CGAP Training Delinquency Management and Interest Rate Setting Participant Materials: Handouts

W-H1 (page 1 of 2)

©CGAP/World Bank, 2013

Interest Rates – Organizational Information Form

PLEASE USE PEN

Name ______________________________ Organization ______________________________

Who are your target clients? How would you describe the level of competition in your area? High Medium Low Credit Interest Rate of Main Credit Product _____% per Month on Flat

Year Declining

Which fees does your MFI charge on your main loan product and when are they charged?

Type of fee

Amount (% or actual)

When are they charged? (At application, disbursal, etc.)

Who sets the interest rate?

What factors does your MFI consider when setting the interest rate?

When was it last reviewed?

W-H1 (page 2 of 2)


How do you communicate the prices and conditions of your financial products to your clients? Is your institution’s staff trained to communicate on interest rates and other conditions of financial products with your clients? In your country, are there regulations on the transparency of loan conditions and are there mandatory formulas for the calculation of effective interest rates?

SAVINGS Does your institution offer deposit services? Yes No

How much interest is the client paid?

SAVINGS – Compulsory/Required Does your MFI require compulsory savings? Yes No If yes, in what amounts?

How and when are the savings collected?

Does your MFI hold these savings? Yes No

Is the client paid interest? Yes No

How much is the client paid? (state percentage or amount, as appropriate)

When is the client paid interest on his or her compulsory savings?

Can the client access the savings? Yes No If yes, how and when? Insurance Does your MFI provide insurance services? Yes No If so, what type of insurance?

W-H1 (page 3 of 2)


FIRST LOAN DETAILS These details will be used to calculate the effective interest rate of your MFI. If you do not have specifics of the first loan, then please enter the data for any single (sample) loan that is offered.

Amount of Loan _____________

Loan Term _____________

Frequency of Payments _____________

Interest Rate on this loan ______________

When Paid (up front, equal payments, etc.)

__________________________________

Fees:

Purpose Amount or percentage

of loan size When they are paid (up

front, ongoing, etc.)

Principal payment amount _____________ per week OR per month OR

Other – Explain (for example, lump sum end of term)

Amount paid in interest _____________ per week OR per month OR

Other – Explain (for example, up front)

W-H2a


Pre-course Skills Audit Managing Delinquency and Setting Interest Rates for Sustainability

Mark your answers on the answer sheet provided. If you are not reasonably sure of the answer, please mark "I don't know" instead of guessing. You will not be graded. The results of this test will be used to help the instructors match their presentations to the background and knowledge of the students.

FOR QUESTIONS 1–7, MARK ON YOUR ANSWER SHEET: T (TRUE) F (FALSE) OR ? (I DON'T KNOW)

1. Most microfinance institutions (MFIs) are financially sustainable. 2. The sources of MFI income are mostly interests and fees. 3. If they want to be financially sustainable, MFIs should charge their borrowers a "market" interest

rate (i.e., a rate close to what commercial banks charge to their usual customers). 4. Loan delinquency can spin out of control faster in an MFI than it might tend to in a commercial

bank. 5. Repayment rate is the best way to monitor the quality of your loan portfolio. 6. Delinquency control is out of the hands of the MFI; it is totally in the hands of the borrower. 7. Outstanding loan portfolio is equal to the total amount of loans disbursed by an MFI. 8. If an MFI is not sustainable, the only way it can achieve sustainability is to increase its source of

income (i.e., higher interest rates, lower delinquency)

FOR QUESTIONS 8–12, SELECT THE APPROPRIATE LETTER AND MARK IT ON THE ANSWER SHEET.

9. Which of the following is the easiest to achieve? A. Operational Self-Sufficiency C. Profitability B. Financial Self-Sufficiency D. I don’t know

10. Which of the following describes meaningful measures of portfolio risk? A. Amount of late payments divided by total gross loan portfolio B. Outstanding amount of loans with one or more payments late, divided by total gross loan

portfolio C. Both of the above D. Neither of the above E. I don't know

11. An interest rate that has been adjusted to reflect the impact of inflation is called a(n) A. Effective rate D. Adjusted rate B. Real rate E. I don’t know C. Nominal rate

12. Provision for loan impairment will affect the A. Balance sheet D. Neither of the above B. Income (profit and loss) statement E. I don’t know C. Both of the above

13. An interest rate that is the stated or quoted rate to be paid on a loan contract is called a(n) A. Effective rate D. Adjusted rate B. Real rate E. I don’t know C. Nominal rate

14. What is the formula for portfolio-at-risk?

15. What is the formula for write-off ratio?

W-H1 (page 2 of 2)


16. What is the potential impact of poor delinquency management on the MFI and on its clients?

17. Name three ways to increase sustainability of a microfinance program.

18. Name three ways to improve relationships with clients.

19. Name four factors that should be considered when determining an interest rate.

20. Name three factors that can improve MFI efficiency.

21. Name three strategies to manage and control delinquency.

W-H2b (Answer Sheet)


Pre-course Skills Audit Managing Delinquency and Setting Interest Rates for Sustainability

Name ______________________________ Organization ______________________________

Position: ___________________________ Length of time in position: ___________________

MARK TRUE, FALSE, OR I DON’T KNOW

1. 5. 2. 6. 3. 7. 4.

MARK A, B, C, D, OR E

8. 11. 9. 12.

10.

13.

14.

15. Three ways to increase sustainability are:

1. 2. 3.

16. Four things to consider when setting an interest rate are:

1. 3.

2. 4.

Portfolio-at-risk =

Write-off rate =

W-H3


Managing Delinquency and Setting Interest Rates for Sustainability—Workshop Goals

EXPLAIN THE RELATIONSHIP OF DELINQUENCY MANAGEMENT AND INTEREST RATES TO SUSTAINABILITY

ANALYZE THE CAUSES OF DELINQUENCY

EXPLAIN THE INSTITUTIONAL COSTS OF DELINQUENCY

CALCULATE AND EXPLAIN PROVISIONING FOR LOAN IMPAIRMENT, IMPAIRMENT LOSS ALLOWANCE, AND WRITE-OFFS

APPLY RATIOS AND TOOLS TO MEASURE AND CONTROL DELINQUENCY

DEFINE INTEREST RATE TERMINOLOGY

CALCULATE EFFECTIVE INTEREST RATES

ESTABLISH INTEREST RATES FOR SUSTAINABILITY

DISCUSS THE IMPACT OF INTEREST RATES ON BORROWERS AND LENDERS

DEVELOP AN INSTITUTIONAL ACTION PLAN ON DELINQUENCY MANAGEMENT AND INTEREST RATE POLICY

DQ1-H1


Costs of Delinquency How delinquency affects an MFI

• Postpones interest income, yet costs remain, so viability is lowered.

• With slower portfolio rotation, lowers productivity of assets and reduces fee income.

• Can spread quickly.

• Costs far more to fight delinquency; prevention is cheaper.

• Raises cost of providing for loan impairment (reserves set aside to cover late payments on loans).

• Reduces cash flow and affects liquidity management.

• Affects institution’s image.

• Lowers staff morale.

• Lowers image of clients in their community.

• Increases likelihood of default, resulting in loss of both income and assets.

• Erratic cash flow and difficulties planning.

DQ1-H1a


Calculating the Costs of Default (considering variable costs)

Initial loan amount $75,000 Interest (15% flat) Loan term, weeks 25 Weekly repayment of principal Weekly repayment of interest Total weekly repayment Payments received 15 Payments lost 10 Lost interest income Lost principal Total lost income and principal Expected revenue ($75,000 loan for 25 weeks) Costs per loan $7,500 Net expected revenue per loan Actual net revenue earned (10 weeks lost payment) Number of Loans Required to Earn Lost Principal (taking into account variable costs of disbursing and managing loans)

___ loans of $75,000

Lost principal/net revenue per $75,000 loan / Number of Loans Required to Earn Lost Interest and Principal (taking into account variable costs of disbursing and managing loans)

___ loans

Lost interest and principal/net revenue per loan /

DQ1-H1b (Answers)


Calculating the Costs of Default (considering variable costs)

Initial loan amount $75,000 Interest (15% flat) 11,250 $86,250 Loan term, weeks 25 Weekly repayment of principal 3,000 Weekly repayment of interest 450 Total weekly repayment 3,450 Payments received 15 51,750 Payments lost 10 34,500 Lost interest income 4,500 Lost principal 30,000 Total lost income and principal 34,500 Expected revenue ($75,000 loan for 25 weeks) 11,250 Costs per loan $7,500 Net expected revenue per loan 3,750 Actual net revenue earned (10 weeks lost payment) −750 Number of Loans Required to Earn Lost Principal (taking into account variable costs of disbursing and managing loans)

8 loans of $75,000

Lost principal/net revenue per $75,000 loan $30,000/$3,750 Number of Loans Required to Earn Lost Interest and Principal (taking into account variable costs of disbursing and managing loans)

9 loans

Lost interest and principal/net revenue per loan $34,500/$3,750

DQ1-H2


Delinquency and Default Definitions

DELINQUENCY • The situation that occurs when loan payments are past due.

• A delinquent loan (or loan in arrears); a loan on which payments are past due

• Also referred to as arrears or late payments; measures the percentage of a loan portfolio-at-risk

• Delinquent payments or payments in arrears—loan payments that are past due; delinquent loans—loans on which any payments are past due (adapted from SEEP Network 2005).

DDEELLIINNQQUUEENNCCYY

Can eat away at a portfolio without anyone realizing it, and then suddenly explode out of control, like a hidden beast.

DEFAULT When a borrower cannot or will not repay a loan and the MFI no longer expects to be repaid (although it keeps trying to collect).

CCOOSSTTSS OOFF DDEEFFAAUULLTT——HHOOWW DDEEFFAAUULLTT AAFFFFEECCTTSS AANN MMFFII

• Providing for loan impairment (provision for bad debts) increases expenses and so reduces surplus.

• Interest income from the loan is never received.

• The institution loses a non-recoverable portion of an outstanding loan.

• Written-off loans result in de-capitalization of the institution.


DQ1-H3 Article about the crisis in India New Delhi, 15 October 2010, Le Monde (extract). The week ahead looks difficult for microfinance in India, but also for the world of microfinance in general. The largest Indian microfinance institution SKS is on the spot. Following a suicide wave among borrowers in the region of Andhra Pradesh, which has the highest density of microfinance institutions, local government has enacted a law to severely condemn the "harassment" of borrowers by loan officers. Last week the leader of the second political party in Andhra Pradesh urged borrowers to suspend payments to microfinance institutions until the government has taken significant measures against the "harassment" of people by loan officers. This is the first time a political party has called for non-repayment and this call more particularly targets the two largest and best-known microfinance institutions from India: SKS and Spandana. They are accused of charging "usury" interest rates and of driving poor women who cannot repay to suicide. This case follows a new wave of suicides (the last was in 2006) of women borrowers in early October. Consumer credit For years, microcredit has been presented as financing the creation of micro-businesses by poor families. Extensive research on the use of credit and the management of these funds showed that nearly eight out of ten loans are used as consumer loans, for health expenditure, for housing or for educational expenses. It is undeniable that these allocations are useful or even crucial to these families, but they do not generate the resources to repay the loans. Bicycling loans Not repaying a loan would expose a family to loss of credibility with lenders and thus to cutting themselves off from any other source of credit, while timely repayment ensures access to new loans. Families have access not only to several microfinance organizations, but also to various informal moneylenders. They borrow from one to pay the other, allowing them to remain "creditworthy". This bicycling of loans often enjoys the complicity of loan officers, who are paid in part by the number of loans disbursed and by repayment performance. Over indebtedness The MFI SKS (implicated in this matter of suicides) is constituted largely of speculation on a fictive solvency of borrowers. Its IPO last August allowed it to increase the number and volume of loans granted and thereby to feed this frenzy of bicycling loans. This increase has strengthened its overall credibility, but has also forced it to be more "brutal" to keep up repayment rates and reassure investors.

DQ1-H4


IMPACT OF DELINQUENCY

IMPACT OF DELINQUENCY ON AN MFI

IMPACT OF DELINQUENCY ON CLIENTS

IMPACT OF DELINQUENCY ON THE INDUSTRY

Interest income is delayed, but expenses remain => decreases financial viability

Client image is harmed Lowers industry credibility and increases reputation risk => deters investors

Slower portfolio rotation => decrease of assets productivity and decrease of interest income

If caused by over indebtedness: decrease in living standard

Risk of spreading => if combined with a political environment adverse to microfinance, may create organized non-repayment movements

Delinquency spreads => Hidden beast

Weakens social ties (in guarantee groups, or if resorting to the guarantor)

Cost of loan loss provisions Indirect cost for good borrowers and savers (loan loss cost impacted on interest rates, no access to their savings)

Cash flow is impaired => impact on liquidity management

Pay penalties, cost of institution transfer

The institution’s image is damaged => reputation risk

Demoralizes staff (sometimes, decrease of bonuses linked to portfolio quality)

No credit renewal

May lead to loan losses and loss of both income and assets, and ultimately institutional failure

Client trust is weakened


Source: SEEP Network 2005.

Income

DQ1-H5

Statement

Financial Revenue Financial Revenue from Loan Portfolio

Interest on Loan Portfolio Fees and Commissions on Loan Portfolio

Financial Revenue from Investments Other Operating Revenue Financial Expense Financial Expense on Funding Liabilities

Interest and Fee Expense on Deposits Interest and Fee Expense on Borrowings

Other Financial Expense Net Financial Income Impairment Losses on Loans

Provision for Loan Impairment Value of Loans Recovered

Operating Expense Personnel Expense Administrative Expense Depreciation and Amortization Expense Other Administrative Expense Net Operating Income Net Non-operating Income/(Expense) Non–operating Revenue Non–operating Expense Net Income (Before Taxes and Donations) Taxes Net Income (After Taxes and Before Donations) Donations Donations for Loan Capital Donations for Operating Expense Net Income (After Taxes and Donations)

Cut here

DQ1-H6


Balance Sheet

ASSETS Cash and Due from Banks Trade Investments Net Loan Portfolio

Gross Loan Portfolio Impairment Loss Allowance

Interest Receivable on Loan Portfolio Accounts Receivable and Other Assets Other Investments Net Fixed Assets

Fixed Assets Accumulated Depreciation and Amortization

Total Assets LIABILITIES Demand Deposits Short-term Time Deposits Short-term Borrowings Interest Payable on Funding Liabilities Accounts Payable and Other Short-term Liabilities Long-term Time Deposits Long-term Borrowings Other Long-term Liabilities Total Liabilities EQUITY Paid-In Capital Donated Equity

Prior Years Current Year

Retained Earnings Prior Years Current Year

Reserves Other Equity Accounts Adjustments to Equity Total Equity


Cut here

DQ1-H7


Direct Cash Flow Statement Cash Flows from Operating Activities Cash Received from Interest, Fees, and Commissions on Loan Portfolio Cash Received from Interest on Investments Cash Received as Other Operating Revenue Value of Loans Repaid (Cash Paid for Financial Expenses on Funding Liabilities) (Cash Paid for Other Financial Expenses) (Cash Paid for Operating Expenses) (Cash Paid for Taxes) (Value of Loans Disbursed) Net (Purchase)/ Sale of Trade Investments Deposits/(Withdrawals) from Clients Cash Received/(Paid) for Other Operating Assets and Liabilities Net Cash from Operating Activities

Cash Flows from Investing Activities Net (Purchase)/Sale of Other Investments Net (Purchase)/Sale of Fixed Assets Net Cash from Investing Activities

Cash Flows from Financing Activities Net Cash Received/(Repaid) for Short- and Long-term Borrowings Issuance/(Repurchase) of Paid-In Capital (Dividends Paid) Donated Equity Net Cash from Financing Activities Net Cash Received/(Paid) for Non–operating Activities Net Change in Cash and Due from Banks Cash and Due from Banks at the Beginning of the Period Exchange Rate Gains/(Losses) on Cash and Cash Equivalents Cash and Due from Banks at the End of the Period


Cut here

DQ1-H8


Sample Portfolio Report

1. Outreach Number

New clients (New groups formed) Client dropouts Total clients (Total groups) Number of women clients Number of branches

2. Loan Portfolio Number Amount

Loans outstanding: Total gross loan portfolio Number of active clients Average amount outstanding per client

Loans written off Disbursements: Total loans disbursed Average loan size disbursed Loans disbursed to first-time borrowers

Other data: Average loan term (months) Average number of credit officers

3. Portfolio Aging Number Amount Portfolio-at-Risk

On-time loans 1–30 days past due 31–60 days past due 61–90 days past due 91–120 days past due 121–180 days past due

Total Source: SEEP Network 2005.

Cut here

DQ1-H9


Discussion Questions

1. Give the name of your statement or report and define it.

2. How and when is it prepared?

3. What relationship does your statement have to other statements?

4. What is the impact of delinquency and default on the statements or report?

DQ1-H10 (page 1 of 4)


Background Information on MFI Financial Statements

INCOME STATEMENT The income statement is a flow statement that represents activity over a given period, such as a day, month, quarter, or year. The income statement may also be referred to as a profit-and-loss statement because it illustrates the overall net profit or loss for that period (nonprofit MFIs may also use the terms net surplus or deficit). The income statement summarizes all the revenue and expense transactions for a defined period, usually the financial year to date. The income statement may have two columns of data showing present and past period performance to facilitate comparison.

The presentation of the income statement is normally divided between revenue accounts and expense accounts. It also usually includes some division of operating accounts and non–operating accounts. Operating accounts include all revenue and expenses that are directly related to the MFI’s core business of making loans, accepting deposits, borrowing funds, and providing other financial services. Non–operating accounts include all revenue and expenses that result from activities outside the MFI’s core financial business, such as training or the sale of merchandise. Although many MFIs have ongoing support from donors, donations and grant funds from donors are considered to be non–operating revenue. All donations for loan capital and operating expenses are included in the income statement.

Revenue refers to money received (or to be received if accrual accounting is used) by an organization for goods sold and services rendered during an accounting period.

Revenue for an MFI includes interest earned on loans to clients, fees earned on loans to clients, interest earned on deposits with a bank, etc.

Expenses represent the costs incurred for goods and services used in the process of earning revenue. Direct expenses for an MFI include financial costs, operating expenses, and provision for loan impairment. The income statement relates to other reports as follows:

• The IS relates to the balance sheet, through the transfer of cash donations and net profit (loss) as well as depreciation and through the relationship between the provision for loan impairment and the allowance.

• It relates to the portfolio report, using historical default rates (and the current reserve) to establish the provision for loan impairment.

• It relates to cash flow through the net profit and loss, as a starting point on the cash flow.

By recording the net profit and loss earned, the income statement measures the financial performance from which indicators on efficiency and profitability can be extracted.

BALANCE SHEET The balance sheet is a stock statement. In other words, it captures the financial position or financial structure of an MFI at a moment in time. A balance sheet is usually produced monthly or quarterly (at a minimum, annually), although MFIs with an adequate management information system can usually produce a balance sheet on a daily or weekly basis. The balance sheet summarizes the ending balance of all asset, liability, and equity accounts.



Recording donations, grants, and in-kind contributions is important for MFIs.

Its main components are assets, liabilities, and equity in balance, specifically: Assets = Liabilities + Equity.

Assets represent what the organization HAS or what is OWNED by the organization or OWED to it by others. Assets are those items in which an organization has invested its funds for the purpose of generating future receipts of cash.

Liabilities represent what is OWED by the organization to others, for example, a loan that has been granted to the organization or obligations that the organization has to provide goods and services in the future.

Equity represents the capital or net worth of the organization. Equity includes capital contributions of any investors or donors, retained earnings, and the current year surplus.

A balance sheet is prepared at least annually, but often more frequently, such as monthly or quarterly.

The balance sheet depends on the transfer of data from the income statement, namely, net surplus (deficit) in the current year; the amount of income (or loss) generated in the current year; and donated equity in the current year (from cash donations on the income statement). The expense for provision for loan impairment is also considered in recording the allowance for loan impairment.

It relates to loan portfolio data for data on gross loan balances and savings collected.

The changes between balance sheets from year to year are the major inputs into the cash flow statement.

It is useful to compare balance sheets from previous periods in order to determine if the organization is growing and how well it is managing its financial resources, to perform trend analysis and to analyze the relative distribution of assets, liabilities, and equity.

