designing lending product
- 1. Chapter-5 Designing Lending Products Cash pattern: To design a loan product to meet borrower needs, it is important to understand the cash patterns of borrowers. Cash patterns are important in so far as they affect the debt capacity of borrowers. Lenders must ensure that borrowers have sufficient cash inflow to cover loan payments when they are due. While analyzing the cash pattern one should analyze the following cash pattern: Cash inflows are the cash received by the business or household in the form of wages, sales revenues, loans, or gifts. Cash outflows are the cash paid by the business or household to cover payments or purchases. Some cash inflows and outflows occur on a regular basis, others at irregular intervals or on an emergency or seasonal basis. Seasonal activities can create times when the borrower generates revenues (such as after a harvest period) and times when there is no revenue (revenue may be received from other activities). However, loan terms often extend over several seasons, during which there can be gaps in revenues. Loans should be based on the cash patterns of borrowers and designed as much as possible to enable the client to repay the loan without undue hardship. This helps the MFI avoid potential losses and encourages clients both to manage their funds prudently and to build up an asset base. (This does not mean that only cash flows from the specific activity being financed are considered; all cash flows are relevant.) The appropriate loan amount is dependent on the purpose of the loan and the ability of the client to repay the loan (that is, debt capacity). When determining the debt capacity of potential clients, it is necessary to consider their cash flow as well as the degree of risk associated with this cash flow and other claims that may come before repayment of a loan to the MFI. Adjusting the debt capacity of a borrower for risk should reflect reasonable expectations about adverse conditions that may affect the borrower’s enterprise. Adjustment for adversity has to reflect the lender’s willingness to assume the risks of borrowers’ inability to repay. The greater the MFI’s capacity to assume risk, the higher the credit limits the lender can offer. Often MFIs have a maximum loan size for first-time borrowers, which increases with each loan. This is designed both to reduce the risk to the MFI and to create an incentive for the clients to repay their loans (namely, the promise of a future larger loan). In addition, increasing loan sizes enable the client to develop a credit history and an understanding of the responsibilities associated with borrowing.
- 2. How Does the Loan Term Affect the Borrower’s Ability to Repay? Loan term: It refers to the period of time during which the entire loan must be repaid. The loan term affects the repayment schedule, the revenue to theMFI, the financing costs for the client, and the ultimate suitability of the use of the loan. The closer an organization matches loan terms to its client’s needs, the easier it is for the client to “carry” the loan and the more likely that payments will be made on time and in full. The following example provides three alternative loan terms with installment payments: For example, Miss Jyoti a dressmaker purchases cloth and supplies every four months to benefit from bulk purchasing, resulting in a four-month business cycle. Her net revenue over the four months (after purchasing supplies for 1,000 and incurring all other expenses but before loan repayment) is 1,600 (400 per month). ALTERNATIVE 1: Four-month loan matching her business cycle. She borrows 1,000 for four months at 3 percent monthly interest, with monthly payments of 269 (calculated on the declining balance method). Her total payments are then 1,076 (interest expense of 76). Revenue of 1,600 less the loan repayment of 1,076 leaves her a net income of 524. Cash flow over the four months is as follows: Period Business Loan Income 0 (1000) 1000 - 1 400 (269) 131 2 400 (269) 131 3 400 (269) 131 4 400 (269) 131 Total 600 (76) 524 In this scenario, the dressmaker has extra income to consume or reinvest as additional working capital if she chooses. The loan term is appropriately matched to her business cycle and cash flow patterns. ALTERNATIVE 2: Two-month loan shorter than her business cycle. She borrows 1,000 for two months at 3 percent per month with monthly payments of 523 and sales of 400 per month. Total payments are 1,046 (interest expense of 46). Revenue of 1,600 less the loan repayment of 1,046 leaves 554. Cash flow is as follows: Period Business Loan Income 0 (1000) 1000 - 1 400 (523) (123) 2 400 (523) (123) 3 400 - 400 4 400 - 400 Total 600 (46) 524
