Introduction:

The micro credit institutions have matured from an NGO related activity to full-fledged lending institutions. Obviously the social business started off as a part of NGO portfolio, as there was a need for establishing relationship with people, at the grass-root level of the economy, who were economically and perennially poor.  Door step lending and collection is the hall mark of micro credit operations in India. The rural households were willing only to spare their time beyond the farm-hours and refused to undertake documentation on account of illiteracy.  Also, it is easy to perceive that the business and its operations are prone to risk as there is no other security other than the honesty and peer-pressure of the borrowers.  While these being the inherent restrictions and risks associated with micro credit lending, it becomes incumbent to measure performance of the business both in terms of risk and growth.  An attempt is being made through this article as to how measurements are made and perceived in this industry.
 
Micro credit institutions assume collection arrears and default risks as a bane to their business.  Hence, more often than not, exercises are performed to recheck portfolios for the defaults.  Reduction in arrears is a healthy process for the institution to become self sufficient and liquid.  The more the arrears, the probability of safety reduces.  Mounting arrears without action has a contagious effect across a portfolio, geographical region, or on the psychology of the ground staff, thereby setting in lethargy among them and the financial vibrancy of the institution.  Sickness sets in as the institution normally deals with people who are poor and have not asset backing to secure the borrowed amount.  It is often seen that on account of poor documentation, absence of any assets with the borrower for recovery, illiteracy and quantum of each loan being too meagre, there is no recourse to legal actions.
 
In view of the above impediments, it is often believed that a constant vigil over the portfolios will reap rewards for micro credit activity over longer periods.  Hence, measuring performance and risk should be a constant endeavor and a perceivable activity among micro credit institutions in India.

Delinquency the top most priority:

The topmost priority of any micro credit institution is to identify delinquency.  When one talks of delinquency in this industry, it means the misconduct or non-performance of a loan, a loan portfolio or the difficulties encountered in recovering loans.  It has a historical background, wherein NGOs often had donor funds and were not serious if a loan happened to go bad.  The money they received was donor’s funds and the donor was not expecting a repayment or a refund.  It was never earned in its true sense.  Often borrowers sensed this opportunity and refrained from paying it back.  Again, historically, small loans have political overtones of repeated write-offs, and the courage posed before the bankers extend to all kinds of loans, even those of micro credit institutions.  By habit and culture, the borrowers are influenced to default.  Of course the reasons could be many more, including household and personal crisis, borrowing more than what can be repaid and multiple loans from different borrowers, loans given without adequate appraisal and refusing to pay because of geographical and location crisis, either political or otherwise.

As in any other businesses, customers tend to pay for the services or supplies on the assumption that they will be continuously served as before.  It is also an expectation that the wish list will keep expanding to meet the entrepreneurial requirement.  The risk shifts from the business entrepreneur to the lending institution. Any deviation from this expectation or a small shift in the service provided to the detriment of the borrower, has a serious repercussion on the relationship and hence the recovery of the loan.

The general practice that is being followed in the industry to measure delinquency is of three types:

Let us analyze what they actually mean and their importance to the lending institution.

Repayment rates: This ratio indicates how well the institution is doing in terms of its collection.  It is the expectation of every micro credit institution that loan amounts are collected/ repaid on the respective due dates, either weekly, fortnightly or monthly, as prescribed in the loan documents.  We all know that it is not possible to service the debts on the respective due dates unless there is a constant stream of revenue flow.  More so is the case with the vulnerable and the poor.  It is a ratio between amounts collected and amounts that have fallen due.  It is  ratio that indicates the willingness of the borrowers to pay or the earnestness of the officials to collect.  It is more a relationship that predicts a good collection ratio.  When the loans are at its infancy, or they have just been borrowed, it shows a healthy picture as the borrowers want to play a safe game with the institution, for more facilities in the future.  But as the portfolio moves further, there is a tendency for the ratio to deteriorate.  The portfolio gets tired and greater efforts are required to get it on track.  This measures the efficiency of the collector and the willingness of the borrower at any given point of time.  A critical peep into this ratio will help in determining the corrective course of action into the future.  This also helps in determining the effective portfolio flows for future funding programs.

Arrears rates: Arrears as we understand are that portion of the loans that have gone beyond the due dates and have remained unpaid.  This ratio is determined by finding out what portion of total loans has become overdue.  In other words it provides a ratio overdue loan to total loans.  While the collection rates describe the amounts collected against what is collectable, both past and present (indicating efficiency in collection), the arrears rate indicates the deterioration of the total loan portfolio.  If interest is recognized as income, the interest arrears are also reckoned into the ratio, with loan portfolio in the denominator also increasing to a similar extent.  

