Importance of Third Party Technology Players in Microfinance

One may appreciate that despite numerous challenges, the microfinance sector at the global level, over the last three decades, has experienced a sustained growth. However, the original objectives of microfinance and the business models adopted by a number of market players did not complement each other as some microfinance institutions saw this as an opportunity to maximize the return on their investment, instead of optimizing it. In support for this approach, some stakeholders may seek refuge in higher risks associated with microfinance lending as well as higher operational costs for doing the business; however, a number of risk mitigation options are now available to such MFIs.

Since the microfinance sector has been a seller’s market and consumers with no alternative were receptive to any financing options offered to them at the seller’s (microfinance institution’s) conditions. The microfinance sector is still largely an unexplored world with tremendous potential and it was eventually realized that microfinance clients need to be served in new ways, with new tools and products.

Initially, a number of microfinance institutions, some with a view to make quick money and others willing to make a positive difference, entered the field with great ease and aplomb but little or no tactical tools to assure and sustain their growth. These players having suffered from a lack of efficiencies and without operational controls or risk discipline indulged in wayward financing that not only harmed themselves, but also their clients.

However these experiences underscored that the latest challenges for the microfinance business world were:

• Risk management,
• Ever-increasing operational expenses,
• Outreach to far-off areas
• Difficulties in repayment process, and
• Loan recovery processes.

Therefore, issues like business efficiency, reduction in operational costs, software development and communications are becoming increasingly relevant to the success of microfinance.

There are two ways to overcome these challenges:

• Invest substantially in relevant business areas which, at the end of the day, would affect return on investments (ROI), or
• Engage third party players that offer specialized services related to overcoming these challenges.

Whichever path is taken, it can be safely assumed that today, for the success of any microfinance business model, the role of third parties is becoming increasingly important.

Similar to commercial banking, the dynamics of microfinance needs better technical tools for almost every step of the model, be it evaluation of prospective borrower’s profile, monitoring of repayment schedules, anticipating impending threats and taking remedial measures.

Understandably, credit bureaus are well positioned to fill in this void as they have the infrastructure in place and by adding information regarding microfinance borrowers and other clients, credit bureaus can offer to significantly reduce credit risk for microfinance institutions. Real time integration between credit bureaus and MFIs is enabled through the telecommunications sector, which also have a role to play in enhancing service outreach while controlling transport and other costs. Mobile banking can significantly lower the cost of delivering these services, as stated in a recent CGAP report.

In today’s business, manual or semi-computerized environments in microfinance institutions is a recipe for disaster. Only sound office management policies and operational controls can ensure effective risk management and reduction in administrative expenses. However, improving business efficiency often requires investment in software development and communications and that is where the real obstacle lies, because capital cost of such inputs is beyond the capacity of most microfinance institutions.

In such a scenario, specialized third party solution providers (be they manufacturers of off-the-shelf solutions or software hosted in the cloud) emerge as viable alternatives. These outfits have in-depth knowledge about microfinance as well as ability to service numerous customers under bilateral fee based agreements without compromising the information security of the constituents.

Such an arrangement, on one side, enables microfinance institutions to avoid related capital cost for technological implements and on the other, improves capacity building processes within the organization, and allows them to focus on their core business.

While operational efficiency and telecom related solutions are easy to handle, presently the concept of cloud computing is likely to face two major obstacles:

• local regulations for microfinance institutions vary from country to country,
• under the existing mind-set, microfinance institutions prefer to have physical control over their database.

Naturally, the first challenge is far easier to overcome than the second.

People are normally resistant to change so it would entail a long continuous awareness campaign on part of stakeholders (technology firms, microfinance investors, etc.) to change the psyche of microfinance practitioners engaged and to convince them that the emerging role of specialized third party players is going to change the dynamics of microfinance in favour of the MFIs.

Credit Scoring in Microfinance – Collecting Data and the Role of Technology

We have previously looked at the various benefits credit bureaus could deliver to microfinance clients, microfinance institutions, as well as to the entire economy, as well as ways to overcome challenges associated with credit bureaus in microfinance . This week we look at the variety of information sources used in credit scoring and the role of technology in this system.

Collecting Data for Credit Bureaus

Credit agencies typically develop credit data and risk profile based on data obtained from a variety of sources, such as banks, retailers, utility companies and government agencies; however, these sources are not always applicable in the microfinance context. The high-touch nature of the microfinance model means loan officers personally gather such information by analyzing the applicant’s business and family demographics. Even if all this information is freely available, which is often not the case, this leads to a more qualitative credit profile, rather than a quantitative credit score, giving way to accuracy problems.

Microfinance credit bureaus eliminate these problems, as loan officers instantaneously gain access to a wide array of verified information, allowing them to take well-calculated risks.

A variety of data may be amalgamated by credit bureaus, and updated regularly, to create reliable credit risk scores. These include:

Financial information about microfinance clients

• About the business: type, length, financial statements, outstanding dues to suppliers, receivables from customers, mobile banking accounts
• About the credit history: Number of previous loans (from all microfinance institutions), total outstanding loans, missed loan repayments, late repayments, on-time repayments and repayments made before schedule, nature of loan collateral, number of scheduled installments, details of previous affiliation with other microfinance institutions, nature of loan contract (group based or individual, and performance against each type of contract), types of loans taken out (housing loans, education loans), other financial products used (micro-savings, micro-insurance, etc.)
• About the family: assets (such as telephones, ownership of house), businesses run by members
• Other: any previous fraudulent behavior

Non-financial information about microfinance clients

• Identification information (to eliminate chance of fraud), family size and particulars of members
• Education and age of client, as well as length of time spent as client

Role of Technology in Microfinance Credit Bureaus

A solid information system is at the heart of a credit bureau, considering the plethora of information gathered and analyzed by these systems on a regular basis.

