MicroFInance Institution’s portfolio is the largest and most important asset, but it is held outside the institution, in the borrowers’ hands. There is a certain level of risk inherent in any portfolio because repayment, which happens in the future, is uncertain.
The level of risk in the portfolio requires regular monitoring and analysis. Meaningful monitoring of risk requires MicroFinance Institutions to produce and use a portfolio report that provides detailed information on the portfolio size, disbursements, repayments, arrears, aging, principal write-offs and other elements necessary to ascertain the level of risk and track portfolio quality.
Write-offs, accounting policy and portfolio quality
When a delinquent loan reaches a certain age in arrears, MicroFinance Institutions may write it off. This write-off and its timing depend on the accounting policy adopted by MicroFinance Institution.
Reporting portfolio quality in a meaningful way depends on two aspects: a sound write-off policy and its consistent application.
Sound accounting policy will call for the institution to establish a loan loss reserve for the outstanding balance of delinquent loans according to the aging of the arrears. Appropriate policy must reflect the repayment intervals and duration of the loan.
An accounting policy that underreports write-offs inflates the real size of the asset base. Conversely, an accounting policy that quickly removes delinquent loans from the books can unnecessarily deplete the real value of the portfolio, while simultaneously overstating portfolio quality.
When reviewing the quality of the portfolio, the analyst must look at the level of write-offs for bad debt as well as the level of delinquency.
Repayment rates and importance of ratio disclosure
Some MicroFinance Institutions will report collection or repayment rates as indicators of portfolio quality. Such rates are based on cash flows for a given period; as such, they do not report cumulative arrears in the portfolio.
In most cases, a consistent repayment rate of 98% is not equivalent to a 2% loan loss rate, and does not give an adequate indication of the level of risk in the portfolio.
Repayment rates will only measure the cash flow of the period. They do not account for accumulated loss or increased future risk tied to those delinquent loans. Using historic repayment rates may be useful for cash flow predictions, but it is a dangerous and deceptive measure of portfolio quality.
Like any ratio, you should always ask for the formulae involved to understand what is actually compared.
Aging of arrears report
The aging of arrears report breaks out the detail of an MicroFinance Institution’s delinquent loan portfolio and assigns different weights to each category of risk.
The report uses aging categories to separate and then regroup the unpaid principal balance of loans by risk category according to how late an installment payment is.
Aging is measured in the number of days late of the loan’s most delinquent payment. These categories range from the recently delinquent (<30 days) to those likely to default (>180 days).
In general, weights or reserve rates, which the institution’s financial management uses to determine the portion of the outstanding delinquent loan balance to keep in reserves, vary from 0% to 100%.
The outstanding portfolio that is current, or on time, carries a 0% reserve rate. The reserve rate increases with the number of days of delinquency to a reserve rate of 100% when the amount of the portfolio is considered unlikely to be recovered.
The sum of these weighted principal balances determines the amount of loan loss reserve that the institution should hold on its balance sheet. MicroFinance Institution’s accounting policy determines the risk categories and reserve rates applied to each category.
MicroFinance Institutions can track experience with repayments over time to generate a profile of the likelihood of default. This historical information can be used to calculate the reserve rate when an MicroFinance Institution is not subject to Central Bank regulations regarding reserves for loan losses.
For example, if data analysis reveals that loans less than 30 days past due have a 10% likelihood of eventual default, the MicroFinance Institution would set the reserve rate at 10% for all unpaid principal balances on loans delinquent less than 30 days.
While historical loan loss rates will inform these categories and rates for MicroFinance Institutions with a sufficient operating track record, start-up MicroFinance Institutions should adopt prudent industry norms appropriate to the structure and types of loan products that they will offer.
Rather than write loans off, financial institutions sometimes decide to restructure loans that are in danger of default.
Often times, this decision comes when a client has experienced an unavoidable crisis, such as a natural disaster or debilitating illness, which has prevented the normal repayment of the loan.
In these cases, the client’s will and ability to repay are almost certain to begin again after a recovery period.
MicroFinance Institutions should undertake loan restructuring only in rare circumstances, and then, only after serious consideration of how the crisis bears on the inherent risk of default. In these rare cases, a loan can be rescheduled.
MicroFinance Institutions should consider restructuring an exception, not the norm, in dealing with delinquent loans. If the institution’s management does decide to keep the loan on the books as a restructured loan, the principal should be reported separately from the healthy portfolio.
Restructured loans should be reported in a separate account with all other restructured loan contracts. Moreover, in order to fully account for the increased risk of default in the restructured portfolio, the MicroFinance Institution should apply a steeper reserve rate.
Benchmarks in MicroFinance Institutions portfolio quality
Like any ratio, portfolio quality as measured by portfolio at risk (PAR) can be compared across institutions when the calculations are standardized. This gives MicroFinance, their managers and board, a means of comparing their portfolio quality to that of institutions with similar methodologies, at similar stages of growth or in their same geographic zone.
Groups formed with similar characteristics for the purpose of comparison are called peer groups. The MicroBanking Standards Project and its MicroBanking Bulletin (www.microbanking-mbb.org) list such ratios comparatively across institutions and within peer groups, providing potential benchmarking for MicroFinance Institutions.
CGAP. “Measuring Microcredit Delinquency: Ratios Can Be Harmful to Your Health,” Occasional Paper No. 3, June 1999.
■ Stearns, Katherine. The Hidden Beast: Delinquency in Microenterprise Programs. Somerville, MA: ACCION International, 1991.
■ Yaron, Jacob. “The Assessment and Measurement of Loan Collections and Loan Recovery,” World Bank Agriculture and Natural Resources Department, 1994.