CREDIT RISK MANAGEMENT: APPRAISAL

Prepared for Micro Finance

By BAMWENDA BENARD An Economist,

CREDIT RISK MANAGEMENT: APPRAISAL 1.0 INTRODUCTION

Credit Risk management is a core concern in the operations of micro finance institutions (MFIs) toady. It is the focus of the Board and Management as well as staff to ensure that loans given out to clients are paid according to agree upon terms and conditions. While financial institutions have faced difficulties in credit management over the years for a multitude of reasons, the major cause of serious credit problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of the MFIs counterparties. The goal of credit risk management is to maximize MFIs risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. MFIs need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. MFIs should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any financial organization. For most MFIs, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of an MFI, on and off, the balance sheet items. MFIs are increasingly facing credit risks (or counterparty risks) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. Since exposure to credit risk continues to be the leading source of problems in MFIs world-wide, MFIs and their supervisors should be able to draw useful lessons from past experiences. MFIs should now have a keen awareness of the

need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred The sound practices set out to address credit risk should cover areas such as: (i) establishing an appropriate credit risk environment; (ii) operating under a sound credit-granting process; (iii) maintaining an appropriate credit administration, measurement and monitoring process; and (iv) ensuring adequate controls over credit risk. Although specific credit risk management practices may differ among MFIs depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program should address these four areas. These practices should also be applied in conjunction with other sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk. The starting point in credit risk management is the MFIs appraisal process. This process help identify the right clients given circumstances of information asymmetry and moral hazard. The process should critically look at the clients credit history, which in the absence of a credit reference bureau in an economy becomes a very cumbersome exercise to determine. This paper focuses on highlighting key tenets in the MFIs environment and appraisal processes to enhance effective credit risk management.

2.0

DEFINITIONS OF KEY TERMS RELATED TO THE CREDIT RISK MANAGEMNET

Credit is defined as an agreement between two parties to lend money (or an item) on one part, and borrow money (or an item) on the other part subject to specified agreed terms and conditions repayable with interest at a future date. Credit can be categorized into cash credit or in-kind credit. Cash credit, often referred to as loan funds is the type whereby the actual cash amount requested

for and approved is disbursed to applicants for use for the purposes for which the money is intended. On the other hand, in-kind credit is whereby capital inputs instead of cash is given to the applicant or the borrower in the form of equipment, machinery, tools or raw materials. The loan receiver or borrower uses the input for the purpose intended in the loan request to generate income, part of which will be used to repay the cash value of the capital input with the required interest. Credit risk is the key risk that MFIs must mange to be sustainable. It is the risk to earnings or capital due to a clients failure to meet the terms of the lending agreement. In MFIs, credit risk in each micro loan is relatively minor given that each loan is usually small as compare to commercial banks. However, due to the short term and unsecured nature of micro lending, micro portfolios tend to become more volatile since the portfolio quality can deteriorate more rapidly than traditional financial institutions. For this reason, it is very important that MFIs monitor portfolio quality closely and take action when necessary. A delinquent loan (or loan in arrears) is a loan on which payments are past due or not been received by the MFI. It is also refers to as loans in arrears or late payments, and it is measured as a percentage of a loan portfolio at risk. Delinquent loans are loans on which any payments are past due. Loan Default occurs when a client completely fails to pay off his/her outstanding loan and the loan period has expired. It actually occurs when a borrower cannot or will not repay his/her loan and the MFI no longer expects to receive payment. 3.0 GENERAL PRINCIPLES FOR CREDIT RISK MANAGEMENT

For effective credit risk management, MFIs need to ensure that there clear condition, policies, procedures and processes to guide the credit management process. These guidelines should be clearly documented and reviewed frequently.

