Lending Methodology

8/8/2019 Lending Methodology

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Microfinance Lending

Methodology

Microfinance Study, Part 2

9/31/2006


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Lending Products Summary

Lending products are characterized by

Loan amounts

Loan terms Collateral requirements (or substitutes)

Interest rates/fees

Compulsory savings/group contribution

requirements


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Loan Amounts

Client cash patterns

Regular (deli, grocery store, utility)

Irregular (high-ticket items) Seasonal (harvest)

Emergency (illness)

Loan amount dependent on

Loan purpose

Client debt capacity


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Loan Term: Why does it matter?

If loan term is longer than business

cycle

Some cases, cannot access loans untilexisting loan is repaid

Tempting to spend early cash flows

Note: 12-month loans in busy urban markets = low

repayment rates


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If loan term is shorter than business

cycle

If no savings to begin with, may not be able togenerate enough cash flow to cover loan

repayment

SO goal is to adjust term structure to

business cycles (debt-servicing capacity ofclients)


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Prepayment clients repay loans early

The good:

Reduce both security risk and temptation to spend

excess amounts of cash

Reduce burden of loan installments later in loan

cycle

Increase speed with which MFI can revolve loan

portfolio


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Prepayment

And the bad:

Difficult to monitor, disrupting MFI cash flows

Less interest for MFI (unless loan is immediately

revolved)

Indicate borrowers are receiving loans from other

lenders with better service, lower rates or more

appropriate terms.

Solution: shorten loan-term of those who

prepay often


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Loan Use

Working capital loans Current (


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Loan Collateral: Substitutes

Group Guarantees

Implicit: other group members are unable to

access a loan if all members are not current in

their loan payments

Actual: group members are liable if other

group members default on their loans

Group guarantee funds Group discretion vs. MFI discretion


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Loan Collateral: Substitutes

Character-based lending

Frequent business visits

Risk of public embarrassment Risk of jail/legal action


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Alternatives to Collateral

Compulsory Savings

Independent vs. group savings funds

Not available for withdrawal while loan isoutstanding (for MFI use caution)

Opportunity Cost = return on savings return

from business investment

Asset-building, not just alternative to collateral Prompt payment incentive Bank Rakyat

Indonesia


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Alternatives to Collateral

Pledging assets based on personal value

Pledge assets whose value is less than the

loan amount (to MFI) what is valuable to the

client?

Personal Guarantees

Enlist cosigners to guarantee loans


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Loan Pricing

Borrowers are empirically not price

sensitive because of limited access to

capital!

Balance between repayment and MFI

sustainability


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Loan Pricing: Four Main MFI Costs

Financing costs

Operating costs

Loan loss provision Cost of capital


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Loan Pricing: Four Main MFI Costs

Financing costs

Operating costs

Loan loss provision Cost of capital


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Loan Pricing: Financing Costs

Outside financing

Grant or loan?

Compulsory savings financing Interest rate?


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Example

1,000 loan portfolio

400 funded by internal savings @ 5% 600 funded by outside sources @ 10%

Take arithmetic mean of the rates and you

get

[(400)(5%) + 600(10%)] / 1000 =

8% cost of funds


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Example

1,000 loan portfolio

700 funded by internal savings @ 5% 300 funded by outside sources @ 10%

Take arithmetic mean of the rates and you

get

Note: if inside sources = grants, then MFIs have incentives to decrease internal funding sources

[(700)(5%) + 300(10%)] / 1000 =

6.5% cost of funds


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Loan Pricing: Operating Costs

Salaries, rent, travel and transportation,

administration, depreciation, etc.

Vary between 12% and 30% ofoutstanding loans


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Loan Pricing

Loan Loss Provisions

Dependent on quality of portfolio (metrics)

Capital costs Depend on market rate of interest and local

inflation rate


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Interest Rates: Declining Balance

Method

Calculate interest as % of amount outstanding

over loan term

Interest charged on amount that borrower still owes

Givenpresent value of loan amount, calculatethepayments going forwardgiven that interest

rates are calculated fromprevious balance

What would monthly payments have to be?

