Delinquency management: for sustainable business of microfinance

Submitted to: Dr. A. N. Vijay Kumar IIPM, Bangalore

Submitted by: Anjali Roy 10PGDM ABPM35

Abstract Microfinance is a type of banking service that is provided to unemployed or low-income individuals or groups who would otherwise have no other means of gaining financial services. Ultimately, the goal of microfinance is to give low income people an opportunity to become selfsufficient by providing a means of saving money, borrowing money and insurance. And

delinquency (a situation that occurs when loan payments are past due) is a major issue in Microfinance. Is one of the killers of microfinance institutions. Success for a Micro-finance institution (MFI) starts with proper delinquency management. International best practice for microfinance suggests that sustainability is an attainable goal for microfinance institutions. Delinquency Management and Control are the critical issues affecting the goal of sustainability for microfinance institutions. Based on the premise that microfinance institutions (MFIs) have to be sustainable for longterm impact, the Delinquency Management is important for MFI managers: So its very important to analyze the causes of delinquency and reviewing the costs of delinquency to the microfinance institutions so as to control delinquency to achieve a sustainable business. The need of the hour for credit card issuers and banks is the pro-active identification of potentially delinquent accounts at the earliest opportunity, and in a real-time environment. Credit card issuers and Retail banks are increasingly looking at solutions that would deliver relevant delinquency related information for intelligent management of delinquencies before they are converted to full-blown defaults

Table of contents S. No. 1 2 3 4 5 6 7 8 9 Particulars Introduction Delinquency in microfinance Effect of delinquency in microfinance Measuring delinquency in microfinance Causes of delinquency in microfinance Preventing delinquency in microfinance Acting on delinquent clients Conclusion References Page No.

1. Introduction Micro Finance in India - An Overview In the post nationalisation era, the banking sector witnessed flow of substantial amount of resources while the banking network underwent an expansion phase without comparables in the world. Credit came to be recognized as a remedy for many of the ills of poverty. Credit packages and programmes were designed based on the perceived needs of the poor. Programmes also underwent qualitative changes based on the experience gained. Besides the programmes initiated by the Central Government, a large number of credit-based programmes were introduced by the state governments with large resource allocations. NABARD, during the early eighties, conducted a series of research studies in association with MYRADA (a leading NGO from South India) and also independently which showed that despite having a wide network of rural bank branches that implemented specific poverty alleviation programmes and self-employment opportunities through bank credit for almost two decades, a very large number of the poor continued to remain outside the fold of the formal banking system. These studies also showed that the existing banking policies, systems and procedures, and deposit and loan products were perhaps not well suited to meet the most immediate needs of the poor. It also appeared that what the poor really needed was a better access to these services and products, rather than cheap subsidised credit. Against this background, a need was felt for alternative policies, systems and procedures, savings and loan products, other complementary services, and new delivery mechanisms, which would fulfil the requirements of the poorest, especially of the women members of such households. The launching of its Pilot phase of the SHG (Self Help Group) Bank Linkage programme in February 1992 could be considered as a landmark development in banking with the poor. The SHG-informal thrift and credit groups of poor came to be recognised as bank clients under the Pilot phase. The strategy involved is simple viz. forming small, cohesive and participative groups of the poor, encouraging them to pool their thrift regularly and using the pooled thrift to make small interest bearing loans to members, and in the process learning the nuances of financial discipline.

Subsequently, bank credit also becomes available to the Group, to augment its resources for lending to its members. It needs to be emphasised that NABARD sees the promotion and bank linking of SHGs not as a credit programme but as part of an overall arrangement for providing financial services to the poor in a sustainable manner and also an empowerment process for the members of these SHGs. NABARD, however, also took a conscious decision to experiment with other successful strategies such as replicating Grameen, wholesaling funds through NGO-MFIs.

2. Delinquency in microfinance Delinquency management is a major issue in Micro-finance. Success for a Micro-finance institution (MFI) starts with proper delinquency management. All staff in one MFI must be trained on delinquency management. From the field to the top management and trustees, everyone must be able to understand the mechanisms of delinquency and manage it. Delinquency management is a skill. It can be learnt like any other skill. Learning how to manage delinquency begins with understanding what is delinquency, its origins and consequences on the organization. Monitoring delinquency is a part of this skill also. Micro-finance staff must be trained on delinquency management from the very beginning, once they enter a MFI. Policies and procedures in any MFI must be designed in accordance with proper delinquency management practices.

