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.