An example


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Method

Loan amount: 1,000

Loan term: 12 months

Interest rate: 20 percent Whats the payment per month? You can

use financial calculator (see article) or

Use the annuity formula!


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Method

PV: Present Value of Annuity = 1,000

r: Interest rate = 20% per year, 1.67% a month

n: Loan term = 12 months

A: Cash flows (our monthly payments)

Solving for A, we get 92.63 as monthly payment


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Method A simpler example

n = 2 months; r = 20% per 2 months, 10% per month; Loan amount = 100

Month Payments

(X)

Principal

(Payment

Interest)

Interest

(Rate * Previous

Balance)

Outstanding

Balance

(Balance

Principal)0 - - - 100

1 X X Interest =

X 10

10%*100 = 10 100 (X 10)

= 110-X

2 X X Interest =

X (10%)*(110-X)

(10%)*(110-X) 110 X [X

(10%)*(110-X)]

Since sum of principal = loan amount, set X 10 + [X 10%*(110-X)] = 100

and you get a payment (X) of$57.62. This is what the annuity formula does!

Try it with the annuity formula on the previous slide!


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Interest Rates: Flat Method

Interest is always calculatedon the initial

(total) loan amount

To calculate interest payment: Rate * Loan Amount

(Dont forget to standardize to same term i.e., per

month or per year)

This results in much higherinterest ratesgiven the same nominal(as opposed to real)

rate!


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Interest Rates

Flat rate charges more than decliningbalance, so some firms may adjust theirinterest calculation method rather than

their nominal rate Customers still know how much theyre

paying by virtue of payments!

(Reduces transparency) When evaluating MFIs, rate calculation

methods are important!


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Interest Rates:

How do you set sustainable rates?

One method to set a sustainable interest

rate (for mature MFIs):

R = AE + CF + LL + K1 - LL - II

R=Annualized effective yield

And the following expressed as percentages of average outstanding loan

portfolio (LP):

AE=Administrative expenses

CF= Cost of funds

L = Loan losses

K= Desired capitalization rate

II= Investment income


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Interest Rates:

How do you set sustainable rates? AE: All annual recurrent costs

Salaries, benefits, rent, utilities, and depreciation, necessarydonated assistance

Range between 10% and 25%

LL: Annual loss due to defaulted loans Good MFIs run around 1% - 2%

CF: Actual cost of funds of MFI when it funds its portfoliowith savings and commercial debt Can use estimation method (financial assets times higher of the

rate that local banks charge medium-quality commercialborrowers or the inflation rate projected for the planning period)

Weighted average cost of capital (WACC) = uses CAPM, will gointo this in more detail later


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Interest Rates:

How do you set sustainable rates?

Capitalization (K): represents net realprofit theMFI would like to achieve, as % of loan portfolio 5% to 15% of average loan portfolio is suggested

Investment Income (II): Income expected to begenerated by financial assets, excluding the loanportfolio

These sum to high rates, but micro-

entrepreneurs will generally provide higherreturns than their wealthier counterparts whoalready have access to capital


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Fees and Service Charges

Often a replacement for higher nominal

rates, and is generally

Calculated on initial loan amount

Collected up front

Greater effect than nominal interest rate hike if

method is declining balance method

Because payment is up frontand is not calculatedwith the declining balance method!


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Fees and Service Charges

An example n = 2 months; Loan amount = 100

Scenario 1 Service fee = 3%; r = 20% per 2 months, 10% monthly; payment = 57.62

(check with yourA

PV formula!) Declining balance interest = payment*n Principal = 57.62*2 100 = 15.24

Service fee payment = 100*3% = 3

Total charge over principal= 18.24

Scenario 2

Service fee = 8%; r = 25% per 2 months, 12.5% monthly; payment = 59.56(check with yourAPV formula!)

