Microfinance Lending

Methodology
Microfinance Study, Part 2
9/31/2006
 Lending Products Summary
• Lending products are characterized by…
– Loan amounts
– Loan terms
– Collateral requirements (or substitutes)
– Interest rates/fees
– Compulsory savings/group contribution
requirements
 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
Loan Term: Why does it matter?
• If loan term is longer than business
cycle…
– Some cases, cannot access loans until
existing loan is repaid
– Tempting to spend early cash flows
• Note: 12-month loans in busy urban markets = low
repayment rates
Loan Term: Why does it matter?
• If loan term is shorter than business
cycle…
– If no savings to begin with, may not be able to
generate enough cash flow to cover loan
repayment
• SO goal is to adjust term structure to
business cycles (debt-servicing capacity of
clients)
Loan Term: Why does it matter?
• 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
Loan Term: Why does it matter?
• 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
 Loan Use
• Working capital loans
– Current (<1-year) expenditures that occur in the
normal course of business
– 2 months – 1 year
• Fixed asset loans
– Expenditures made for the purchase of assets that
are used over time in the business
– Larger amount, longer term
– Higher risk; offset by legal title of asset as collateral
by MFI
• Fungibility – money used to cover other
expenses (use may be less important than
capacity to repay)
 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
 Loan Collateral: Substitutes
• Character-based lending
• Frequent business visits
• Risk of public embarrassment
• Risk of jail/legal action
 Alternatives to Collateral
• Compulsory Savings
– Independent vs. group savings funds
– Not available for withdrawal while loan is
outstanding (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
 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
 Loan Pricing
• Borrowers are empirically not price
sensitive because of limited access to
capital!
– Balance between repayment and MFI
sustainability
Loan Pricing: Four Main MFI Costs
• Financing costs
• Operating costs
• Loan loss provision
• Cost of capital
Loan Pricing: Four Main MFI Costs
• Financing costs
• Operating costs
• Loan loss provision
• Cost of capital
 Loan Pricing: Financing Costs
• Outside financing
– Grant or loan?
• Compulsory savings financing
– Interest rate?
 Loan Pricing: Financing Costs
• 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
 Loan Pricing: Financing Costs
• 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…
[(700)(5%) + 300(10%)] / 1000 =
6.5% cost of funds
Note: if inside sources = grants, then MFIs have incentives to decrease internal funding sources
 Loan Pricing: Operating Costs
• Salaries, rent, travel and transportation,
administration, depreciation, etc.
• Vary between 12% and 30% of
outstanding loans
 Loan Pricing
• Loan Loss Provisions
– Dependent on quality of portfolio (metrics)
• Capital costs
– Depend on market rate of interest and local
inflation rate
 Interest Rates: Declining Balance
Method
• Calculate interest as % of amount outstanding
over loan term
– Interest charged on amount that borrower still owes
• Given present value of loan amount, calculate
the payments going forward given that interest
rates are calculated from previous balance
• What would monthly payments have to be?
• An example…
 Interest Rates: Declining Balance
Method
• Loan amount: 1,000
• Loan term: 12 months
• Interest rate: 20 percent
• What’s the payment per month? You can
use financial calculator (see article) or…
• Use the annuity formula!
 Interest Rates: Declining Balance
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

 Interest Rates: Declining Balance
Method
• A simpler example…
– n = 2 months; r = 20% per 2 months, 10% per month; Loan amount = 100

Month Payments Principal Interest Outstanding

(X) (Payment – (Rate * Previous Balance
Interest) Balance) (Balance –
Principal)
0 - - - 100
1 X X – Interest = 10%*100 = 10 100 – (X – 10)
X – 10 = 110-X