CASH FLOW STATEMENT As its name states, the cash flow statement is a flow statement that represents the inflows and outflows of cash during a specified period. Of the three main financial statements, the cash flow (or sources and uses of funds) is the statement MFIs are least likely to create. A monthly cash flow statement is a valuable liquidity management tool, and without sufficient cash, MFIs cannot disburse loans, pay employees, and settle debts.

The cash flow statement summarizes each transaction or event that causes cash to increase (the sources of cash) or decrease (the uses of cash). Increases in cash, however, are not sources; rather, the sources of cash are the events that cause the cash increase. Similarly, decreases in cash are not uses; the events causing cash to decrease are the uses. For example, the increase in the gross loan portfolio is not the use of cash; rather, the use is the disbursement of loans to clients. The sources of cash can include events that cause the following changes:

• A decrease in assets other than cash, such as receiving loan repayments from clients;

• An increase in liabilities, such as accepting a deposit or borrowing from a bank;

• An increase in paid-in capital, such as selling shares to investors or members; and

• An increase in retained earnings through generating net income (after taxes and donations).



The uses of cash can include events that cause the following changes:

• Increases in assets other than cash, such as making loans to clients;

• Decreases in liabilities, such as repaying a deposit or paying the principal on borrowed funds;

• Decreases in paid-in capital, such as repurchasing shares or reimbursing member shares; and

• Decreases in retained earnings through generating a net loss (after taxes and donations) or payment of dividends to shareholders.

A cash flow statement classifies these inflows and outflows of cash into the following three major categories:

• Operating activities, the cash receipts and payments related to the MFI’s ongoing provision of financial services, including lending and deposit services;

• Investing activities, the cash receipts or outlays for acquiring or selling fixed assets or financial investments; and

• Financing activities, the borrowing and repayment of borrowings, the sale and redemption of paid-in capital, and the payment of dividends.

For financial institutions, the distinction between operating activities and financing activities may be a bit confusing. Operating activities include most activities that would appear as operating income and operating expenses on the income statement, as well as all lending activity that appears on a portfolio report. For example, accepting and repaying deposits is considered an operating activity because these actions are financial services, whereas borrowing is considered a financing activity. All interest paid on deposits and borrowings, however, is considered an operating activity.

Several accounts in a cash flow statement are similar to those in an income statement, particularly if an MFI uses cash accounting. For instance, “Cash received from income, fees, and commissions on loan portfolio” is the same as “Financial revenue from loan portfolio” if the MFI uses cash accounting. If an MFI accrues interest, these two accounts may not be the same.

A cash flow statement also shows clearly how an organization obtains cash (sources of funds) and how it spends cash (uses of funds), including the borrowing and repayment of debt, capital transactions, and other factors that affect the cash position.

It relates to other statements through the balance sheet—that is, the increases and decreases in assets and liabilities from one balance sheet to the next—as well as through the income statement.

PORTFOLIO REPORT AND ACTIVITY REPORT A portfolio report and activity report link the loan portfolio information of the three previously discussed statements—income statement, balance sheet, and cash flow. The purpose of the portfolio report is to represent in detail an MFI’s microlending activity, present the quality of the loan portfolio, and provide detail on how the MFI has provisioned against potential losses. Unlike other statements, the design of this report varies from MFI to MFI. The content, however, should be consistent and must include the following:



• Portfolio activity information,

• Movement in the impairment loss allowance, and

• A portfolio aging schedule.

The closely linked movement in the impairment loss allowance and the portfolio aging schedule are related to an MFI’s assessment of the default risk associated with its loan portfolio. Impairment loss allowance is a contra (negative) asset account that reduces the value of the gross loan portfolio. The value of that allowance is determined by first creating a portfolio aging schedule.

All MFIs should have a policy for calculating and creating an impairment loss allowance and writing off loans. The generally accepted method for MFIs to assess default risk is based on the timeliness of principal payments on loans. The assumption is that the longer a loan remains past due, the more at risk the outstanding balance of the loan will become. This remaining outstanding balance is referred to as the portfolio-at-risk (PAR). Understanding the difference between arrears and portfolio-at-risk is important. Arrears measure the sum of all past-due payments, whereas portfolio-at-risk is the total value of loans outstanding that have one or more past-due payments—a much larger amount. The word delinquency may refer to either, which leads to confusion.

MFIs create a portfolio aging schedule by segregating their loans into groups based on their “age,” or how many days have passed since the first payment was missed. Each of these categories is multiplied by a loss allowance (or provisioning) rate, which represents the perceived chance of the loan not being repaid. The portfolio-at-risk for each age is then multiplied by the appropriate loss allowance rate. The sum of these calculations is the amount the MFI should set aside in the impairment loss allowance. If the existing impairment loss allowance is less than what is required, the MFI will need to increase it, usually monthly or quarterly, through a provision for loan impairment.

MFIs should also have a policy on writing off loans. Both the gross loan portfolio and the impairment loss allowance are reduced by the outstanding balance of the loan for the amount of the write-off, which reduces the MFI’s total assets. This action is the financial representation of the management’s belief that the loan is unlikely to be repaid. Of course, the MFI should continue to seek to recover these loans until all legal and other efforts have failed. If the write-off exceeds the value of the impairment loss allowance, the MFI must first increase the impairment loss allowance by increasing the impairment losses on loans before reducing the gross loan portfolio and the impairment loss allowance.

Adapted from Measuring Performance of Microfinance Institutions: A Framework for Reporting, Analysis, and Monitoring. Developed by the SEEP Network Financial Services Working Group and Alternative Credit Technologies, LLC, 2005.

DQ2-H1


Loan Performance and Collection Ratios – Individual

Take 5 to 10 minutes individually to complete this form based on your organization’s current operating procedures.

Indicator How do you compute it? (formula)

What plans are made based on this indicator?

Portfolio-at-Risk (PAR)

Used: Yes No

Arrears Rate Past-Due Rate

Used: Yes No

Repayment Rate Used: Yes No

Current Recovery Rate

Used: Yes No

Annual Write-Off (Loan Loss) Rate

Used: Yes No

Other Used: Yes No

DQ2-H2


Loan Performance and Collection Ratios

Accounting provides an ongoing history of financial activity. Ratios will allow you to examine financial relationships to diagnose the well-being of your project. Key ratios should be monitored regularly to measure performance. The chart that follows defines and describes the purpose of each indicator.

INDICATOR RATIO MEASUREMENT

Portfolio-at-Risk By Age

Unpaid principal balance of all loans with payments at least 1, 30, or more days past

due + renegotiated loans Gross Loan Portfolio

Answer the question: “How much could you lose if all late borrowers default?” Aging separates more risky loans from less risky. (The longer a loan goes unpaid, the higher the risk it will never be paid.)

Arrears Rate Past Due Rate

Amount past due Gross Loan Portfolio

Answer the question: “How commonplace is nonpay-ment?” Measures amount of loan principal that is due but not paid.

Repayment Rate

Amount received (current and past due) less prepayments

Total amount due this period + amounts past due from previous periods

Shows amount paid compared with amount due or expected during a specific period. Does not provide useful information about the performance of the gross loan portfolio.

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

Fluctuates from month to month. Is meaningful only for longer periods. Can be processed algebraically to predict eventual loan loss rates.

Annual Write-Off Rate

Value of loans written off as unrecoverable Average Gross Loan Portfolio

Useful in interest rate setting. Annual cost of default, which must be balanced by higher interest income.

DQ2-H3


Sustainable Access to Finance for Microenterprise (SAFE) Case Sample portfolio of four small groups (as of December 31, 2005)

2 3 4 5 6 7 8 9 10 11 12

Client Disbursement

Date Term

(months) Loan

Amount

Monthly Principal Payment

Total Amount

Paid Amount

Outstanding

Total Amount Past Due

1 pmt 1 to 30 Days

2 pmts 31 to 60

Days

3 pmts 61 to 90

Days

>4 pmts >90

Days A 13-Dec-04 5 200 40 200 0 B 23-Dec-04 4 175 44 175 0 C 23-Dec-04 3 150 50 0 written off nonrecoverable in June 2005 D 27-Jan-05 6 250 42 250 0 E 13-Mar-05 3 100 33 100 0 F 21-Jun-05 6 350 58 350 0 G 11-Jul-05 6 200 33 167 33 H 31-Jul-05 10 600 60 300 300 I 20-Aug-05 6 175 29 117 58 J 24-Sep-05 6 300 50 150 150 K 23-Nov-05 7 500 71 71 429 L 11-Jul-05 8 550 69 206 344 138 69 69 M 21-Aug-05 6 350 58 0 350 232 58 58 58 58 N 30-Aug-05 5 300 60 120 180 120 60 60 O 4-Oct-05 4 175 44 44 131 44 44 P 1-Aug-05 4 220 55 110 110 110 55 55 Q 13-Dec-05 4 200 50 0 200 R 28-Dec-05 5 250 50 0 250

Note: For amounts past due 1-30 days past due equals one missed payment 31- 60 days past due is equivalent to two missed payments 61-90 days past due is three missed payments Over 90 days past due, more than four missed payments

DQ2-H4a


Repayment Rate Problems

1. What was the repayment rate of the SAFE portfolio for December?

2. In what ways is December’s repayment rate useful for the program management?

3. What does December’s repayment rate indicate about the quality or amount of risk in the SAFE portfolio?

DQ2-H4b


Repayment Rate Problems: Solution Guide

Client Amount Due in

December Amount Paid in December

Amount Past Due before December 1

A B C F 58 58 G 33 33 H 60 60 I 29 29 J 50 50 K 71 71 L 69 69 M 58 174 N 60 60 O 44 0 P 55 55

Repayment Rate =

DQ2-H4c (Answers)


Repayment Rate Problems

1. What was the repayment rate of the SAFE portfolio for December?

58 + 33 + 60 + 29 + 50 + 71 301 301 + 644 945

2. In what ways is December’s repayment rate useful for the program management?

• To compare with the repayment rates of previous months.

• To compare actual with projected repayment rates.

• To analyze whether repayments are increasing or decreasing.

• Changes in repayment rates will provide some indication as to the effectiveness of any special efforts to recover past due payments. Could be used as an incentive scheme indicator for loan officers.

• Helpful when projecting cash flows to know what percentage of the amount due and past due is being received each month.

3. What does December’s repayment rate indicate about the quality or amount of risk in the SAFE portfolio?

• Repayment is NOT an indicator of the quality or amount of risk in the portfolio (the portfolio is not in the numerator or the denominator of the ratio).

• Repayment rate indicates the recovery performance of the program during a specific period (preferably short, such as one month).

= 32% =

DQ2-H5


Sample Portfolio of Four Loans

XXClient 4

OOXClient 3

OXClient 2

XXXClient 1

Today

XXClient 4

OOXClient 3

OXClient 2

XXXClient 1

Today

• Each box represents $10O = delinquent installment• four clients in portfolioX = payment

KEY:

• Each box represents $10O = delinquent installment• four clients in portfolioX = payment

KEY:

DQ2-H6 (Optional)


Sustainable Access to Finance for Microenterprise (SAFE) Case

The SAFE program was established in 2001 and began its credit operations in the same year. The program was received with a lot of enthusiasm by local micro-entrepreneurs. The first branch was opened in January 2002, and by December 2004 there were 20 branches with almost 20,000 clients/members. It is registered currently as a non financial institution and under this regulation it cannot take deposits from the public, however it may do so in the future if it meets certain requirements to take deposits from its members.

LOANS SAFE has recently streamlined its loan products. It is now concentrating on one main product type that has proved to be highly successful. Currently the basic loan is offered in four levels with varying repayment periods (from 5 to 24 months), loan sizes (from 300 up to 20,000) and interest rates (26% to 34% nominal flat interest rate). Repayments are predetermined as either weekly or monthly. There is a possibility of a three-month grace period (repayment of interest only) for repeat loans. Most loans are solidarity group lending. New loans are granted to individual members of the group following outlined procedures. A member is eligible for subsequent loans depending on her repayment performance. SAFE also has a number of individual loans -- these are only granted to group members who have had a good repayment record with SAFE. Performance to date has been excellent after the first 30days/1 payment. However, SAFE does seem to have a problem with delinquency on the first payment. They have no plans for handling such situations; they have no clear-cut policies or procedures and no policy for impairment loss allowance. However it is clear that improvement and change is needed in these areas. MIS The management information system enables SAFE to produce reliable, useful and up-to-date information on its loan portfolio and financial position. SAFE keeps accurate records on its clients and their payments also through a loan tracking system. The Accounting and Loan tracking systems are integrated and reports include microfinance best practices ratios, comparisons of planned versus actual results, budgets and projections. With growth, SAFE has also noticed other oddities in its program. For example, they are experiencing high client turnover . SAFE is also concerned about remaining a viable MFI. It is presently highly dependent on donor grants for its operations and its loan fund and realizes that the grants will not continue indefinitely. SAFE is unclear on what next steps to take to ensure its growth and sustainability in the future.

DQ2-H7a


Portfolio-at-Risk (PAR) Calculations Use the SAFE Portfolio Report sample (DQ2-H3) to answer these questions.

1. Calculate PAR for each situation where past due is defined as:

a) more than 1 day past due.

b) more than 30 days past due.

c) more than 90 days past due.

2. Calculate the amount past due (as a rate), defining past due as loans with payments more than 30 days late.

3. What do the above percentages reveal about the quality of the portfolio?

4. If the program made 10 new loans of US$300 each, worth a total of US$3,000 in December 2004, what would the delinquency rate be?

a) Use PAR formula; assume more than 30 days past due as delinquent.

b) Why is the rate so much lower than it was without these new loans?

5. Consider these same new loans as being made October 1, 2004, and the monthly payment for each loan as US$50. Five of the clients with new loans had missed their November 1 and December 1 payments (that is, their first and second payments). The new gross loan portfolio is US$5,035. Using the PAR formula, and assuming more than 30 days past due as delinquent, what would the delinquency rate be?

DQ2-H7b (Answers)


Portfolio-at-Risk (PAR) Calculations Use the SAFE Portfolio Report sample (DQ2-H3) to answer these questions.

1. Calculate PAR for each situation where past due is defined as: a) more than 1 day past due.

344 + 350 + 180 + 131 + 110 1115 2535 2535

b) more than 30 days past due. 344 + 350 + 180 + 110 984 2535 2535

c) more than 90 days past due. 350 2535

2. Calculate the amount past due (as a rate), defining past due as loans with payments more than 30 days late.

242 + 58 + 58 358 2535 2535

3. What do the above percentages reveal about the quality of the portfolio? At one day past due the MFI stands to lose 44 percent (nearly half) of its entire portfolio,

but at 90 days the MFI stills stands to lose almost 14 percent of its portfolio. Comparing the amount past due more than 30 days—14.1 percent — and the PAR more

than 30 days—38.8%—one notes the vast difference when considering the balance of the outstanding loan as at risk.

Using the amount past due could lead to a different opinion than the PAR and mislead the MFI into thinking its portfolio is healthier than it actually is.

4. If the program made 10 new loans of US$300 each, worth a total of US$3,000 in December 2004, what would the delinquency rate be? a) Use PAR formula; assume more than 30 days past due as delinquent.

984 984 2535 + 3000 5535

b) Why is the rate so much lower than it was without these new loans? Rapidly growing portfolios can hide delinquency. In these cases one should look at

actual amounts past due to see how the portfolio is changing.

5. Consider these same new loans as being made October 1, 2004, and the monthly payment for each loan as US$50. Five of the clients with new loans had missed their November 1 and December 1 payments (that is, their first and second payments). The new gross loan portfolio is US$5,035. Using the PAR formula, and assuming more than 30 days past due as delinquent, what would the delinquency rate be?

984 + 1500 5035

= 44%

= 38.8%

= 13.8%

= 14.1%

=

=

=

= 17.7%

= 49%

=

DQ2-H8b (Advanced) DQ2-H8a (Simple)


Loan Loss Definitions

An IMPAIRMENT LOSS ALLOWANCE is an account that represents the amount of outstanding principal that is not expected to be recovered by a micro-finance organization.

It is a negative asset on the balance sheet and reduces the gross loan portfolio.

PROVISION FOR LOAN IMPAIRMENT is the amount expensed on the income and expenses statement.

It increases the impairment loss allowance.

LOAN LOSSES or WRITE-OFFs occur only as an accounting entry. They do not mean that the MFI should not continue to pursue payment.

Both decrease the allowance and the gross loan portfolio.

Sources: Ledgerwood 1996; SEEP Network 2005.

DQ2-H8b (Advanced)


Accounting for Provisions for Loan Impairment and Write-Offs

IMPAIRMENT LOSS ALLOWANCE An account that represents the amount of outstanding principal that is not expected to be recovered by a microfinance organization.

A negative asset on the balance sheet that reduces the gross loan portfolio. (An alternative presentation is to show it as a liability.)

PROVISION FOR LOAN IMPAIRMENT The amount expensed on the income and expenses statement.

It increases the impairment loss allowance.

LOAN LOSSES or WRITE-OFFs Occur only as an accounting entry (they do not mean that loan recovery should not continue to be pursued).

They decrease the impairment loss allowance and the gross loan portfolio.

A provision records the possibility that an asset in the Balance Sheet is not 100% realizable. The loss of value of assets may arise through wear and tear such as the depreciation of physical assets, loss of stocks, or unrecoverable debts. Provisions expense this anticipated loss of value in the portfolio gradually over the appropriate periods in which that asset generates income, instead of waiting until the actual loss of the asset is realized. Provisions are only accounting estimates and entries, and they do not involve a movement of cash, like saving for a rainy day. Provisions for loan impairment charged to a period are expensed in the Income and Expense Statement. The corresponding credit accumulates over time in the Balance Sheet as impairment loss allowance, shown as a negative asset: The accounting transaction is: Dr Provision for loan impairment Cr Loan loss reserve

Loan losses or write-offs occur when it is determined that loans are unrecoverable. Because the possibility that some loans would be unrecoverable has been provided for in the accounting books through impairment loss allowance, loan losses are written off against impairment loss allowances and are also removed from the gross loan portfolio. The accounting transaction is: Dr Impairment loss allowance Cr Gross loan portfolio Write-offs do not affect the net portfolio unless an increase in the impairment loss allowance is made. When write-offs are recovered, they are booked in the income and expense statement as other operating revenue.

Sources: Ledgerwood 1996; SEEP Network 2005.

DQ2-H9


Loan Loss in Your MFI

1. Using your experience in your organization, consider the likelihood of recovering loans once they are past due, given the periods in the sample aging report below.

My MFI Likely

Recovery Rate (%)

One payment past due Two payments past due Three payments past due Four payments past due More than four payments past due

2. What is the allowance rate used by your MFI?

How was it determined and by whom?

How often is it reviewed?

3. Describe the write-off policy of your MFI.

DQ2-H10a


SAFE Impairment Loss Allowance Calculation

While SAFE has usually aged its portfolio it has not methodically used aging for the purpose of establishing the Impairment Loss Allowance. It has decided to adapt the MicroBanking Bulletin (MBB) Benchmarking Allowance Rates so that it may easily compare itself to benchmarks in the future. When SAFE has an established history, it will review the rates to ensure that it has sufficient allowance for impaired loans. Refer to the Loan table below and make an allowance for each category of aged loans.

Category Value of Portfolio

(MBB) Loss

Allowance Rate (%)

Impairment Loss

Allowance

Current Portfolio 34,188 1 payment (1-30 days )past due 9,467 10%

2 payments (31-60 days) past due 103 30% 3 payments (61-90 days) past due 170 30%

4 - 6 payments (91-180 days) past due 119 60% > 6 payments (180 days) past due 85 100% Renegotiated Portfolio 1 - 30 days -

Renegotiated Portfolio more than 30 days - TOTAL 44132

Formula Impairment Loss Allowance Ratio: a) Calculate Impairment Loss Allowance Ratio b) Calculate Portfolio at Risk (PAR)

a. For all non current loans with one or more missed payments

b. With 2 or more missed payments c) Comment on the quality of this portfolio

Total Impairment Loss Allowance Gross Loan Portfolio

DQ2-H10b (Answers)


SAFE Impairment Loss Allowance Calculation

1. Refer to the impairment loss allowance table below and make an allowance for each category of aged loans.

Category Value of Portfolio

Loss Allowance

Rate (%)

Impairment Loss

Allowance Current Portfolio 34,188

1 payment (1-30 days )past due 9,467 10% 947 2 payments (31-60 days) past due 103 30% 31 3 payments (61-90 days) past due 170 30% 51

4 - 6 payments (91-180 days) past due 119 60% 71 > 6 payments (180 days) past due 85 100% 85 Renegotiated Portfolio 1 - 30 days - 10%

Renegotiated Portfolio more than 30 days - 30% TOTAL 44132 1185

a) Calculate Impairment Loss Allowance Ratio

1,185 = 0.0268 = 2.68% 44,132

b) Calculate Portfolio at Risk (PAR) after 1 payment late

9,944 = 0.2253 = 22.5% 44,132

c) If you calculate the PAR for loans which are 2 or more payments late, what then

happens to PAR?