Declining balance interest = 59.56*2 100 = 19.12

Service fee = 8

Total charge over principal= 27.12


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Cross-Subsidization of Loans

Grameen Bank

8% rates on housing loans are subsidized by

20% rate for general loans

Housing loans have eligibility criteria (must

have received at least 2 general loans, must

have an excellent repayment record, must

have utilized loans for the purpose specifiedon application)


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Cross-Subsidization of Loans

Unit Desa system in Bank Rakyat

Indonesia

Higher return on average assets than bank as

whole

Indirectly, high rates on poor loans subsidize

low rates to wealthy

Lower transaction costs for wealthier clients whopay lower rates on bigger loans


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Calculating Effective Rates

The effective rate of interest refers to theinclusion of all direct financial costs of a loan inone interest rate

What does thatmean? The rate should incorporate interest, fees, the interest

calculation method, other loan requirements, cost offorced savings

Does notinclude transaction costs, such as costs on

borrower related to opening an account,transportation, child-care, etc., since these vary byregion


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Calculating Effective Rates:

Included Variables Nominal interest rate (r)

Method of interest calculation

Payment of interest at the beginning of the loan or overthe term of the loan

Service fees either up front or over the term of the loan

Contribution to guarantee, insurance or group fund

Compulsory savings or compensating balances

Payment frequency

Loan term

Loan amount


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Calculating Effective Rates

Aside: does the effective rate change if

loan amount increases?

It does if variables are not given aspercent of

loan


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Estimation Method

Does notaccount for time value of money

and payment frequency

Increase in loan term and decrease in

payment frequency distorts value of effective

rate (because of time value of money)

Not recommended


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Estimation Method

Can be used to determine effect of interest

rate calculation method, loan term and

loan fee

Effective Rate =Average principal amount outstanding

Amount paid in interest and fees a

Average principal

amount outstanding Number of payments

Sum of principal amounts outstanding

=

Note: Increasing nominal rates, decreasing loan terms, or increasing fees

increases the effective rate


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Internal Rate of Return (IRR)

IRR must be used to incorporate all

financial costs of a loan

The specific interest rate by which the

sequence of installments must be discounted

to obtain an amount equal to the initial credit

amount

Rememberpresent value = 1/(1+i)n

?Time value of money? IRR!


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IRR: Three Steps

Determine the actual cash flows

Determine the effective rate for the period

(computed via calculator) Multiply or compound the IRR by the

number of periods to determine the annual

rate


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IRR: Parameters and Inputs

PV= present value, or the net amount of cash disbursedto the borrower at the beginning of the loan

i= interest rate, which must be expressed in same timeunits as n below

n = loan term, which must equal the number of paymentsto be made

PMT=payment made each period

FV= future value, or the amount remaining after the

repayment schedule is completed (zero except for loanswith compulsory savings that are returned to theborrower)


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IRR: How to calculate

If PMTs are always the same (which is

never the case), you can use annuity

formula we saw earlier

Otherwise, we can model this in Excel


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Excel Model: Base Case

Base Case

er ear

er o

( o s)

O s a d Bala ce - E-

a e s

r c al

eres

a e

o r c al


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Excel Model: Alternative 1Alternative 1: Flat Interest

1n

i er ear

i 1 er ont

1 ont

t tandin alance 1

a ent

rinci al

ntere t

a ent

o rinci al 1

Effective Rate Calculation

PV 1000

n 4

Effective Annual Rate 56.3% per year

Effective Monthly Rate 4.7% per month

0 1 2 3 4 (months)

Outstanding Balance 1000 766.9247 522.9125 267.45 -3.41901E-06

Payments 280 280 280 280

Principal 233.0753 244.0123 255.4625 267.4499833

Interest 46.92472 35.98773 24.53752 12.55001673

Payment = 280

Sum of Principal = 1000

The rest are done the same way, except that the payment value keeps changing due to change in cash f lows!