What is Delinquency? The situation that occurs when loan payments are past due. Also referred to as arrears or late payments, measures the percentage of a loan portfolio at risk (USAID). Delinquency occurs when one loan payment is one day late Zero percent delinquency is an obtainable and a reasonable goal but requires the commitment of the whole agency. Acceptance of a delinquency level above zero percent is the decision of the institution itself and is a decision that has its own costs.

International standards definitions of delinquency Delinquency is the situation that occurs when loan payments are past due (CGAP). A delinquent loan is a loan on which payments are past due (Cal meadow). Delinquent payments are loan payments which are past due. Delinquency occurs when one loan payment is one day late. Delinquent payments/payments in arrears are loan payments which are past due; delinquent loans are loans on which any payments are past due. (adapted from SEEP)

3. Effect of delinquency in microfinance Its very important to identify the effect of delinquency in Micro-finance to understand the importance of minimizing delinquency in Micro-finance. This section discusses the consequences of delinquency on a Micro-finance institution. It presents the different effects of delinquency on several issues related to the operations of a Micro-finance institution. It highlights how the level of delinquency reveals the developmental approach of one MFI. Mohammed Yunus is professor of Economy from Bangladesh. He created in the 70s the Grameen bank in Bangladesh. He is one of the pioneers in Micro-finance. Some refer to him as the father of Micro-finance. He was one of the first one believing in the possibility to lend money to very poor women to help them to start and operate an income generating activity. The Grameen bank is now one of the biggest MFI in the world. Its methodology has been replicated in a lot of countries including the Philippines. Grameen methodology relies on the constitution of groups of poor women. The complete logic of M. Yunus is that Credit without strict discipline is nothing but charity. Charity does not help to overcome poverty. Poverty is a disease that has a paralyzing effect on mind and body. A meaningful poverty alleviation program is one that helps people gather will and strength to make cracks in the walls around them

Mohammed Yunus implies that a strong sense of discipline in credit will give to the poor beneficiaries of a poverty alleviation program the habits to be disciplined in their life. Mohammed Yunus think that discipline is synonymous with will. He believes that the will is the main strength poor people have to improve their living conditions.

Effects of delinquency Delinquency is the biggest threat in Micro-finance: it threatens the long term institutional viability. It questions the survival of the organization and the poor. The major effects of delinquency in MFIs are following: (Costs of Delinquency and Default) Delinquency is expensive for an MFI. It affects a program by: Slowing rotation of portfolio Loss of confidence in the organization for good payers Demotivation in the MFI staff Causing program to lose credibility Delaying of earnings Less time to promote and grant loans Increase in collection costs and recovery operations Decreasing operation spreads (less time to promote) Leading to ever-increasing repayment problems Threatening long-term institutional viability

4. Measuring delinquency in microfinance Having measures of delinquency is necessary to act on delinquency. Understanding the meaning of indicators is the basis to analyze the causes of delinquency and design the appropriate answer. So here we will deal with the indicators that measure delinquency and how to use these indicators to manage delinquency.

Quality of loan portfolio The outstanding portfolio of a Micro-finance institution is defined as the principal amount of loan balances outstanding. In other word, it is the remaining balance in principal of all the outstanding loans. The outstanding portfolio is the main asset of an MFI. This is the outstanding portfolio which generates income with interest and fees. It is also what the clients are demanding. As a conclusion, it is the reason for existence of one MFI. Assessing the outstanding portfolio can be done in two ways: quantitatively and qualitatively. Quantitative measure of the outstanding portfolio means measuring the size of the portfolio. It is expressed with an amount given in a specific currency. Qualitative measure of the outstanding portfolio means measuring its capability to generate income. In other words this is the financial efficiency of the money lent to clients. An outstanding portfolio which contains a lot of bad debt is not a qualitative portfolio. A bad debt corresponds to loans that are late. A loan with late payments is a bad debt as it has less chance to be fully paid by the clients. A loan with late payments is a risky loan. The bigger the number of late payment, the higher the risk not to be paid for the MFI. The higher the number of myspayments, the lower the quality of the portfolio. Measuring the quality of the portfolio is the best measure of delinquency as it measure the risk not to be paid. Measuring the loan portfolio quality can be done with ratios. Ratios allow you to examine financial relationships to diagnose the well-being of your institution. Key ratios should be monitored regularly to measure performance. PAR is the best indicator for assessing the risk of potential losses. Arrears rate overestimates portfolio quality Although PAR is the best when looking at portfolio quality, it is difficult to apply to village banking schemes that accept partial payments. The institution makes the loan to the village bank as a whole and often does not track individual clients. PAR also has limitations for rapid growth portfolios and will be lower after adjusting for write-offs. This may mask institutional lending problems.