(103 + 170 + 119 + 85) = _ 477_ = 0.0108 = 1.08% 44,132 44,132 d) Comment on the quality of this portfolio

PAR > 1 Day is very dangerous. SAFE must adopt a policy of zero tolerance for delinquency

and improve on-time payment. Most of the late loans are one payment late, so SAFE needs to find out why clients are slipping by one payment and then catching up in the next period. Comparing SAFE with fully financially self-sufficient MFIs in the MicroBanking Bulletin would be useful.


DQ2-H11 SAFE INCOME STATEMENT

Ref. Account Name 2009 2010

I1 Financial Revenue 6 342 10 082 I2 Financial Revenue from Loan Portfolio 6 342 10 082 I3 Interest on Loan Portfolio 6 342 10 082 I4 Fees and Commissions on Loan PortfolioI5 Financial Revenue from InvestmentI6 Other Operating RevenueI7 Financial Expense 292 823 I8 Financial Expense on Funding Liabilities 292 823 I9 Interest and Fee Expense on Deposits

I10 Interest and Fee Expense on Borrowings 292 823 I11 Other Financial ExpenseI12 Net Financial Income 6 050 9 259 I13 Impairment Losses on Loans 262 430 I14 Provisions for Loan Impairment 292 472 I15 Value of Loans Recovered (30) (42) I16 Operating Expense 3 264 4 562 I17 Personnel Expense 2 116 3 009 I18 Administrative Expense 1 148 1 553 I19 Depreciation and Amortization Expense 234 387 I20 Other Administrative Expense 914 1 166 I21 Net Operating Income 2 524 4 267 I22 Net Non-Operating Income/(Expense) 117 312 I23 Non-Operating Revenue 117 312 I24 Non-Operating ExpenseI25 Net Income (Before Taxes and Donations) 2 641 4 579 I26 Taxes 20 31 I27 Net Income (After Taxes and Before Donations) 2 621 4 548 I28 Donations 320 350 I29 Donations for Loan Capital 249 316 I30 Donations for Operating Expense 71 34 I31 Net Income (After Taxes and Donations) 2 941 4 898


DQ2-H11 (cont.)

SAFE BALANCE SHEET


ASSETSB1 Cash and Due from Banks 801 1 781 B2 Trade InvestmentsB3 Net Loan Portfolio 24 012 43 024 B4 Gross Loan Portfolio 24 690 44 132 B5 Impairment Loss Allowance (678) (1 108) B6 Interest Receivable on Loan Portfolio 288 425 B7 Accounts Receivable and Other Assets 26 10 B8 Other InvestmentsB9 Net Fixed Assets 2 321 2 748 B10 Fixed Assets 2 936 3 750 B11 Accumulated Depreciation and Amortizat (615) (1 002) B12 TOTAL ASSETS 27 448 47 988

LIABILITIESB13 Demand Deposits - - B14 Short-term Time DepositsB15 Short-term Borrowings 10 454 17 156 B16 Interest Payable on Funding Liabilities 25 62 B17 Accounts Payable & Other Short-term Liabi 428 342 B18 Long-term Time DepositsB19 Long-term Borrowings 5 417 12 797 B20 Other Long-term LiabilitiesB21 TOTAL LIABILITIES 16 324 30 357

EQUITYB22 Paid-in CapitalB23 Donated Equity 2 934 3 284 B24 Prior Years 2 614 2 934 B25 Current Year 320 350 B26 Retained Earnings 8 189 12 737 B27 Prior Years 5 568 8 189 B28 Current Year 2 621 4 548 B29 Reserves 1 1 610 B30 Other Equity AccountsB31 Adjustments to EquityB32 TOTAL EQUITY 11 124 17 631

TOTAL LIABILITIES + EQUITY 27 448 47 988


DQ2-H12 Record an Adjustment for Loan Impairment and COMPLETE the Income Statement and Balance Sheet 2010 Current Impairment Loan Allowance =

2010 Recommended Impairment Allowance as per aging report =

2010 Adjustment =

ADJUST FOR IMPAIRMENT

SAFE INCOME STATEMENT

Ref. Account Name 2003 (000)

2004 (000)

I1 Financial Revenue 6,342 10,082 I2 Financial Revenue from Loan Portfolio 6,342 10,082 I3 Interest on Loan Portfolio 6,342 10,082 I4 Fees and Commissions on Loan PortfolioI5 Financial Revenue from InvestmentI6 Other Operating RevenueI7 Financial Expense 292 823 I8 Financial Expense on Funding Liabilities 292 823 I9 Interest and Fee Expense on Deposits

I10 Interest and Fee Expense on Borrowings 292 823 I11 Other Financial ExpenseI12 Net Financial Income 6,050 9,259 I13 Impairment Losses on Loans 231 I14 Provisions for Loan Impairment 261 I15 Value of Loans Recovered (30) (42) I16 Operating Expense 3,295 I17 Personnel Expense 2,116 3,009 I18 Administrative Expense 1,179 1,553 I19 Depreciation and Amortization Expense 234 387 I20 Other Administrative Expense 945 1,166 I21 Net Operating Income 2,524 I22 Net Non-Operating Income/(Expense) 117 312 I23 Non-Operating Revenue 117 312 I24 Non-Operating ExpenseI25 Net Income (Before Taxes and Donations) 2,641 I26 Taxes 20 31 I27 Net Income (After Taxes & Before Donations) 2,621 I28 Donations 320 350 I29 Donations for Loan Capital 249 316 I30 Donations for Operating Expense 71 34 I31 Net Income (After Taxes and Donations) 2,941


DQ2-H12 (cont.)

ADJUST FOR IMPAIRMENT

SAFE BALANCE SHEET



ASSETSB1 Cash and Due from Banks 801 1 781 B2 Trade InvestmentsB3 Net Loan Portfolio 24 012 B4 Gross Loan Portfolio 24 690 B5 Impairment Loss Allowance (678) B6 Interest Receivable on Loan Portfolio 288 425 B7 Accounts Receivable and Other Assets 26 10 B8 Other InvestmentsB9 Net Fixed Assets 2 321 2 748 B10 Fixed Assets 2 936 3 750 B11 Accumulated Depreciation and Amortizat (615) (1 002) B12 TOTAL ASSETS 27 448

LIABILITIESB13 Demand Deposits - - B14 Short-term Time DepositsB15 Short-term Borrowings 10 454 17 156 B16 Interest Payable on Funding Liabilities 25 62 B17 Accounts Payable & Other Short-term Liabi 428 342 B18 Long-term Time DepositsB19 Long-term Borrowings 5 417 12 797 B20 Other Long-term LiabilitiesB21 TOTAL LIABILITIES 16 324

EQUITYB22 Paid-in CapitalB23 Donated Equity 2 934 3 284 B24 Prior Years 2 614 2 934 B25 Current Year 320 350 B26 Retained Earnings 8 189 12 614 B27 Prior Years 5 568 8 189 B28 Current Year 2 621 4 425 B29 Reserves 1 1 610 B30 Other Equity AccountsB31 Adjustments to EquityB32 TOTAL EQUITY 11 124

TOTAL LIABILITIES + EQUITY 27 448


DQ2-H13

SAFE Financial Statements with Provision for Loan Impairment and Impairment Loss Allowance

SAFE INCOME STATEMENTProvision Adjustment

For the Year Ended December 31


2010 (000)

I1 Financial Revenue 6 342 10 082 I2 Financial Revenue from Loan Portfolio 6 342 10 082 I3 Interest on Loan Portfolio 6 342 10 082 I4 Fees and Commissions on Loan PortfolioI5 Financial Revenue from InvestmentI6 Other Operating RevenueI7 Financial Expense 292 823 I8 Financial Expense on Funding Liabilities 292 823 I9 Interest and Fee Expense on Deposits

I10 Interest and Fee Expense on Borrowing 292 823 I11 Other Financial ExpenseI12 Net Financial Income 6 050 9 259 I13 Impairment Losses on Loans 231 507 I14 Provisions for Loan Impairment 261 549 I15 Value of Loans Recovered (30) (42) I16 Operating Expense 3 295 4 562 I17 Personnel Expense 2 116 3 009 I18 Administrative Expense 1 179 1 553 I19 Depreciation and Amortization Expense 234 387 I20 Other Administrative Expense 945 1 166 I21 Net Operating Income 2 524 4 190 I22 Net Non-Operating Income/(Expense) 117 312 I23 Non-Operating Revenue 117 312 I24 Non-Operating ExpenseI25 Net Income (Before Taxes and Donation 2 641 4 502 I26 Taxes 20 31 I27 Net Income (After Taxes and Before Do 2 621 4 471 I28 Donations 320 350 I29 Donations for Loan Capital 249 316 I30 Donations for Operating Expense 71 34 I31 Net Income (After Taxes and Donations 2 941 4 821


SAFE BALANCE SHEETImpairment Loss Adjustment

As of December 31

Ref. Account Name 2009 (000) 2010 (000)



EQUITYB22 Paid-in CapitalB23 Donated Equity 2 934 3 284 B24 Prior Years 2 614 2 934 B25 Current Year 320 350

B26 Retained Earnings 8 189 12 660 B27 Prior Years 5 568 8 189 B28 Current Year 2 621 4 471 B29 Reserves 1 1 610 B30 Other Equity AccountsB31 Adjustments to EquityB32 TOTAL EQUITY 11 124 17 554


DQ2-H13 (Cont.)


DQ-H14 WRITE OFF ALL LOANS OVER 180 DAYS OR 6 PAYMENTS PAST DUE

SAFE BALANCE SHEET Impairment Loss Adjustment


2010 (000)

ASSETSB1 Cash and Due from Banks 801 1 781 B2 Trade InvestmentsB3 Net Loan Portfolio 24 012 B4 Gross Loan Portfolio 24 690 B5 Impairment Loss Allowance (678) B6 Interest Receivable on Loan Portfolio 288 425 B7 Accounts Receivable and Other Assets 26 10 B8 Other InvestmentsB9 Net Fixed Assets 2 321 2 748 B10 Fixed Assets 2 936 3 750 B11 Accumulated Depreciation and Amortiza (615) (1 002) B12 TOTAL ASSETS 27 448

LIABILITIESB13 Demand Deposits - - B14 Short-term Time DepositsB15 Short-term Borrowings 10 454 17 156 B16 Interest Payable on Funding Liabilities 25 62 B17 Accounts Payable & Other Short-term Liab 428 342 B18 Long-term Time DepositsB19 Long-term Borrowings 5 417 12 797 B20 Other Long-term LiabilitiesB21 TOTAL LIABILITIES 16 324


B26 Retained Earnings 8 189 B27 Prior Years 5 568 8 189 B28 Current Year 2 621

B29 Reserves 1 1 610 B30 Other Equity AccountsB31 Adjustments to EquityB32 TOTAL EQUITY 11 124

TOTAL LIABILITIES + EQUITY 27 448


DQ2-H15 SAFE BALANCE SHEET – AFTER WRITE OFF

Ref. Account Name 2009 (000) 2010 (000)




B26 Retained Earnings 8 189 12 660 B27 Prior Years 5 568 8 189 B28 Current Year 2 621 4 471 B29 Reserves 1 1 610 B30 Other Equity AccountsB31 Adjustments to EquityB32 TOTAL EQUITY 11 124 17 554


DQ2-H13


DQ3-H1

Potential reasons for non-repayment on time

Unwilling to pay but able to pay MFI

• Poor appraisal • Lack of regular client satisfaction

monitoring • Inappropriate loan products, poorly

designed services Clients

• Loan used for other means than reason provided to MFI

• Bad faith / Client refuses to pay • Lack of incentives to repay (costly

transactions, low risk on collateral, dissatisfaction with services)

Willing to pay but unable to pay

MFI • Inappropriate loan products, poorly

designed services • Poor appraisal • Inadequate application of policies • Sanctioning of amount that is higher

than the client’s capacity • Inappropriate forms of collateral • Lack of regular client satisfaction

monitoring • Poor communication on repaying terms

and conditions

Clients • Problems with business (Business

failure, unexpected repair work, theft) • Loss of employment • Incapacity to work • Over indebtedness • Insufficient understanding of loan terms

and conditions External

• Natural disaster • Economic crisis • Political unrest • Forced removal • fierce competition • government intervention

Adapted from “Swadhaar’s Policy on Collection of Overdues from Delinquent Clients and Other Recovery Policies » published in 2011, www.smartcampaign.org.

DQ3-H2

Borrowers’ Perceptions

In your group, brainstorm a list of benefits (incentives) and costs (disincentives), both financial and nonfinancial, of payment options from the borrowers’ perspective. Please have at least two to three responses in each square.

On-Time Payments Late or No Payments

B E N E F I T S

C O S T S

DQ3-H2sol

Borrowers’ Perceptions

On-Time Payments Late or No Payments • 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 on second or third loans

• interest rebate

• lower expenses if interest payments are not made

• capital (or portion) from loan maintained in business or used for other purposes

• fewer or no trips to financial institution to make payments (lower transaction costs)

• lower transaction costs of attending meetings and other activities of the lending institution

• possibility of not having to repay at all, if there is a low cost of default

• payment interest and capital of current loan

• time and transportation costs to make payments

• opportunity costs

• Late fees for late payments

• delay in 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 officers

• hassle of pressure from group members if a group loan

• negative reputation among peers

B E N E F I T S

C O S T S

DQ3-H3

Organizational Causes of Delinquency and Solutions

Situation Possible Causes Prevention Strategies Management Solution Proposals + will to repay - capacity to repay (willing but unable)

- will to repay + capacity to repay (unwilling but able)

DQ3-H3sol

Organizational Causes of Delinquency and Solutions

Situation Possible Causes Prevention Strategies Management Solution proposals + will to repay - capacity to repay (willing but unable)

• Inappropriate loan products, poorly-designed services

• Poor appraisal • Inadequate application of policies • Sanctioning of amount that is higher than

the client’s capacity • Inadequate forms of collateral • Lack of monitoring of client satisfaction • Inadequate communication on

repayment terms and conditions • Problems with business (Business failure,

unexpected repair work, theft • Loss of employment • Work incapacity • Over indebtedness • Insufficient understanding of loan terms

and conditions • Natural disaster • Economic crisis • Political unrest • Forced removal • Government intervention

• Loan officer training (thorough analysis of repayment capacity / loan monitoring methods)

• Clear definition of roles and responsibilities of credit committee

• Define borrower’s debt threshold and acceptable levels of debt from other sources.

• Check with credit bureaus / competition • Know clients well • Credit-life insurance • Insurance products (health, agriculture,

etc.) • Suit products to clients’ activities and

needs • Transparency on terms and conditions /

Financial education

• Understand causes – satisfaction surveys.

• Adjust repayment terms so that client can continue to pay, strictly according to MFI policy

• Encourage partial payments

- will to repay + capacity to repay (unwilling but able)

• Poor appraisal • Lack of regular client satisfaction

monitoring • Inappropriate loan products, poorly

designed services

• Clear information on terms and conditions,

• Proactive complaints system • Incentives for on-time repayment

• Involve officers in understanding client dissatisfaction

• Seize collateral (after gradual warning procedure)

• Involve guarantor

DQ3-H3sol


Situation Possible Causes Prevention Strategies Management Solution proposals • Loan used for other means than reason

provided to MFI • Bad faith / Unwillingness of clients to

repay • Lack of incentives to repay (costly

transactions, low risk on collateral, dissatisfaction with services)

• Market study to check if products provided are meeting needs

• Know clients well / Have good relations to establish good client satisfaction as an incentive to repay

• Involve collection officer, trained according to the institution’s ethical values.

DQ3-H4

Best Practices in collections strategies

Addressing the problem before there is a problem!

• Develop a positive institutional culture of repayment — most delinquency is not caused by bad borrowers but by the absence of an ethical and efficient collection methodology! Convey an image and philosophy showing that late payments harm the MFI and its clients.

• Know your clients so as to provide products they need. To do this, efficient client monitoring is important. There are many tools to assess and monitor client poverty level.1 MFIs can also develop their own systems (as Busaa Gonofaa2 in Ethiopia). These tools allow client monitoring and segmentation according to poverty level, client type, satisfaction level, knowledge of terms and conditions, etc.

• Communicate clearly loan terms and conditions and check that borrowers understand products, contract terms, their rights and obligations.

• Listen to clients: establish rescheduling with the client, implement an efficient system for complaints management—treating complaints quickly may help staff address client concerns before they turn into delinquency.

• Encourage on-time repayment through incentives—quick treatment of new request for services, interest rebates, training opportunities, bonuses…

• Ensure loan size and conditions are not hindering repayment. Loans should not be based on projections or collateral alone, but on repayment capacity. Loan approval policies must give clear guidelines on debt threshold and acceptable levels of debt from other sources.

REINFORCE COLLECTION PRACTICES

• Encourage strict but ethical discipline for collection – the MFI must never resort to coercion practices or intimidation (physical force, humiliation, use of collateral which are fundamental for client survival). Loan officers must be well trained to observe and listen to clients.

• Train staff in the collections process, negotiation techniques and rescheduling or refinancing policies.

• Motivate staff with incentives based on portfolio quality, a motivating work environment, benefits, access to training opportunities …

DEVELOP COLLECTION STRATEGIES

• Define a client contact policy: Who will make the first contact in case of late payment? How? When? Where? It is important to define the parameters of the collection process and/or a code of conduct to define acceptable and non-acceptable practices to ensure customers are treated with dignity.

• Tools to help MFIs define a code of conduct as well as examples of ethical policies and collection methods are available on Smart Campaign’s website, http://www.smartcampaign.org.

1 PAT from USAID (www.povertytools.org), PPI (www.progressoutofpoverty.org), 2 microfinancement.cirad.fr/fr/news/bim/Bim-2009/CdP-09-01-27.pdf

http://www.smartcampaign.org/

http://www.progressoutofpoverty.org/


• Establish collection methods: Regardless of the collector: internal department or third party, methods must be clear and documented and must reflect the MFI’s values.

• Define steps in collection process, necessary action for each step, elements to take into account when making a decision (client segmentation)

• Establish an acceptable threshold of delinquency based on deep understanding of costs and effects of delinquency on the MFI. If there are no official provisioning rules edited by the authorities, define provisioning and write-off policies based on client history. Ensure products and assets appear accurately in financial statements.

ENSURE QUALITY INFORMATION GATHERING AND MANAGEMENT

• Implement efficient MIS with data allowing management to analyze regularly portfolio quality and its evolution trends and identify potential causes of delinquency to improve products.

• Ensure quality of client information (Check different sources—written documents, visits).

• Client segmentation according to will and capacity to repay may help the MFI understand and therefore manage delinquency better.

• Establish an internal past-due committee (loan officers, collections agents, branch managers, and others.) to discuss and analyze specific past-due clients and discuss the best collections strategies

• Implement an internal audit system to check the monitoring and control of methods and policies regarding appraisal, collection and dispute settlements between the MFI and its clients.

Adapted from ACCION, Best Practice in Collection Strategies (2008) and Gemini Technical Notes, Methods Of Managing Delinquency (2005).


DQ3-D5

The Collections Process

DQ3-H5 cont.

1

SWADHAAR’S POLICY ON COLLECTION OF OVERDUES FROM DELINQUENT CLIENTS AND OTHER

RECOVERY POLICIES

Meet Swadhar FinServe Pvt. Ltd

Swadhaar FinServe Pvt. Ltd. (SFPL) is an Indian Non Banking Financial Company serving the states of

Maharashtra and Gujarat. Based in Mumbai, SFPL serves Western India’s urban poor, striving to

increase their access to financial services so that they may increase their economic capacity and

develop a more secure financial future. SFPL currently offers two loan products: a joint-liability

group loan targeting economically active women, and an individual business loan targeting both

male and female micro entrepreneurs. In March 2010, SFPL had 27,391 active clients and a portfolio

of 195.64 mm Indian Rupees (US$ 4.34 million).