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Excel Models

Try the other alternatives at home, they all

basicallywork like the first alternative!

Alternatives 5 and 6 incorporate compulsory

savings, meaning we need to calculate future

value of those savings at the end of the loan

term

If savings are not held by theM

FI, then theamounts should not enter into our

computation


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Effective Cost vs. Effective Yield

Yield refers to the revenue earned by the

lender on the portfolio outstanding,

including interest revenue and fees

Used to determine if enough revenue will be

generated to cover all costs


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Effective Cost vs. Effective Yield

Two main differences

Components that are not held by (and therefore do

not result in revenue to) the lender are notincluded in

yield, but included in costs Return to lender computed based on average

portfolio outstanding, not on borrowers initial loan

amount

If all components of loan are both costs to borrower

and revenue for lender, then only difference is

methodusedtoannualizerate


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Compounding vs. Multiplying

Cost to the borrower

This cost is compoundedby the number of

payment periods in the year because

IRR is amount borrowerforgoes by repaying

loan in installments (principal amount

available declines with each installment)

Return earned per period if the borrowercould reinvest would compoundover time


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Compounding vs. Multiplying

Yield to the lender

Per period rate is multiplied

Assume revenue generated is used to cover

expenses and is not reinvested therefore,

average portfolio outstanding does not

increase!


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Annualizing IRR

Compounding: (1 + IRR/100)a 1

Where a = number of periods in one year

Use forborrowercost

Multiplying: IRR * a

Where a = number of periods in one year

Use forlender (MFI) yield


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Lending in Context (Bastelaer)

MFIs have leveraged current social

structures termed social capital to

increase repayment rates and returns

Rotating Savings and Credit Associations

(ROSCAs)

Group contribution to fund, distribute funds to one

individual, re-fund, repeat, dismantle when finished

Moneylenders

Trade credit (supplier to buyer relationships)


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Lending Schemes Around the

World (as related to Lebanon ~2001)

Mobile banks (collectors and lendors)

Up to 100% rates on postponed payments

15% monthly interest (+4 extra days of

interest)

Savings and lending associations

ROSCAs


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Group lending

Loan disbursed to borrowers in group; peer

pressure is basic guarantee for loan

repayment

Developed by Grameen Bank

Group Solidarity lending

Loan disbursed to groups rather thanindividuals

Developed by ACCION International


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Group lending

Loan disbursed to borrowers in group; peer

pressure is basic guarantee for loan

repayment

Developed by Grameen Bank;

Group Solidarity lending

Loan disbursed to groups rather thanindividuals

Developed by ACCION International


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Rural community banks

Saving/lending institutions run by local

community committees

Secure financial services; build group

solidarity; facilitate savings

Developed by Foundation for International

Community Assistance (FINCA) Number of members varies between 30 and

50


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Self-financing village banks

Rural community manages village bank,

which serves the entire village, not just its

members

Developed by the International Centre for

Research and Development in mid-1980s

Goal is to self-sustain on savings


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Credit unions/lending and savings

cooperatives

Began operating in developing countries in

1950s

Provide savings and loan facilities for

individuals

Act as intermediaries in money transfersbetween urban and rural areas and between

savers and lenders


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Transformation lending

Targets micro-enterprises with intention of

growing sales and revenues and number of

people employed

Often transfers funds from banks to micro-

enterprises to transform into small businesses


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Commercial and development banks(downscaling)

Development banks: publicly owned

institutions established to provide financialservices to specific strategic sectors (i.e.agriculture/industry) sometimes at subsidizedrates

Commercial banks: private institutions thatprovide services to high-income clients thatrun service-oriented businesses


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Mozambique ~1997: Loan Term

Example

Range from 10%-60% (nominal)

Commercial rates: 20%-30%

Discount rate: 12.95% (32% in 1996)

Lending Methodology

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