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CONDITIONS FOR CREDIT ACQUISITION

MFIs should have very clear and well document ways and means of targeting their credit services to the right clients, lest even those that do not deserve it will be served leading to repayment problems. For instance, the destitutes and extremely poor communities should not be given credit, but should initially access grants to enable them reach a level were they can leverage credit. Thus, people who should access credit are: 3.2 Persons who are interested and prepared to work Those who have skills that can easily use credit obtained profitably. Person who agree to the conditions of the credit to be taken. Those who have the purpose for which the credit is meant PRINCIPLES OF GOOD LENDING

In order to ensure that moneys received as loans are repaid or recovered to make the credit facility sustainable, the following must be pursued: Interviews and appraisals of borrowers should be carefully undertaken to determine the borrowers integrity and reliability in using and repaying the loan. Borrowers ability to repay the amount requested. Purpose of loan must be satisfactory to the credit source. Borrowers ensure that loans requested for can actually undertake the businesses successfully. Alternative sources of repayment must be ascertained. Repayment terms must be realistic to both the lender and borrower. Security in form of collateral must be adequate to compensate for any default.

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STEPS IN CREDIT DELIVERY Sensitization stage/training: Lender furnishes the borrower with

For any MFI, the following are the standard stages of credit delivery: information on credit terms The loan application stage: borrower approaches lender with written or verbal request for funds to undertake or expand a venture. The loan appraisal stag: Borrower furnishes the lender with information about himself/herself and the business. Lender visits the location of activity of the borrower to get more information and offer advises 3.4 3.5 Loan request review Collateral / security guarantee requirement Loan disbursement Monitoring of borrowers business activities Loan recovery Borrowers savings RESPONSIBILITIES OF THE LOAN APPLICANT Applicant should convince lender on the establishment of the business or the viability of the business (business plan) Applicant complete loan application form provided by the lender. Applicant provides information on the business. E.g. Registration, bank statement, audited accounts etc. Applicant prepares cash flow for the loan investment. Have patience to enable the credit institution to review the application. RESPONSIBILITIES OF MICRO FINANCE INSTITUTION

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Lender provides all information about the credit facility to borrower. Information will enable borrower to decide to take or reject loan. MFI conducts or investigates the borrower. MFI establishes the existence of a security/ guarantor/ collateral MFI establishes the viability of the business venture. Lender must establish the applicants ability to repay the loan. Lender disburses the loan exactly when it is needed. Lenders conduct regular monitoring of the loans. ROLE OF THE MICRO FINANCE OFFICER Receives and processes loan applications. Submits clients applications to the Management of the MFI He attends group meetings. Supervises group loan disbursements, monitors and recovers loans. Serves as the liaison between the individual or groups and the MFI management. Co-ordinates all field level activities of the credit program. Provides feed-back on field level activities to the MFI management. Submits monthly returns on the loan position, and other related matters. Organizes training and counseling sessions for the clients. LOAN PRICING

Loan Pricing is a critical element of credit risk management. All MFIs need to establish a loan-pricing policy. The policy should make products and services affordable, but should cover all the program costs. It should be noted that the pricing policy sometimes may depend upon the development stage of the lending institution. Well established micro credit program with a high volume of loan portfolio may offer less priced financial services due to the benefits of economies of scale.

MFI products and services must be priced to cover the following: 3.8 All administrative costs Cost of capital including inflation Loan losses Allowance for increasing equity Profitability LOAN PRODUCT DESIGN

To mitigate credit risks, MFIs should start by designing loan products that meet clients needs. For instance the features for agricultural loans should not be the same as the features for commercial loans offered by a given MFI. This is so because their cash flows for repayment are completely different. The Loan product features that need to be vividly considered include: Loan size Interest rates Repayment schedules Collateral requirements Other special terms.(grace period, up front payment of fees and commissions, savings requirements etc) Loan products should be designed to address the specific purpose for which the loan is intended. For example, a loan to purchase inventory for a neighbourhood grocery store might have a different repayment schedule and use different collateral than a loan for a sewing machine. A loan for purchasing seeds and fertilizers to grow maize may have another structure, perhaps with repayment coming in lump sum at harvest time. Loan products for non-business purposes, such as housing, emergency, education and consumption smoothening, also require different design features.