- 3. With a two-month loan term and a four-month business cycle, the borrower does not generate enough revenue in the first two months to make the loan payments. If she had no savings to begin with or no access to other income or credit to support the loan payments, she would not have been able to repay the loan. ALTERNATIVE 3: Six-month loan longer than her business cycle. She borrows 1,000 for six months at 3 percent per month with monthly payments of 184.60 and sales of 400 per month for four months only. (Assume that because she does not have a full 1,000 built up in working capital at the end of the four months, she cannot buy more inventory at the “bulk purchase” price and thus has two months of no income While this may not always be realistic, it is presented here to illustrate the fact that in some circumstances longer loan terms are detrimental to the borrowers, particularly if they cannot access future loans until the existing loan is paid back.) Total payments are 1,107.60 (interest expense of 107.60). Revenue of 1,600 less the loan repayment of 1,107.60 leaves 492.40. Cash flow is as follows: Period Business Loan Income 0 (1000) 1000 - 1 400 (184.6) 215.6 2 400 (184.6) 215.6 3 400 (184.6) 215.6 4 400 (184.6) 215.6 5 0 (184.6) (184.60) 6 0 (184.6) (184.60) Total 600 (107.6) 492.40 In this scenario the cash flow in the first four months is easier for the borrower; however, she may be tempted to spend the higher net income in the early months of the loan, resulting in potential difficulty making loan payments during the last two months. She also has less net income due to the greater amount of interest paid. This example illustrates why 12-month loans in busy urban markets often result in delinquency and defaults toward the end of the loan term. Also, the borrower ends up being underemployed for two months, because she does not have access to credit to buy more inventory. If the loan term were shorter and she was thus able to borrow again, she could continue to be fully engaged in her business. The preceding three alternatives demonstrate that cash flow in part determines the debt-servicing capacity of borrowers. This influences the appropriate loan terms and loan amounts, which in turn determine the debt-servicing requirements. MFIs should design the loan terms and loan amounts to meet the debt-servicing capacity of their clients. This becomes less of a concern the more profitable the business becomes because greater revenue can potentially result in enough additional income to build up sufficient savings, so that the client no longer needs to borrow unless she or he wants to expand the business. (In such a case the MFI has successfully improved the economic position of its client and should not consider this client “drop out” to be negative or indicative of poor service or products.)
- 4. Depending on cash patterns and loan terms, clients may at times prefer to prepay their loans. Prepayments have two major advantages for the client. They can reduce both the security risk and the temptation to spend excess amounts of cash. They can reduce the burden of the loan installments later in the loan cycle. Prepayments result in one clear advantage for an MFI: by having the loan repaid earlier, the MFI can revolve the loan portfolio more quickly and thereby reach more clients. However, prepayments are difficult to monitor, and if they are significant they can disrupt the cash flow of an MFI (or its branches). This may affect the ability to accurately predict cash flow requirements. In some MFIs full loan repayment results automatically in a larger loan to the client. This may result in the MFI having reduced funds available to lend to other clients. In addition, when interest is calculated on the declining balance, a prepayment usually includes the principal owing and any interest due up to the amount of the prepayment. This means that when loans are prepaid, less interest revenue is received than initially forecast, resulting in decreased income for the MFI (unless the funds can be immediately lent out again). If a particular subset of borrowers (for example, market vendors) tend to prepay their loans on a regular basis, it is advisable to shorten the loan term to suit the needs of that client group. Loan terms should be designed to minimize the need for prepayments. This involves matching the loan term to the cash patterns both to help clients budget their cash flows and to lower the likelihood of prepayments or delinquency. Finally, prepayments can also indicate that borrowers are receiving loans from another lender, which may be providing better service, lower interest rates, or more appropriate terms. If this is the case, the MFI needs to examine its loan products and those of other lenders. Payments Frequency: Loan payments can be made on an installment basis (weekly, biweekly, monthly) or in a lump sum at the end of the loan term, depending on the cash patterns of the borrower. For the most part, interest and principal are paid together. However, some MFIs charge interest up front (paid at the beginning of the loan term) and principal over the term of the loan, while others collect interest periodically and the principal at the end of the loan term. Activities that generate ongoing revenue can be designed with installment payments. In this way the client is able to repay the loan over time without having to save the loan amount (for repayment) over the term of the loan The frequency of the loan payments depends on the needs of the client and the ability of the MFI to ensure repayment. Some moneylenders collect payments every day, particularly if their borrowers are market vendors receiving cash on a daily basis. Other lenders collect on a monthly basis, because they are not conveniently accessible to the borrower (that is, the bank branch is located far from the borrower’s business). A balance must be reached between the transaction costs associated with frequent payments and the risk of default through poor cash management associated with infrequent repayments.