The following table shows the purpose of each indicator and gives a range of acceptable ratios. Performance Ratios and Loan Portfolio Quality Indicator Portfolio at Risk (PAR) By Age Ratio Measurement

Answers the question How much unpaid principal balance of all loans with could you lose if all late borrowers at least 1, 30, or more days past due default? Portfolio aging separates more risk loans from less risky. (The outstanding portfolio longer a loan goes unpaid, the higher the risk it will never be paid.) Answers the question How commonplace is non-payment? Measures amount of loan principal that is due but not paid. Shows amount paid compared to amount due or expected during a specific period. Does not provide useful information about the performance of the outstanding portfolio. Fluctuates from month to month. Is meaningful only for longer periods. Can be processed algebraically to predict eventual loan loss rates. Annual cost of default, which must be balanced by higher interest income.

Arrears Rate Past Due Rate Repayment rate

amount past due outstanding portfolio

amount received (current and past due) less prepayments total amount due this period + amount past due from previous periods

Current recovery rate

amount received this period (P or P+I) amount due this period (P or P+I) under original loan terms P = Principal I = Interest

Annual loan loss rate

amt of loans written off as unrecoverable average outstanding portfolio

Other indicators measuring of delinquency are also currently used: Repayment rate = amount received (less prepayments)/total amount due this period (including past due from previous period). It shows the amount paid compared to the amount expected. It is a measure of the MFI capability to be paid on time.

Repayment ratio on maturity = amount received on maturity date/total amount due. It shows the amount paid compared the amount expected to be paid on maturity. It measures the capability of a MFI to be paid on time, on maturity. In other words it measures the capability of the MFI to make the clients respect their contract. When a repayment rate is computed on maturity, there is no longer prepayment as all payment are due. Furthermore, the total amount due is equal to the amount lent to the borrower, as all payments are due. % Non-past due clients or % past due clients: it helps to understand if my delinquent clients have big or small arrears. It shows how the delinquency is spread among the clientele. In other words, it shows how far the delinquency is a common practice among my clients. Arrears rate or past due rate = amount of arrears or past due/outstanding portfolio. It gives an indication on how common is non-payment within my portfolio. Arrears rate is usually smaller that portfolio at risk as it consider only the late payments and do not consider the remaining balance. The amount of late payment is just a part of the remaining balance. Collection ratio: this ratio might have been quoted by the participants. Collection ratio gives the opportunity to the management to assess the collection performance of the field staff. But this ration does not give a precise assessment of the delinquency level within the MFI. It shows that improvements might be necessary in the collection performance. It is mainly a managerial tool. It serves also as a cash-flow planning tool. Based on the average performance in collection, the MFI can plan the amount of cash that will be collected regularly.

5. Causes of delinquency Understanding the causes of delinquency helps to design the appropriate answers to delinquency. It helps also to determine the acceptable level of delinquency in one MFI. So this section will deal with identifying the reasons of delinquency, understanding the clients motivation to become delinquent and identifying which factors are controllable and which are not. Ultimately the microfinance institution itself is responsible for delinquency (even when the proximate cause seems external to the MFI) because it sets its own principles, promotes its own repayment culture, instills credit discipline in staff and borrowers, and must plan for events

beyond its control. There are many stakeholders in delinquency, but only the MFI can do something about it. Uncontrollable factors in delinquency - are factors that do not depend on the MFI or on the clients. Natural disasters: as earthquakes, floods, fires. Changes in government policy: new tax, crackdown on street vendor. Individual crisis: illness, death in the family. State of local, national or world economy: financial crisis in South-East Asia.

