Credit Scoring in Microfinance – Overcoming Challenges

Last week’s article looked at the various benefits of credit scoring in microfinance; this week’s entry looks at different challenges related to setting up external credit scoring systems in microfinance and the ways to overcome them.

Setting up credit information bureaus in microfinance is no easy feat. Here are some challenges (and suggested solutions) that project developers must look out for:

MFIs Lack Technological Capability

Good credit scoring systems are complex and technology-dependant; however, many microfinance institutions lack the technological capability to use these systems. For instance, internet connectivity may be a problem in rural areas of developing countries, or the loan officers may lack the skills needed to fully utilize the functions of the credit bureau.

Solution: A variety of communication channels may be used to deliver credit scores, such as the internet, text messages, telephones, etc. MFIs may also have to undergo capacity building exercises to ensure they are ready to use the system; these would include trainings imparted to loan officers as well as build up of technological base as well as the setup of formalized credit screening and approval processes.

Asymmetry of Information

True, microfinance credit bureaus overcome the problem of information asymmetry for loan officers, but obtaining this information can be difficult to begin with because most information sources are informal and disparate.

Solution: microfinance institutions must all be on board to willingly share vital information about clients, which may help other microfinance institutions. This information must also be update regularly, so direct communication links between MFIs and the credit bureau may be formed.

Unrealistic Expectations From the Credit Scoring System

Microfinance institutions should not expect the technologically driven credit scoring system to replace a loan officer’s risk assessment activities. Experiences from the developed world show that complete reliance on credit scoring systems can often be detrimental. Technology is not always fool-proof.

Solution: MFIs should be aware that credit bureaus simply assist and complement a loan officer’s work because sometimes, qualitative analysis is more importance (e.g. a dishonest applicant). The following excerpt adeptly explains the role of credit scoring in a typical microfinance institution:

Scoring is a third voice in the credit committee, helping the loan officer and credit manager finalize decisions on cases that, without scoring, would be approved. In microfinance, scoring does not approve applicants who, without scoring, would have been rejected. Rather, scoring highlights cases that are riskier than the credit committee thought, leading to in-depth review and perhaps changes to the loan contract. Some very high-risk cases are rejected, and very low-risk cases are rewarded to improve loyalty (for example, with a line of credit or reduced interest rates). Source: Credit Scoring, Banks, and Microfinance: Balancing High-Tech with High-Touch

Reluctance on Part of MFIs to Use the Credit Scoring System

Microfinance institutions may be resistant to the idea of relying on credit scores, simply because the idea is foreign and requires money, or because it requires basic technological know-how, or even because it requires additional effort. Additionally, some MFIs may not wish to share detailed client data for fear of losing out on the competitive arena. Even a stellar credit scoring system is a failure if microfinance institutions do not use it.

Solution: microfinance institutions should be encouraged to adopt the credit scoring system by making the system simple, keeping membership fees to a minimum, training workers about using the system, showing them the expected value addition (read article about benefits of credit bureaus in microfinance) and managing the ‘change’ in work practices through change management techniques.

Reference:
Dellien, H and Schreiner, M. (2005). Credit Scoring, Banks, and Microfinance: Balancing High-Tech with High-Touch. Available: http://www.microfinance.com/English/Papers/Scoring_High_Tech_High_Touch.pdf. Last accessed 30th Oct 2010.

Importance of Credit Bureaus in Microfinance – Part 2

Four Types of Benefits of Credit Scoring for Microfinance Institutions…cont.

3. Marketing Benefits

Credit bureaus help differentiate promising borrowers from risky ones, and create micro-segments in accordance with the delinquency rates of prospective clients. Marketers in microfinance institutions can devise financial services to cater to each risk profile (such as micro-insurance for high-risk farmer, or micro-savings for medium-risk craftsman) and develop strategies to improve the collection rate as well.

4. Other managerial implications

Formal credit scoring systems are generally more accurate compared to manual risk assessment tools because they rely on explicit risk variables and employ the collective wisdom of all partner microfinance institutions. This helps promote prompt, standardized and reliable decisions, reduces the chance of fraudulent activities and quickly indentifies any negative trends in the portfolio quality, which may be rectified immediately.

To sum it up, here is what Dellien and Schreiner (2005) have to say:

Scoring for microfinance reduces arrears and conserves loan officers’ time, increasing profits and improving outreach. scoring can both increase portfolio size and reduce arrears. With many of the worst loans avoided, portfolio-at-risk (defined as the balance of any loan in arrears) also decreases. (For evidence, read their paper).