- 5. For seasonal activities, it may be appropriate to design the loan such that a lump sum payment is made once the activity is completed. Harvesting activities is a good example.(Note that other household income can be used to repay the loan in small amounts.) However, caution mustbe exercised with lump sum payments, particularly if there is risk that the harvest (or other seasonal activity) may fail. If when the loan is due there is no revenue being generated, the risk of default is high. Some MFIs that finance seasonal activities design their loans with installment payments so that at harvest times the borrowers keep most of their harvest revenue, because the majority of the loan has already been repaid by the end of the harvest. This works to increase the savings (assets) of borrowers. MFIs may also combine installment loans with lump sum payments, collecting a minimal amount of the loan (for example, interest) over the loan term, with the remainder paid at the end of the harvest season (the principal). Working Capital and Fixed Asset Loans: The amount of the loan and the appropriate loan term are affected by what the loan will be used for. There are generally two types of loans—working capital loans and fixed asset loans. Working capital loans are for current expenditures that occur in the normal course of business. Working capital refers to the investment in current or short-term assets to be used within one year. Examples are wood purchased for carpentry, food or goods purchased for market selling, or chick feed purchased for poultry rearing. A loan made for working capital should have a loan term that matches the business cycle of the borrower (as described above). Working capital loans from MFIs are generally for two months to one year. Fixed asset loans are those made for the purchase of assets that are used over time in the business. These assets typically have a life span of more than one year. Fixed assets are usually defined as machinery, equipment, and property. Examples of fixed assets include motorcycles, sewing machines, egg incubators, or rickshaws. Since the productive activity does not directly use up the fixed asset (that is, not sold as part of the product), its impact upon profitability is felt over a longer period of time. A loan made for a fixed asset is generally for a larger amount and for a longer term than a working capital loan (that is, fixed asset loans do not necessarily match the business cycle). This results in higher risk for an MFI, offset somewhat if the organization takes legal title of the purchased asset as collateral. Table 5.1 provides examples of loan uses for working capital or fixed assets. Although longer loan terms may be required for fixed asset purchases, some MFIs find that they do not need to introduce special loan products if they are relatively inexpensive and the loan can be repaid over 12 months or less. More and more often MFIs are acknowledging the fungibility of money, that is, the ability at various times to use funds borrowed for a certain activity for other
- 6. household expenses. Accordingly, the purpose of the loan is not as important as the borrower’s capacity to repay it. Loan Collateral Generally, MFIs lend to low-income clients who often have very few assets. Consequently, traditional collateral such as property, land, machinery, and other capital assets is often not available. Various innovative means of reducing the risk of loan loss have been developed, including collateral substitutes and alternative collateral. Collateral Substitutes One of the most common collateral substitutes is peer pressure, either on its own or jointly with group guarantees (see chapter 3). In addition, there are other frequently used forms of collateral substitute. GROUP GUARANTEES. Many MFIs facilitate the formation of groups whose members jointly guarantee each other’s loans. Guarantees are either implicit guarantees, with other group members unable to access a loan if all members are not current in their loan payments, or actual guarantees, with group members liable if other group members default on their loans. Some MFIs require group members to contribute to a group guarantee fund, which is used if one or more borrowers fail to repay. Use of the group guarantee fund is sometimes at the discretion of the group itself and sometimes decided by the MFI. If it is used at the group’s discretion, the group will often lend money from the guarantee fund to the group member who is unable to pay. The member who “borrows” from the group fund is then responsible for paying