Portfolio at risk (PAR): It is defined as the value of outstanding loan balances that are in arrears (principal only) to the total portfolio outstanding at present.  It is expressed as a percentage.  The formula is stated as follows:

Unpaid principal balances remaining in arrears/ total of all loans *100 [interest is not considered here]
It helps one to analyze the default trend of a portfolio, of a region, geographical location, etc., and helps in comparability of portfolios.  One can lay down standards to determine the risk appetite the lending institution is willing to have.  PAR by itself is a broad indicator and may need analysis before the ratio is accepted to ones satisfaction.  PAR is calculated for different periods to understand this ratio for different ages of loan defaults as tabled below:
 

 
This can thus be computed for any other period as above.  The ratios can be made to look healthy, if the terms of repayment are altered in favor of the borrower.  Anything that has the object of altering the numerator or the denominator has its effect on PAR.  It is therefore important to understand the fundamentals before relying on PAR absolutely. If one were to consider the micro credit loans as an investment portfolio, then any failure to recover them along with interest will be deemed that it has not met its financial objective and therefore a certain portfolio is at risk.

It is common to see PAR being manipulated by excluding renegotiated loans and by writing-off bad loans from the portfolio.  While PAR is a good indicator, one must be careful of its abuses. It is therefore good to address this by seeking for write-off ratio as indicated below:

Write-off Ratio = Value of loans written-off during the period/ Average gross loan portfolio in the period

Measuring loan size for the customers:   As per regulations, micro finance has a limitation on its lending among its customers. The conditions prescribed for a qualifying asset includes:

 
 
Subject to the above limitations, there are tests to be conducted for the appropriate loan size.  Assuming that the loan is from a product portfolio of the micro credit institution, it is important to measure the loan size for the borrower. What are the measures that are sought after? They include:
 

The loan officer tries to understand the requirement of a loan and the capacity of the individual are the group (joint liability groups of 5 to 8 people or the self help groups of 10 to 20 people) to discharge the loan obligation.  He/she collects sales, liabilities, assets and the borrowers past performance to determine and judge what amount needs to be advanced.  Here the repayment capacity is determined by understanding the average monthly payment to estimated sales and profits from the entrepreneur’s endeavor.  The repayment ratio to sales should not challenge reinvestment and livelihoods options of the borrower.  If this is not carefully scrutinized, obviously the debt is going to turn out to be a bitter pill. 

When we discuss about debt-equity information, it is a rudimentary step in understanding the credit-worthiness of the borrower.  The net-worth of an individual or the group has a greater role to play in increasing the risk appetite of the borrower and hence the capacity to borrow more.  This also provides data for the Micro Finance Institution (MFI) to take risk along and for the entrepreneur.  Any increase in leverage of debt to equity increases the risk for the MFI and that needs to be carefully guarded either by measurement or by the gut feel.

Although it is well known that micro lending is a character based loan, which assumes that a man of good character is likely to return the loan in good faith, we often tend to saddle loans on them not understanding that they have no entrepreneurial skills.  Therefore measurement of skills plays an important role in determining the quantum of loan to be disbursed.

Loan loss ratio:
The next important ratio that needs to be measured to determine the health of an MFI or a micro credit institution is the loan loss ratio.  It indicates what portion of the institution’s loan portfolio is lost over a period, normally in a year. This will indicate the extent to which the loss has to be provided for and provides an upfront cushion towards such losses against income earned during the period. 

ALLR = (1- RR)*100/N * 2
ALLR – Annual Loan Loss Rate
RR – Repayment Rate or the Collection Rate
N – Loan Term Expressed in Years

If the collection rate is 95%, then the loan loss should obviously be 5%, if the loan cycle was for a year.  But this will get altered depending on the loan cycle of the portfolio.  If 5% is lost in one loan cycle of 4 months, then loss per year would be 15% per year.  If the loan cycle term of a portfolio is beyond a year then the percentage loss tends to decrease.
The table below indicates the manner in which the formula performs:
 

 
The scores beyond 100% look incredible, but the portfolio loss is so great under these circumstances that the activity needs to be stopped on account of the compounding effect.  
The best method of avoiding loan losses or the delinquency is to improve daily collection rates and a clean-up report that provides or indicates how the past unrecovered amounts are collected for different age periods.
 

 
Measurement of outreach:
Measurement of outreach is an important indicator for the success or failure of an institution. The outreach can be in terms of depth, servicing the same area intensively, or may be wide spread to reach out to more geographical areas.  Whatever may be the strategy, the best measurement of outreach is to identify the number of clients and the number of products served.  The density of the clients against each product will indicate the need to continue it and its effectiveness.  This also provides a benchmark against how it has performed when compared to its past.  It will help the institution to determine the number of active clients to the total members.  Qualitatively, it is important to understand how many of them are repeat borrowers or how many of them have multiple loans from different competing borrowers.  This provides an indication of the risk that the institution is growing through.  Outreach and depth also helps in designing the products and the pace at which the institutions have to tread into risky territories.
 
