need to embed a variable component to the loan interest rate. The key for affordability is to make sure that loan payment increases are capped both in frequency and amount.

Loan Underwriting
Loan underwriting is the process of determining a borrower's credit worthiness, or in other words his or her ability and willingness to repay a loan. It is the most important function that a microlender can perform to minimize credit risk. In commercial banking loan underwriting relies on the availability of financial information on a borrower from standard and formal sources. Sources of information include income tax returns, payroll stubs and contributions to pension funds. Unfortunately, in most markets in which microlenders operate this information is not available either because it is not kept or because the borrower exists outside the formal financial sector. This means that in order to underwrite, the microlender will need to gather its own information on a borrower. While labor intensive, successful microlenders have developed effective procedures for doing this.

Determination of ability to pay is primarily a function of a borrower's income and financial obligations. This is usually expressed as the ratio of a borrower's monthly payment obligations to the borrower's gross income. Typically, a higher ratio corresponds to a lower ability of a borrower to repay a loan. In the absence of formal information sources, verification of income and obligations can be done though a process of interviewing and observation.

For example, successful microlending programs will often verify income by sending a person out to interview an applicant's employer. If the applicant is self employed, the microlender will interview the borrower's customers or even spend an afternoon watching the applicant's business to estimate sales receipts. Interviews are also conducted in the borrower's home to establish the number of dependents, possible financial obligations (e.g., payments being made on a car or appliance) and to give the microlender a general sense of the moral character of the borrower. It is also important to mention that proof of regular receipt of remittances can also contribute to household income and be used to qualify for a loan.

Willingness to pay is usually measured by the loan-to-value ratio (LTV). This is a measure of how large a loan is compared to the value of the collateral put up for the loan. Willingness to repay usually falls as the LTV increases. This is usually very difficult for microlenders. Establishing a borrower's willingness to repay a loan thus becomes a qualitative exercise that incorporates the interview and observation process mentioned above as well as an assessment of a community's history in repaying loans.

Microlenders can, and do, perform comprehensive underwriting of their clients without the benefit of formal systems. The trade-off is time and cost. These methods are necessarily labor intensive but without them microlenders run the risk of originating loans that will default.

Loan Servicing
Loan servicing is the act of collecting payments and maintaining the balance of a loan. It is a critical function for preserving the value of a loan portfolio; good loan servicing can help ensure that high credit risk borrowers maintain their loan in good standing whereas poor loan servicing can result in defaulting of loans from what were once low credit risk individuals. Loan servicing is also the function that many lenders, both commercial and microlenders, fail to execute properly when dealing with lower income clients.

In commercial banking, loan payments are made by bank draft or by directly debiting payroll or a bank account. Things are not always so easy in the world of microfinance. The typical borrower usually does not have access to a bank account and often does not receive a formal salary. This means that for many customers of microlenders making loan payments can be difficult and put them in the position of making the choice to take time off from work (and possibly get fired) in order to deliver a loan payment or choose not to make a payment. Microlenders and others such as low-income mortgage lenders have made a lot of progress in payment collection. Some of the more important lessons learned are as follows:

1. Make it easy for a borrower to pay. Successful lenders will set up payment kiosks in communities. The kiosks are typically open before the typical work day starts and after it ends. Another effective method, albeit more labor intensive and potentially more dangerous, is door-to-door collections.

2. Provide positive incentives for payment. Borrowers respond well to positive incentives for good payment history. Microlenders and mortgage lenders have successfully used incentives such as payment rebates, small appliances and food to achieve very high levels of repayment. For example, one Mexican lender offered a free bag of corn meal if a borrower made timely payments for six months. The result was a delinquency rate of less than 1%.

3. Be proactive in dealing with delinquencies. Rather than wait until a loan goes into default, a microlender should investigate a loan within weeks of it first becoming delinquent. Often, the cause of a delinquency is due to illness or unemployment. If caught early enough a lender can give the borrower assistance as well as workout a equitable repayment plan.

Conclusion
As microlenders expand their operations and become integrated into the formal financial sector, the need for strict discipline in managing credit risk will grow. Developing sustainable sources of funding and equity investment will require well managed loan portfolios and the requisite finance systems. That said, successful microlending will also require lenders to make sure their operations meet the needs of their clients. Through this nexus, it is likely that microlenders will evolve into effective community banks that, in the near future, will provide critical financial services to the 80% of the world's population that is currently un-banked.

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Article Tags: acceptable level, credit risk, delinquencies, department of the treasury, determinants, empirical studies, financial obligations, informal sector, managing credit, microfinance industry, microlenders, microlending, moral hazard, mortgage markets, sector clients, service approach, successful management, systemic level, united states department, united states department of the treasury



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