Why SFPL was selected as a winner

SFPL was selected as a winner for this call for tools because their submission meets the Smart

Campaign’s evaluation criteria for Principle Three: Appropriate Collection Practices. SFPL’s collection

policy includes a code of conduct for collection that outlines acceptable and unacceptable behavior

for members of staff or any person authorized to represent the MFI in collections. SFPL’s policies are

compatible with the Smart Campaign’s appropriate collection practices and clearly instruct staff and

agents involved in collections to treat customers with dignity, even when they fail to meet their

contractual obligations. The policies are backed by procedures that include clear, detailed steps and

timeframes for collections. Finally, they do not conflict with the other five principles of the Smart

Campaign.

Tool Organization

1. Pages 2-3 contain SFPL’s Code of Conduct and General Guidelines for Collections, intended to

regulate conduct for all collections, both for group and individual loan clients, undertaken by SFPL or

conducted on its behalf. Based on India’s Micro Finance Institutions Network (MFIN) code of conduct

and the Reserve Bank of India’s (RBI) policies and guidelines, the code and the guidelines direct SFPL

collection agents to avoid all abusive and unethical treatment of clients.

2. Pages 4-5 present SFPL’s Delinquency Quadrant, which is a matrix that prescribes appropriate

recovery strategies based on a client’s willingness and capacity to pay, compared with the possible

reasons for payment delinquency. This matrix is applicable to both group and individual loan clients

and is for use by SFPL staff.

3. Pages 6-10 describe SFPL’s Loan Recovery for loans between 1-30 days late for SFPL’s Group

Loan product. These are the specific procedures that group-loan staff is directed to follow for loan

recovery. Note: The specific staff positions, timelines and activities presented in the procedures are

specific to the loan product, institution and legal framework of the country. They may not be

applicable for all products and institutions.

2

1. A Code of Conduct for Collections

The Micro Finance Institutions Network (MFIN) Code of Conduct states that:

a. Though each MFI tries to ensure on-time recovery of dues, it is imperative that they shall not use

any abusive, violent, or unethical methods of collection and recovery efforts should be in line with

guidelines issued from Reserve Bank of India’s (RBI) from time to time.

b. A valid receipt (in whatever form as decided by each member) should be provided for each

collection from the borrower.

Hence guidelines on Swadhaar’s own policy on recovery and debt collection have been laid down on

the lines of the RBI policies and Code of Conduct of MFIN:

The debt collection policy of Swadhaar is built around dignity and respect to its clients. Swadhaar will

not follow policies that are unduly coercive in collection of dues. The policy is built on courtesy, fair

treatment and persuasion. Swadhaar believes in following fair practices with regard to collection of

dues and thereby fostering customer confidence and long-term relationship. All the practices

adopted by Swadhaar for follow up and recovery of dues will be in consonance with the Law.

General Guidelines:

All members of staff or any person authorized to represent Swadhaar in collection and recovery

would follow the guidelines set out below:

1. The client would be contacted ordinarily at the place of his/her choice and in the absence of any

specified place, at the place of his/her residence and if unavailable at his/her residence, at the

place of business/occupation.

2. Identity and authority of persons authorized to represent Swadhaar for follow up and recovery

of dues would be made known to the borrowers at the first instance. Swadhaar staff or any

person authorized to represent Swadhaar in collection of dues will identify himself / herself and

display the identity card issued by Swadhaar upon request.

3. Swadhaar would respect privacy of its borrowers.

4. Swadhaar is committed to ensure that all written and verbal communication with its borrowers

will be in simple local language and Swadhaar will adopt civil manners for interaction with

borrowers.

5. Normally Swadhaar’s representatives will contact the borrower between 0700 hrs and 1900 hrs,

unless the special circumstance of his/her business or occupation requires Swadhaar to contact

at a different time. This should be documented.

6. Borrower’s requests to avoid calls at a particular time or at a particular place would be honored

as far as possible.

7. Swadhaar will document the efforts made for the recovery of dues and the copies of

communication set to clients, if any, will be kept on record.

3

8. All assistance will be given to resolve disputes or differences regarding dues in a mutually

acceptable and in an orderly manner.

9. Inappropriate occasions such as bereavement in the family or such other calamitous occasions

will be avoided for making calls/visits to collect overdue amounts.

10. Swadhaar hires its own recovery officers and hence strictly controls the client visits. However in

the event that Swadhaar appoints third party agencies for debt collection, it will ensure that

such agents refrain from action that could damage the integrity and reputation of Swadhaar and

that they observe strict customer confidentiality. All letters issued by recovery agents will

contain the name and address of a responsible Swadhaar senior officer whom the customer can

contact at his location.

11. Swadhaar will not resort to intimidation or harassment of any kind, either verbal or physical,

against any person in their debt collection efforts, including acts intended to humiliate publicly

or intrude the privacy of the clients family members and friends, making threatening and

anonymous calls or making false and misleading representations.

12. Giving notice to borrowers: While written communications, telephonic reminders or visits by

Swadhaar’s representatives to the borrowers place or residence will be used as loan follow up

measures, Swadhaar will not initiate any legal or other recovery measures without giving due

notice in writing.

4

2. Delinquency Quadrant

Quadrant Explanation (of client willingness and capacity to pay)

Client Type1 Possible Reasons

(for payment delinquency) Recovery Strategy

I

Has willingness to pay and capacity to pay

Good client. That particular instalment delayed due to temporary decrease in cash flow of client or household member

Expected to pay back when she gets the money in 1-2 days

Salary/payment being late

Sudden unplanned expense in the household etc. (one-time incidence)

Field collections by LO

Encourage part payments

Involve co-signor and guarantor in recovery

Remind about incentives for good client record

II

Willingness to pay but no capacity to pay

Situation of the client has changed post-appraisal OR

Problems within family that has an effect on client

Problems with business (Business failure, repair work, shifting, damaged, displaced of business place)

Unexpected and high household expenditure

Possible poor appraisal by LO

Over indebtedness of client and thus is unable to pay on current terms

Death of family member

Client injury- unable /hard to work

Client has health problem

Sickness of family member

Merchandise /client’s money has been stolen

Loss of employment

Natural disaster or political unrest (riots, etc) for

Adjust the repayment terms so that she can continue to pay smaller amounts that she can afford

Recommend for rescheduling

Prove willingness to repay by paying regular smaller instalments

1 The categorisation into different client types is to be done by the Loan Officer (LO) and Recovery Officer (RO) for clients who are 1-30 days late and > 30 days late

respectively. The LO/RO has to interpret which category the client falls into based on the reason for delay, client’s general behaviour/response to the recovery actions, the co-signor and guarantor opinions, the previous experience with the client etc.

5

Quadrant Explanation (of client willingness and capacity to pay)

Client Type1 Possible Reasons

(for payment delinquency) Recovery Strategy

which rescheduling can be done within 60 days

III

No willingness and no capacity to pay

Situation of the client is different from what is given in the appraisal form.

Poor appraisal – Over-estimation of income / sales

Sanctioning of amount that is higher than the client’s capacity

Disappearance of client (or client shifts residence without informing MFI or the client has shifted back to village)

Given loan to another person

Handover to recovery dept.

Leverage pressure on co-signor and guarantor for payment

Case to be notified to the Monitors and the Training depts

IV

No willingness to pay but has capacity to pay/Intentional default

Willful defaulter

Client does not see any value in continuing with the services of Swadhaar

Improper appraisal of non-financial indicators

Loan used for other means than reason provided to MFI

Fraud

Client refuses to pay

Client lied during evaluation

Try to assess the reason

Use the help of the Social Initiatives team

Employ gentle persuasion tactics moving on to more strict/firm handling

Put pressure on co-signor and guarantor

If possible, legal action

3. Loan Recovery for loans between 1-30 days late (For Group Loans)

Introduction This section deals with the policies and processes of recovery of a loan which is delinquent. A delinquent loan is a loan in which any payment is past due, i.e. a loan is considered as delinquent if any part of the instalment amount is overdue even for one day past the due date.

The recovery actions involve different departments depending on the required activity to recover the delayed repayments. At the branch level the Loan Officers will lead the process with guidance and support from the Team Leader (TL) and assistance by the Administrative Assistant (AA). In addition, there are dedicated sections like the Recovery Department and the Legal Department to carry out specific activities. The process also needs constant support from the MIS and IT systems to provide information so that effective and timely follow-up, management and analysis of the portfolio can be done.

Delinquency Management & Loan Recovery Policies

Guidelines for Recovery Actions

The following considerations should be kept in mind when conducting a default visit to a client/group, and when determining the type of action that should be taken:

1. Total number of days late

2. The total amount overdue

3. The number of installments overdue

4. The client’s attitude during the visit

5. The group’s attitude during the visit

6. Reason given for default

7. Amount of time the person has been a client of Swadhaar

8. The credit history of the client

9. If a loan was given for business purposes, type of business

10. Family circumstances

11. The default rate in the area or zone in which the client lives and/or operates her business

The two most important aspects to be kept in mind while following up a delinquent loan are the Willingness and Capacity of the client to repay the loan on the current terms. The matrix in annex XX (page 8-9) gives direction on the action to be taken based on these two features.

All the personnel responsible for recovery should always treat the client professionally with respect in course of this recovery process.

The recovery processes should be followed without fail as given in the manual; any deviation from the prescribed process to be recorded along with the reason for the same and proper authorization from the approving authority.

One of the major tasks of the loan officers is to encourage clients to make on-time loan payments. The loan officers should continuously remind clients of the advantages of making on-time payments: a possible increase in the loan size for future loans, access to additional products, preferential client treatment, etc. Social collateral of group liability should be leveraged as much as possible in the

7

recovery process. Clients cannot receive a new loan if the previous loan has not been paid off in full first.

Preventive Visit Policies

On or before the due date, the Group Loan Officer (GLO) will either call or visit the ‘authorized member’ to remind them of the upcoming instalment due date.

The following clients should be included for a ‘preventive call/visit’: 1. Clients who are paying the first instalment of their loan (irrespective of their loan cycle) and 2. Clients whose previous instalment was late.

The GLO will have to make this decision on a case-by-case basis. The objective of the ‘reminder visit’ is to take preventive measures to minimize potential delinquencies. GLOs are required to advise the ‘authorized member’s and the members about the following, with a view to prevent difficulties and delays at the time of payment:

To be ready with the corresponding amounts of payments and to keep required denominations, change etc. at the time of payments.

To make payments on the due dates.

To verify that the transaction receipt amount and the amount paid match.

To insist on receipts for any payments made.

Penalties and Charges

Penal interest and other charges for late repayments have been placed in the Swahit Product Sheet.

Settlement of Delinquent Loans

Settlement of loans is the last resort by Swadhaar to close the loan taken by a client. Settlements should be done only on a case-by-case basis as it could be detrimental to the repayment culture of an area. Settlement means the negotiation & agreement with client to repay only part of the loan – either part of principal, interest or penalty, in exchange for a closure letter from Swadhaar. Swadhaar should continue to encourage a client to pay off his/her full loan by using the group guarantee or by reminding the client the need to repay full loan amount. It is possible that if a loan is settled, the client(s) might influence other borrowers to hold out until Swadhaar agrees to reduce and settle the outstanding loan. Settlements will take place in branch or with TL/AM present in field, this measure is to prevent misuse or misrepresenting the cash collected from settlements in field.

Criteria for selection of clients to whom we might agree to settle the loan:

a) Client who shows the willingness to repay part of the loan in a one-time payment as they do not have the capacity to pay the full outstanding loan.

b) Client who indicates that they are moving out or closing their residence/business and are willing to repay part of the loan.

c) Clients who have a large outstanding loan but are unwilling to repay the full amount.

d) Clients whose loans are so small that the cost of recovery is much higher than the amount outstanding.

Management and Analysis of Delinquency

a) The exchange of information as well as the feedback between different GLOs and RO/Legal Department must be promoted with an objective to maintaining the quality of the branch’s portfolio.

b) It will be the responsibility of TL to undertake a weekly analysis of the branch’s portfolio to determine specific causes and to implement preventive strategies of delinquency management.

8

c) Details of the delinquent loans are updated automatically on a daily basis in the system in the Customer Arrears Report for each GLO.

d) All loans whose repayments of an instalment has been delayed by a day or more appear in the Customer Arrears Report.

Control a) The TL is responsible to ensure on a daily basis that default management policies and

procedures are implemented correctly and fully at the branch. b) The TL is responsible to ensure that the tracking sheets of the GLO are filled on a daily basis.

The TL can ask to see the tracking sheets of the RO on a daily basis (format of the Delinquency Tracking Sheet is placed in Annexure XX).

c) Recovery Department is responsible to ensure that RO tracking sheets are filled in on a daily basis.

d) The TL will keep the tracking sheet of each defaulting client in a binder. As long as the client is in default the tracking sheet will remain with the TL and will be filled out each time the client or group was contacted through a visit or by phone. Failed attempts to reach the client and the group should be included. When the client has repaid the loan in full or the file is sent to the RD, the tracking sheet will be filed in the client file.

e) Similarly, the RO will keep the tracking sheet of each defaulting client in a separate binder until the file is handed over to the Legal Department or the client pays the loan in full; then the tracking sheet will be kept back in the client file.

f) The GLO and RO involved in the recovery management have to file a report on the steps and actions taken for recovery, particularly of the behaviour of client in order to have a clearer idea of his/her intention and willingness to pay.

Procedure for delinquency management (for 1-30 days overdue loans)

The reason for the delinquency should be recorded in the tracking sheets and verified to the extent possible. For all delinquent loans, the concerned GLO continues to visit the respective clients from the due date to collect a possible payment (please refer to Loan Repayment Chapter 5, Section 5.3.3 for additional details). Days are calculated as calendar days NOT working days.

Who? Step What?

AA 1

Prints out the daily Customer Arrears Report, makes the appropriate number of copies (one for each loan officer), and provides the aggregate report to the TL in a maximum time of half an hour from start of business hours.

TL 2

Reviews the daily Customer Arrears Report (for TL) & takes note of:

New defaulters

Partial and full payments that have been made

Verbal commitments that have been broken

TL or Senior LO 3

Meets with the loan officers in rotation (minimum twice a week) to discuss and examine:

The tracking sheets of each of the delinquent clients

The action plan for each delinquent client/group

The default management activities undertaken by each loan officer the previous day

The default management activities that each loan officer should undertake that day

LO & TL 4 Conducts tracking activities following the delinquency management action plan elaborated below

9

Who? Step What?

5 Fills in the tracking sheet at the end of each contact (attempted contacts included) with the client and/or group (contact can be through either a visit or by phone)

TL

6

If the client/group has not paid by day 25, the LO & TL visits the client and group one last time (see Delinquency Management Action Plan: Section 6.4.1) and asks client to make full payment within Day 30, else account shall be transferred to the Recovery Department. She/he gives the order to prepare the case for handover to the Recovery Department.

7 If no payment has been received by day 30, LO transfers file to the Recovery Department.

Delinquency Management Action Plan at Branch Level

No. Days

Late Who? What?

1 day late GLO

Visit 1:to the client

Determines the reasons for the late payment

Informs the client of the advantages of making on-time payments

Informs the client that penalty interest and fees will be charged effective from the date of default

Asks for a verbal commitment by the client to pay the outstanding amount on a set date

Fills in the tracking sheet

3-5 days late GLO

Visit 2: to the group members

Further investigates the reasons for the late payment

Informs the client and group of the advantages of making on-time payments

Visits the group members

Asks for a verbal commitment by the client and/or group to pay the outstanding amount on a set date


6-9 days late GLO

Visit 3: in a group meeting


Calls a group meeting

Informs the client and group of the disadvantages of not making on-time payments;

Becomes more forceful with the client and group

If the client and/or group do not have the capacity to pay: asks the client/group to at least make small regular payments to show their willingness to pay

Asks for a verbal commitment by the client and/or group to pay the outstanding amount on a set date


10

No. Days

Late Who? What?

10-15 days late

TL & GLO

Visit 4: in a group meeting


Informs client of the disadvantages of not making on-time payments

Asks for a written commitment by client to pay the outstanding amount on a set date


16- 24 days late

GLO

Continued visits: (regular visits to client and group members)

Follows-up on the continued defaulting of the client and group

Asks for a verbal commitment by the client and group to pay the outstanding amount on a set date


25 to 30 days late

TL, GLO & RO

Last Visit: to the client and/or group

Informs the client and group members of the actions that Swadhaar can take against the group in case of non-payment

Hand delivers the first letter: Type A (see format in Annexure XX) to the client. The same letter is posted from the office too, to show proof of delivery.

Informs the group that the file will be transferred to the Recovery Department if the full payment is not made by Day 30

If the client is not at home/ at place of business, leaves letter at the house/business place

If the GLO determines that the client does not have the willingness to pay then the case must be referred to the TL, who must conduct a visit (see visit 4) and determine the action that should be taken against the client. This action can consist of the continued application of pressure at the branch level OR the immediate transfer to the Recovery Department. The branch must receive the written approval of the next higher authority to transfer a case that is less than 30 days late to the Recovery Department. Accompanying forms for collections and delinquency management

Name of Annexure/Forms Annexure No.

Willingness & Capacity to Repay 19

Delinquent Client Tracking Sheet 20

Standard Letter of Warning: Letter type A 21

Reschedule 1 22

Reschedule 2 23

Number 26 November 2008

Best Practices in Collections Strategies Past-due or non-collectible loans are part and parcel of the financial sector. As past-due rates surpass expected limits, though, this piece of the credit cycle can become a true problem. While often seen as a final step in the lending cycle, collections1 actually plays a much more integral role in the overall process. In recent years microfinance institutions (MFIs) have sought to develop new and more effective strategies for collections. This increased attention to collections is in part due to an industry-wide emphasis on credit promotion and analysis as well as to the changing and increasingly competitive environments in which MFIs are operating. Drawing from the experiences of collections programs throughout Latin America2 and through the implementation of initial collections activities in India that are mainly focusing on Individual lending methodology, this InSight explores “best practices” and considerations that an MFI should take into account when attempting to successfully implement collections activities. I. The Role of Collections Collections is an important service that helps to both maintain clients and free up money for lending again. It is a strategic process that is key to generating good habits and a payment culture among clients. It can also be seen as a business activity whose primary objective is to generate returns for the institution, converting losses into income. MFIs should view collections as an essential piece of the credit cycle, not just the final step. During the collections process, institutions receive feedback on policies and activities within each sub- process of the lending cycle: promotion, evaluation, approval, and disbursement.

1 Note that the term “collections” used in this InSight refers to both activities to recover past-due loans (loans with one or more days of default) and activities to prevent delinquency within the institutions. In Asia, situations of “due-date collections” have been referred to as “on-time collections” activity. 2 Banco Solidario, Ecuador; Financiera El Comercio, Paraguay; RealMicrocrédito, Brazil; Banco Columbia, Argentina.

Collections is an integral part of the credit cycle.

Best Practices in Collections Strategies 2

Why is there delinquency in Microfinance Institutions? There is a belief that delinquency starts when a client misses a payment date, resulting in a collections problem. However, many delinquency problems would be avoided if MFIs ensured that the earlier lending processes were conducted correctly. Following are several examples of common errors in lending sub-processes occurring prior to collections:

Promotion: The product does not meet clients’ real needs; there is no clear definition of the target client; clients’ use of the loan does not match foreseen uses of the loan funds included in the product definition; there is no emphasis on a “long-term lending relationship” based on punctual payment; loan officers, credit agents, promotion officers, etc., lack necessary training.

Evaluation: Failure in the methodology application including loan amounts that exceed

clients’ capacity to pay and over-indebtedness; client has poor references or a poor attitude towards paying on time; there is no cross-checking of information to verify consistency, or documentation control; there are no clear policies for renewal; lack of risk-management tools to improve the understanding of default probability of the client, to identify the environmental causes that may affect the proper collections of the disbursed loan, and to alert management about the multiple events associated with a weak identification of operational risk (e.g. frauds, weak infrastructure, process gaps).