In designing loan products to minimise credit risk, consider the key characteristics of the loan including the loan amount, length of the term and the repayment frequency. For new clients, MFIs commonly adopt conservative product design features, such as small loan amounts, short loan terms and frequent repayment periods. This conservative approach is particularly relevant for clients who lack business records (i.e. they cannot provide evidence of their capacity to repay) and cannot offer collateral. Once the client establishes a track record with the lender, the MFI often increases the flexibility in loan terms to make the product more appropriate to borrowers needs. This change reflects a balance between risk and control. New clients are categorised as high risk. Once they establish credit history with the MFI, they can usually be considered as lower risk clients, and the lender can reduce some of the stringent controls. The process of loosening the stringent controls also rewards timely repayments. The MFI should inform clients from the beginning that their ability to access more accommodating services depends on their repayment history. If they repay on time, they can access preferred product features such as larger loan sizes, lower interest rates, and less frequent repayment periods. Also, another positive benefit of reducing controls for low risk clients and/or the repeat borrowers is that it helps reduce client desertion. 3.9 LOAN POLICIES AND PROCEDURES

Overall loan policies and procedures are the core of loan portfolio management in an MFI. Such policies and procedures must have clear documentations on: Client selection and eligibility criteria MFI lending methodology Group formation and development policy Client orientation and training policy 9

Loan characteristics and repayment terms Group meetings Loan application and disbursement Group administration and accounting Responsibility of guarantors Reimbursement of guarantors Loan tracking at group levels and forms Tracking of past dues Staff responsibilities Weekly/Monthly reports and formats

3.9.1 POLICY GUIDELINES FOR ELIGIBILITY INDIVIDUAL LOANS Past experience or knowledge in business with an established track record, with demonstrated commitment to the said business Permanent resident or operates business at a fixed premise or location Mature i.e. above 18 years but not exceeding 60 years of age Should not have any other financial and contingent commitments in other Organizations Existence of bank account Soundness of mind

3.9.2 POLICY GUIDELINES FOR ELIGIBILITY GROUP LOANS Existence of group byelaws, constitution or articles of association, with built in accountability for borrowing for individuals within a group Past performance records minutes and financial statements Geographical location of members Members as a group or individuals should not have other financial commitments in other financial institutions Group Bank Account 10

Manageable group size of between 5 and 15 persons Group guarantee and having individuals of good repute Certificate of registration or incorporation, clearance certificates - license and tax Good track record Assets of each individual and group to be used as security in respect of business borrowing performance

3.10

KEY ELEMENTS IN THE LENDING METHODOLOGY

Peer lending peer or group lending reduces credit risk by spreading the risk of lending without collateral over a larger number of borrowers and transferring the burdens of encouraging repayment and collection from loan officers to clients. For example MFIs use 2-2-1 disbursal mechanism, which encourages the clients in the group who have not yet received a loan to put pressure on the first two members to repay their loans, thereby ensuring their access to a loan. Character assessment MFIs develop expertise at assessing the character of borrowers and become familiar with those characteristics that reduce the risk of future loan default due to credit risk or fraud. For example MFIs consider clients who have reputations for being honest and hardworking to be attracting lower credit and fraud risks. Varied loan terms by disbursing loans regularly or by issuing loans with different term lengths, the MFI reduces its liquidity risk exposure by having loans mature and renewed frequently. Limits on loan size increases MFIs reduce credit risk by increasing loan sizes in strict increments to ensure clients can manage gradually larger loans. In addition, MFIs manage risk by basing loan sizes on clients demonstrated capacity to repay.

