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.

Technology is a Crucial Element for Microfinance

Intelligent design is the answer.

Internal Control in Microfinance

In certain economies, the microfinance sector is at the risk of implosion as reckless growth in lending portfolios of microfinance providers has brought on a repayment crisis, marked by high default rates. These incidents demonstrate that mere growth is lethal if it is not backed up by institutional and technical capacity building to deal with the growth. Prudent policies and procedures, which integrate the expansion of each organizational discipline, go a long way in protecting microfinance institutes from biting off more than they can chew, and risking the impairment of their loan portfolios and the well-being of their clients. As a result, MFIs must start investing time and money into strengthening internal control systems that are backed by appropriate technology solutions.

Improving Management and Generating Returns for Investor

Technology is more intrinsic to microfinance than we realize. Impressive repayment rates have now caught the eye of investors who are willing to provide much needed capital in return for social and financial gains on their funds. Unfortunately, since a majority of microfinance providers rely on manual bookkeeping, this high-touch, volume-based business model prevents them from gaining efficiencies and keeping costs under control as their client base grows. The alternative sources of profit are higher interest rates and service charges, but they are undesirable in the social context of microfinance.

One solution is to adopt scalable microfinance information technology that not only delivers cost savings, data security but also provides absorbs masses of data in order to provide accurate and timely reports for better managerial decision-making. Such information systems may be developed in-house or by an external vendor, which enables microfinance providers to focus on their core business.

Serving Needs of Micro Entrepreneurs

Speaking of core business, MFIs are eager to explore different geographical markets and cater to each segment’s varying needs with customized products. The explosive growth of mobile banking in Sub-Saharan Africa is a telling example of how the right strategy, backed by the right technology, can open new horizons for microfinance providers. Specialized information systems not only cater to each MFI’s unique processes and each market segment’s nuanced characteristics, they also allow MFIs to experiment with product elements and tweak them to suit client needs.

Managing Credit Risk

Another tool that ensures MFIs expand in a manner that is cautious enough for clients, yet rewarding enough for investors, is a microfinance credit bureau. By developing risk profiles of individual borrowers, credit bureaus deliver immense short term gains, which include:

• Better understanding of clients and their needs,
• Improved Know your Customer (KYC) implementation,
• Lower cost of credit for low-risk clients,
• Product customization according to risk profile,
• Reduced transaction cost and quicker loan processing in the presence of immediate risk profiles,
• Prompt credit collection as borrowers seek to improve their ratings, and
• Better portfolio management with the removal of risky loans.

These benefits yield long term gains, such as:

Greater credit discipline as multiple borrowings are prevented,

Responsible finance, marked by better decision-making and safe portfolio growth,

Better supervision of sector by investors and regulators,

Greater availability of information, which will attract competition, and

Improve financial and social performance of the MFI itself

The role of technology in microfinance, in terms of each area discussed above, will be discovered in upcoming posts on this blog. Indubitably, the possibilities for innovation, growth and impact are immense, and the power of technology can be leveraged to deliver the ‘intelligent design’ needed to help microfinance achieve its potential.

Further reading:

Neralla, D. (2010). Adopting ASP Model for Cost Effective Technology Solution in MFIs.Microfinance Insights. 16
Dutheil, M. (2006). Microfinance Bureaus : Balancing Vision and Pragmatic Solutions. Available: info.worldbank.org/etools/library/latestversion.asp?235943. Last accessed 2, April, 2010.