Approval: Decisions are influenced by pressure to meet goals; decisions are subjective,

based on the level of trust in the loan officer and lacking an objective credit analysis.

Disbursement: Failure to conduct objective analysis to determine best loan conditions, such as loan amount, term and installment amount, and selection of the repayment date; clients lack motivation to pay on time due to unclear payment instructions and expectations at the point of loan disbursement; few alternative payment channels, such as the Internet-payment options and third-party agents, that could reduce transaction costs for clients; operating errors, such as failure to identify the account holder or a lack of signatures on contracts and loan documents, as well as delays in disbursement preventing the client from making use of the loan as intended (e.g. a lost investment opportunity results in the loan being used instead for consumption purposes).

In addition to the errors that may occur in the sub-processes, high delinquency rates may also stem from an overall lack of collections forethought. Collections is often seen as a secondary or, in some cases, nonexistent activity and lacks a defined strategy. Delinquency rates may also be spurred by external factors over which an MFI has no control, such as problems related to the sector, social concerns, illness, theft, fraud, natural disasters, and other emergencies. When MFIs see an increase in delinquency it is important to carefully analyze the past-due portfolio in order to more accurately identify the origin and causes of the delinquency and estimate the probability of repayment, while at the same time defining the most effective and efficient collections strategies. Risk-management tools contribute to the identification of threats and menaces to the operations to mitigate their impact.


II. The Collections Process The collections process is defined as the set of coordinated, appropriate, and timely activities aimed at full collection of loans from clients. The process is intended to convert the MFI’s receivables into liquid assets as quickly and efficiently as possible, while at the same time maintaining the goodwill of the client in case of future transactions. As such, the collections process requires significant interaction with the client, beginning with a careful analysis of the client’s situation and continuing through timely and frequent contact over the duration of the loan. Clients should be offered payment alternatives that are timely and appropriate to each situation, and all collections activities should be recorded to facilitate continuous monitoring and follow-up as well as control of client compliance with negotiated agreements. Some typical collections activities are described below, followed by a flowchart illustrating the collections process:

a) Analysis of the particular case: Who is the client? What is his situation? What were the

original loan conditions? Why did the loan fall past-due? Consider internal and external sources of information such as credit bureaus and bad-debtor lists.

b) Contact with the client: What information does the client provide? Where is the client

located? What actions were taken previously? c) Assessment: What problem is at the root of the current delinquency? What type of client

are we dealing with? d) Suggesting an alternative: What are the possible solutions? The objective here is to sell

the benefits of paying on time in order to foster a positive payment culture with the client. e) Securing payment commitments: Area we negotiating effectively? The MFI must clearly

identify when, where, how, and how much the client will pay and must remember, for example, how a client in a situation of over-indebtedness or decreased income will prioritize the payment of his bills. Are we able to get the client to commit to prioritizing repayment of this loan?

f) Compliance with payment commitments: Did the client pay on the agreed-upon date?

Does the client demonstrate a desire to repay the loan? The objective here is to demonstrate consistency throughout the collections process. It is not enough to reach an agreement and depend on the client’s apparent goodwill and positive attitude; collections staff must follow up on payment commitments.

g) Recording collections activities: Are collections activities carried out in a coordinated

manner? Put yourself in the position of the staff member next in line for collections activities with that client.

h) Follow-up on the case: Are we aware of the client’s situation and the collections

activities the case has been subject to? i) Intensification of collections activities: What is the best action to secure collections of

the loan in the most immediate manner? What assets does the client possess? How much can be collected through legal action? The sole objective when a past-due loan reaches this point is collections, even if it means losing the client.


j) Defining a loss: The MFI must also clearly define the conditions under which a credit is deemed a loss; that is, when to cease collections activities. This may be when all possible attempts to recover the funds have proven unsuccessful and/or when the probability of payment is very low. The MFI must measure the cost/benefit of legal action, reporting past-due client and other actions permitted by law.

The Collections Process


The client should see collections as an ongoing rather than sporadic activity, which means that it is very important that the various actors in the process—such as call centers, loan officers, and collections agents—act in a coordinated and timely manner. The client must feel that the MFI has its finger on the pulse of the situation at all times, acting quickly, flexibly, and definitively to control the situation. It is also extremely important that collections activities be directed at all individuals involved in the loan—including spouse, guarantors, family, or friends who served as references—in accordance with the client’s risk profile and probability of repayment. Generally, microentrepreneurs do not provide collateral guarantees to MFIs. Therefore, many institutions develop non-traditional mechanisms that are basically a type of psychological pressure, called “non-traditional guarantees.” Often, these non-traditional guarantees cannot be executed for legal reasons or because the cost of executing them is greater than the value of the guarantee itself. This makes it even more important that collections activities are founded on efficient strategies and timely negotiations prior to recurring to legal collections, unless all previous actions have proven inefficient for reasons external to the collections process. A poorly defined or understood collections process can lead to inadequate, costly strategies and the breakdown of the process itself. Below are some common errors:

Tendency to restructure, refinance, or disburse a new loan to repay a past-due loan without the proper analysis and monitoring of the client’s current situation: These are poor practices that temporarily mask the true state of the portfolio and inevitably will worsen the situation. Refinancing should require a new evaluation, including a complete and objective analysis of each particular case, and should never be applied as a general strategy or campaign, which do not change payment behaviors. It is also important to note when such a policy might be appropriate (e.g. natural disaster, market fire—when a whole subset of clients has been affected).

Tendency to seize goods from the business or home as a means to collect on the loan: This practice could distract collections agents from their main responsibility, basically turning them into something akin to an intermediary or salesperson. The MFI incurs high storage and administration costs as a result of receiving these goods and sends the wrong message to the client with respect to the client’s financial obligations. Oftentimes the client prefers to lose the assets without making an effort to repay the loan, thus weakening the institution’s position and image in the market.

Tendency to be subjective: Considering certain clients and cases as a total loss or

placing too much trust in the goodwill of the client can detract from the collections process and lead to a loss of time and money for the institution.

It is vital to the long-term health of an MFI that it recognize each client requires a considerable investment of time, money, and effort from the different parties participating in collections. Attracting new clients is more expensive than maintaining existing ones. III. Best Practices in Collections In order to achieve healthy, sustainable growth, MFIs must plan collections strategies prior to launching a new program or product. The following subsections discuss the “best practice” for collections as well as examples, where applicable, of Micro finance institutions in which they have been implemented. These practices come into play well before the loan is delinquent,


striving to create proactive strategies to diminish the occurrence of overdue loans. They recognize the valuable role that well-trained internal and external collections staff perform. They offer suggestions for the precise collection and maintenance of data, segmentation of clients and offering of “collections products” or payment alternatives tailored to the needs of the client. And, finally, they provide a listing of policies and procedures that contribute to successful collection of delinquent loans. Best Practice #1 – Adopt Proactive Strategies to Quell Delinquency Before it Starts Addressing the problem before there is a problem proves to be one of the most effective strategies available in reducing delinquency. Preventive action is less costly, and the best collections activities are those that manage clients who are not yet past due carefully. There are a number of proactive strategies that a MFI may employ in the management of those clients before their loans are due. Educate Borrowers about Product Features and Collections Fees and Charges Borrower education can go a long way towards reducing default rates. Prior to disbursement, institutions should educate and train the client and guarantor about the implications of obtaining a loan, how the product works, the benefits of paying on time and the payment schedule, while also providing information about the closest and easiest way for this particular client to make loan payments. Expenses related to the collections process must be transferred back to the client. It is important to stress during the client-education stage both the benefits received due to punctual payments as well as the costs incurred by the client for late payments. Some institutions communicate this as a “reward for punctual payment,” offering discounts. In other situations, such as in India where the predominant method of “on-time collections” involves payment at the client’s place of work or home, it becomes important to provide incentives or other rewards to clients who actually do make payments at the branch or via payment agents. Establish Mutually-Agreeable Payment Dates Involving the client in the establishment of mutually-agreeable payment dates may increase the probability of repayment. Generally this date must match the date on which the client experiences peaks in revenue

In Practice – Ecuador Banco Solidario

Banco Solidario emphasized the importance of educating clients about good payment practices, handing out printed material on the benefits of paying on time and the responsibilities of the guarantor at customer service windows prior to disbursement. Another pro-active strategy was the development of a point system to reward clients who paid on time by conducting “solidarity” raffles and reminding clients of their payment dates via the internal call center and loan-officer visits.

In Practice – India

In India, where the group-loan methodology (Grameen Bank methodology) is widespread, institutions recommend that each client meeting includes the reading of a type of “code of conduct” or “code of ethics,” in the local language. The code emphasizes, among other points, the importance of punctual payments, the solidarity that binds each member to an obligation to pay if one of the other members cannot make a payment, the importance of saving, and the value brought by the investment of the loan in productive activity that generates additional income.


or liquidity. At the same time, it should be far enough away from payment dates for other important obligations, such as rent, school fees, and other debts. Address Customer-Service Complaints Quickly In the development of new loan products linked to the purchase of assets, such as mobile phones and computers, it has sometimes been the case that the item bought turns out to be defective and/or the client did not receive adequate customer service from the supplier, resulting in cessation of client payments. By timely attention paid to complaints, staff members may be able to address clients’ concerns before they result in a late payment. A similar situation could also be the result of fraudulent staff action, etc. In this case the institution must analyze the situation and, if it determines that late payment is due to problems with the good or service, propose a timely solution in order to “reactivate” the client. Use Positive Reinforcement Positive reinforcement, as simple as it seems, also plays a valuable role. The lending institution can recognize and reward clients who pay on time by offering them immediate access to renewals, larger loan amounts, preferential (lower) interest rates, certificates of good payment, training, and prizes. These actions should be implemented with the support of the marketing department and integrated into the sales strategy. Best Practice #2 – Improve Internal Productivity of the Collections area It could be said that a collections department is only as good as the staff working in it. A well-designed collections strategy weighs the strengths and weaknesses of the institution, addressing general questions such as whether collections should be handled internally or externally through a third party as well as considering what measures should be in place to ensure staff are properly trained, motivated, and measured. Also, it can promote healthy competition among the collections employees. Determine the Appropriate Collections Procedures Collections activities command an immense amount of time and resources in order to be implemented well. MFIs have a choice to make—whether to hire a specialized collections agency or to create an internal collections unit. Before deciding, however, the MFI must analyze its options carefully, noting available resources, costs, and benefits associated with each path and the existence of collections agencies in the market. The following tables list potential advantages and disadvantages of both.


Option 1: Outsourcing to Collections Agencies

Advantages

Collections agencies offer trained and specialized staff that are able to dedicate the appropriate time to collections activities.

Costly control and supervision of collections activities are transferred to the collections agency.

The client is often intimidated by the appearance of a new collections agent or company.

The agency is more prepared to work through a variety of collections approaches, including call centers, collectors, on-site collections agents, and collections points.

Disadvantages

Collections agencies lack experience with the low-income sector.

Agencies may not be available in all markets or countries.

They have little interest in client relationships, making client “reactivation” difficult.

Communication between the MFI and the collections agency may become complicated. There may be duplication of efforts or contradictions presented to the client.

The collections agency’s direct contact with the client may reveal problems within the MFI, resulting in a loss of confidentiality.

External collections agents may have less success collecting if the client fails to “acknowledge” them, alleging they have no authority in their case.

External collections agents may not adhere to the same ethical standards as promoted by the MFI when dealing with clients.

In Practice – Brazil Real Microcrédito

Real Microcrédito (RMC) employed the services of Banco ABN AMRO REAL(Call Center) for loans that had fallen at least five days past-due, as well as the services of a specialized collections agency. One of the lessons learned from this experience was that by using dedicated staff in the call center as well as with the specialized collections agency, RMC was able to provide a more personalized and appropriate service to its microfinance clients. These channels provided by Banco ABN-AMRO REAL had traditionally been reserved for mainstream, high-income clients. RMC was thus able to increase and improve the quality of contact with clients. For example, a special collections speech was personalized for RMC clients, and guarantors were called, a practice which had not used by the bank in its traditional collections activities. Communication between internal collections agents and the collections agency also improved, facilitating negotiations with the client.


Option 2: Creating an Internal Collections Unit

Advantages

Internal units have more thorough knowledge of the client and the market.

They are careful to maintain a relationship with the client, leading to possible client reactivation.

Internal units facilitate internal feedback on the lending process as a whole.

Staff feels more committed to the organization and to its objectives.

The MFI’s internal database holds information for the development of predictive collections.

The MFI retains control over the client interface, thus having more direct control over ensuring collections practices remain in line with institution’s ethical standards.

Disadvantages

Internal units require specialized staff training that few MFIs have the time or resources to offer. The control and supervision of collections activities and staff also imposes high costs.

There is a lack of personal and professional recognition for collections staff. Collections has a reputation of being not very enjoyable, and, in some cultural contexts, quite negative.

An internal unit distracts from promotion and analysis activities, especially during periods of expansion.

MFIs have little experience in collections.

Select and Train Staff Members Once the decision is made to either create an internal collections unit or work with an outside collections agency, the MFI must identify the position and roles in the collections process, if any, that should be filled by internal staff and selected accordingly based on the appropriate profile for each position. It is important to define the roles and responsibilities of each participant in the collections process (e.g. field agents, call center, collections agencies, attorneys). This includes

In Practice – Paraguay Financiera El Comercio

The shareholders and board members of the Financiera El Comercio in Paraguay created their own external collections agency, called “Gestión,” which managed past-due loans over 180 days from El Comercio by using specialized collections officers and lawyers. The company also provided call center services for loans past due up to 30 days to support El Comercio loan officers in their collections activities. After some years of operations, El Comercio has actually reinstated its collections activities within the institution. The main reasons behind this decision were high operating costs to maintain two separate administrative structures (two accounts, two boards), separation between both institutions (they did not speak the same language), and the absence of feedback channels between “Gestión” and the risk-management unit of El Comercio to review policies and procedures.


exact levels of participation. For example, call-center staff may contact the client, but should not negotiate payment, as they are not trained to take on this task. Training is vital to achieving successful loan collections and good customer service. It is important to educate staff members in techniques and strategies, such as how to address the typical arguments of the delinquent client, how to relate to difficult people, what types of clients exist, tips and verbal cues for communication, the typical profile of the delinquent client, and negotiation techniques. Additionally, MFIs must ensure staff members have a full understanding of the accurate application of collections tools and knowledge of relevant legal resolutions. Create Staff Incentives Incentives are established to motivate staff to direct their considerable talents to obtaining desired results. In addition to improving the effectiveness of collections, incentives may also promote a workplace environment of healthy competition. The incentives could be defined based on results of collections activities, according to changes in percentages of past-due amounts at each different stages of delinquency. A simple system of “commission for collections” could be designed to include higher commissions for the collections of more delinquent loans. Incentives could be monetary or in-kind, depending on what form best suits the environment. Alternatively, the collections goal could be measured based on the reduction of monthly provision expenses. Identification of clear and objective targets and parameters are crucial in order to define incentive systems/schemes, design of collections policies and strategies as well as measure success and compliance. In order to comply with these objectives, it is important to use earlier warning signals as preparedness for delinquency, such as a PAR (portfolio at risk) of 1 day or 2,3, and 5 days, rather than the traditional PAR of 15, 30, and 60 days. Earlier delinquency targets and parameters aid to establish a collections culture of zero delinquency tolerance and also contribute in identifying past-due loans quickly where the possibility of recuperation of delinquent loan are higher during early stage and will help to avoid the masking of an increase in delinquency through portfolio growth, allowing immediate actions to take place. Best Practice #3 – Ensure Quality Information Gathering and Management The precise and opportune information about the delinquent clients, loan situation and important information that bring feedback about the credit cycle is relevant for the successful on collections Develop Efficient Information and Support Systems To properly analyze collections activities, it is necessary for the institution to have in place an efficient information system to facilitate the monitoring of past-due clients and the production of clear and precise reports. Generally there are three kinds of reports:

Management reports, such us lists of past-due clients to visit by loan/collections officer, list of past-due clients by amount and days late, or daily collections report, used by field staff to follow up with clients These reports are usually generated daily.

In Practice – Ecuador Banco Solidario

Banco Solidario developed a training plan for collections staff based on ACCION’s knowledge and experience. The training plan aimed primarily at providing the institution with a 360-degree view of the role of collections in the overall lending cycle, for example collections as a loan-renewal and customer- service tool as well as training in collections strategies.


Monitoring reports, such us delinquent portfolio by product, ratios of efficiency on

collections, and summaries of portfolio by ageing and zone, used by middle and high management to analyze and address delinquent portfolio performance. These reports are usually generated weekly or monthly.

Risk-Management reports, which monitor collections impact over portfolio

performance by tracking indicators for normalization, billing cycles, recovered balances, and individual roll down ratios. These reports can be generated daily to track seasonality or monthly for forecasting purposes and performance management.

The system should also maintain a history of actions taken and collections activities implemented. This is especially important when there are many potential channels for collections (loan officers, collections agents, call centers, collections campaigns, etc.) in order to ensure continuity in terms of collections activities carried out by each participant and avoid duplication of efforts and contradictions. Ensure Quality of Client Information Just as regular client contact is key to an effective collections process, so is the collection of quality client information necessary for successful client location. During the initial application process, the MFI should request several pieces of information, including the client’s full name, address and clear instructions on how to locate the client (map of location), telephone number and personal and commercial references. During each step of the collections process and by each participant in it, this information should be verified and updated as necessary in order to facilitate seamless contact with the client throughout the process. MFIs must develop tools and strategies for updating client information in the database, without compromising secure access controls or quality of information. One possible way to ensure integrity of the information is through the development of an incentive system for staff to encourage timely and accurate database updates. Establish an Internal Past-Due Committee A past-due committee is made up of branch staff who participate in the collections process, including loan officers, collections agents, branch managers, and others. Periodic meetings are held to discuss and analyze specific past-due clients and collections strategies and processes. During committee meetings suggestions may be offered, and participants learn from the errors identified in the evaluation and approval process/phase. The committee also discusses and analyzes portfolio statistics, challenges and achievements. The past-due committee is useful to develop a culture of good collections practices within the institution and helps provide feedback to management on the MFI’s collections strategies,

In Practice – Paraguay El Comercio

El Comercio in Paraguay used client information to solve a common problem of client location. MFIs have a difficult time locating clients who have closed their businesses and moved. To address this problem, El Comercio began to review the clients’ files and contact the personal references noted in order to locate the client. Previously thought to be useful only in the clients’ character analysis during the evaluation process, these references are usually family or close friends who are able to provide information on the whereabouts of the missing clients, information vital to the collections of past-due loans.


policies, and procedures. It also helps to control delinquency, encourages good decision-making practices, and provides a valuable forum for learning/training from the field. Establish Internal Methodological Control Units Internal methodological control units, or methodological audit units, are strategic units created within MFIs to address the lack of a monitoring and control system for the specific products and services of the microfinance industry. During an individual loan assessment by an MFI, the typical formal-sector documentation used to support the credit analysis is substituted by a report generated by the loan officer in the field detailing the client’s family and business situation. Traditional banking-sector audit systems have proven to be inadequate for the microfinance industry, thus increasing the motivation for internal audit departments to monitor not only the collections process but address all sub-processes of the lending cycle. Methodological control is an important tool for obtaining ongoing feedback and assessment. It is used to keep management informed regarding the quality of operations in the branches and the correct application of credit policies and processes. Methodological control should then prevent deviations from the established methodology that could potentially have a negative impact on portfolio quality. Methodological-control-units have been successfully implemented to decrease delinquency in institutions such as Financiera El Comercio, Banco Columbia, Real Microcrédito, and Banco Solidario. Best Practice #4 – Develop Well-Defined Strategies for Collections of Delinquent Loans Developing a strong collections unit requires clearly defined, documented and consistent policies and procedures that guide staff through the collections process and instruct them on how to respond in particular situations. Such policies and procedures should include a variety of strategies. Establish Client-Contact Policies When should the MFI make initial contact? Is the best way to contact the client through telephone, email, postal service or visits? The key to selecting the best method is weighing the costs and benefits of each available method based on number of days past-due and the probability of total debt collections. Contact policies may include preventative strategies, such as a payment reminder, and should include a plan defining dates of future contact and the steps to be taken in the collections process. Risk-Based Collections Any financial institution faces an enormous volume of decisions that must be made every day. In collections, we must decide when to contact the client, who should contact him, how to approach him, what product to offer, how to deal with broken promises, how to deal with lost or missing clients, what to do in cases of tragedies or natural disasters, and many other decisions that cannot be entirely delegated onto the experience of a loan officer. Risk-based collections strategies provide valuable tools for the decision-making process. Implementing a risk-based collections strategy requires at least the preparation of the following:

A thorough review of the external information available regarding regulatory environment, limitations, competition, the target market, etc;

The design of the databases to support the construction of risk-management reports for performance monitoring and for the development of the tools aiding collections decisions;


The Collections Scorecard in Practice – Optimizing the sending of debt-collection notices to clients both with and without credit scores.