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Loan approval processes some MFIs require a credit committee to approve larger loans, which reduces the chance of making poor loan decisions (transaction or fraud risks) and increases the control for loans that pose a greater financial risk to the institution (credit risk) and fraud risk. Forced savings or co-signature requirements forced savings and cosignature requirements act as collateral substitutes, which reduce the risk of default by transferring part of the risk to the borrower or third party. Small loan sizes by making many small loans, the MFI reduces its credit and liquidity risk exposure by diversifying its loan portfolio Centre mechanisms some MFIs transfer the risk associated with handling cash to clients by making clients responsible for collecting loan payments and depositing them at formal financial institutions. This continuously reduces transaction Record keeping 3.11 CLIENT SCREENING AND SELECTION: There shall be screening of all prospective clients by Credit Officer. Standardized loan application forms will be available to the Credit officer, who shall complete them on behalf of the clients. The application forms will capture basic information about the clients, the type of business and their locations, estimated cost and returns on what they intend do etc. Completed application forms will be submitted to the loans committee together with recommendations from the Credit Officer. The loan approval committee sits and considers each loan and its terms. Letters stating this approval and the loan terms are written to the clients, with repayment schedules attached. 12

Seminars will also be organized for them before loan disbursements to explain loan terms and conditions to clients Group guarantee documents are signed by the Executive and group members.

3.11.1 THE FIVE CS OF CLIENT SCREENING Credit risk management involves screening clients to ensure that they have the willingness and ability to repay a loan. When analysing client creditworthiness, MFIs typically use the 5 Cs summarized in the table immediately below: The five Cs of client screening Character Capacity Capital Collateral An indication of the applicants willingness to repay and ability to run the enterprise Whether the cash flow of the business (or household) can service loan repayments Assets and liabilities of the business and/or household Access to an asset that the applicant is willing to surrender in case of non-payment, or a guarantee by a respected person to repay a Conditions loan in default A business plan that considers the level of competition and the market for the product or service, and legal and economic environment. If any of these components is poorly analysed, credit risk increases. To limit this risk, institutions develop policies and procedures to analyse each component. These five components are relevant to all types of lending institutions. The weight assigned to each component will vary depending on the lending methodology (i.e. solidarity group, village banking or individual), the loan size, and whether it is a new or repeat customer. Loan Officers and their immediate supervisors should consider the 5 Cs when making credit decisions, and they should be held accountable for those decisions. The detailed explanation for the 5 Cs includes:

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Character In micro finance, character is a single most important means of screening new applicants. By assessing a clients character, the lender gains important insights into the clients willingness to repay. Although the MFI does not want to put clients in a difficult situation, clients with good character will find a way of repaying their loans even if their businesses fail. The importance of character as the key trait to select new borrowers is heightened by the fact that many micro enterprises do not have sufficient records to demonstrate their capacity to repay. Screening for character varies by the lending methodology. In group lending programs, the group assumes the responsibility for selecting members of strong motivation and character because members guarantee each others loans. With the individual lending, besides interviewing the neighbours and opinion leaders in the community, Loan Officers also need to ensure that the information provided by the applicant is internally consistent. This is often through a threestage method whereby applicants provide information about themselves and their business in a loan application. Then the Loan Officer visits the household and/or business to, among other things, verify that the application information is correct. Finally, the Loan Officer checks other sources to assess the reliability of the information, such as landlord regarding the amount of rent and the length of residence, or a supplier regarding frequency and size of inventory purchases. The common methods for screening clients character are summarized as: Check personal and community references to assess the applicants reputation. Use peer groups in which clients select other group members who they believe are honest and reliable. Maintain a black list of past poor performers to avoid repeat lending to bad clients.

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Interview clients to understand their motivation for borrowing Check credit history with suppliers, other credit organisations, or with credit reference bureau if available.

