Microfinance: part 2: why and how

RMA Journal, The, June, 2004 by Gail Buyske

Part 1 of this article introduced the microfinance industry and related the impressive experiences of some of the largest microfinance lenders. Part 2 addresses the keys to successful microfinance lending, other developments in the international microfinance field, microfinance today at major international banks, and microfinance in the U.S.

What can Bank Rakyatt Indonesia teach us? Perhaps you might say, a lot about a little. Its $1.3 billion loan portfolio is made up of loans averaging just $440 each. Here's the kicker: Despite 65% growth in this portfolio over the past two years, BRI's loans-past-due ratio is 4.37%. (1) The experiences and lessons learned by BRI and others can tell us a good deal about serving low-income and poor populations profitably.

Microfinance is based on sound lending practices that seem disarmingly simple. In effect, microfinance reteaches us what we already knew about good banking, but also shows us that it can be applied to a population that most commercial bankers previously thought unapproachable.

It's important to understand that the majority of microfinance programs are initiated with financial and technical support from international donors. This support helps microfinance lenders achieve the economies of scale necessary for sustainability as well as for sharing international best practices. Support in the form of subsidized interest rates, however, is not encouraged because they ultimately compromise the financial sustainability of a microfinance program. Several key characteristics are shared by successful microfinance programs worldwide.

Ensuring Loan Quality

Cash flow analysis. Undeterred by the typically rudimentary information available, microfinance lenders construct a cash flow analysis of the borrower based on simple observation of the borrower's business, comparatives (such as typical profit margins) for other borrowers in the same business, and review of the borrower's formal and informal financial information. In addition, it's essential to probe into the borrower's other obligations: One of the most common reasons for default is the borrower's lack of candor in this area.

Character analysis. Character analysis is an unavoidable aspect of microfinance lending. Many borrowers do not have a track record and credit bureau records for them often do not exist. Some successful microfinance programs even include a visit to the borrower's home as part of the analytical process, because such visits can provide valuable information about the borrower's standard of living (and thus how much money might be taken out of the business), possible collateral items, and a general sense of the borrower's personal life.

Frequent loan repayments. Loan payments can be as often as daily; more often, they are weekly or monthly. Such loan repayment schedules are important both as a monitoring function and as a means of training the borrowers--who often have never borrowed from a formal financial institution--in financial discipline.

Zero default tolerance. Successful microfinance loan officers follow up personally with delinquent borrowers within 24 hours of the delinquency and, depending on the reason for the late payment, may initiate liquidation of the collateral. The combination of regularly scheduled principal payments and zero default tolerance is critical in impressing upon borrowers the seriousness of their financial commitments.

Loan officer incentives. Loan officer compensation is structured to reward timely repayments, with as much as 50% of compensation based on portfolio performance. In addition, compensation is adjusted on every payday, thus providing strong near-term incentives to meet--and exceed--performance guidelines.

Capturing cash flow. New borrowers are required to funnel the majority of their turnover through the lender's account facilities. In addition, some programs (particularly for group lending) have mandatory savings requirements for borrowers.

Maximizing Productivity

Decentralized decision making. Ongoing efforts are made to maximize decentralization of decision making, recognizing that quick loan decisions (same-day turnaround is not uncommon) can be critical for small traders operating with limited working capital and thin margins. Decentralization also keeps the decision makers close to the borrowers and enables them to respond quickly to changes in borrower or overall market conditions.

Loan officer productivity. Even though loan officer salaries in emerging economics are relatively low, the small size of the loans still requires high levels of loan officer productivity to achieve financial sustainability. Ratios of 100 and more loans per employee are typical for the most experienced lenders, with the Equity Building Society (EBS) of Kenya achieving a high among MIX members of 838 loans per employee. (2) The loan officer compensation programs noted above also contribute to maximizing productivity.

Encouraging repeat borrowing. Maximizing repeat borrowing helps amortize the time spent on developing a relationship. Microfinance lenders sometimes make advance commitments so that borrowers know they will be able to borrow a larger sum of money after they successfully repay their existing loan.