Internal Control Perspective: Achieving Sustainable Growth in Microfinance – Part III

This is the third 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. Read Part 1 (Marketing Perspective) and Part 2 (Human Resource Perspective).

Other Non-Financial Internal Matters

Managing information that will improve internal controls, specifically, credit discipline of microfinance providers.

1. Client Analysis and Selection

Short-term incentive schemes (mentioned in the last post) encourage loan officers to acquire as many clients as quickly as possible, and therefore, compromise on quality. Instead of making them more efficient, employees may deliberately shorten or ignore rigorous loan approval procedures because following them takes time, and strict guidelines may reject several applicants. Poor decisions are made as little consideration is given to:

Crucial facts of loan requests,

Repayment capacities of clients,

Viability of business plans, and

Credit history and credit risk.

Some solutions are as follows:

Establish detailed and sound credit policies and procedures, and

Automate approval process so all steps are followed and special concessions are not possible without managerial approval.

2. Multiple borrowing and Credit Pollution

The traditional rule of ‘one loan per client’ is overlooked as microfinance providers compete for a limited customer base in saturated markets. The alternative is to search for new clients in other markets, but that option is more costly in the short-run, and therefore, less appealing. As a result, microfinance shifts from a supplier’s market to a buyer’s market and customer bargaining power rises, because of which, three problems can arise:

Reduced incentive for client to invest loan money into productive uses (because a he/she can easily take out a second loan to pay off the first),

Clients may be inclined to borrow more than they can repay and become over-indebted (simply because they have access to additional funds), and

Clients will not worry about defaulting and losing their credit history with their MFI (because they can get a new loan elsewhere and build fresh credit histories with other MFIs).

Some solutions are as follows:

Establish a centralized credit bureau to gather data about clients, based on their incomes, businesses, occupation, family size, age, present and past loans, skills, etc.  MFIs must be given quick access to this information to make timely, informed decisions that will come in handy at the Client Analysis and Selection stage, mentioned above. (Note: The topic of credit bureaus in microfinance is extensive and complex and deserves an individual post, which will come soon).

Program the organization’s information system to track more than one loan per client (in cases where client’s repayment capacity is adequate).

3. Lax Credit Monitoring and Recovery Policies

Traditionally, loan officers visit clients once a week, or conducted weekly group meetings to work out possible problems and to collect loan installments. However, as MFIs quickly add to their client base, these tasks present logistical and economic problems. Therefore, managers often reduce the frequency of field visits or deploy external agents to conduct group meetings and collect money on the MFI’s behalf. As this responsibility is relinquished to non-employees, so too is control over the process and this decentralization can lead to the following problems:

External agents are in a position to amass more influence over borrowers than the MFI itself (which can be dangerous if used against the microfinance provider), and

Non-compliance with credit procedures, along with possibility of fraud or transactional errors.

Some solutions are as follows:

Install mobile banking solution to deliver cost savings and efficiencies (permit repayment of microloans through mobile phones),

Set up automated payment terminals that reduce frequency of field visits for collection purposes, and

Generate reports that highlight clients who missed payments, so loan officers can prioritize their visits.

4. Poor Informational Flow Between Organizational Functions

As microfinance providers spread out to accommodate more clients, products, workers and markets, they need to efficiently gather and digest masses of information for various purposes, including those mentioned under marketing and human resource issues. Naturally, a manual communication and reporting system will crumble within no time because for the MFI to be responsive and successful, information needs to move between various functional areas and departments promptly, if not in real time.

The solution, of course, is to develop an extensive automated information system.

The next, and last post in this series will discuss various problems a high-growth microfinance provider faces in the areas of auditing and accounting. Read Part 1 (Marketing Perspective) and Part 2 (Human Resource Perspective).

Marketing Perspective: Achieving Sustainable Growth in Microfinance – Part I

It has already been established that microfinance institutes (MFIs) who seek profits through aggressive growth of clients, are at risk as their systems and controls begin to strain under the pressures of expansion. CGAP recently revealed that MFIs in the four countries facing repayment crises (Nicaragua, Morocco, Bosnia and Herzegovina, and Pakistan) enjoyed years of high growth, and then developed vulnerabilities in the following areas:

• Marketing function – rapid rise in client base and delivery channels, steep business targets without laying emphasis on long term client relationships with micro entrepreneurs.
• Human resource function – deficient human resources, short-term & commission-based performance incentives, high staff turnover ratio, and inability of middle management to handle growth of microfinance institute.
• Other Non-Financial Internal Matters – lopsided & disorganized loan approval processes, widespread multiple borrowing and credit pollution, lax credit monitoring and recovery policies of microloans, poor informational flow between organizational functions.
• Accounting function – unsuitable accounting function, poor risk management, incomplete internal audit, and inadequate delinquency management.

Avoiding such hazards is a matter of management wisdom, rather than luck. Proper capacity building, led by an efficient information system that supports the MFI’s strategy and integrates all business processes (finance, marketing, human resource, technology and operations), will ensure sustainable growth due to prompt recognition of threats and opportunities. Various functional pitfalls, as well as their solutions, which have been gathered from the CGAP report and other sources, will be presented through a series of blog posts over the next few weeks.

Marketing function

Managing information that will improve the marketing function of microfinance providers.

1. Sudden Expansion in Client Base and Delivery Channels

With a rapid rise in client base, MFIs need to deal with more individuals, groups, as well as micro enterprises in new locations, through different delivery channels. Each one of these client groups have unique needs, backgrounds, religions, political opinions, working styles, skills, etc. and microfinance providers must be privy to these characteristics so customers can be better served. In other words, high growth MFIs must quickly face the daunting task of information logistics associated with micro-segmentation as its finest.

Some solutions are as follows:

Keep track of customer details and behavior through an information system (both formal and informal) and use it to devise Customer Relationship Management programs,

Link this information system (customer database) to a credit rating bureau,

Detailed analysis of market shifts to identify strategic opportunities and threats, and

Regular review of product performance and value proposition.

Identification of high-value and profitable clients that can be focused on to generate profits.

Details of seasonal spikes and troughs in demand to help the development of customized products.

2. Business Targets and Client Relationships

The high-touch nature of microfinance surges the importance of client relationships. Loan officers regularly visit clients at their homes or in groups, not only because clients value personal relationships over professional ties, but also to ensure everything is in order at the client’s end. Naturally, this becomes difficult and costly once the number of clients balloons up.

Furthermore, workers are rewarded for the quality of their loan portfolios (default rate, loan write-offs, etc.) which often leads to aggressive credit recovery practices by loan officers who are primarily concerned with their own performance, instead of the long-term welfare of struggling clients. As a result, the quality of customer service deteriorates, relationships between clients and MFIs become unsustainable, and credit discipline takes a toll (which will be discussed in a later post in this series).

Some solutions are as follows:

Search for cost savings through technology-led operational efficiencies and not by shifting to a ‘low-touch’ model, which sacrifices control and monitoring,

Establish good quality client service procedures and marketing practices relevant to microfinance,

Regular assessment of social performance(feedback and surveys) to determine client satisfaction levels,

Install appropriate credit  risk management tools to create specialized products and credit recovery procedures for high-risk clients,

Integrate compensation policy with risk management mechanisms, and

Analyze client retention and acquisition rates to determine how much is sustainable.

This was the first 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. The other three posts of this series can be read at the following links:

• Human Resource Perspective: Achieving Sustainable Growth in Microfinance – Part II
• Internal Control Perspective: Achieving Sustainable Growth in Microfinance – Part III
• Financial Perspective: Achieving Sustainable Growth in Microfinance – Part IV.

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.