Key formulae A: Delinquency

Lessons in Microfinance MANAGING ARREARS AND DEFAULTS

LESSON 10

The largest asset most financial service providers have is the loans they have made to customers, and therefore protecting their loan portfolio is of critical importance to their long term survival. However, it is an unusual asset because although the loaned money belongs to the institution, borrowers are using it away from the direct control of the institution. Therefore there is a risk attached to the loan portfolio1, as they cannot always be sure that it will get this money back. Moreover, the size and quality (amount of risk) of the portfolio change continually as loans are disbursed, payments are made, and loans and payments become due. This lesson explores how a financial institution can measure and monitor the quality of their portfolio, how arrears are dealt with, and how credit operations can be managed to minimise portfolio risk. Measuring portfolio quality Key formulae A: Delinquency Total amount overdue Total portfolio outstanding

x 100

B: Portfolio at risk Total outstanding balance of loans with payments overdue

x 100

Total portfolio outstanding

C: Loan loss rate Amount declared nonrecoverable in a given period Average outstanding portfolio

x 100

D: Loan repayment Total amount collected in a given period Total amount due (including any amounts overdue)

x 100

Delinquency, portfolio at risk and loan loss are three widely used measures, which in combination, present an accurate picture of the quality of loan portfolios. A loan is considered to be at risk when any portion of the loan principal has not been repaid when the due date has passed. Delinquency (see formula A) is a commonly used measure but it actually understates the real risk to the portfolio by ignoring the fact that the whole outstanding loan balance is effectively at risk once somebody defaults on a payment. To overcome this problem and to provide a better indication of the quality of the portfolio, especially for longer-term loans or a rapidly changing portfolio, the portfolio at risk (see formula B) is used instead. It is possible to improve the analysis by taking into account the age of the arrears. For example loans with payments overdue by 30 days are not as risky as those with payments overdue by more than 90 days. Thus overdue loans should be divided into categories according to the length of time a payment has been outstanding.

If an organisation deems it unlikely that a loan will be recovered (usually recommended if it has been overdue, without any repayments made, for more than one year), it should be written-off as non-recoverable. Loan loss rates show how much of a portfolio has already been lost or writtenoff in a given period. It is best to use the average outstanding portfolio of the period rather than the end of year figure, if the size of the portfolio has changed considerably during the year (see formula C). 1

The portfolio or amount outstanding at any given moment is the total loan principal owed by borrowers and that the institution expects to be repaid. Note, interest is not considered part of the portfolio, as this contributes to the institution's income and is not an asset in the way the loan principal is. Lesson Summary © RFLC

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Loan loss reserves To protect themselves from sudden decreases in their assets, most financial institutions create a loan loss reserve as a liability in their balance sheets. This means an allowance for bad debts is included as an expense in the profit and loss account. The amount set aside depends very much on the quality of the portfolio and the organisation's past experience of recovering overdue loans. It is important to remember that writing a loan off should not stop the lending organisation from trying to recover the loan Loan repayment rates Most microfinance providers hope for repayment rates over 95%. Repayment rates are expressed as a percentage of the amount due in a specified period (see formula D), whereas the delinquency rate expresses arrears as a percentage of the total outstanding loan portfolio at a specified point in time. Therefore, repayment rates and delinquency rates do not add up to 100% because the formulae measure amounts paid or amounts overdue as percentages of different things. Repayment rates are a useful internal management tool for monitoring recovery and making projections, but they are not a measure of portfolio quality. Rescheduling and refinancing These are legitimate ways of reducing or removing recorded arrears without reducing the portfolio. Rescheduling a loan involves changing the payment schedule so that the borrower is no longer in arrears (or will be able to avoid going into arrears), whereas refinancing a loan implies lending more money to a borrower who still has an outstanding balance, usually to pay off the previous loan and to provide some new financing to the business. To an institution suffering from arrears problems, refinancing or rescheduling loans can appear an attractive option to reduce high levels of delinquency, but it may worsen the portfolio in the long run by actually encouraging delinquency (as delinquent borrowers see benefits in falling behind on payments). Nevertheless, rescheduling and refinancing is a reasonable strategy to use when a genuine problem (e.g. fire, theft, flood, major illness) befalls a well-intentioned entrepreneur, but should not be used as a blanket solution to delinquency problems. Minimising the impact of delinquency Delinquency has a significant effect on an institution's costs, income and financial situation. Delays in receiving income in the form of interest make it difficult for the institution to manage its cash flow and when loans are overdue for a long time, interest may be written off, thus reducing income. Delinquency also slows down the rotation of the portfolio and reduces the income earning potential. It is important to remember that in most cases, high levels of delinquency should not be blamed on the borrowers but on the financial institution for not devising effective methods of lending to and recovering from their clients.

Here are some important ways of managing credit operations to reduce portfolio risk: 1. Instil a strong institutional philosophy throughout the organisation that makes clear to both staff and clients that late payments are unacceptable. 2. Establish an effective credit methodology with lending decisions based on the five "Cs":  Character – integrity, honesty, trustworthiness, hard-working  Capacity to repay  Capital available to run enterprises or provide reserves  Collateral - guarantees or pledged assets  Conditions affecting profitability

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3. Establish firm incentives and disincentives to minimise delinquency. 4. Establish easy-to-use management and information systems which enable both field staff and management to take prompt action to deal with arrears.

The recommended reading for Lesson 10 is: R. Rosenberg Measuring Microcredit Delinquency: Ratios Can Be Harmful to Your Health CGAP Occasional Paper No. 3 1999 D. Norell How to Reduce Arrears in Microfinance Institutions Journal of Microfinance Vol.3 No.1 2001 D. von Stauffenberg, T. Jansson, N. Kenyon, M. Barluenga-Badiola Performance Indicators for Microfinance Institutions: A Technical Guide pp 5-14 - Portfolio Quality MicroRate & IADB 2003

At the end we suggested some follow-up activities: Why don't you? Think about a time that you have been in debt. What was the main single factor that motivated you to repay? Was it your desire to keep a good credit rating and to be able to get another loan, your fear of social disapproval, your reluctance to lose the security you had pledged...? Make a note of whatever it was, and ask a sample of your friends, men and women if possible, to answer the same question. Compare your findings with the ways in which local banks or microfinance institutions try to motivate borrowers to repay. Are they consistent or not? If not, why not?

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