Microfinance Credit Bureau Architecture

The diagram briefly explains the information flows in a typical credit scoring setup (considering an external credit bureau is involved). Initially, the microfinance credit bureau database is loaded with information from various sources (banks, government, microfinance institutions, mobile banking firms, etc.) to form risk profiles, which are shared with loan officers from different MFIs, as and when requested. Since the communication channel is two-way, information about microfinance clients (new clients, loan repayments, etc.) is regularly sent to the credit bureau in different ways, as discussed later.

Client data is private, and is therefore sent in a secure environment where information is encrypted and password protected. At the same time, the credit bureau must ensure compliance with the regulatory framework of the company it operates in.

Nature of System Integration of Credit Bureau with Microfinance Institution

Credit bureaus can be integrated with the information systems of microfinance institutions in a manner that caters to the informational needs of loan officers. There are two basic types of system integration in this case:

• Real time information sharing: the credit bureau database can be linked directly with the core system of (large) microfinance institutions to instantaneously update the credit profile of borrowers.
• Intermittent information sharing: light-volume (small MFIs) users automatically transmit client information through internet connections in batches, at the end of the day, or when authorized. Similarly, when loan officers wish to determine a client’s credit score, they may send hundreds of queries in a single batch, or make individual inquiries. In return, microfinance institutions may simply receive blacklists of clients with poor credit scores, or detailed credit reports.

Having said this, the information system provider should preferably have a history of managing large sets of data, and attention should be paid to whether the firm has the relevant skills and capabilities of delivering such a complex project.

Reference:

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

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.

Financial Perspective: Achieving Sustainable Growth in Microfinance – Part IV

This is the fourth part of a four-post series that discusses capacity building measures which microfinance institutes (MFIs) must take to ensure their high growth rates are sustainable.

Accounting and Auditing

Managing information that will improve the accounting and auditing functions of microfinance providers.

Problems related to the accounting and auditing functions of high-growth MFIs are rather straight-forward:

Quick disbursement of larger loans may present difficulty in maintaining accuracy and transparency,

Rapid rise in client size, branch network, and loan portfolio can flood poorly developed or manual accounting and administrative systems.

Each microfinance product (business loans, housing loans, consumption loans, micro-savings, micro-insurance, etc.) requires unique handling in the accounting system.

MFIs need to keep track of their own costs and performance, and ensure their own creditors and investors get the return due, in the form of interest or profit.

Growing delinquency rate as a result of poor credit control.

As expected, these points stem from decisions about marketing, human resource, and internal control functions because they all impact an MFI’s bottom line. The solution to these problems, therefore, is twofold:

Establish automated reporting and auditing mechanisms that bring any anomalies or problems to the attention of managers, and then,

Rectify the main causes of these anomalies and problems (mentioned under human resource, internal control and marketing solutions in earlier posts).

The first point is detailed below:

1. Regular Reporting About Various Business Areas

The management information system must be programmed to generate daily, weekly, monthly and yearly reports about managerial and financial data, such as:

Loan portfolios of individual clients, workers, branches, and markets,

Market penetration statistics,

Client data pertaining to geographic concentrations

Credit ratings of each client, from internal and external credit information bureaus,

Interest receipts and dues (loan tracking)

Late payments, overdue loans portfolio and updated ‘portfolio at risk’ figures,

Provisions for bad debt,

Loan write-offs, against each client and market, and

Performance of each product, etc.

Accurate and timely reports summarize a microfinance provider’s overall performance and highlight critical trends, specifically in terms of loan delinquencies, which serve as a warning against the threat of a repayment crisis. Alternatively, positive trends can be discovered, such as under-served markets, which promise to yield long term benefits for MFIs.

2. Internal Audit and Credit Risk Management

MFIs can minimize the frequency of deliberate errors (fraud, covering poor company performance or preferential treatment of certain clients), as well as accidental mistakes (during manual bookkeeping), if they follow strict internal auditing practices. Once full disclosure of financial performance, accounting policies, internal controls and risks are out in the open, managers can quickly take control and rectify the situation.

3. Delinquency Management

Although delinquency management is largely the function of internal credit controls (minimizing defaults), a small part of it actually falls within the financial terrain of ‘determining a sustainable interest rate’. Calculating the cost of credit to the poor is a complex task since it depends on various factors, such as operational costs, cost of funds for the MFI, contingency reserves, tax expense, credit rating, and profit, etc.

Furthermore, once interest rates have been set, possible variations on an individual basis may be necessary, depending on risk or other factors. For instance, after natural disasters strike, some borrowers may request that their loans are either rescheduled, or waived altogether, or even that new loans are distributed to cover the loss.

MFIs must realize that such restructuring often conceals poor portfolio quality, and unless robust information systems are in place, trends in delinquencies will keep rising, until the organization is faced with a full-fledged repayment crisis, as in Pakistan, Nicaragua, Bosnia and Herzegovina and Morocco.

This concludes our series of posts about the role of technology in ensuring sustainable growth for MFIs. The next blog entry will discuss the importance of management information systems in delivering cost savings and bonding together the microfinance provider’s business. You can previous parts on the following links:

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.