How Risky Are MicroFinance Clients?

21 02 2009

One of the reasons why so many people around the world are not eligible for traditional credit and financial services is because they don’t have any collateral to offer to the lender.  However, ironically, collateral alone is often not enough anyway. If you look at traditional borrowers in the U.S., who take out mortgages while putting their house down as a collateral or other loans, the default rates are still quite high (even before the crisis)

So is physical collateral a necessity? Or can credit be given without it?

About 2 Percent

One of the big questions that people have when they first learn about microfinance is – what is the repayment rate? Oftentimes, people are sceptical that the poor actually repay their debt.

In general, this can vary from organization to organization, but a 98% repayment rate or higher is typical. In other words, only 2% of the loans or less actually go into default.

So, how can it be that microfinance clients in Tajikistan seem to be more likely to repay their loans that typical borrowers in the U.S.? What measures do MFIs take to keep their portfolio-at-risk numbers low? What can be effective means of collateral when there is nothing physical a client can offer to the lender?

Solidarity Guarantee

One of the most common techniques used by many MFIs to secure their loans is to lend through groups, where every member of the group is responsible for the group’s repayments. In other words, if one borrower fails to repay, the others have to cover for him or her or the entire group suffers.

Why does that work? In part, because the groups do their own, internal analysis to determine who is trustworthy and who they will accept into the group. And secondly, when people have very little, the most important asset they hold is their reputation, so they have an additional interest in repaying their loan to maintain that.

Small, 3-person group. They can range from 3 to 10 people.

Small, 3-person group. They can range from 3 to 10 people.

One of the credit officers told me a story about a client who was late on her payment. The loan officer went into her village a few times to tell the borrower about the consequences of a late payment. After a few visits, the borrower came into the office to pay up and asked him not to come to the village anymore because she was afraid of what people would think if they’d find out that she was late. Reputation matters.

One step at a time

Solidarity and reputation are important factors, but they are not the only motivators. Many new clients typically start off with small loans at first and need to prove their repayment ability before gaining access to larger amounts and better interest rates. At my MFI, it’s not uncommon to see clients on their 6th, 7th or even 9th loans – each one larger than the previous one.

One client that I’ve met (below), received her first loan for about 1,000 Somoni (300 USD), her 2nd one for 3,000 Somoni (900 USD) and was currently applying for her 5th loan for 5,500 Somoni. In a sense, this is a way for people to build a credit history in places where credit agencies, like Experian and TransUnion in the U.S., do not exist.

Lola Toshmatova, a bulk sunflower seeds saleswoman, is now on her 5th loan

Lola Toshmatova, a bulk sunflower seeds saleswoman, is now on her 5th loan

Keeping your clients close

A very interesting risk-reducing technique that I observed at my MFI is the monitoring system that the credit officers have in place. For every new client that comes onboard, the loan officers visits them several times right after dispersing the loan to ensure that the loan was used correctly. But, moreover, they follow up with quarterly visits to evaluate the business and ensure that everything is going smoothly. This way, any problems are identified and dealt with early on.

I’d say that this level of attention is pretty unheard of in the United States. After all, when was the last time that the person at your bank visited you after you took out a mortgage or a student loan to see how you’re doing. Even though, the loan sizes here can be 100 smaller than in the West. Although this is a time intensive endeavor, this is one effective strategy to stay on top of your investment.

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2 responses

21 02 2009
Andrey

Well, Boba, I think you have a overly simplified view of the American credit system. In your example of the college loan, there is no need to come visit you. The money is being paid directly to the school, you don’t get a check in your mail that you can spend some other way.

Also, when my parents took out a business loan for their dental practice, they were given an account manager who advised them and visited them a few times in the office. Furthermore, once again the money was never given to my parents. There was a credit line and every invoice they needed to pay had to be approved by the bank.

If we assigned a loan officer to every 40 clients of citibank or bank of America, we’ll need millions of them.

You can argue that dept was overleveraged, there was too much securitization and the credit rating agencies were out of control. But I don’t think that many of the microcredit practices are parallel or even applicable to the financial sector in the West.

22 02 2009
Boba

Hey Andruha,

You are correct – I did present an overly simplified version of the American credit system. I didn’t intend to imply that the U.S. system is inferior – quite the opposite.

But the point that I did want to stress is that it would be very difficult or even impossible to replicate it here, so different solutions were developed.

Interestingly enough, after I wrote this post, I met up with my landlord – who used to be on the Board of Directors at a fairly large commercial bank – and he was telling me that “loan repayments” are a big problem here. In his words, Tajikistan has long been supported on aid and donations and people developed a “mentalitet” that things don’t have to be paid back. So, in his experience, getting people to pay back their debts has been a huge problem – especially during the civil war.

Borya

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