Benefits at Macro Level

Following the logic used earlier, if microfinance institutions benefit, the entire financial sector prospers. As mentioned in the Microfinance Hub Blog, credit bureaus encourage MFIs to collaborate through information sharing, instead of competing, and in the long run, the sector can limit default rates, check multiple borrowing and meet its social and financial objectives while ensuring institutional sustainability.

Data mining of credit bureaus not only helps supervise the microfinance sector’s performance but also facilitates economic research geared towards policy improvement. For instance, the pro-active discovery of negative trends, such as the accumulation of bad debt in a particular region, can alert policy makers and microfinance networks/associations and the problem can be address before it becomes a crisis. This was one of the lessons learned from the microfinance crisis in India and Morocco.

One of the reasons large financial institutions avoid lending to microfinance clients is because profiling clients based on personal information is difficult. However, credit bureaus eliminate this problem to a great extent and the entry barriers faced by large banks are lowered.

The result of all this, is a reduction in poverty.

Conclusion

Formal credit scoring processes can deliver numerous advantages, as explained in this article but credit bureaus may never fully replace the traditional loan approval process. This is because individuals characteristics of clients can make a big difference in the high-touch microfinance model. Nevertheless, credit bureaus do alter the traditional model and shift it towards the high-tech approach to consumer loans used by conventional financial institutions (Dellien and Schreiner, 2005).

Next week’s post talks about exactly that – technological elements, processes and key success factors of successful credit scoring systems in microfinance.

Further Reading and References:

Lenisa, F. (2007). The Importance of Credit Information & Credit Scoring for Micro Lending & Microfinance Institutions. Available: http://siteresources.worldbank.org/FSLP/Resources/FrankLenisa_CreditInformation.pdf. Last accessed 30th Oct 2010.

Dutheil, M. (2006). Microfinance Bureaus : Balancing Vision and Pragmatic Solutions. Available: info.worldbank.org/etools/library/latestversion.asp?235943. Last accessed 2, April, 2010.

Dellien, H and Schreiner, M. (2005). Credit Scoring, Banks, and Microfinance: Balancing High-Tech with High-Touch. Available: http://www.microfinance.com/English/Papers/Scoring_High_Tech_High_Touch.pdf. Last accessed 30th Oct 2010.

Importance of Credit Bureaus in Microfinance – Part 1

Credit Information Bureaus (CIBs) are a somewhat new agenda in microfinance, even though they have been an integral part of traditional finance for decades. Quantitative data (income sources, cash flow repayment rate, number of outstanding loans, etc.) used for credit risk scoring of microfinance clients is vital considering the growth rate of the sector as well as the booming competition within. Obstacles related to credit reporting in this high-touch model must be swiftly overcome in order to leverage the huge benefits credit scoring has to offer in the microfinance context.

Four Benefits of Credit Scoring for Microfinance Clients

Microfinance clients stand to gain a lot through the installation of credit rating systems. Here are four benefits:

1. Quick service

Credit bureaus can efficiently provide access to information needed to sort out high-risk clients from low-risk clients. Automation of the loan approval process significantly reduces the time taken to evaluate loan applications, thereby saving the client’s time, which may be better invested in the actual business. The quicker the loan is approved, the quicker the client may start his/her business project.

2. Better financial discipline

Credit scoring mechanisms penalize microfinance (high-risk) clients with poor repayment histories and reward microfinance clients with good credit discipline. Default-prone clients are subjected to unfavourable loan conditions (smaller size, higher interest rate, frequent repayment schedule, etc.), while low-risk clients are eligible to avail favourable pricing structures and better customer service. In other words, credit scoring helps encourage microfinance clients to adopt prudent financial management practices (such as prompt repayment, avoidance of over-indebtedness, reduce chance of personal bankruptcies, etc.) which improve their credit report.

3. Access to more options

Credit bureaus centrally store information about all microfinance clients in a country and this data can be universally accessed by different microfinance institutions. As a result, clients can easily apply for microcredit in different towns or cities and this ‘frictionless transferability of borrowers’ increases the range of MFIs clients can approach (which also encourages MFIs to be more competitive).

4. Fair selection process

There is always a possibility that loan officers manipulate client information in order to favour certain customers, or that loan officers mistakenly refuse credit to valid applicants. This possibility of nepotism and false negatives is greatly reduced if quantitative, non-subjective data is systematically analysed to arrive at a credit score.