Capacity To assess the clients capacity to repay, Loan Officers conduct both business and household assessments. One challenge in determining the business capacity to repay is the fungibility of money-what the client says she will use the loan for and what she actually uses the loan for may be different. Because the lines between a micro entrepreneurs business and household activities are often blurred, it is important for the Loan Officer to understand the flow of funds within and between the two. It is difficult to assess the repayment capacity of a low-income applicant. Estimates of income and expenses may not be reliable, and applicants often do not have supporting financial records. Experienced Loan Officers develop methods of improving the quality of these estimates by determining the basis on which they are made and then testing whether the assumptions are valid. However, wide variations may still exist between estimated and actual cash flow of a business, even if the applicant is not internationally misleading the Loan Officer. To compensate for these challenges, some MFIs take a conservative approach and assess a clients capacity to repay without taking into account the effect of the loan on the business. That means that the current net income of the business is certain is a certain multiple of the proposed instalment amount; in other words, the applicant estimates that the business is already generating enough revenue to repay the loan. MFIs also use small initial loan sizes and an on going process of collecting information to overcome the challenge of assessing the applicants repayment

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capacity. Initial loan sizes tend to be smaller than the applicant request because the Loan Officer does not have good information to assess repayment capacity. Clients are then asked to maintain basic business information on income and expenses so that Loan Officers can make credit decisions based on more reliable information and tailor subsequent loans to the cash flow of the business. With small loan sizes, it is appropriate that the applicants character is the key screening element, as loan sizes increase, however, there needs to be shift soft information like character to harder information such as capacity. To make good credit decisions, therefore, it is important that Loan Officers collect information over time that will allow them to understand the capacity of their clients businesses. Capital Besides assessing the cash flow of the businesses to determine if it has the capacity to repay a loan, many MFIs should collect information on the assets and liabilities of the business to construct its balance sheet. This allows the Loan Officer to determine if the business is solvent and how much capital the client has already invested in the business. With the smallest loan, this component is probably the least important, but its significance increases as loan sizes increase. In some cases, loan sizes are linked to the equity of the business. Some MFIs also conduct an asset inventory to reduce credit risk. Although they may not say so explicitly, Loan Officers convey the messages that, if the client does not repay, the institution might seize these assets. This is known as implicit collateral. Collateral One reasons for the development of the micro finance industry is that banks do not serve persons who cannot offer traditional collateral. Many micro lending methodologies use peer groups, restrictive product terms and compulsory

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savings as collateral substitutes. Subsequent lending innovations have resulted in the provision of micro loans with non-traditional collateral, such as household assets and co-signers. Pawn lending and asset leasing are other methods of overcoming collateral constraints. Perhaps more important than the type of collateral is how it is used. In micro finance, collateral is primarily employed as an indication of the applicants commitment. It is rarely used as a secondary repayment source because the outstanding balance is so small that it is not cost-effective to liquidate the collateral. Only when clients are not acting in good faith do micro lenders take a hard line stance and seize collateral. Consequently, MFIs tend to be less concerned about the ratio of the loan size of the value of collateral than how the clients would feel if the collateral was taken from them. As the loan size increases, however, this soft approach to collateral needs to change so that larger loans are indeed backed by appropriate security. Conditions The fifth component, conditions, is often the hardest for Loan Officers to assess. Many MFIs adopt a micro enterprise development approach to micro finance, which means that they are as concerned with improving the business as recovering their loan. As such, the process of assessing the level of competition, the size of clients market, and potential external threats, can play an important role in helping the client to make smart business decisions and help the Loan Officer to make good credit decisions. Since Loan Officers do not usually have expertise to analyse conditions of all types of businesses, the primary means of controlling the credit risk posed by business conditions is to require that applicants be in business for a certain number of month (usually 6 to 12 months) before they are eligible for a loan. This requirement means that applicants will have sufficient experience to answer

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questions about market conditions. The existing business requirement also makes it easier to assess repayment capacity and business capital needs. 3.12 PRODUCTS AND SERVICES THAT FIT CLIENTS PREFERENCES

The micro finance market is increasing becoming very competitive with small MFIs up-scaling to become regulated and the banks downscaling. This requires products and services to be tailor to suit client needs. Any lender therefore, should consider the following emerging issues: Proximity to the service provider; Simplicity in the loan application; Accessibility; Individual loans; Competitive interest rates; Flexibility; Close monitoring of loan utilization.

