Credit risk, the most common and often the most serious vulnerability in a microfinance institution, is the deterioration in loan portfolio quality that results in loan losses and high delinquency management costs. Also known as default risk, credit risk relates to client failure to meet the terms of a loan contract.
One microloan does not pose a significant credit risk because it is such a small percentage of the total portfolio. Since most microloans are unsecured, however, delinquency can quickly spread from a handful of loans to a significant portion of the portfolio. This contagious effect is exacerbated by the fact that microfinance portfolios often have a high concentration in certain business sectors. Consequently, a large number of clients may be exposed to the same external threat, like a crackdown on street vending or a livestock disease. These factors create volatility in microloan portfolio quality, heightening the importance of controlling credit risk.