Four Types of Benefits of Credit Scoring for Microfinance Institutions

It goes without saying that microfinance institutions benefit if their clients benefit; however, apart from that indirect advantage, credit bureaus benefit MFIs in four areas.

1. Financial benefits

Credit bureaus impact financial statements in three ways: firstly, owing to the theory of economies of scale, credit bureaus reduce the transaction cost of credit risk assessment; secondly, because of efficient loan processing and universal access to client information, microfinance institutions can advance more loans to clients, thereby increasing sales; and thirdly, the microcredit pricing structure is optimized as per client risk (i.e. interest rates and provisioning for bad debts can easily be varied according to the client’s credit score).

2. Risk Management

Credit scoring systems essentially help microfinance institutions manage credit risk, whether the end result is risk mitigation or avoidance. Keeping in view in-depth knowledge of client’s credit histories, high-risk clients may be accepted and put through certain processes to reduce risk exposure.

For instance, client with high outstanding balances can be asked to submit their repayments more regularly, may be monitored more frequently, or may be accepted for small loan sizes only. Greater analysis of a high-risk profile may reveal certain low-risk characteristics (such as promising business plan, expected bumper crop in the next season) that balance out the overall profile and make the client eligible for favourable terms.

As mentioned earlier, the quantitative analysis of risk reduces the chance of mistakes, and this automated risk assessment is carried out at comparatively lower costs.

…cont.

The next post talks about two other benefits MFIs stand to gain through credit scoring systems, as well as the macro-level advantages of microfinance credit bureaus.

ATMs in Microfinance – Part 2

Getting the ATM Solution Right…Cont.

• Usage Barriers – new technology itself can be slightly intimidating, especially for those who are unfamiliar with the English language, which is commonly used in gadgets such as cell phones and ATMs. The rural population in many developing economies may find is easy to operate ATMs through pictorial instructions, or instructions written in their local languages.

• Communication line – ATMs need to send transaction details over a reliable wireless network to the relevant database in order to record debit and credit entries in user accounts, whether they are bank accounts of mobile wallet accounts. A good and cost-effective internet connection is required to instantaneously process data online (an OLAP database may be used). In order to keep internet costs under control, transaction details may be sent to the database for processing in batches, perhaps twice a day (an OLTP database may be used).

• Security and trust – since ATM machines are a modified version of bank branches, they are exposed to criminal theft and misuse in a variety of ways. ATM machines may be tampered to steal ATM cards, funds may be given to the wrong person if the pin-code is misplaced by a user, or currency notes may be stolen altogether. While there are many ways to address these concerns, one not-so-obvious solution is to use biometrics, instead of pin-codes to correctly identify people. Mass usage will only entail once customers trust the technology, and good security arrangements facilitate the development of trust.

Benefits and drawbacks of ATM Machines in Microfinance

ATM networks offer plenty of benefits to microfinance institutions and fulfil the vision of financial inclusion in three ways:

• Cash float management – supply chain management is slightly complicated in mobile banking because of cash-float issues. Mobile banking agents need to keep plenty of cash in hand in order to service cash-out requests from customers, the frequency of which are difficult to predict. As a result, these agents must travel to the nearest bank, which could be several miles away, or be inaccessible in the evening or at night. ATM networks can solve this problem based on their ubiquitous nature.

• 24/7 availability – The day-and-night availability of ATMs offers three benefits:
  • Customers enjoy a great deal of freedom in paying back their loan instalments as they need not leave their jobs/businesses to attend weekly or monthly group meetings.
  • Customers based in regions far and wide can easily access low-cost financial services.
  • These machines replace loan officers to a certain degree (customers can deposit their money on their own) which leaves them with more time to focus on customer acquisition and personalized interactions that have a lot of value.
• Easy distribution of government support funds for the poor, such as social security payments or post-disaster relief assistance.

• Customer empowerment – customers grow accustomed to using an array of services offered through ATM networks, which improves their financial independence, as highlighted in the following excerpt from a CGAP report:

For Prodem FFP, the primary benefit of the ATM network was greater convenience for customers and increased deposit mobilization. Customers used the ATMs for many transactions that previously required staff attention, and were able to conduct business in many locations. In turn, this makes it more convenient for clients to save, which increased the volume of deposit funds available to the institution.

• Safety – Low-income groups usually rely on unsafe means of storing money, such as underneath their mattress, or by investing it in livestock, which may be sold at a later date when cash is needed. ATMs are a safe way to store this money and the service is offered free of cost.

Lastly, here is a video of an ATM prototype that is ideal for the developing world.