The first step in limiting credit risk involves screening clients to ensure that they have the willingness and ability to repay a loan. When analyzing client creditworthiness, microfinance institutions typically use the five Cs as follows If any of these components is poorly analyzed, credit risk increases. To limit this risk, institutions develop policies and procedures to analyze each component.
(1) Character
(2) Capacity
(3) Capital
(4) Collateral
(5) Conditions
These five components are relevant to all types of lending institutions. The weight assigned to each component will vary depending on the lending methodology (i.e. solidarity group, village banking or individual), the loan size, and whether it is a new or repeat customer.
Not everyone who applies for a loan is a good credit risk. Regardless of the lending methodology, loan officers should be expected to make wise credit decisions. Unfortunately, in some MFIs, staff members act more like loan administrators than loan officers do. If all of the paperwork is in order and the applicants have fulfilled whatever savings and meeting requirements there might be, then they automatically receive a loan. This often results in poor portfolio quality. Loan officers and their immediate supervisors should consider the 5 Cs when making credit decisions and they should be held accountable for those decisions.
Character: In microfinance, character is the single most important means of screening new applicants. By assessing a client’s character, the lender gains important insight into the client’s willingness to repay. Although the MFI does not want to put clients in a difficult situation, clients with good character will find a way of repaying their loans even if their businesses fail. The importance of character as the key trait to select new borrowers is heightened by the fact that many microenterprises do not have sufficient records to demonstrate their capacity to repay.
Screening for character varies by the lending methodology. In group-lending programs, the group assumes responsibility for selecting members of strong motivation and character because members guarantee each other’s loans.
With individual lending, besides interviewing neighbors and opinion leaders in the community, loan officers also need to ensure that information provided by the applicant is internally consistent. This is often tested through a three-stage method whereby applicants provide information about themselves and their business in a loan application. Then the loan officer visits the household and/or business to, among other things, verify that the application information is correct. Finally, the loan officer checks other sources regarding the reliability of the information, such as a landlord regarding the size of rent and the length of residence, or a supplier regarding the frequency and size of inventory purchases.
Capacity: To assess an applicant’s capacity to repay, loan officers conduct both business and household assessments. One challenge in determining the business’ capacity to repay is the fungibility of money: what the client says she will use the loan for and what she actually uses the loan for may be different. Because the lines between a microentrepreneur’s business and household activities are often blurred, it is important for the loan officer to understand the flow of funds within and between the two.
It is difficult to assess the repayment capacity of a low-income applicant. Estimates of income and expenses may not be reliable, and applicants often do not have supporting financial records. Experienced loan officers develop methods of improving the quality of these estimates by determining the basis on which they are made and then testing whether the assumptions are valid. However, wide variations may still exist between estimated and actual cash flow of a business, even if the applicant is not intentionally misleading the loan officer.
To overcome these challenges, some MFIs assess a client’s capacity to repay without taking into account the effect of the loan on the business. That means that the current net income of the business is a certain multiple of the proposed installment amount; in other words, the applicant estimates that the business is already generating enough revenue to repay the loan. MFIs also use small initial loan sizes and an ongoing process of collecting information to overcome the challenge of assessing the applicant’s repayment capacity. Initial loan sizes tend to be smaller than the applicant requests because the loan officer does not have good information to assess repayment capacity. Clients are then asked to maintain basic business information on income and expenses so that loan officers can make credit decisions based on more reliable information and tailor subsequent loans to the cash flow of the business.
With small loan sizes, it is appropriate that the applicant’s character is the key screening element. As loan sizes increase, however, there needs to be a shift from “soft” information like character to harder information such as capacity. To make good credit decisions, therefore, it is important that loan officers collect information over time that will allow them to understand of the capacity of their clients’ businesses.
Capital: Besides assessing the cash flow of the business to determine if it has the capacity to repay a loan, many MFIs collect information on the assets and liabilities of the business to construct a simple balance sheet. This allows the loan officer to determine if the business is solvent and how much capital the client has already invested in the business. With the smallest loans, this component is probably the least important, but its significance increases as loan sizes increase. In some cases, loan sizes are linked to the equity in the business. Some MFIs also conduct an asset inventory to reduce credit risk. Although they may not say so explicitly, loan officers convey the message that, if the client does not repay, the institution might seize these assets. This is known as implicit collateral.
Collateral: One reason for the development of the microfinance industry is that traditional banks do not serve persons who cannot offer traditional collateral. Many microlending methodologies use peer groups, restrictive product terms and compulsory savings as collateral substitutes. Subsequent lending innovations provide microloans with nontraditional collateral, such as household assets and cosigners. Pawn lending and asset leasing are other methods of overcoming collateral constraints.
Perhaps more important than the type of collateral is how it is used. In microfinance, collateral is primarily employed as an indication of the applicant’s commitment. It is rarely used as a secondary repayment source because the outstanding balance is so small that it is not cost-effective to liquidate the collateral, much less legally register it if such a service is available. Only when clients are not acting in good faith do microlenders take a hard line stance and seize collateral. Consequently, MFIs tend to be less concerned about the ratio of the loan size to the value of collateral than how the clients would feel if the collateral was taken from them. As the loan size increases, however, this soft approach to collateral needs to change so those larger loans are indeed backed by appropriate security.
Conditions: The fifth component, conditions, is often the hardest for loan officers to assess. Many MFIs adopt a microenterprise development approach to microfinance, which means that they are as concerned with improving the business as recovering their loan. As such, the process of assessing the level of competition, the size of the client’s market, and potential external threats, can play an important role in helping the client to make smart business decisions and help the loan officer to make good credit decisions.
Since loan officers do not usually have the expertise to analyze the conditions of all types of businesses, the primary means of controlling the credit risk posed by business conditions is to require that applicants be in business for a certain number of months (usually 6 to 12 months) before they are eligible for a loan. This requirement means that applicants will have sufficient experience to answer questions about market conditions. The existing business requirement also makes it easier to assess repayment capacity and business capital needs.