3.12.1 SIMPLIFY AND STANDARDIZE OPERATIONS Recruit staff from local communities where the MFI operations exist. This will enable easy collection of information for loan appraisal and monitoring; For group loans use community credit committee for initial screening and loan appraisal, loan disbursement, loan monitoring, loan collection, acceptance of deposits and withdrawal of savings; 3.13 Simplify application procedure to reduce time for appraisal; Simplify and decentralize loan decision-making procedures; ENSURING GOOD LOAN REPAYMENT Assess the environmental and economic risks prior to initiating lending; Carefully screen client families and income flows; Skillfully evaluate clients business plan;

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 3.14

Rely on track record and physical collateral for larger loans; Ensure clients are clear and familiar on loan terms and conditions, procedures, loan contracts, penalties, etc.; Develop mechanisms to facilitate on-time repayment, quick follow-up on late loans and verbal reminders on credit officer s visits; Motivate clients to repay on time by creating incentives fast repeat loans, increase in loan sizes; Enforce repayment mechanisms use guarantor pressure, village leaders or local authorities in difficult cases Allocate provisions to appropriately cover for risks loan loss provision. CREDIT DECISION Repayment Capacity Willingness for Repayment Market Management Capacities Business Performance Actual Need for Credit Existence of suitable Collateral

3.14.1 FACTORS INFLUENCING CREDIT DECISION:

3.14.2 PROCEDURE FOR DETERMINING LOAN PERIOD AND AMOUNT General rule for loan period: Small amounts should have loan periods of not more than 4 month. Middle-sized amounts should have loan periods of not more than 6 month. Larger amounts should not exceed 12 month. Note: The longer the period the higher the risk!

Procedure:

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70% of the repayment capacity is the maximum amount that can be charged as the monthly installment. Fix the loan period according to the general rule Determine the principal of the installment for this loan amount according to loan period

3.14.3 PROCEDURE FOR DETERMINING FREQUENCY Look at the monthly installment Add up 2 days average sales If the sum of 2 days can cover the monthly installment, apply monthly frequency. If not, divide the monthly installment by 2 to get the bi-weekly installment. If the sum can cover the bi-weekly installment, then apply bi-weekly frequency. If not, increase the repayment frequency again. Divide the monthly installment by 4 in order to get the weekly installment. Sum up principal and interest in order to obtain the total monthly installment Compare the resulting installment with the 70% of repayment capacity If the installment exceeds the 70% of the repayment capacity, retry with a lower amount. 3.14.4 DECISION ON COLLATERAL This is a management decision, depending on practical levels of risks the MFI is facing. However, it is recommended that value of the collateral should cover 120% of the loan amount. 3.14.5 HOW FACTORS INFLUENCE THE CREDIT DECISIONS Low repayment capacity: Reduce loan amount/Denial

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Lack of willingness: Denial of credit Market related problems: Reduce amount and period Poor management capacity: Reduce amount and period Very low profitability: Denial of credit High indebtedness: reduce loan amount Unrealistic need for credit: Denial of credit Insufficient collateral: Denial of credit EVALUATION OF RECURRENT CLIENTS

Recurrent customers should only be granted a follow-up credit if they complied with the following rules: Achieve a maximum of 5 days past due in the repayment of one installment Total number of days past due during the whole loan period is less than 20 days. We repeat the evaluation consisting of two visits, because the business and household might have changed In addition, we have to compare the former status with the current results in order to understand and verify possible change 4.0 GROUPS AND GROUP FORMATION

A group is usually defined as a collection of humans who share certain characteristics, interact with one another, accept expectations and obligations as members of the group, and share a common identity. Whereas groups are not an essential methodology for all micro-finance projects, they are the most popular method for service delivery particularly in rural areas where communities are sparsely populated. However, the following should be noted when creating groups to deliver micro finance services:

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Group formation can be problematic especially when groups are formed to execute a specific lending contract, without considerations of other factors that may be binding to the groups;

4.1

If groups are to be formed, they work best when there is a commonality of traditions, experiences and needs; Much time must be set aside for the task of cohesive group formation to ensure that trust develops to a level whereby solidarity can be achieved; ISSUES TO CONSIDER WHEN APPRAISING GROUP LOANS Groups are properly formed, trained and recognized or assessed The non poor should not be allowed to join the group Loan utilization check is done thoroughly i.e loans must be for business, not consumption. Poor attendance in meetings should be evaluated and taken seriously Triangulate information on the purpose of the loan proposal Level of economic development of the area where the program is operating should be assessed.

