Credit risk management techniques of small scale microfinance institutions in India

By Priya Chetty on March 10, 2017
Image by Patrick Savalle on Flickr

In the previous article, the need for credit risk management in small-scale microfinance institutions was reviewed. Small-scale microfinance constitutes a sizeable chunk of the entire microfinance industry in India. Microfinance institutions face a large amount of credit risk today. Keeping that in mind these institutions are using different approaches and techniques. This has been done to mitigate the risk pertaining to the failure of repayment by the customers.

Traditional techniques are not enough to mitigate the credit risk for small-scale microfinance institutions

Credit risk techniques are concerned with reviewing the portfolio of the customers completely. Similarly, the techniques also study the sectoral trends of the demand for loans. The ultimate aim of such techniques is to minimize loan losses. This motive is achieved by the banks by the way of following an accurate customer scrutinizing process and its close monitoring. Usually, small-scale microfinance institutions do not get much financial assistance. So they only employ the traditional methods to manage the credit risk. This is done by following some of the techniques or methods that are discussed below.

Increasing credit risk in Indian small scale microfinance institutions should be tackled by introducing new techniques
Portfolio risk of small-scale microfinance institutions in major states in India

Small-scale microfinance institutions have put various tools to develop the culture of loss minimization in their organizations. There is a dire needing felt for such tools and techniques that have been adopted from other financial institutions. However, these methods varied as per their own current customers and the environment, to mitigate the risk of loan losses by the respective customers.

Group lending

Group lending is the technique that is extensively used by small-scale MFIs’. In this method, the credit is provided to the borrowers without collateral who get together to form the groups. The method is undertaken eagerly by the Micro Finance Institutions due to the feature of joint liability that is attached to it, thereby aiding in diversifying the risks. The technique is related to the process of Information asymmetry or inadequate information. Similarly, the step of moral hazard taken by the customers through switching to risky projects leads to an increase in the liability of other members as well (Kodongo & G.kendi, 2013). This further helps in supervising the steps of members by the social group members as they maintain the peer pressure.

Progressive lending

Progressive lending or step lending is another risk mitigating tool. Under this technique, the lender should check the loan repayment capabilities and records of the borrower, concurrently with providing him with the loan. As such, the loan is given in small amounts to the borrower at the outset and after which, the amount is augmented based upon the loan repayment record of the customer (K & Veerashekharappa, 2011). The technique assures the competencies of the borrower simultaneously by providing them with credit facilities.

Collateral substitutes

It is an eminent fact that microfinance institutions deal in an environment where the collateral is scarce. However, these institutions still manage to operate by the way of employing Collateral Substitute techniques. Under the technique, small-scale microfinance institutions maintain an emergency fund by the way of collecting various valuables of the customers. This may even include borrower’s degree certificates, important documents or identity cards. In addition, 5% of the amount in cash is also maintained to act as a collateral benefit in case of the failure of repayment (Ibtissem & Bouri, 2013).

Portfolio diversification

Portfolio reporting and portfolio diversification assist institutions in reshaping their portfolios. Such portfolio reports carefully assess the monthly trends of loss pertaining to loan repayment failure. It becomes a prominent need of such enterprises to continuously assess the trends of credit failure, and check the status of repayment in various sectors and the risk profiles to limit the exposure to credit hazards (Idama, 2014). However one must decide on the loan structure for different sectors as per its various characteristics and the respective risk profiles. This is done in order to diminish the chances and trends of delinquencies.

Providing business development services

Another complementing method of mitigation of credit risks for such small-scale Micro Finance Institutions is the ‘Credit Plus’ facility or the ‘Business Development Services’. These services are offered to the customers in order to empower them in their business. This will indirectly help in surging the chances of the loan re-payment by them. This facility goes beyond providing the provisions of financial services to the clients. It is concerned with increasing their technical, managerial and business skills. This will in turn help in modernizing their understanding of their businesses.

This is the method by which loan repayment by clients will be secured by the way of supporting and giving strength to them in their respective businesses (Ibtissem & Bouri, 2013). The correlation between this technique and the repayment amount of credit relevant to the borrowers is high.

Strict schedules for repayment

These institutions ensure some strict schedules for the repayment of loans by borrowers. This is because the risk of non-payment by the borrowers is high in such institutions. The institutions, as such, need strict guidelines. Especially in the cases where there is an absence of collateral and there is no assurance of the client’s income. Under such a system, these institutions identify the borrowers who have a higher probability of default in the initial stages only and issue early warning signs. Also, under such a system, the additional income source of the clients is also assured to guarantee the payments and reduce the credit risks faced by the Micro Finance Institutions (Ibtissem & Bouri, 2013).

Cost constraints for employing modern risk management techniques

Small-scale microfinance institutions do not use modern techniques for credit risk management. Similarly, technological methods are inefficient as compared to those employed by other medium and large institutions. The main reason behind this is the cost. However, they are beneficial in many ways in reducing the credit risk confronted by them. The motive of all the techniques specified above is to confirm or guarantee the repayment of the amount by the clients. However such institutions should adjust their own policies as per the payment structure or trends.

References

  • Ibtissem, B., & Bouri, A. (2013). CREDIT RISK MANAGEMENT IN MICROFINANCE: THE CONCEPTUAL FRAMEWORK. ACRN Journal of Finance and Risk Perspectives, 2(1), 9–24.
  • Idama, A., A.I., A., & N., N. (2014). Credit Risk Portfolio Management in Microfinance Banks: Conceptual and Practical Insights. Universal Journal of Applied Science, 2(6), 111–119.
  • K, N. K., & Veerashekharappa. (2011). Progressive Lending as a Dynamic Incentive Mechanism in Microfinance Group Lending Programmes: Empirical Evidence from India. Bangalore.
  • Kodongo, O., & G.kendi, L. (2013). Individual lending versus group lending: An evaluation with Kenya’s microfinance data. Review of Development Finance, 3(2).

Priya is the co-founder and Managing Partner of Project Guru, a research and analytics firm based in Gurgaon. She is responsible for the human resource planning and operations functions. Her expertise in analytics has been used in a number of service-based industries like education and financial services.

Her foundational educational is from St. Xaviers High School (Mumbai). She also holds MBA degree in Marketing and Finance from the Indian Institute of Planning and Management, Delhi (2008).

Some of the notable projects she has worked on include:

  • Using systems thinking to improve sustainability in operations: A study carried out in Malaysia in partnership with Universiti Kuala Lumpur.
  • Assessing customer satisfaction with in-house doctors of Jiva Ayurveda (a project executed for the company)
  • Predicting the potential impact of green hydrogen microgirds (A project executed for the Government of South Africa)

She is a key contributor to the in-house research platform Knowledge Tank.

She currently holds over 300 citations from her contributions to the platform.

She has also been a guest speaker at various institutes such as JIMS (Delhi), BPIT (Delhi), and SVU (Tirupati).

 

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