Factors such as these require constant monitoring and consideration. While the MFI may not be able to control them, they can influence the quality of the portfolio. The MFI should be able to compensate for them in its design, methodology and collection procedures. In late 90, huge floods had tragic effects in Bangladesh. Many of the Grameen bank clients lost everything. The MFI had to adjust its policies to face the issue. Indeed, Grameen granted new loans for their clients who lost everything. These loans aimed at helping their clients to re-start an activity. Some MFI advocate with governments in order to influence them to take measures in favour of their clients. Thus the legal framework can be improved for poor people operating a small business. Example: allowing street vendors to operate. MFI can also provide services that reduce the vulnerability of their clients in front of individual crisis. A Micro insurance scheme is a good tool to reduce the vulnerability of MFIs clients for death or diseases. MFI can also linkage with other NGO that provide other services to reduce the vulnerability of their clients: linkage with social programs or health programs. This entails a close coordination at the field level. Controllable factors- Controllable factors are numerous. Among the controllable factors, the following can be identified. Methodology Behavior or knowledge of staff Value/image of MFI

 Organization of work / management

The identification of the precise reasons for delinquency is very important as it will determine the solution that must be found. Understanding the root cause of delinquency is also the most difficult as it implies to assess all the MFI: its organization, its methodology, its image, the capabilities of its staff, etc. Conclusion on the causes of delinquency- Most factors are controllable. Very few factors are uncontrollable. There are no bad borrowers but MFI that do not implement an effective methodology or are not well organized. Identifying the precise causes of delinquency for a MFI is a necessary step to address it.

6. Preventing delinquency in microfinance- Prevention is better than cure This topic will deal with the ways to avoid delinquency before it occurs. Preventing delinquency is an issue that needs to be separate into several sub-issues. So we have to understand the key issues for effective prevention of delinquency and have to enumerate solutions to prevent delinquency based on the key issues. Key Elements of Delinquency Prevention
Understand the causes of the problem before developing a solution

Programs image and philosophy

Methodology

Borrower selection Loan size and terms Incentives

Information Systems Reliable, accurate and timely data Relevant detail for level of use (BOD, Mgmt, Staff) Relevant and timely dissemination Cost-effective

Delinquency is caused by MFIs that have not implemented an effective methodology; MFIs need to discipline borrowers and create an image of being intolerant of late payments; Loan sizes and terms should not make repayment difficult.

7. Acting on delinquent clients Acting on delinquent clients means implementing actions to motivate them to pay back. This section deals with actions that can be implemented once clients became delinquent. It stresses the necessity to have specific approach to handle delinquent clients. It proposes different contents for discussion to motivate delinquent clients to re-start their payments. Several kind of action can be taken: Legal action: MFI can request legal authority to put pressure on their clients (example: Barangay or court). These actions can be very efficient but they are most of the time very costly. They are barely implemented. To be efficient, these actions must be standardized and systematic. Most of the time, these actions are taken when all other actions failed. Internal process: MFI can have a set of standardized action to be taken in case of delinquency. Managers or specialized staff can visit delinquent clients as a new face with more authority is often more frightening for a delinquent. Notices can be sent also. In order to be efficient, these internal actions must be systematic and standardized. Direct client motivation: motivating delinquent clients to pay is one of the hardest part in the work of field staff. They have to be prepared to handle this situation. Some staff are naturally good in it. Nevertheless, this skill can improved. First convincing arguments must be identified. Managers can help staff to improve their convincing skills by coaching them. Training with play role can also help a lot. Convincing argument can be split into two categories: those which remind the benefits to pay on time and those which remind the cost and risk of being delinquent. For most clients, convincing arguments will be enough to motivate them to pay. The difficult part of the job is to find which will convince them. It is advisable to start with trying to motivate positively delinquent clients, reminding them the benefits. Then costs and risks can be enumerated. Of course, to be efficient, internal process that can follow this one-on-one

discussion must be properly implemented to prove delinquent clients that the costs and risks are real. Example of benefits that can be reminded: Accessing other loans (with possible bigger amount). Accessing to other services (training, counseling) Positive reputation among peers & Lower interest

Example of costs and risks that can be reminded: Additional interest Pressure from the group or neighbor/bad reputation Legal action

Benefits and cost to clients for on time and late payments On time payments Benefits for clients

Late or no payments Lower expenses if interest payments not made Maintain capital (or portion) from loan in business or use for other purposes Fewer or no trips to financial institution to make payments (lower transaction costs, in case of branch or area collection) Lower transaction costs of attending meetings and other activities of lending institution May not have to repay at all, if there is a low cost to default Late fees for late payments Delay future loans or loss of access to future loans Possible legal action and costs Possible loss of collateral Loss of access to other program services Hassle of frequent visits by loan