2 X X – Interest = (10%)*(110-X) 110 – X – [X –

X – (10%)*(110-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!
 Interest Rates: Flat Method
• Interest is always calculated on the initial
(total) loan amount
• To calculate interest payment:
– Rate * Loan Amount
• (Don’t forget to standardize to same term – i.e., per
month or per year)
– This results in much higher interest rates
given the same nominal (as opposed to real)
rate!
 Interest Rates
• Flat rate charges more than declining
balance, so some firms may adjust their
interest calculation method rather than
their nominal rate
• Customers still know how much they’re
paying by virtue of payments!
– (Reduces transparency)
• When evaluating MFIs, rate calculation
methods are important!
 Interest Rates:
How do you set sustainable rates?
• One method to set a sustainable interest
rate (for mature MFIs):
AE + CF + LL + K
R= - II
1 - LL
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
 Interest Rates:
How do you set sustainable rates?
• AE: All annual recurrent costs
– Salaries, benefits, rent, utilities, and depreciation, necessary
donated 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 portfolio
with savings and commercial debt
– Can use estimation method (financial assets times higher of the
rate that local banks charge medium-quality commercial
borrowers or the inflation rate projected for the planning period)
– Weighted average cost of capital (WACC) = uses CAPM, will go
into this in more detail later
 Interest Rates:
How do you set sustainable rates?
• Capitalization (K): represents net real profit the
MFI would like to achieve, as % of loan portfolio
– 5% to 15% of average loan portfolio is suggested
• Investment Income (II): Income expected to be
generated by financial assets, excluding the loan
portfolio
• These sum to high rates, but micro-
entrepreneurs will generally provide higher
returns than their wealthier counterparts who
already have access to capital
 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 front and is not calculated
with the declining balance method!
 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 your APV 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 your APV formula!)
– Declining balance interest = 59.56*2 – 100 = 19.12
– Service fee = 8
– Total charge over principal = 27.12
 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 specified
on application)
 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 who
pay lower rates on bigger loans
 Calculating Effective Rates
• “The effective rate of interest refers to the
inclusion of all direct financial costs of a loan in
one interest rate”
• What does that mean?
– The rate should incorporate interest, fees, the interest
calculation method, other loan requirements, cost of
forced savings
– Does not include transaction costs, such as costs on
borrower related to opening an account,
transportation, child-care, etc., since these vary by
region
 Calculating Effective Rates:
Included Variables
• Nominal interest rate (r)
• Method of interest calculation
• Payment of interest at the beginning of the loan or over
the 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
 Calculating Effective Rates
• Aside: does the effective rate change if
loan amount increases?
– It does if variables are not given as percent of
loan
 Calculating Effective Rates:
Estimation Method
• Does not account 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
 Calculating Effective Rates:
Estimation Method
• Can be used to determine effect of interest
rate calculation method, loan term and
loan fee
Amount paid in interest and fees a
Effective Rate = Average principal amount outstanding

Average principal Sum of principal amounts outstanding

= Number of payments
amount outstanding

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

increases the effective rate
Calculating Effective Rates: 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”
• Remember present value = 1/(1+i)n?
Time value of money? IRR!
 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
 IRR: Parameters and Inputs
• PV = present value, or the net amount of cash disbursed
to the borrower at the beginning of the loan
• i = interest rate, which must be expressed in same time
units as n below
• n = loan term, which must equal the number of payments
to be made
• PMT = payment made each period
• FV = future value, or the amount remaining after the
repayment schedule is completed (zero except for loans
with compulsory savings that are returned to the
borrower)
 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…
 Excel Model: Base Case
Base Case
PV 1000
n 4
i 36% per year
i/12 3% per month

0 1 2 3 4 (months)
Outstanding Balance 1000 760.973 514.7751 261.1913 -6.25278E-13
Payments 269.027 269.027 269.027 269.0270452
Principal 239.027 246.1979 253.5838 261.191306
Interest 30 22.82919 15.44325 7.83573918

Payment = 269.027
Sum of Principal = 1000
Excel Model: Alternative 1
Alternative 1: Flat Interest
PV 1000
n 4
i 36% per year
i/12 3% per month

0 1 2 3 4 (months)
Outstanding Balance 1000 750 500 250 0
Payments 280 280 280 280
Principal 250 250 250 250
Interest 30 30 30 30

Payment = 280
Sum of Principal = 1000

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 k eeps changing due to change in cash flows!
 Excel Models
• Try the other alternatives at home, they all
basically work 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 the MFI, then the
amounts should not enter into our
computation
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
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 not included in
yield, but included in costs
– Return to lender computed based on average portfolio
outstanding, not on borrower’s initial loan amount
– If all components of loan are both costs to borrower
and revenue for lender, then only difference is
method used to annualize rate
 Compounding vs. Multiplying
• Cost to the borrower
– This cost is compounded by the number of
payment periods in the year because…
– IRR is amount borrower forgoes by repaying
loan in installments (principal amount
available declines with each installment)
– Return earned per period if the borrower
could reinvest would compound over time
 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!
 Annualizing IRR
• Compounding: (1 + IRR/100)a – 1
– Where a = number of periods in one year
– Use for borrower cost
• Multiplying: IRR * a
– Where a = number of periods in one year
– Use for lender (MFI) yield
 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)
 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
 Lending Schemes Around the
World (as related to Lebanon ~2001)
• 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 than
individuals
– Developed by ACCION International
 Lending Schemes Around the
World (as related to Lebanon ~2001)
• 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 than
individuals
– Developed by ACCION International
 Lending Schemes Around the
World (as related to Lebanon ~2001)
• 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
 Lending Schemes Around the
World (as related to Lebanon ~2001)
• 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
 Lending Schemes Around the
World (as related to Lebanon ~2001)
• 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 transfers
between urban and rural areas and between
savers and lenders
 Lending Schemes Around the
World (as related to Lebanon ~2001)
• 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
 Lending Schemes Around the
World (as related to Lebanon ~2001)
• Commercial and development banks
(downscaling)
– Development banks: publicly owned
institutions established to provide financial
services to specific strategic sectors (i.e.
agriculture/industry) sometimes at subsidized
rates
– Commercial banks: private institutions that
provide services to high-income clients that
run service-oriented businesses
 Mozambique ~1997: Loan Term
Example
• Range from 10%-60% (nominal)
• Commercial rates: 20%-30%
• Discount rate: 12.95% (32% in 1996)