OPTIMAL APPROACH TO CREDIT RISK MANAGEMENT IN MICROFINANCE

Abstract

Credit risk management need urgent attention by recently regulated and evolving microfinance companies in the light of rapidly changing market, increased competition, difference in regulatory guidelines for NBFC-MFIs and that of other entities engaged in microfinance business

Disclaimer

I had written this piece on the request of communication team of Microfinance Institution Network (MFIN) and it was to be published in March 2020 but it got stuck up with the changed priorities after the onset of global pandemic. While data used in the article is little old, the theme remain relevant especially to Light Microfinance Pvt Ltd where we realized the immense benefit in terms of maintaining the portfolio quality during this pandemic. The objective is to share the experience and make a case for enhanced attention towards prudent risk management. This is one of the approaches towards credit risk management and we do not claim it to be the best one among many other existing and possible approaches.

Context

There has been unprecedented growth of the microfinance industry since RBI came up with a new set of regulatory guidelines in December 2012. The industry (NBFC-MFIs, SFBs, Banks and other NBFCs) has grown over 13 times in less than 8 years since then. The industry has shown resilience during the Andhra Pradesh crisis (2010), demonetization (2016), communal uprisings in different parts of the country and continues to grow rapidly even during the current liquidity crisis which started with the ILFS fiasco (2018) at a time when the overall NBFC sector is struggling for liquidity and growth. However, the stress level in the microfinance asset class is also growing because of the changing situation on the ground and increased competition. The Portfolio at Risk >30days (PAR >30, principal overdue for more than 30 days) of the industry has been growing steadily from the level of below 1% of the Gross Loan Portfolio (GLP) in the pre-regulation era to over 2% of the GLP currently. This definitely calls for urgent attention on risk mitigation measures by industry players.

Microfinance Dedicated Credit Bureau and its Limitations

The extent of risk was minimal with low penetration, fewer microfinance companies, small average loan size prior to 2012. Credit information about potential borrowers was not available but lenders with conservative approach of reducing the loan size and household verification was considered adequate to keep the PAR>30 at well below 1% level.

According to MFIN reports, with the Gross Loan Portfolio (GLP) of over 2 Lakh Crore, the industry has grown more than 13 times since 2012. There are many more NBFC-MFIs, Small Finance Bank (SFBs), Public and Private banks, other NBFCs, Business Correspondents (BCs) of banks and financial institutions in the market. Average loan outstanding has increased significantly by 221% in less than 8 years. 

The Credit Information Companies (CICs) set up after the new RBI guidelines went a long way in credit risk mitigation. The credit information helped the companies to significantly reduce multiple lending, set credit discipline among borrowers, helped expand to underpenetrated areas and provided data for periodic review of customers for rectification measures. However, the benefit could have been more had the frequency of data sharing by companies to CICs was done daily rather than on a weekly or monthly basis. 

Emerging Credit Risk in Microfinance

The Turn Around Time (TAT) from sourcing of borrowers to loan disbursement in microfinance industry is 5-7 days which is far lower than other traditional financial services industry. While monthly submission of credit information about borrowers to CICs works for other financial services companies as TAT in those cases are more than a month, it is not adequate to eliminate multiple lending in the microfinance industry. According to the latest MFIN report, there were 4% of the 5.46 Cr borrowers with loan outstanding of more than Rs 1 lakh from more than 3 distinct companies and 15% of the total borrowers have been disbursed more than Rs 1 lakh loan in amount, a limit decided for low income households by the regulator prior to October 2019. This is a significant risk for the industry, and it can be mitigated if the companies get timely and precise information about indebtedness of borrowers before lending. This is possible if all companies in microfinance universe (NBFC-MFIs, Banks, SFBs, other NBFCs) share credit information about clients on daily basis with CICs.

And even larger anomaly is that NBFC-MFIs constitute only 31% share of the total Gross Loan Portfolio (GLP) of microfinance loans. The remaining 69% of the GLP is shared by Universal Banks, Small Finance Banks and other NBFCs who have no regulatory cap on the extent of lending, unlike NBFC-MFIs who are restricted to lend only up to Rs 1.25 lakh to a borrower and one borrower cannot borrow from more than 2 NBFC-MFIs at the same time. Clearly the regulation is restrictive for NBFC-MFIs and open for other significant players, it is incumbent on NBFC-MFIs to take extra measures for credit risk management rather than depending only on credit information from CICs.

