In this LessonMicrofinance institutions offer their clients loans using specific lending technologies, or methodologies. These processes by which loans are delivered, aim to increase the value of the product to the client, while simultaneously decreasing the risk and the costs to the institution. MFIs have accumulated strong experience in various methodologies, and there are as many methodologies and adaptations as microcredit operations. Effective methodologies have three things in common: they adhere to basic microlending principles, they adapt to fit the customers’ preferences and they are suited to the capabilities of the institution to manage the products and services.
Like all markets, credit markets have suppliers (lenders), customers (borrowers), and goods and services (loans). The interaction between lenders and borrowers determines the price (interest) and the quantity (number of loans). The existence of incomplete information poses a problem for reaching the most satisfying outcome for both parties. On the one hand, lenders do not know which borrowers will repay their loans; a problem of adverse selection might arise. Setting a high interest rate might adversely select for those who present a higher risk, resulting in unacceptable levels of delinquency and default. On the other hand, once a loan has been disbursed, it becomes difficult to monitor the borrower’s behaviour. Again, a higher interest rate could pose a moral hazard problem, inciting borrowers to undertake riskier investments, with higher chances of failure, and thus lowering the likelihood of their actually paying the price in the loan contract. Moral hazard derives from the fact that the borrower does not bear the full consequences of any loss in the asset that he holds of another, in this case the lender, and may therefore endanger the value of that asset. Moral hazard problems are also prevalent in deposit taking intermediaries. An excellent discussion of adverse selection and moral hazard can be found in Rodrigo Chaves and Claudio Gonzalez-Vega’s article listed in the Additional Reading section.
MFIs have developed lending technologies to help overcome credit market information problems, enhancing the value of the product, while limiting the risk to the institution. A variety of such measures can be seen in both group and individual lending methodologies. Measures may include informal collateral with great intangible value to the borrower, peer pressure in solidarity groups or the local community, and forced savings deposits. One of the strongest incentives is the dynamic one: access to continuous and possibly larger future loans. Only permanent, financially viable institutions, however, can avail themselves of this repayment incentive.
Access to financial services involves more than just financial costs. Accessing financial services can have much higher costs to the borrower than the interest rate. These costs are often neglected when calculating the total cost of a service. Bus fare and notarized documents can add to the total cost of the service. Reducing the MFI’s distance from its target market allows users to access these services at a lower cost. Likewise, keeping the number of formal and costly steps in processing a loan application to a minimum means a less expensive service to a borrower. Group meetings and time spent away from the business represent lost income to a client, indirectly increasing the cost of the service. Additional costs borne by the client and not part of the MFI’s income do not benefit the institution, and make the service more costly for the client.
Development programmes often use targeting to reach an intended population for their services. Methods vary widely according to the type of service delivered, but all are designed to limit access to those outside the target group, and increase access to those within it. Some microfinance programmes use targeting to reach a specific group by using directed measures such as wealth ranking or screening on the basis of gender, economic activity or total assets held by a household. This type of targeting increases costs to the MFI and detracts from basic principles of flexibility and convenience of service. More appropriate methods are market driven, such as locating MFI offices in poor neighborhoods close to potential customers, effectively raising the costs to those outside the intended market, while simultaneously increasing convenience to the intended market. The most effective way to target a particular market segment is to design products that will attract the desired market as customers.
High dropout rates plague a number of MFIs. Even those undergoing extensive expansion may experience significant dropout, without realizing it. Simply tracking portfolio growth does not tell the MFI about who holds outstanding loans. The term ‘dropout’ covers a variety of cases. Sometimes, clients are simply “resting” between loans; their cash flow or current economic opportunities may not call for a new loan. Other times, clients may leave an institution because its products and delivery do not match their needs; in other words, they perceive the product or service as undesirable. When there is competition, clients have a choice to borrow or save with a variety of institutions. Whatever the cause, understanding the factors belying dropout will help an institution uncover the limitations of its current products and methodology and adapt these to the financial service preferences of its customers.
This lesson presented two major types of microcredit methodologies: individual and group lending methods. While an MFI must adapt either methodology to fit its market, environment and delivery capacity, it must also consider the advantages and drawbacks to each type of methodology.