4.2

RECOMMENDATIONS FOR CONSTRUCTING PEER GROUP FOR LENDING The client population must have ongoing business or prior experience, have a majority of women in most settings, and be a mix of manufacturing, service and trade; Groups should select their own members, be comprised of three to 10 members (one member per family), and group leaders should be selected by the group; The operations should be decentralized and the extension staff should work in the communities, overcome cultural barriers to formal institutions, and become knowledgeable about the clients business environment; The loan amount and terms should be appropriate to client needs and the loan size should increase as business and client experience grows. 22

The application for a loan should be limited to basic information, not to require standard project credit analysis and the application should be turned around in three to seven days;

Interest charges should be supplemented with other fees, borrowing charges should oftentimes exceed commercial rates and total charges should cover real lending costs;

There should be incentives and sanctions for on-time repayment, future loans should be pegged to the groups repayment, and up-to-date information systems should alert staff to delinquencies;

Savings facilities should be valued by group members, intra-group emergency funds should serve as a safety net, and savings should be included within a funds management strategy;

Training should build upon existing client skills, cost effective and responsive training methods should be developed, and self help organizations should address social and economic needs;

The lender should demonstrate borrower trust through solidarity group operations; The lender should be obliged to provide a service of value to borrowers, and there should be an effort to generate borrower loyalty and mutual accountability

5.0

CREDIT SCORING

Scoring technology analyzes historical client data, identifies links between client characteristics and behavior, and assumes those links will persist to predict how clients will act. The technology can help a microfinance institution (MFI) analyze how its clients have behaved in the past to make more reliable loan application decisions, devise more effective collections strategies, better target marketing efforts, and increase client retention. For example, an MFIs credit scoring model might find that its borrowers without business experience are more likely to default on loans.

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5.1

HOW DOES SCORING WORK?

Scoring develops a scorecard that loan officers use by inputting client data to create scores that predict several types of client behavior.

Mark Schreiner describes different scorecards developed for specific purposes: Credit scoring: Automates the application approval process by predicting the likelihood that the applicant will develop repayment problems. Visit scoring: Enables loan officers to prioritize their efforts on clients most likely to respond to the MFIs marketing effort. Collections scoring: Maximizes the effectiveness of the arrears recovery process by assigning collection strategies based on the clients profile. Desertion scoring: Identifies customers most likely to leave the institution, enabling an MFI to proactively manage its customer relationships. 5.2 REQUIREMENTS FOR CREDIT SCORING Centralized database of relevant client information Database dedicated to scoring information Management commitment to project implementation Management commitment to fostering organizational and cultural change Resources and staff from technology and credit departments to integrate, maintain, and refine scoring applications 5.2 BENEFITS OF CREDIT SCORING Improves the efficiency of loan evaluations, recovery of arrears, and customer retention Frees staff to spend more time on the subjective gray areas of decisionmaking

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Offers a basis for variable pricing by including individual client risk in lending decisions Lays a foundation for more sophisticated risk management and marketing applications

5.3

WHO SHOULD CONSIDER CREDIT SCORING? MFIs that want to supplement subjective loan officer decision-making with data-driven analysis may want to consider scoring. MFIs that implement scoring are typically large, well-managed institutions that have several years of historical client data stored in a central database. MFIs that want to supplement subjective loan officer decision-making with data-driven analysis may want to consider scoring. However, scoring is generally not as suitable for MFIs that use joint-liability and village banking methodologies because the behavior of clients in these groups is often driven more by group interactions than individual client characteristics.

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