Without Score With Score With Score Activity No. days past-due High Priority –

No. days past-due Low Priority - No. days past-due

7 5 15 First letter 15 10 20 Second letter 40 30 45 Third latter 60 45 60 Legal notice

Traditionally, collections notices are sent based on the number of days past-due, without establishing priorities and probabilities. When applying a collections score, timing when the collections notice is sent depends primarily on the priority determined based on client risk and the probability of collections.

Training for staff responsible for risk management and collections strategy definitions; Definition of the tool for calculating the level of risk the client presents, whether that

client is recoverable, and the best strategy for recovery. The first tool for identifying the probability of default of a client is data mining. Alberto Teskiewicz defines data mining as: The process of identifying significant correlations, patterns and trends that are hidden among the wealth of information in the database, through the combination of statistics, mathematics, and recognition of patterns. It is an interactive process that allows the institution to convert data into knowledge, generating benefits that translate into lower costs and higher income.3 While many institutions currently consider data mining vital to portfolio evaluation, it is still not used as an important tool to maximize the effectiveness of collections activities. Data mining allows MFIs to forecast the probability of recovery and provides them with a score useful in prioritizing past-due loans based on recuperation probability. Another tool available for risk management of collections is the “Collections Scorecard,” a system for assigning points based on the characteristics of a client in order to obtain a numeric value that reflects how likely this client is to default relative to other individuals. It is important to note that a collections scorecard does not indicate how much risk you should expect; instead, it indicates how a particular loan is expected to perform relative to other loans. After segmenting clients based on their probability to repay, the MFI develops a set of strategies for collecting from the different segments, while optimizing its financial, human and infrastructure resources. The success of risk-based collections depends not only on the

3 Alberto Teskiewicz, “Modelos predictivos para cobranza y refinanciación” [Predictive Modeling for Collections and Refinancing]. First Collection Summit, Credit Management Solutions, Buenos Aires, Argentina 2007.


development of the score used to forecast repayment probability and the optimized collections strategies, but also on the appropriate implementation and monitoring of the defined strategies. Such strategies are now very common in consumer credit (individual credit) but are still not very advanced within the microfinance sector.

Segmentation Another methodology used to implement successful collections strategies is client segmentation. Not all clients are the same, nor are their reasons for delinquency. Effective client segmentation results primarily from identifying the cause of delinquency and classifying the client based on attitude, capacity to pay, solvency and location. Effective client segmentation is not achieved early on; classification is a difficult task, which is why it is important to follow up with clients and monitor the number of days any client falls past-due. As the number of past-due days increases, strategies should change as the MFI and collections agents come to know the client better. At the beginning the focus is on retaining the client, but as the number of days past-due increases the focus changes to recovering the loaned funds. Segmentation is additional to the risk-level determination (data mining or score-based methodologies discussed above). However, if the institution does not have access to additional tools, the MFI can apply a simple classification strategy, such as the following:

Clients who are willing and able to pay require simple collections activities. In many cases effective negotiation of new payment conditions is enough to recover the past-due amount and maintain the client. These individuals are usually clients who forgot to pay, did not receive the payment schedule indicating payment dates, or asked someone else who did not follow through to deposit their payment for them.

Clients who are willing but unable to pay require feasible alternatives and options. In

these cases the most effective negotiating involves changing the loan conditions (restructuring, refinancing, etc). Depending on the payment behavior after re-negotiating the conditions, this client could also be a candidate for renewal. Generally these clients have experienced an unforeseen emergency, are going through a difficult situation, are victims of an investment gone bad, or are outspending their income.

Clients who are able but not willing to pay require MFIs to ponder a question—is the

lack of payment due to problems with the quality of service offered to this client? If the answer is “yes,” such problems must be immediately resolved. If the answer is “no,” collections must involve an immediate and more intensive strategy. If the new strategy is unsuccessful, then immediate legal action is recommended. It is not unusual to discover that these clients initially received erroneous information, that they disagree with the loan conditions or that payments were made but were not applied because of operational errors.

Clients who are neither willing nor able to pay require immediate legal action.

Generally these are fraudulent clients with a bad credit history or poorly evaluated/approved credits. However, before moving forward it is important to determine their degree of solvency—that is whether the clients possess sufficient assets to obtain repayment. If they do not, any actions taken could be counterproductive. The MFI must evaluate the cost/benefit of any action taken with these clients.


It is evident from this proposed segmentation that there is a direct relationship between the client’s intention to pay and the probability of recovering the loan—as the client’s intention to pay diminishes over time, so does the probability of loan collections. For this reason, action must be taken immediately on past-due loans in order to increase the effectiveness of collections. Payment Alternatives Payment alternatives are important negotiating tools and key to the ultimate success of the collections process. MFIs must offer various payment alternatives adjusted to fit the diverse needs and situations of clients. This is akin to arming collections agents so they can win the debt-collections battle. The timely use of these tools is also important and demonstrates the institution’s capacity to react and respond to delinquency. Traditionally, MFIs have used restructuring and refinancing as the only payment alternatives. These two options do not necessarily address the needs presented by the wide gamut of client situations and imply a need for innovations and the creation of other alternatives. To be able to offer innovative alternatives, MFIs need the support of a strong and flexible information system. In general, if it is not possible to collect the loan in a single payment, valid alternatives should be identified. This should occur even if it means extending the loan term, implementing periodic evaluations or collecting minimum installment payments for a specified period of months and the remaining balance upon maturity. The client’s repayment behavior should be evaluated towards the final repayment, always considering the costs and benefits. Payment alternatives may also include discounting late fees and charges from the total amount of the loan; if the loan is paid off more quickly rather than over a longer period of time the discount should be greater. For example, a client who is able and willing to pay the total amount past-due would receive a greater discount in fees than a client who requests 15 months to repay, thus creating an incentive for quicker loan repayment.

IV. Additional Collections Concerns While the implementation of the collections best practices is a vital first step to creating an effective collections strategy, there are a number of additional concerns that must be addressed, including the role that consumer protection plays in the overall collections strategy as well as the analysis of the collections cost structure.

In Practice – Brazil Real Microcrédito

Real Microcrédito (RMC) developed an innovative system called “agreement to pay” based on a system of discounting penalty interest and fees in direct relation to the new term established for total repayment. In this way, for example, the client who chooses the shortest repayment term received a greater discount. This collections product was designed as a campaign within a pre-established timeframe; it is not an ongoing service. This option was offered to clients with a certain minimum number of days past-due and needed to be managed with discretion since, for example, if the minimum number of days past-due was set at 90, a client who is 60 days past-due and desired to pay back the debt could potentially be required to wait until the loan is 90 days past due to receive the benefit.


Consumer Protection and Collections Emphasizing the importance of long-term client relationships is key to designing and developing efficient collections strategies. Though it is true that timely loan collections is vital to the MFI’s survival, achieving client repayment must never include inappropriate coercion or intimidation techniques, such as physical force, humiliation, contact at inappropriate hours of the day, or the seizure of assets that are basic to the client’s daily survival. The current regulatory framework related to consumer protection in each country must be taken into account when establishing collections strategies. To maintain a healthy balance between consumer protection and collections, the MFI must develop a culture of professional service and respect for clients. This includes selecting staff with the right profile, offering regular training opportunities, and implementing clearly defined processes backed by accurate information and information systems. A recent ACCION publication4 on consumer protection mentions the development of “appropriate debt collections practices” as a fundamental principle of customer service. MFIs can ensure that staff respect and practice this principle by:

Monitoring collections activities: Through internal audit and control units, MFIs may conduct random visits to a representative sample of past-due clients from each branch in order to supervise the application of appropriate collections policies and procedures in the field and to obtain client feedback regarding service quality.

Forming “focus groups”: Focus groups comprised of delinquent clients not only allow

MFIs to obtain feedback on service quality, but also allow institutions to understand client’s payment priorities, which can be influenced by the quality of service provided by the institution.

Requiring frequent and detailed reporting: Collections staff should report regularly on

their interactions with clients and present reports to branch managers and other relevant parties as a part of the overall analysis and evaluation of collections activities.

Setting a time limit for interaction: MFIs should impose time limits for loan-officer

interaction with a delinquent client, after which the case should be transferred to a different loan officer. The involvement of different actors (loan officers, collections agents, branch managers) in the collections process may help to reduce the possibility of fraud and/or mistreatment of the client.

It is important to clarify that interviewing or surveying delinquent clients must be managed carefully. Mishandling could be counterproductive, as experience has shown that mishandled client interaction can be used by the client as a solid argument for non-payment. Often it is much better to ask indirect questions or even to interview clients through a third party in order to obtain accurate and objective feedback about service provided during collections activities. The delinquent client is in an extremely delicate situation, and the quality of customer service provided to them is fundamental to maintaining client loyalty and recovering the full amount of the debt.

4 Patricia Lee Devaney, “Bringing Pro-Consumer Ideals to the Client—A Consumer Protection Guide for Financial Institutions Serving the Poor” (ACCION Monograph No. 14, ACCION International, May 2006).


Promotion and Collections Consumer protection also plays a role in the relationship between promotion and collections, as does the long-term health of the MFI. Financial institutions clearly define their main activities as loan disbursement and collections. The more efficient they are at performing these activities, the better their results will be. Promotion, or sales, and collections are closely related. It is exactly because of this interdependence that MFIs cannot focus on only promotion or only collections. They must be managed together in an efficient manner in order for an MFI to achieve sustainability. One basic principle is “loan disbursement is not complete until the debt has been completely recovered.” Maintaining an appropriate balance between promotion and collections is a key factor critical to the MFI’s survival and ultimate success. In the rush towards mass expansion to new markets and client retention via more financial services, many institutions have introduced new products—such as credit cards, parallel loans, seasonal loans, and home-improvement loans—and entered new markets. Often these changes have been introduced when there is already an increase in the level of client indebtedness due to a rise in banking opportunities in the sector. This combination of changes has led to heightened loan-portfolio deterioration, for which traditional collections strategies have proven insufficient. As a result, many MFIs have seen the need to develop and implement new collections strategies at the same time as they were introducing expansion programs. Collections Cost Analysis To calculate the cost of the collections process, the MFI must first determine a number of factors, including the size and number of participants in the process, number of collections agents or collectors, salaries, incentives, commission of staff members and whether specialized services will be used. Generally, the number of on-site collections agents represents over 50% of the total staff of the collections area, since this type of collections allows for better client location and is directly proportionate to the size of portfolio (number of clients). This also applies to the call center, law firms, etc. Following is a typical breakdown of expenses for a collections unit that outsources some collections activities:

Concept Percent of total expense

Salaries & incentives 40 – 60%

Other operating expenses (transportation, rent, etc.) 20%

Fees to collections agencies or specialized services5 20 – 40%

Source: “Riesgo y Rentabilidad, Banca al consumidor y proceso de adquisición de cuentas,” collections training course presented by Empresa Winners, 1998.

The total cost of the collections process (CCP) is the sum of all of the above:

CCP = Salaries + Other operating expenses + Fees for services

5 In this example the authors are assuming that the MFI has a mixed collections strategy, outsourcing some of the collections activities.


Loan-loss and provision expenses, including actual loan losses (LL), are also related to past-due loans. Therefore, the total cost of collections (TCC) could be represented as: TCC = CCP + LL To optimize the efficiency of the total costs of collections the institution must consider the costs of the collections process vs. loan losses and provisions. The two must be inversely proportional—as collections costs increase, loan losses and provisions must decrease. A hypothetical example is provided in the following table:

Period Cost of Collections Process (CCP)

Loan Loss & Provisions (LL)

Total

1 0 10,000 10,000 2 2,000 8,000 10,000 3 3,000 6,500 9,500 4 4,000 5,000 9,000 5 5,000 4,500 9,500 6 6,500 4,000 10,500

Source: “Riesgo y Rentabilidad, Banca al consumidor y proceso de adquisición de cuentas” (Collections training course presented by Empresa Winners, 1998).

From this example we can conclude that the objectives of a typical collections unit are:

to obtain optimal results through the collections process and to increase collections costs (CCP) vs. loan-loss and provisions expenses (LL).

V. Conclusion Collections is a customer service that MFIs must consider before launching new credit programs. Not only does it play an integral role in the overall lending cycle, but it is also a valuable source of feedback on the processes that take place prior to collections. Contrary to the popular belief that delinquency starts only when a client misses a payment date, in many cases it is the processes themselves are the original catalysts of delinquency. The best practices presented here do not represent a comprehensive list of strategies that may be employed to address and reduce delinquency, but they are, from the authors’ experiences, the most effective. Additionally, institutions should be aware of the consumer protection concerns relating to collections as well as the appropriate cost structure in place to ensure appropriate allocation of funds. What should be taken away is the understanding that excellent collections strategies should begin before there is a delinquency problem and end only after the loan is deemed a loss.


Glossary of terms Collections—Actions taken within a financial institution to both prevent delinquency and recover past-due loans. Refinance—Modifications of an existing loan made by a lender in response to a borrower’s long-term inability to pay the loan. This usually involves modifications on the current loan conditions that would include additional money. Borrowers are often requested to fulfill some compulsory requirements. Restructure/reschedule—Modifications of an existing loan in response to a borrower’s short-term inability to pay the loan. This action usually involves only modifications on the loan term and frequency. Past-due/delinquent loan—Loans with at least one payment installment not made on or before the agreed upon payment date. Usually MFIs define a loan as past-due or delinquent if payment is one day late.


References Brachfield, Pere J. “Jaque a los impagados: el recobro de los impagados mediante la negociación efectiva con los morosos”.[Cornering unpaid debtors: recovering unpaid debts through effective negotiations with delinquent clients]. Barcelona: Ediciones Gestión 2000, S.A., 2004. ———. “Recobrar impagados y negociar con morosos” [Recovering unpaid debts and negotiating with delinquent clients]. Barcelona: Ediciones Gestión 2000, S.A, 2002. _______“De o golpe na inadimplência.”Revista Vendamas, São Paulo, Brazil. . February 2006. Devaney, Patricia Lee. “Bringing Pro-Consumer Ideals to the Client.” ACCION Monograph No. 14, ACCION International, May 2006. Misino, Dominick J. “Negotiate and Win: Unbeatable Real-World Strategies from the NYPD’S Top Negotiator”. New York: McGraw Hill, 2004.

_______“Riesgo y Rentabilidad, Banca al consumidor y proceso de adquisición de cuentas.” Collections training presented by Empresa Winners, 1998. Rial, Astrid, “Las Mejores practicas en las cobranzas al Consumidor” [Best Practices in Consumer Collections]. London: VRL Publishing, Ltd., 2004. Teskiewicz, Alberto. “Modelos predictivos para cobranza y refinanciación” [Predictive Modeling for Collections and Refinancing]. First Collections Summit, Credit Management Solutions, Buenos Aires, Argentina 2007. “ Collections Policies and manuals” from microfinance institutions profiled in this piece. Mori, Tiodita y Carranza, Luz. Forum “La Cobranza Eficaz y su rol en el circuito integral del Activo,” Training for Banco Solidario—Collections unit in Quito and Guayaquil cities, Ecuador, September 11-16, 2006. Nimal A, Fernando. “Managing Microfinance Risks – Some observations and suggestions”, Asian Development Bank, July 2008. Centre for the study of financial Innovation – CSFI, “Microfinance Banana Skins 2008 – Risk in a blooming industry”, 2008.

This report was prepared by Bettina Wittlinger, Luz Carranza and Tiodita Mori, staff consultants for ACCION International—International Operations. The authors worked in the implementation of collections programs for Banco Solidario, Financiera El Comercio, Banco Columbia, RealMicrocredito and programs in India between 2003 and the date of publication of this InSight. The article was edited by Kelley Mesa, Anita Gardeva, and Jori Ortegon. Special thanks for her valuable commentary for this InSight go to Veronica Aznaran, who has eleven years of experience in the Peruvian financial system, specializing in collections for SMEs and commercial lending in Peru. Many thanks for their valuable commentaries and revision of this InSight go to Andres Calderon, Vice President of Risk at ACCION International, and Victoria White, India Program Director at ACCION. Thanks, too, go to Susana Barton Principal Director–Innovations & Integrated Solutions at ACCION, for her constant support and for bringing the facilities to write the present InSight. ACCION International’s InSight series is designed to highlight practical applications, policy viewpoints and ongoing research of ACCION. To download other editions of InSight free of charge, please visit www.accion.org/insight. Other titles in ACCION’s InSight series include: InSight 1: ACCION Poverty Assessment Framework InSight 2: Economic Profile for 15 MicroKing Clients in Zimbabwe InSight 3: Making Microfinance Transparent: ACCION Policy Paper on Transparency InSight 4: Building the Homes of the Poor: Housing Improvement Lending at Mibanco InSight 5: Poverty Outreach Findings: Mibanco, Peru InSight 6: The Service Company Model: A New Strategy for Commercial Banks

in Microfinance InSight 7: Market Intelligence: Making Market Research Work for Microfinance InSight 8: ACCION Poverty Outreach Findings: SOGESOL, Haiti InSight 9: ACCION PortaCredit: Increasing MFI Efficiency with Technology InSight 10: Leveraging the Impact of Remittances through Microfinance Products InSight 11: ACCION’s Experiences with Rural Finance in Latin America and Africa InSight 12: Developing Housing Microfinance Products in Central America InSight 13: ACCION Poverty Outreach Findings: BancoSol, Bolivia InSight 14: Practical Skills for Microentrepreneurs: ACCION’s Experiences with the ABCs of Business Program InSight 15: Bridging the Finance Gap: ACCION’s Experience with Guarantee Funds for Microfinance Institutions InSight 16: MFIs and Foreign Exchange Risk: The Experience of ACCION’s Latin

American Affiliates InSight 17: ACCION Poverty Outreach Findings: Apoyo Integral, El Salvador InSight 18: Who Will Buy Our Paper: Microfinance Cracking the Capital Markets InSight 19: Providing Cost-Effective Credit to Small-Scale Single-Crop Farmers: The Case of

Financiera El Comercio InSight 20: Financially Viable Training for Microentrepreneurs InSight 21: Getting to Scale in Housing MF: A Study of ACCION Partners in Latin America InSight 22: Microfinance Cracking the Capital Markets II InSight 23: The Banco Compartamos Initial Public Offering InSight 24: Guidelines to Evaluate Social Performance InSight 25: Challenges and Opportunities for Banking Remittances: Key Elements Needed to Develop a Strategy to Bank Recipients of Remittances


DQ4-H1

Microfinance Program in Crisis: A Mini Case Study Mrs. Theresa Samuel, the chief accountant of Kidepo Microfinance Program (KCP), was in a slight panic after she had completed a training program on delinquency management. She realized that many of the procedures, measures, and attitudes that were proposed in the training were not being used at KCP, such as taking measurements beyond the simple “amount past due” formula to monitor portfolio quality or aging arrears. She had only been at KCP for a year, but as far as she knew, no nonperforming loans had ever been written off in KCP's four years of existence, nor did KCP ever refinance loans with overdue payments. What is more, KCP did not really have a clear standard for delinquency rates other than its motto "Keep it low." As chief accountant, she was sure KCP did not have an impairment loss allowance in its accounting books.

Theresa’s fears were well founded. Even with the inadequate loan tracking system of KCP, which had not been updated since the agency started, she determined that the delinquency rate using the “portfolio-at-risk” formula was 42 percent last year. The program had seen steady growth in its loan portfolio size, and this had apparently helped conceal the problem. Despite this growth, KCP also had unused loan funds, since donors keep supplying KCP with new capital.

Other measurements Theresa took were equally worrisome, so the KCP Management Committee set up a task force to do something. They put Theresa in charge, since she had found the problem.

