Shashwat Mody

How Microfinance Institutions Can Manage Default Risk AND Build Financial Inclusion

In its original incarnation, microfinance was a tool targeting the lower- and lower-middle class segments as a tool for economic self-empowerment. Generally, however, individual microfinance institutions (MFIs) successes – as viewed through the lens of higher valuation and other financial incentives – were based almost exclusively on high client growth (on average above 50 percent annually) and low default rates (on average below 4 percent). While sufficient for strategic evaluation and benchmark of success at the senior level, those two measures can be counterproductive for MFIs looking to achieve real social impact through financial inclusion.

Achieving low default rates and higher client growth rates together is only possible when the client’s current cash flows are more than adequate to cover the average loan size of the institution, with a steadily increasing loan size being the client’s incentive to borrow. For a base-level loan officer, high client growth and low default rates can only be achieved when they move away from the target population of poorer populations, inching instead toward so-called middle-class borrowers, those who are more financially secure but still not able to acquire a loan from a bank.

Ultimately, this creates a reality in which there are two distinct types of borrowers in any MFI – a middle (income) class borrower and lower (income) class borrower. Acknowledging, then, that an MFI’s mission and vision must accommodate and differentiate between both types of borrowers will be key in receiving on-time repayments in the future.

For example, currently, if an individual finds that a fellow group member receives a $1,000 loan for housing, frequently that individual automatically assumes they too are eligible for the same loan amount, regardless of their present cash flows. This is often not the case, and MFIs are finding that they must allow for staggered credit limits based on the capacity of individual members for repayment. Many MFIs are currently in the habit of standardizing loan sizes by group, and managing this transition delicately is critical as borrowers may feel frustrated by not being able to qualify for larger loan sizes, allowing disenfranchisement to manifest itself in defaults.

To illustrate, consider this experience from a remote area of Jharkhand, India. On the first loan cycle, a group was given an Rs 8k ($150) loan, followed by a second loan of Rs 15k ($300). The loan officer had initially rated the five group members as being of the same socio-economic status, though it was quite apparent that some had motorbikes and houses with concrete walls while others rode cycles and lived in homes with thatched roofs. Group liability (where the rest of the group pays the default amount) was only enforceable for a maximum of two to three installments, so two members defaulted because they simply did not have a solid enough income base to repay the larger loan demanded by the other members of their group.

This scenario is quite common across groups, and thus default risks are higher because of the inability of MFIs to forecast client cash flows during and after each cycle. This is typically due to the inaccuracy of classification information, starting all the way from when the loan officer first acquired clients and incorrectly classified them based on household cash flows. Further, MFIs often have rigid management information systems, without the capability to handle varying credit limits within groups.

From my experience, MFIs can limit this default risk by accurately assessing the credit capacity of clients through the following process:

1) Acknowledge the presence and mission to serve clients with varying credit absorption rates – this could sometimes be against the stated goals of the organization, but turning a blind eye only makes problems worse for all clients by encouraging loan officers and branch managers to inaccurately categorize client repayment capacities.

2) Identify which clients have stronger or weaker capacity to repay, categorize them accurately, then provide them with loan products that balance their varying credit limits with a need to enforce group liability.

3) Transition successful middle class clients into individual lending products after a few loan cycles, much like what the Grameen Bank and other innovative MFIs have done.

One note on the third point: The Grameen Bank did not encounter the same default problems since most MFIs in Bangladesh were initially competing on client numbers and not on loan sizes. In many geographies such as Latin America, India and Southeast Asia, MFIs are competing on both loan sizes and client numbers, and therefore are reluctant to make distinctions based on clients’ ability to repay. Ultimately, all MFIs will find that they must embrace tiered lending as increased client satisfaction in the form of fewer defaults will be critical to their survival in a competitive marketplace, especially in today’s day and age, when clients have the option of taking loans from multiple MFIs.

Shashwat Mody is an Aga Khan Scholar, and is currently pursuing an MBA at The Wharton School, University of Pennsylvania. His full bio is here.

Image credit: Flickr user HowardLake

financial inclusion, microfinance