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 – 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.