A rapid study of the credit program revealed that the loan portfolios of a small number of loan officers had far worse repayment rates than the average, although these loan officers claimed they were unaware of this because of limited information from KCP's tracking system. The study also found that a sampling of borrowers with delinquent loans seemed not to have real reasons for late payment and were rather unconcerned about being in arrears. KCP's program uses both individual and solidarity-style credit methods, and the latter type of loan is currently performing much better.

Members of the task force proposed four solutions: (1) automatic refinancing, (2) much faster growth to cover the problem, (3) immediate write-off of all loans over six months in arrears to improve repayment rates, and (4) redefining of delinquency so KCP would look better. Theresa decided to call her fellow course participants for advice.

GROUP WORK

1. Discuss the appropriateness of the four solutions. Give reasons for your position on each proposed solution.

2. Suggest up to five immediate actions that might contribute to a quick improvement of the KCP situation (be as bold as you think appropriate).

3. Give Theresa guidance on what actions the task force should propose to the Management Committee that should be taken within the next year. Theresa says the bosses want up to 10 new ideas, a clear explanation of how each will help, and a sense of priority among the proposals so they will know where to start.

4. You will have three minutes to present your action plan to the large group.

Hint: Start with an analysis of the problem and its causes


DQ4-H1sol Managing a Delinquency Crisis

(1) Automatic refinancing

(2) Much faster growth to cover the problem

(3) Immediate write-off of all loans over six months in arrears to improve repayment rates

(4) Redefining of delinquency so KCP would look better.

Relevance of the 4 proposals of solutions to the case study None of the solutions proposed in the case study are adequate:

- Refinancing does not solve the problem, it only postpones it. - Rapid growth will result in hiding delinquency and worsening risks on

inadequate loan policies that generate delinquency. - Write-offs of loan over 6 months in arrears are not a solution because it is first

necessary to assess the exact portfolio quality, to understand causes and to adapt the response to the type of cause.

KCP needs to adopt a provisioning policy and international standards for the calculation of portfolio quality ratios. Nevertheless, redefining the concept of delinquency does not solve the issue of delinquency. The solution requires deeper changes in policy and methods, which in turn will require loan officer training.

Action plan drafted by participants (summary) Short-term actions may include: - Conducting detailed repayment analysis and quickly launching collection

procedures. - Encouraging loan officers to collect and follow their portfolio’s performance better,

while observing appropriate practices and bearing in mind local regulations and cultural aspects of the MFI’s intervention zone.

- Investigating officers with a severely degraded portfolio and their clients, to determine causes of arrears.

- Based on this investigation, imposing sanctions on wrong methods or unacceptable behavior from loan officers, or reviewing their training (portfolio quality, products and methods, appropriate collection practices, etc.).

- Sharing the experience and practices of officers who obtain on-time repayments and whose clients are satisfied.

- Calculating the various portfolio performance ratios: portfolio at risk ratios (with portfolio aging), delinquency rate, repayment rate and collection rate.

- Raising loan officers and branch managers’ awareness about the importance of collection.

- Improving availability of information for loan officers so they can perform monitoring.

- Informing borrowers better about terms and what they will need to repay.

Long-term actions may include: - Reviewing credit policy. - Creating a procedures manual: defining clear loan approval procedures and

collection conditions (with clear and precise conditions in cases where rescheduling could be applicable).

- Defining a code of ethics for loan officers. - Training or resuming training for staff - Improving the information system and defining relevant indicators for portfolio

monitoring and client satisfaction - Improving internal audit to ensure vigilance on portfolio quality and on remedies - Identifying and dealing with defaults based on the calculated ratios. - Providing more efficient products well-suited to clients’ needs (based on client

survey results and analysis of the causes of delinquency). - Changing company culture to spread the word that the MFI now has a portfolio at

risk policy below x % (in general, MFI set PAR 30 between 1 and 5%). - Increase staff motivation (for example: incentives for loan officers linked to their

portfolio’s performance but also to their respect of ethics). - Planning and organizing loan officers’ activities better. - Ensuring Board and management involvement in efforts to make loan officers and

branch managers aware of the importance of collection.

IR1-H1a

Levels of Sustainability (Adapted from Otero and Rhyne, A New View of Micro enterprise Finance, 1994)

Institutional performance can be analyzed in terms of four levels of sustainability. Level One - the lowest1

• Highly subsidized institution • Grants or soft loans cover operating expenses and establish a revolving loan fund. • If performing poorly, a loan fund’s value erodes quickly through delinquency and

inflation. • Revenues fall short of operating expenses so the need for grants doesn’t end. • MFIs are characterized by high operating costs and either a reluctance to charge full

cost-recovery interest rates or ignorance of the high effective interest rates being charged.

• Financial sustainability is a challenge (see MIX data below)

Level Two • Interest income covers some operating expenses and subsidized cost of funds. • Using proven principles, MFIs increase the efficiency of their credit methodology. • MFIs raise funds by borrowing below market rates. • Some grants are still needed, but subsidies are significantly smaller than at level one. • Most charge above commercial banks’ interest rates but below informal sector rates.

Level Three • Most subsidies are eliminated, so interest income covers all operating costs. • MFIs at this level tend to have large-scale operations. • Dependence on some element of subsidy is difficult to eradicate; for example, an MFI’s

cost of capital can still be below market and receive financing from soft loans funds.

Level Four - the highest • At the highest level of sustainability, fees and income cover the real cost of funds, loan

loss reserves, operations, and inflation. • The institution's activities are fully financed with the savings of clients and/or funds

raised at market rates from local financial institutions. • The MFI maintains full cost pricing policies, to cover costs and growth; it also checks

that its loan conditions (interest rates + fees) are affordable for clients and checks that the cost of inefficiency is not passed down to clients.

1 This typology does not necessarily reflect the case of greenfields, which usually have access to financial resources at market rates upon starting operations and are likely to set interest rates relatively high, even while still accessing subsidies to set up operations.

IR1-H1b

Discussion – Challenges in Profitability (MIX data)

Financially self-sufficient MFI

Financially non self-sufficient MFI

% financially self-sufficient MFI

Africa 69 72 49% Asia 205 71 74% Central Asia 121 58 68% Latin America 241 102 70% Middle East /North Africa 38 17 69% Total 674 320 68%

MIX Sources – 2009 data

How would you interpret this data?

IR1-H1c

Challenges in Setting Interest Rates

A. How can we price products given the diversity of situations (loan size, distance and dispersion of clients)? How do we determine a "reasonable", an "excessive", or an "exorbitant" rate? How can we set an appropriate rate for the MFI and its clients? The microfinance industry has proven that its clients can pay back their loans and are able to pay the interest rates that MFIs offer. However, we have also seen rising criticism of excessive or even exorbitant rates in certain cases. MFIs must therefore be able to set rates that cover their costs and remain acceptable for clients.

Different product characteristics, lower average loan amounts, distance or dispersion of clients can lead to higher operational costs that result in higher interest rates. There isn't "one" interest rate in the microfinance market. Indeed, this is the cause of great skepticism from the general public: why so many different rates in different countries for the same type of product? Why so many different rates according to products within the same country? That is why MFIs need to understand how to set an interest rate and to be transparent on its calculation. The work of the MFTransparency initiative presents a list of interest rates by type of products and by country. It is beneficial since it enables better transparency and better conditions for rate setting.

MFIs must reduce their costs as much as possible by being efficient, so their clients do not have to bear the cost of their inefficiency.

B. MFIs have access to commercial funds: what is the gap between cost of funds and cost of loans? There is no rule defining the spread between interest rate and cost of funds. Some participants may have heard of Mohammed Yunus' approach, defining three zones: • Green Zone: (Interest Rate – Cost of Funds) ≤ 10 percentage points. • Yellow Zone: (Interest Rate – Cost of Funds) ≤ 15 percentage points. • Red Zone: (Interest Rate – Cost of Funds) > 15 percentage points.

According to this approach, only institutions in the green zone are considered "poverty-focused" while those in the zone are "usury". Nonetheless, studies of MFIs on MIX in 2008 and 2009 identified that: • 75% of MFIs are in the "red" zone, mainly because of operational costs (and not

because of excessive profits); • No MFI benefits from "supernatural" profits and even if all profits were canceled,

the distribution of MFIs in the three zones would not fundamentally change; • MFIs with lower average loan sizes (which indicate targeting of poor clients), are

more often in the red zone; and • Non-profit institutions are more likely to be in the red zone than for-profit

institutions.

According to MIX analyses, Yunus' approach does not necessarily mirror reality, if it is applied in a simplistic manner. There are many MFI in the red zone who are poverty-

focused and private operators in the green zone who are not (or who are less) poverty-focused. However these considerations can give us orders of magnitude for acceptable interests and social and financial goals to reach.

To sum up, there is no frame of reference yet to define acceptable gaps. Again, the challenge is to grasp the numerous elements that influence price setting, and to be transparent on the calculation used.

For in-depth work on the different approaches to responsible pricing, refer to

"Responsible Pricing: the State of Practice" a work document from Smart Campaign, July, 2010 (http://www.smartcampaign.org/tools-a-resources/243).

C. What are "reasonable" levels of profitability and growth? An MFI must determine "reasonable" levels of profitability and growth: what acceptable growth level ("K" in the financial sustainability formula) can be borne by clients through the interest rate? What is the MFI's growth strategy?

Again, in terms of profitability, what is the expected return on assets and equity, what was the profit achieved in past years and will the MFI consider reducing its interest rates if its operational efficiency has increased and its profits are sufficient?

The industry is considering these issues (see for example the Universal Social Performance Standards from "Social Performance Task Force": http://www.sptf.info/sp-standards). At this stage, there is no definition of acceptable or unacceptable level, but it is important for MFIs to know their context (Are there potential clients not served, whom the MFI must seek to serve, or on the opposite strong competition that would induce risks of over indebtedness? Is it better to consider growth toward non-served zones such as rural zones for example, rather than to stay in "over-exploited" urban sectors? Should we try to serve our current clients better with a diversified offer rather than try to find new clients?)

In terms of profitability, again, a "reasonable" level of profit has not been set, but each MFI may think about ways to use its profits to benefit clients: lowering interest rates, expanding toward new zones, diversifying its services, improving quality, etc.

D. Targeting excluded clients and profitability: How can an MFI reconcile both? Here we can build upon ideas particularly developed in an article published in December 2009 in MicroBanking Bulletin #19 and based on the analysis of social and financial performance results:

Institutions that target poor and excluded populations more actively tend to have higher operational costs.

Nevertheless, we notice that geographic targeting (when an institution sets up in zones which really need it) and methodological targeting (when lending methodologies are particularly suited to the constraints of the poorest), correspond to better staff productivity. This can be explained not only by the fact that these approaches are generally based on a stronger participation of clients (cooperatives, village banks for example), but also because they allow the MFI to turn to market niches less prone to competition.

In contrast, institutions taking part in the study tend to have reached operational sufficiency, maybe, as believed Ouattara et al. (1998), due to downward pressure on interest rates applied by clients engaged in governance.

E. MFIs attracted private investors: How can they meet investors' expectations and client needs?

Funding in the microfinance industry looks radically different compared to 15 years ago. Newcomers such as investment funds and foundations offer new financing options. The public sector continues to play a role through ministries' budget and funds. More attention is given to local sources of funds.

Sources of funds: bi- or multi-lateral donor agencies; conventional funds from public donors; developmental partners; private foundations; local capital markets, etc.

These different investors have varied expectations in terms of profitability, and those who have essentially commercial objectives may push for a raise of interest rates. The MFI is responsible for choosing its partners carefully and ensuring that their social and financial goals match.

Source: Summary of documents from July 2011 available on cgap.org, lamicrofinance.org, sptf.info par Lapenu C.

and Brusky B.

IR1-H2

KEY CONCEPTS AND DEFINITIONS

Nominal interest rate

The nominal interest rate is the interest rate that the borrower must pay for his or her loan. It is stated in the loan contract, usually as a monthly or annual percentage. It does not reflect inflation and does not include commissions or other fees regarding the loan.

Effective interest rate

The effective interest rate takes into account all financial costs such as interest, commissions, fees, in a calculation based on the outstanding capital. It also includes the effects of compound interest. The effective rate corresponds to the financial cost of the loan for the borrower. It includes all financial charges in percentage of the credit available during each repayment period. (The best calculation method is the function ‘internal return rate’ on a financial calculator).

Annual effective interest rate (EIR)

The annual percentage rate is an effective interest rate. It includes all costs linked to financing: interest, commissions, fees. It includes the effects of compound interest. It allows reliable comparisons between products and institutions. To calculate the EIR, use Microfinance Transparency’s Excel tool (www.microfinancetransparency.org). The tool enables the calculation of EIR according to the BCEAO2 method, or the method recommended by MFT, which includes compulsory savings.

Annual percentage rate (APR)

The annual percentage rate is an effective interest rate. It includes all costs linked to financing: interest, commissions, fees. However it does not include the effects of compound interest. It allows reliable comparisons between products and institutions. This method is used in the United States. To calculate the APR, use Microfinance Transparency’s Excel tool (www.microfinancetransparency.org). The tool enables the calculation of APR with or without compulsory savings.

Real interest rate A real interest rate is adjusted to include inflation. A negative real interest rate implies that the rate is lower than the inflation rate. A positive interest rate is used to describe a rate higher than inflation.

Interest rate differential

The differential is the amount between the nominal rate applied to the loan and the nominal rate applied to the savings. It is a percentage.

Fixed or flat rate method

Interest is calculated by multiplying the loan term (in months) by the monthly interest rate and by the initial capital, regardless of the repayment schedule. (It may schedule a lump sum repayment or monthly payments for example).

Declining rate method

Interest is calculated on the principal amount effectively in the hands of the borrower during each amortization period. For example, if a borrower has a loan of 100 over two months, with two equal repayments of the capital and interest at 3 percent per month, he or she will pay 3 (3 % x 100) of interest in the first month and 1.5 in the second month. The monthly repayments will therefore not be equal: 53 in the first month et 51.5 in the second. Generally, institutions and clients prefer constant payments.

Fees

Fees are usually a fixed amount, paid in a lump sum. They are part of the credit process; e.g., application, notary or legal fees. The fee amount is usually independent from the loan amount.

Commissions

Commissions are usually punctual charges. They are proportional to the loan amount. Usually a commission is not paid on an on-going basis.

Penalties

Penalties are extra interest billed on a loan when payments are omitted or late. Penalties for delay are usually mentioned in loan contracts as a percentage of increase of the interest rate applied to the loan. They are sometimes fixed, with a predetermined amount.

Compound interest

Compounding interest means including interest in the calculation of interest on a savings deposit. This happens when interest remain on the account for several periods and the bank ‘capitalizes’ the interest (adds the interest to the savings balance) and pays interest on this balance during the following periods.

Variable rate

Variable rates change during the loan term to reflect the evolution of rates on the market. The mode of adjustment of these rates is stated clearly in the loan contract.

Indexed Rates that are linked to something other than the local currency. For example, a rate indexed on inflation or on foreign currency. (Sometimes called floating rate).

2 The effective interest rate methdo used by the BCEAO in WAEMU zone does not take into account compulsory savings or financial guarantees required to access a loan.

http://www.microfinancetransparency.org/

http://www.microfinancetransparency.org/

IR2-H1


SAFE Financial Statements (Projected 2015) Ref. INCOME STATEMENT (Projected) 2015 I1 Financial Revenue 71,812 I2 Financial Revenue from Loan Portfolio 70,000 I3 Interest on Loan Portfolio 70,000 I4 Fees and Commissions on Loan Portfolio I5 Financial Revenue from Investment I6 Other Operating Revenue 1,812 I7 Financial Expense 25,000 I8 Financial Expense on Funding Liabilities 25,000 I9 Interest and Fee Expense on Deposits 4,000 I10 Interest and Fee Expense on Borrowings 21,000 I11 Other Financial Expense I12 Net Financial Income 46,812 I13 Impairment Losses on Loans 500 I14 Provisions for Loan Impairment 500 I15 Value of Loans Recovered I16 Operating Expense 47,250 I17 Personnel Expense 21,250 I18 Administrative Expense 26,000 I19 Depreciation and Amortization Expense 500 I20 Other Administrative Expense 25,500 I21 Net Operating Income (938) I22 Net Non-Operating Income/(Expense) 5,000 I23 Non-Operating Revenue 5,000 I24 Non-Operating Expense I25 Net Income (Before Taxes and Donations) 4,062 I26 Taxes I27 Net Income (After Taxes & Before Donations) 4,062 I28 Donations 1,000 I29 Donations for Loan Capital 800 I30 Donations for Operating Expense 200 I31 Net Income (After Taxes and Donations) 5,062

Ref. SAFE BALANCE SHEET (Projected) 2014 (000) 2015 (000)

ASSETS B1 Cash and Due from Banks 8,015 10,253 B2 Trade Investments - B3 Net Loan Portfolio 183,720 245,971 B4 Gross Loan Portfolio 189,402 253,579 B5 Impairment Loss Allowance (5,682) (7,607) B6 Interest Receivable on Loan Portfolio 1,913 2,447 B7 Accounts Receivable and Other Assets 45 58 B8 Other Investments - B9 Net Fixed Assets 5,274 6,829 B10 Fixed Assets 6,750 8,625 B11 Accumulated Depreciation and Amortization (1,476) (1,796) B12 TOTAL ASSETS 198,966 265,558

LIABILITIES B13 Demand Deposits 23,500 45,757 B14 Short-term Time Deposits B15 Short-term Borrowings 66,193 71,343 B16 Interest Payable on Funding Liabilities 236 346 B17 Accounts Payable & Other Short-term Liabilities 1,300 1,907 B18 Long-term Time Deposits - - B19 Long-term Borrowings 69,775 96,645 B20 Other Long-term Liabilities - B21 TOTAL LIABILITIES 161,003 215,997

EQUITY B22 Paid-in Capital 7,941 12,162 B23 Donated Equity 8,000 9,000 B24 Prior Years B25 Current Year B26 Retained Earnings 19,765 24,827 B27 Prior Years B28 Current Year B29 Reserves 2,257 3,571 B30 Other Equity Accounts B31 Adjustments to Equity B32 TOTAL EQUITY 37,963 49,560 TOTAL LIABILITIES + EQUITY 198,966 265,557

IR2-H2a


Applying the Formula for Setting Financially Sustainable Interest Rates (SAFE example)

Refer to SAFE’s projected financial statements for the year 2015. You have the following additional information:

• Commercial banks charge 25% for medium-quality borrowers.

• Short-term investments earn a net 10% per year.

• The projected inflation rate is 15%.

• SAFE targets a capitalization rate of 10% to support future growth.

• Loan losses are expected at 4,297.

• Of savings, SAFE pays its voluntary clients 15% per year.

Compute the annualized interest rate that SAFE would have to charge its clients in order to reach its target and be sustainable.

Discuss the rate you calculated. How do we explain this rate? What are the consequences on SAFE’s strategy?