Lending through groups can offer MFIs an efficient way to reach large numbers of poor borrowers who may not possess traditional forms of collateral. Group lending allows the MFI to shift certain costs of administration and lending risk to the members of the group. Many aspects of group methodologies save time and money for the institution, and allow them to operate at a lower cost. These include such features as group screening and a single disbursement and repayment collection for a group, which lowers the transaction costs for the institution by allowing it to administer a number of loans, through a single contact. However, lower costs are not a guaranteed feature of group lending. In some cases an MFI may spend more time and money trying to organize and keep groups together than if individual loans were offered to the same clients.
The joint and several liability of the group or repayment responsibility of the village bank also allows an MFI to reduce its credit risk. As clients take on larger loans and larger and smaller loans are mixed within the same group, the social capital that underlies this joint liability begins to strain. Clients become less willing to underwrite the other group members’ loans. Group loans can also be more susceptible to contagious delinquency. Likewise, when designing standard group lending products, the MFI must strike a balance between an institution-centered and a client-centered approach. While group loans of fixed sizes and stepped increases may allow an MFI to manage its risks, it may not match the clients’ needs for financial services. If given the opportunity, many group members would prefer an individual loan, counting on their own ability to repay the debt, rather taking on the risk that other members of the group will run into trouble and need to access the group guarantee. Some institutions develop individual lending products as a separate loan offering; others develop them for ‘graduates’ of their group lending methodologies. The latter approach offers the MFI a credit history on which to base its decision for an individual loan. Individual loan products allow more flexibility to address the particular financial service needs of customers. Terms and amounts can vary according to the type of financing needed, and are more closely matched to the needs of the client. Individual loans normally do not come at a small price to the institution. They can be more costly to administer because they involve more detailed screening by the MFI staff and involve an analysis of the client’s household economic portfolio and investment opportunity. Loan transactions are not streamlined through groups. As a result, MFIs tend to offer individual loans for larger amounts, or provide individual loans using a group meeting as a convenient place for disbursement rather than using a group as an on-lending or guarantee mechanism. Increased efficiency and productivity measures through technology and minimal paperwork for second and subsequent loans also help the institution control administrative costs.
“Evolution of Credit Methodologies Concept Paper”, Microenterprise Best Practices, Concept Paper Number 12, March 1997.
“Principles of Financially Viable Lending To Poor Entrepreneurs”, USAID Microenterprise Development Brief Number 3, February 1995.
GTZ. “Comparative Analysis of Savings Mobilization Strategies,” CGAP, 1997. (*)
Churchill, Craig. Client-Focused Lending: The Art of Individual Lending, Toronto: Calmeadow, 1999.
Chaves, Rodrigo A. and Claudio Gonzalez-Vega, “Principles of Regulation and Prudential Supervision and their Relevance for Microenterprise Finance Organizations,” in Maria Otero and Elisabeth Rhyne (eds.), The New World of Microenterprise Finance: Building Healthy Financial Institutions for the Poor. West Hartford, Connecticut: Kumarian Press, 1994, pp. 55-75.
Robinson, Marguerite S. The Microfinance Revolution: Sustainable Finance for the Poor. Washington, D.C.: World Bank and Open Society Institute, 2001.
Yaron, Jacob, McDonald P. Benjamin Jr., and Gerda L. Piprek. Rural Finance: Issues, Design, and Best Practices. Environmentally and Socially Sustainable Development Studies and Monographs Series 14. Washington, D.C.: World Bank, 1997.
Bhatt, N. and S. Tang. “The Problem of Transaction Costs in Group-based Microlending: an Institutional Perspective,” World Development, 26:4 (1998), pp. 623-637.
Read the following two scenarios describing different lending operations and credit methodologies. How might these be streamlined and adapted to clients’ demand?
Read the following scenario about a microfinance client, her needs and the lending methodologies available to meet those needs. What service would you choose for her?
Below are three various methodologies of MFIs operating in the neighborhood where you live and work. Whose services would you prefer? What do you like most/least about each methodology?