With the mainstreaming of low-income households into the economy, micro-enterprises are no longer de-coupled, and the industry is witnessing visible impacts because of business cycles and economic slowdowns. While the industry has grown by over 20% in December 2019 on a year on year basis, more than 30% of the NBFC-MFIs have degrown during October to December, 2019 because of the ongoing liquidity crunch. The field staffs in the microfinance companies have to put significantly more effort and higher duration of their days to ensure timely collection of loan instalments in the current tough environment of growing unemployment and economic stress . Increased competition in the industry and systemic limitations has put the industry in vulnerable situation and it is seeing increased instances of multiple lending, dummy and ghost borrowers, ring leaders and staff frauds. This is reflected in the form of month on month increase in delinquency data of the industry.

High attrition of field staffs has emerged as another risk for the industry and it is directly impacting the portfolio quality of companies. There are instances where the entire field team of a branch or cluster of branches is absconding thereby impacting the collection of due repayments of all other companies operating in the region. Additionally, companies are witnessing staff frauds and high attrition in locations where field employees have to go door-to-door for overdue collection to defaulting borrowers. This is difficult for the field employees and often results in increased instances of fraud and attrition as it cannot be monitored completely. The sustainable solution lies in pre-empting the overdue cases by screening out risky borrowers in the first place.

The industry is also witnessing increased instances of external credit risks emanating from natural calamities mainly in the form of floods and draughts, communal uprisings, loan waiver announcements and mass protests against state and central governments on contentious issues. While these risks cannot be controlled internally, companies must factor them and keep conducting mock drills for minimizing the damage when it happens.

Dedicated Field Credit Team: Challenges and Relevance

NBFC-MFIs have to work under strict regulatory pricing and margin caps. This puts pressure on operating expenses of the companies if they are to be financially sustainable. A majority of the companies depend only on credit information about borrowers from the CICs to mitigate credit risk and typically do not factor in any additional budget for credit risk mitigation. However, this is inadequate considering the rapidly changing market and dynamic nature of credit risk. Separate field credit team with a different set of KRAs (Key Result Areas) and a separate reporting structure is the need of the hour to weed out unscrupulous borrowers, to educate the borrowers about financial inclusion, to facilitate the onboarding of potential clients according to customer protection principle and fair practice code, to educate them about ill impacts of over-indebtedness and to set their expectations right by preparing them for potential crisis situations and to educate them about how ring leaders and other such social elements can damage their credit record. This requires additional effort and time to set the right work flow for the credit team and to integrate them in the client onboarding process in a manner that does not increase TAT while still ensuring that credit worthy customers are not denied their required loans.

Microfinance companies having separate field credit team are witnessing the benefits in the form of significantly lower delinquencies, more satisfied customers, better retention of customers and employees, improved rating and grading of enterprise thereby reducing the finance cost. The quality of customer onboarding process improves as sales teams are motivated to bring only credit worthy customers for enrollment. Field credit team is required to visit each household, verify the income, expense, indebtedness and net savings to determine eligibility of the borrowers for appropriate loan amounts. It also conducts reference checks about the borrowers, gathers information about ring leaders, past record of customer defaults in the region, communal uprising and other sensitive issues impacting credit risk. The credit team has access to a large database of issues and opinion leaders, good locations, locations not conducive for business, etc. The credit team keeps a close watch on the ground and periodically undertakes training of the field staffs about any changes and focus areas in credit risk mitigation. This is very effective in reducing the credit risk primarily because the team has a different set of KRA towards enhancing the credit quality as opposed to KRAs of sales team for business growth.

The rejection ratio of the loan applicants increases with separate field credit team in place. To give a sense, out of 100 customers, a preliminary enquiry from CIC would find say 55 customers to be eligible for next steps for a loan. Of these, the field credit team selects only 35 borrowers as creditworthy for entire cycle of loan. This leads to rejection of 20 additional loan applicants on additional credit parameters who would otherwise be eligible as per information from the CIC.

It is important to do a proper cost benefit analysis of having a separate field credit team. The first impression may be that having a separate field credit team would not only increase the operational expense but would also limit business opportunity because of the higher rejection ratio of the loan applicants. However, if done correctly, reality is just opposite, the benefits in the form of portfolio quality, customer and staff retention, lesser finance cost, smoother business growth and expansion, goodwill and brand value of the company far outweigh the cost incurred towards credit team. It is time for the industry to move to a more stringent credit assessment regimen. The entire industry stands to benefit from it.