While measuring this parameter it is interesting to identify whether the growth in a portfolio is on account of increase of loans in value terms or is it the new borrowers who have come in.  This then gives an idea of the quality of disbursement when the ratio of new loans is taken out with that of the existing loans.  The risk profile changes depending upon the ratios obtained.  Another indication that emerges from this exercise is the poverty profile of the region.  If the borrowing capacity in value terms has not increased, but the increase is on account of new borrowers at the lower end, it is a clear indicator that the poverty index has not changed substantially.  It provides a vital clue for the future strategies of the institution.  

Impact of administrative and personnel costs:
The overall profitability and the break-even operating point are decided by understanding the administrative and personnel costs.  This apart, the efficiency of operation also gets revealed if this is tracked against the loan portfolio.  Comparing the ratios between two periods offers lessons regarding performance efficiency and they can also be measured against the industry’s average.
This is expressed as follows:

Operating expense ratio = Personnel & Administrative expense / Average gross loan portfolio for the period  

The formula becomes more meaningful, if it is measured in terms of cost per client:
Cost per client = Personnel and administrative expense/ Number of active clients

If the loan size varies, it is better to calculate this ratio as a cost per unit of loan.
It is often observed that many micro credit institutions do not build in the required database or may not follow the MIS route to capture data from time to time.  These institutions are dealing with the vulnerable group, often influenced by political and environmental factors.  Hence, it is incumbent that the risk factors and risk appetite are measured, in order to be vigilant against unanticipated threats in the external environment.

Risk analysis and measurement:

This is an important section in micro credit management.  As the institution matures and caters to greater volume and depth, it is important to monitor risk.  Vulnerable groups repeatedly repaying loans get exhausted with the passage of time.  Peer pressure and motivation, to keep them active in groups, will become a non-negotiable act.  The institutional energy, the enthusiasm of the credit officers and the activeness of the groups go a long way in sustaining the willingness of the borrowers to repay.
 
Risk management and its measurement, to decide the institutional risk appetite, is a constant endeavor.  It depends upon the knowledge that one acquires in the course of business.  It again calls for applying analysis indicators and deciding when and how it should be applied.  Personal, social and political factors play a great role in deciding what actions are to be taken in a given situation.  It is more to do with relationships in the field and the bonding that one develops in rural and urban areas.  Obviously the game plan is different in different regions.
 
Perception of risk varies depending on several factors. The categories of risk in micro credit business that helps in perceiving it and in determining the exposure, are as tabled below:
 

 

Issues in risk management:

Micro finance institutions have a dual role to play. These include ensuring financial viability like any other business and reaching out to the poor as a business goal.  The question that one seeks in a scenario like this is whether they complement each other or is there a trade-off between the two.  Not an easy answer to choose between the two.  The risk appetite hovers around what strategy is adopted and in what proportion.  Is it viability and therefore growth is gradual, or is it the outreach that hedges risk?  Neither the lending institution can suffer incurring cash losses, and thereby destroying itself, nor can the borrowers service the full cost when the institution caters only to a few clients.  The answer to this lies in identifying break-even volumes, for different levels of fixed cost.
 
Variable Cost Recover = Total Costs – Fixed Costs/ Average Portfolio Outstanding
Contribution = (Yield from the portfolio – Variable cost rate) * Average Portfolio Outstanding
Break Even Point = Fixed Costs/ Contribution
 
The Break Even Point is an indicator of what volume or portfolio needs to be handled to avoid cash loss.
 
Financial Self Sufficiency:
Financial self sufficiency is an important indicator to decide whether the yield from business is sufficient to cover all expenses and if not what is actually being covered.  From the available literature they are of three types, and the same are as tabled below:
 

 
Conclusion:
Measuring performance is an ongoing process to ensure healthy growth and development of the micro finance sector.  It is primarily attending to needs of the vulnerable, and therefore is a risky venture, which is likely to turn up sticky loans on account of multiple coherent reasons.  The margins between costs of borrowing and lending are extremely thin, so the risks have to be monitored at regular intervals.  Measurement of various parameters, starting from the individual borrowers to the macro economy has a soothing effect on the controls and management of risks, associated with this industry.  Lot more needs to be devised as measuring tools, when the loan portfolio, and for that matter the business, diversifies. While it is good to do social business, with the object of uplifting the poor, but that should not result in tormenting the institution itself.  This therefore calls for not only identifying how the institution has done for itself, but must have the capacity to measure its impact on the economic development of the region and also the development of individual households.  It is only then that micro credit institutions will have done justice in its endeavor.  It is factually true that the unorganized sector is approximately sixty percent of the economy and something needs to be drastically done to uplift them from poverty.
     
  
By K.S. Ravi