Cost for clients

Probability of immediate larger follow up loans Development of positive credit history Positive reputation among peers Access to training, savings or other program services Access to advice from credit officers Award or prizes for timely repayment. Lower interest rates on second & third loans Interest rebates Pay interest and capital on current loan Pay time and transportation costs to make payments Opportunity costs (if time is spent in meetings, it prevents the clients from working on his/her business).

officers Hassle of pressure from group members if group loans Negative reputation among peers The MFI must understand what are the borrowers perceptions to design appropriate process for incentives.

iGATE Patni Pre-Delinquency Management (PDM) Solution The Pre-Delinquency Management solution offering from iGATE Patni enables pro-active credit risk mitigation through identification of potentially delinquent customers/accounts before they actually turn delinquent. The PDM solution is built on proprietary transactional scoring and behavioral scoring models. The solution undertakes both peer-to-peer comparative analysis & customer behavioral analysis to proactively identify and analyze potentially/habitually delinquent accounts and customers.

Unique features of PDM Solution- The unique features of iGATE Patni's PDM solution include:

Transactional analysis of potentially delinquent accounts to assess credit orientation and credit worthiness Integration of credit scoring intelligence with pre-delinquency assessment Objective, intuitive and comprehensive set of practical business rules based on different transactional modes, patterns and types Enables application of separate sets of rules for different customer classes/groups based on various customer segmentation modes/models Ability to create and customize business rule sets to suit the particular credit profile and risk aspects of specific groups of customers Allocation of different weights to specific business rules applied to each customer group offers the optimal flexibility to define delinquency assessment models as per the credit profile and transactional profile of underlying customer segments

Delinquency assessment to be undertaken without impeding transactional analysis

8. Summary: Delinquency Causes and Controls Accept that most delinquency is caused not by bad borrowers but by MFIs that have not implemented an effective methodology. Create an image and philosophy that does not consider late payments acceptable. The benefit of creating disciplined borrowers is critical to the success of the micro finance institution. Clients must value the credit service. Loan products should suit clients needs, the delivery process should be convenient, and clients should be made to feel that the organization respects and cares about them. Incentives wont work if the clients do not value the access to the credit. There are no bad borrowers only bad loans. Make sure loan sizes and terms do not make repayment difficult. Do not base loans on projections, base on capacity to repay. Establish an incentive system that uses both financial and non-financial incentives to encourage on time repayments. For the borrower these can include larger loans, follow up loans, interest rebates, and access to training (or disincentivespenalty fees, no further access to loans, collection of collateral, legal action.)

Design an incentive system for the field staff/loan officers that include on-time payments as an important variable. An incentive system places the responsibility for portfolio quality on the shoulders of the loan officers who with support can best respond to repayment problems. It can motivate officers to look for and eliminate the causes of arrears. Ensure that from the borrowers perspective the benefits of on time repayment and costs of late repayment far outweigh the benefits of late repayment and costs of on-time repayment.

Develop systems that provide information to field workers that enable them to conduct effective and timely follow-up of loans and to manage their portfolios efficiently. The easier it is for the field staff to figure out whose payments are due and when, who is late and by how much, the more time they can spend with borrowers.

Develop a portfolio information system that enables management to conduct timely and useful analysis of portfolio quality, determine trends in the portfolio over time, and identify possible causes of delinquency.

Effective delinquency follow-up procedures are needed. Develop policy that lists the steps one takes when a loan becomes past due. Examples included activating the group to follow up, visiting clients, holding frequent staff meetings to discuss problem loans, etc.

Establish a target level of acceptable delinquency based on thorough understanding of the costs and effects of delinquency on the program. Establish prudent loan loss reserves and write off policies. Ensure that income and assets are accurately reflected in the financial statements.

9. References PDF on Delinquency Measurement and Control AND Interest Rate Calculation and Setting, CGAP. Report on Delinquency Management and Interest Rate Setting for Microfinance Institutions, 2009, CGAP Delinquency management Training manual, prepared by Gregory DOUCET, Urban Program for Livelihood Finance and Training (UPLIFT), May 28, 2004 Version

Report on Measuring Microcredit Delinquency: Ratios Can Be Harmful to Your Health June, 1999 Richard Rosenberg, CGAP

Websites www.investopedia.com www.wikipedia,com www.nabard.org www.grameen-info.org www.microfinancegateway.com