IR2-H2b (Answers)


Applying the Formula for Setting Sustainable Interest Rates (SAFE example)

R = AE + LL + CF + K − II 1 − LL = 0.22 + 0.02 + 0.23 + 0.1 = 0.57 1 - 0.02 0.98 = 58.2%

Average outstanding portfolio Opening balance 183720 Plus closing balance + 245971

429691

Divided by 2 = 214846

Administrative expenses: AE = 47250 = 22% 214,846

Loan Loss: LL = 4297 = 2% 214,846

Cost of funds: CF = 48845 = 23% 214846

Weighted Average Cost Cost Avg. voluntary savings 34,629 x 0.15 = 5194 Avg. borrowings 151,978 x 0.25 = 37,995 Plus + (Avg. total equity 43,762 226,210 avg. financial assets1 minus avg. fixed assets) − 6052 − 18,8500 minus avg. liabilities 37,710 x 0.15 5,656 37,710 48,845

Desired capitalization rate 10%

Investment income II = 0 = 0% 214,846

1 Financial assets are total assets minus fixed assets.


IR3-H1 CALCULATING EFFECTIVE INTEREST RATES

DECLINING BALANCE LOAN AMOUNT -- $1,000 12 Month Loan Term Monthly Loan Payments of $92.60 Fee -- 3% ($30) Interest Rate -- 20% per annum

Month Payments Principal Interest O/S Balance

0 1,000.00 1 92.60 75.93 16.67 924.07 2 92.60 77.20 15.40 846.87 3 92.60 78.49 14.11 768.38 4 92.60 79.79 12.81 688.59 5 92.60 81.12 11.48 607.47 6 92.60 82.48 10.12 524.99 7 92.60 83.85 8.75 441.14 8 92.60 85.25 7.35 355.89 9 92.60 86.67 5.93 269.22 10 92.60 88.11 4.49 181.11 11 92.60 89.58 3.02 91.53 12 92.60 91.07 1.53 - FLAT METHOD LOAN AMOUNT -- $1,000 12 Month Loan Term Monthly Loan Payments of $100 Fee -- 3% ($30) Interest Rate -- 20% per annum

Month Payments Principal Interest O/S Balance 0 1,000.00 1 100.00 83.33 16.67 916.67 2 100.00 83.33 16.67 833.34 3 100.00 83.33 16.67 750.01 4 100.00 83.33 16.67 666.68 5 100.00 83.33 16.67 583.35 6 100.00 83.33 16.67 500.02 7 100.00 83.33 16.67 416.69 8 100.00 83.33 16.67 333.36 9 100.00 83.33 16.67 250.03 10 100.00 83.33 16.67 166.70 11 100.00 83.33 16.67 83.37 12 100.00 83.33 16.67 -


IR3-H1 worksheet

Calculating Effective Interest Rates - worksheet For best results, use a financial calculator or spreadsheet to complete the exercise. Use the sample loan information provided.

1. Calculate the effective interest rate, including fees, for both FLAT RATE and DECLINING BALANCE:

a) declining balance method: b) flat rate method:

2. For the FLAT RATE and DECLINING BALANCE, calculate what happens to the effective rate when

a) the fee increases to 8% (fees = $80) b) the loan term decreases from 12 months to 3 months (fee is back to the original

3%) c) the repayment term changes from monthly to weekly (50 weeks). The change in

loan conditions modifies the amount of repayments and the amount of the last repayment)


IR3-H1 answers

Calculating Effective Interest Rates - worksheet For best results, use a financial calculator or spreadsheet to complete the exercise. Use the sample loan information provided.

1. Calculate the effective interest rate, including fees, for both declining balance and flat rate:

a) declining balance method:

b) flat rate method:


2. For the FLAT RATE and DECLINING BALANCE, calculate what happens to the effective rate when

a) the fee increases to 8% (fees = $80) FLAT RATE

DECLINING BALANCE


b) the loan term decreases from 12 months to 3 months (fee is back to the original 3%): FLAT RATE

DECLINING BALANCE


c) the repayment term changes from monthly to weekly (50 weeks). The change in loan conditions modifies the amount of repayments and the amount of the last repayment)

FLAT RATE

DECLINING BALANCE


IR3-H2

Effective Cost of Borrowing*

EFFECTIVE COST CALCULATION The effective rate of interest refers to the inclusion of all direct financial costs on a loan in one interest rate. Effective interest rates differ from nominal rates of interest in that they incorporate interest, fees, the interest calculation method, and other loan requirements into the financial cost of the loan. To be completely correct, the effective rate should also include the cost of forced savings or group fund contributions by the borrower. To do this, a financial calculator is required to calculate the internal rate of return (IRR).

For the purposes of this course the effective rate of interest is calculated on an estimation basis using a formula that does not require a financial calculator.** (Note that this method does not take into account cash flow, which is considered in the IRR calculation. Although the difference between both methods is minimal for short periods, the longer the loan term and the less frequent the payments, the greater the effective cost will be and hence the greater the difference between the estimated effective cost and the IRR calculation.) The use of MFTransparency’s calculation tool is recommended.1

The simple method is therefore presented for your information. The complete method should be used with the help of a financial calculator or the MFTransparency spreadsheet to include cash flow.

Effective rates of interest are useful for determining whether the conditions of one loan make it more expensive or less expensive for the borrower relative to another loan.

When interest is calculated on a declining balance, and there are no additional financial costs to a loan, the effective interest rate is the same as the nominal interest rate. Many microfinance organizations, however, calculate the interest on a flat basis, charge fees as well as interest, and often require the borrowers to maintain savings. This makes the effective interest rate on the loans higher than the nominal rate. Often, clients are unaware of how MFI calculate interest rates, and MFIs do not explain EIR or APR: only the nominal rate is quoted to clients. This lack of transparency goes against the client protection principles and is increasingly monitored by regulators.

The effective cost to the client consists of the amount the borrower pays in interest and fees divided by the amount of money the borrower has outstanding over the period of time the loan is outstanding. An estimation of the effective cost can be calculated as follows (does not include the effect of forced savings):

Effective cost = amount paid in interest and fees

average principal amount outstanding

Note: Average principal amount outstanding = sum of principal amounts outstanding

number of payments

1 http://www.mftransparency.org/pages/ctp-tool/


To calculate the effective cost per payment period, simply divide the resulting figure by the number of periods.

The effective cost changes in relation to the interest calculation method, the fee, and the loan term.

The following examples estimate the effective cost of a loan with interest calculated on a flat basis and on a declining basis:

FLAT RATE LOAN AMOUNT – $1,000 12 Month Loan Term Monthly Loan Payments of $100 Fee – 3% ($30) Interest Rate – 20% per annum

Month Payments Principal Interest O/S Balance 0 1,000.00 1 100.00 83.33 16.67 916.67 2 100.00 83.33 16.67 833.34 3 100.00 83.33 16.67 750.01 4 100.00 83.33 16.67 666.68 5 100.00 83.33 16.67 583.35 6 100.00 83.33 16.67 500.02 7 100.00 83.33 16.67 416.69 8 100.00 83.33 16.67 333.36 9 100.00 83.33 16.67 250.03 10 100.00 83.33 16.67 166.70 11 100.00 83.33 16.67 83.37 12 100.00 83.33 16.67 –

Total Interest Paid = 200.00

Effective Cost =

200.00 + 30 541.69

42% per annum (3.5% per month)

This results in an effective cost per month of 3.5%. Calculating the effective cost for loans with interest calculated on a flat basis is fairly simple, as each payment has the same portion of principal and interest.

Calculating the effective cost for loans with interest calculated on the declining balance method is more complicated because the amount on which the interest payments are calculated (the amount of principal outstanding) is different for each payment period.


DECLINING BALANCE LOAN AMOUNT – $1,000 12 Month Loan Term Monthly Loan Payments of $92.60 Fee – 3% ($30) Interest Rate – 20% per annum

Month Payments Principal Interest O/S Balance 0 1,000.00 1 92.60 75.93 16.67 924.07 2 92.60 77.20 15.40 846.87 3 92.60 78.49 14.11 768.38 4 92.60 79.79 12.81 688.59 5 92.60 81.12 11.48 607.47 6 92.60 82.48 10.12 524.99 7 92.60 83.85 8.75 441.14 8 92.60 85.25 7.35 355.89 9 92.60 86.67 5.93 269.22 10 92.60 88.11 4.49 181.11 11 92.60 89.58 3.02 91.53 12 92.60 91.07 1.53 –

Total Interest Paid = 111.66

Effective Cost =

111.66 + 30 558.27

25% per annum (2.1% per month)

Calculating the interest on the declining balance results in an effective cost per month of 2.1%.

From the above examples, we can see that the interest rate calculation method has a large impact on the effective cost. With all other factors remaining the same, the cost decreases from 42% (3.5% per month) to 25% (2.1% per month) when the method of calculation is changed from flat to declining balance. As mentioned, the interest calculation method, the fee, and the loan term all affect the effective cost. The following table illustrates the effect that a change in the loan fee and a change in the loan term have relative to the effective cost.


Calculation 20% Annual Rate

Service Fee Loan Term (months)

Effective Cost/Month

BASE CASE 1 Flat 3% 12 3.5% Increase fees Flat 8% 12 4.3% Decrease term Flat 3% 3 4.0%

BASE CASE 2 Declining Balance 3% 12 2.1% Increase fees Declining Balance 8% 12 2.9% Decrease term Declining Balance 3% 3 3.2%

Note that the effect of an increase in the fees from 3% to 8% has the same effect (increase of 0.8% per month in effective cost) whether the loan is calculated on a declining basis or flat method. Decreasing the term to 3 months from 12 months has a greater effect on the effective rate for the declining balance calculation method (increase of 1.1% in effective cost/month) than the flat method (increases of 0.5% in effective cost/month). This it because a shorter loan term with interest calculated on a flat basis is a much more costly loan; for example, the client has use of the money for less time but pays the same nominal amount of interest.

EFFECTIVE RATE CALCULATION Calculate the effective rate for Base Cases 1 and 2 with an increase in the fee to 8% and a decrease in the loan term to 3 months together. How do those changes affect the effective rate?

EFFECTIVE YIELD Generally, the effective cost to the client of borrowing relates to the effective “yield” earned by a microfinance organization. Yield refers to the revenue earned by the lender on the gross loan portfolio. For example, if the effective cost per loan is calculated (using the estimation method above) at 35%, the yield to the organization will approximate 35% of the gross loan portfolio, since interest and loan fees are paid to the lending organization. This is reduced by the amount of delinquent (or non-revenue-generating) loans and late payments, and can also be affected by low loan turnover (idle funds). The effective yield differs from the effective cost to the borrower because yield doesn't include other costs, such as savings, etc.

* Excerpted from Ledgerwood, Joanna. 1996. Financial Management Training for Micro Finance Organizations, Finance: Study Guide. Calmeadow, Toronto..

** This method of estimating the effective rates was developed by Chuck Waterfield in Designing for Financial Viability of Microenterprise: Credit Progammes. Gemini Technical Note 4. Bethesda: Development Alternatives Inc.

IR4-H1a


Costs to Borrowers

FINANCIAL COSTS

TRANSACTION COSTS

OPPORTUNITY COSTS

IR4-H1b (Answers)


Costs to Borrowers

FINANCIAL COSTS

Money, cash, paid to the MFI for the loan • INTEREST • FEES – Loan or membership • Commissions • Discounting • Group fund or insurance fund contributions • SAVINGS REQUIREMENTS

TRANSACTION COSTS

Money paid out to access a loan and not paid directly to the MFI; costs other than those paid to the financial institution but often imposed by lenders through the delivery system • Transportation costs involved in receiving and repaying a loan • Fees paid to obtain financial documents or business registration • Costs of needed professional services (e.g., lawyers, business plan consultant) • Photos for mandatory Identification cards • Cost of maintaining a bank account that is a requisite for obtaining a loan • Communication costs • Bribes

OPPORTUNITY COSTS

Noncash costs incurred by the borrower associated with forgone opportunities related to accessing the loan; frequently greater than financial and transaction costs • Forgone income because money isn’t available to be used elsewhere • Attendance at meetings and the corresponding absence from the business • Missed procurement or investment opportunities • Extra time spent processing a loan because of lost or misplaced documents by either

MFI or borrower Costs of holding savings rather than using the money directly in the business

• Group guarantee responsibilities • Time spent by borrower collecting needed information to access loan

IR4-H2a


Calculating Costs to Borrowers

You are a tailor who needs $100 for three months to purchase material to fulfill a contract. If you buy the material this week, you will get a 20% discount. You earn approximately $300 a month for 200 hours of work or an hourly wage of $1.50.

The MFI closest to your neighborhood charges 2% interest flat per month and a small processing and monitoring fee of 3% of the loan value. They would allow you to repay the $100 loan plus interest at the end of the three-month term.

The MFI would require you to take a one-week (five-day) course for two hours a day; the course costs $2 total. Since you live on the fringes of the town, it takes two hours to travel to and from the institution. You would need to go five times for the course and then four times to apply for, receive, and repay the loan. Bus fare is $0.40 for a return trip. This example assumes that half of the time you spend in training and traveling would otherwise be spent working in your business (thus 14 of the 28 hours spent training and traveling would cost you $1.50 per hour). The loan would be disbursed in two weeks.

1. Complete the chart below, filling in the actual amounts paid for each cost noted.

Type of Cost Explanation Subtotal

($) Total

($) %

of total

Financial Costs

Transaction Costs

Opportunity Costs

Total Borrowing Costs

2. Calculate the effective interest rate.

3. If transaction and opportunity costs are included in calculation, what is the effective interest rate and costs to the borrower? What does this say about our operations?

IR4-H2b (Answers)


Calculating Costs to Borrowers

1.

Type of Cost Explanation Subtotal

($) Total

($) %

of total

Financial Costs

Interest (2%/month = $2 x 3 mo. Training fee Monitoring fee (3% of loan amount)

6.00 2.00 3.00

11.00 20%

Transaction Costs

Bus fare to training ($.040/trip x 5) Bus fare for loan ($.040 x 4)

2.00 1.60

3.60 6%

Opportunity Costs

10 hours in training (10 x $1.50 x ½) 10 hours transportation for training 8 hours transportation for loan (8 x $1.50 x ½) Lost discount on material purchase

7.50 7.50 6.00

20.00

41.00 74%

Total Borrowing Costs $55.60

2. Effective interest rate (using simple formula)

$11/100 = 11% x 4 = 44% annual

3. Effective interest rate with transaction and opportunity costs:

$55.60/100 = 55.6% x 4 = 222.40% per annum

Therefore the annual cost to the client is 222.4% of what he or she borrows.

In the tailor’s case, the cost of borrowing $100 is $55.60.

Discussion: Which costs could be avoided? Which costs must generate extra added value to be justified? How should the MFI ensure that the costs it transfers to its clients are justified?

IR4-H3


Costs of Credit

From the BORROWER’S perspective: Financial Costs Transaction Costs

+ Opportunity Costs = TOTAL BORROWING COSTS

CHALLENGE: TO MINIMIZE TRANSACTION AND OPPORTUNITY COSTS BECAUSE THEY DON’T BENEFIT EITHER THE BORROWER OR THE LENDER (BUT THERE MAY BE COSTS THAT REMAIN NECESSARY FOR THE MFI OR THAT ARE LINKED TO SERVICES USEFUL FOR CLIENTS AND WHICH COULD CONTRIBUTE TO EFFECTIVE LOAN REPAYMENT).

From the LENDER’S perspective: Operational Costs Loan Loss Reserve

+ Financial Costs = TOTAL LENDING COSTS

CHALLENGE: TO REDUCE OPERATIONAL COSTS AND BECOME MORE EFFICIENT IN ORDER TO OFFER HIGH QUALITY SERVICES TO CLIENTS AND COMPETE WHILE ENSURING EFFECTIVE LOAN REPAYMENT.

IR5-H1

Participant Action Plan Form

Name: _______________________________

The final phase of this of the course is designed to give you an opportunity to apply the concepts and skills that you have learned to actual on-the-job problem(s) of your choice. This should provide real and lasting meaning to your training experience. It will also provide you with a maximum return from your investment of time and effort in this workshop. Select an interest rate issue about which you have genuine concerns, that is, an area that requires some worthwhile improvement or remedial action. The issue may involve overcoming a deficiency or meeting a new challenge or opportunity. You alone know where a real need for change or improvement exists. Use this worksheet to help you work through the details of your problem-solving activity.

I Defining the problem

1. The exact nature of the interest rate issue I want to address is:

2. The causes of my concern are:

II Seeking a Solution

1. The steps I will take to address this issue are:

2. The obstacles I will need to be overcome are:

3. The deadlines for completing each of these steps are:


IR5-H2

Recommended Reading on Preventing and Managing Delinquency

ACCION, 2008. Best Practice in Collection Practices (ACCION) http:// resources.centerforfinancialinclusion.org/insight/IS26en.pdf Smart Campaign, 2011. Swadhaar’s Policy on Collection of Overdues from Delinquent Clients and Other Recovery Policies Smart Note, 2010 « Collections with Dignity at FinComún » http:// www.smartcampaign.org/tools-a-resources/2/48

Recommended Reading on Setting Interest Rates

Smart Note, 2010 “Responsible and Transparent Pricing at Mi-Bospo” http://www.smartcampaign.org/tools-a-resources/330 Reed, L., 2010. Responsible Pricing, the State of the Practice. Discussion Paper, Smart Campaign, Washington, DC. http://www.smartcampaign.org/.../Responsible_Pricing-The_State_of_the_Practice.pdf Resources on MicroFinanceTransparency

http://www.smartcampaign.org/tools-a-resources/2/48

http://www.smartcampaign.org/tools-a-resources/330


IR5-H3a

Post-training Skills Audit Managing Delinquency and Setting Interest Rates for Sustainability

Mark your answers on the answer sheet provided. If you are not reasonably sure of the answer, please mark "I don't know" instead of guessing. You will not be graded. The results of this test will be used to help the instructors match their presentations to the background and knowledge of the students.

FOR QUESTIONS 1–7, MARK ON YOUR ANSWER SHEET: T (TRUE) F (FALSE) OR ? (I DON'T KNOW)

1. Most microfinance institutions (MFIs) are financially sustainable. 2. Most MFIs draw their source of income from interests and fees. 3. If they want to be financially sustainable, MFIs should charge their borrowers a "market" interest

rate (i.e., a rate close to what commercial banks charge to their usual customers). 4. Loan delinquency can spin out of control faster in an MFI than it might tend to in a commercial

bank. 5. Repayment rate is the best way to monitor the quality of your loan portfolio. 6. Delinquency control is out of the hands of the MFI; it is totally in the hands of the borrower. 7. Outstanding loan portfolio is equal to the total amount of loans disbursed by an MFI. 8. If an MFI is not sustainable, the only way it can become sustainable is by increasing its source of

income (i.e. higher interest rates, lower delinquency)

FOR QUESTIONS 8–12, SELECT THE APPROPRIATE LETTER AND MARK IT ON THE ANSWER SHEET.

9. Which of the following is the easiest to achieve? A. Operational Self-Sufficiency C. Profitability B. Financial Self-Sufficiency D. I don’t know

10. Which of the following describes meaningful measures of portfolio risk? A. Amount of late payments divided by total gross loan portfolio B. Outstanding amount of loans with one or more payments late, divided by total gross loan

portfolio C. Both of the above D. Neither of the above E. I don't know

11. An interest rate that has been adjusted to reflect the impact of inflation is called a(n) A. Effective rate D. Adjusted rate B. Real rate E. I don’t know C. Nominal rate

12. Provision for loan impairment will affect the A. Balance sheet D. Neither of the above B. Income (profit and loss) statement E. I don’t know C. Both of the above

13. An interest rate that is the stated or quoted rate to be paid on a loan contract is called a(n) A. Effective rate D. Adjusted rate B. Real rate E. I don’t know C. Nominal rate


14. What is the formula for portfolio-at-risk?

15. What is the formula for write-off ratio?

16. What are the potential consequences of poor delinquency management on the MFI and its clients?

17. Name three ways to increase sustainability of a microfinance program.

18. Name three ways to improve relationships with clients.

19. Name four factors that should be considered when determining an interest rate.

20. Name three factors that can improve an MFI’s efficiency.

21. Name three strategies to manage and control delinquency.


Post-training Skills Audit Managing Delinquency and Setting Interest Rates for Sustainability

Name ______________________________ Organization _______________________________

Position: ____________________________ Length of time in position: ___________________

MARK TRUE, FALSE, OR I DON’T KNOW

1. 5. 2. 6. 3. 7. 4.

MARK A, B, C, D, OR E

8. 11. 9. 12.

10.

13.

14.

15. Three ways to increase sustainability are:

1. 2. 3.

Portfolio-at-risk =

Write-off rate =


16. Four things to consider when setting an interest rate are:

1. 3.

2. 4.


IR5-H4

Post-training Audit Managing Delinquency and Setting Interest Rates for Sustainability

_______________________________ __________________________________ Name Role/Position in the Organization

To serve as a review for you and an evaluation for us, we ask you to complete this brief audit.

Please write what you have learned about the following topics. Please try to include formulas, definitions, specific points, and any other comments you recall. You will have 15 minutes. Please use a pen.

Thank you.

1. Causes of Delinquency

Costs of Delinquency

2. Measuring Delinquency

3. Controlling Delinquency


4. Managing a delinquency crisis

5 Role of Interest Rates, Rationale

6 Types of Interest Rates

7 Costs of Credit to Borrower

8. Setting Interest Rates for Institutional Sustainability

9. Other lessons

Education

CGAP Training Delinquency Management and Interest Rate Setting Participant Materials: Handouts