the fund back. If use of the group guarantee fund is managed by the MFI, the fund is seized to the extent of the defaulted loan, with other group members making up any shortfall. Failure to do so means that the entire group no longer has access to credit. CHARACTER-BASED LENDING. Some MFIs lend to people based on a good reputation in the community. Prior to making a loan the credit officer visits various establishments in the community and asks about the potential client’s character and behavior. FREQUENT VISITS TO THE BUSINESS BY THE CREDIT OFFICER. Provided the branch or credit officers are within a reasonable geographical distance from their clients, frequent visits help to ensure that the client is maintaining the business and intends to repay the loan. Frequent visits also allow the credit officer to understand her or his clients’ businesses and the appropriateness of the loan (amount, term, frequency of payments, and so forth). Visits also contribute to developing mutual respect between the client and the
- 7. credit officer as they learn to appreciate and understand each other’s commitment to their work. RISK OF PUBLIC EMBARRASSMENT. Often clients will repay loans if they feel that they will be embarrassed in front of their family, peers, and neighbors. This would be the case if public signs, notices printed in the local newspaper, or announcements made at community meetings list borrowers who do not repay. RISK OF JAIL OR LEGAL ACTION. Depending on the legal context in a country, some MFIs have sued or, in rarecases, even jailed clients for nonpayment. Sometimes, simply the risk of legal repercussion is enough to encourage repayment. Alternative Forms of Collateral There are at least three commonly used alternative forms of collateral. COMPULSORY SAVINGS. Many MFIs require clients to hold a balance (stated as a percentage of the loan) in savings (or as contributions to group funds) for first or subsequent loans (or both). Compulsory savings differ from voluntary savings in that they are not generally available for withdrawal while a loan is outstanding. In this way compulsory savings act as a form of collateral. By being required to set aside funds as savings, borrowers are restricted from utilizing those funds in their business activities or other income producing investments. Usually the deposit interest rate paid (if any) on the savings is lower than the return earned by the borrowers if the savings were put into their business or other investments. This results in an opportunity cost equal to the difference between what the client earns on compulsory savings and the return that could be earned otherwise. Compulsory savings can have a positive impact on clients by smoothing out their consumption patterns and providing funds for emergencies provided the savings are available for withdrawal by the borrower. Most compulsory savings are available for withdrawal only at the end of the loan term, providing the loan has been repaid in full. Clients thus have additional cash flow for investment or consumption at the end of the loan term. Compulsory savings also provide a means of building assets for clients; not all MFIs view compulsory savings as strictly an alternative form of collateral. A variation of compulsory savings required by Bank Rakyat Indonesia is for borrowers to pay additional interest each month, which is returned to them at the end of the loan provided they have made full, on-time payments each month. This is referred to as a “prompt payment incentive” and results in the borrower receiving a lump sum at the end of the loan term. This benefits the borrower and provides a concrete incentive to repay the loan on time, thus benefiting the bank as well. Compulsory savings also provide a source of lending and investment funds for the MFI. They are generally a stable source of funds because they are illiquid (that is, savings are not generally available for withdrawal by the
- 8. borrowers while their loans are outstanding). However, it is essential that the MFI act in a prudent manner when on-lending or investing client savings to ensure that the funds will be repaid and can be returned to the client in full when necessary. ASSETS PLEDGED AT LESS THAN THE VALUE OF THE LOAN. Sometimes, regardless of the actual market value of assets owned by the borrower, the act of pledging assets (such as furniture or appliances) and the consequent realization that they can be lost (resulting in inconvenience) causes the client to repay the loan. It is important that the MFI formally seize the assets that have been pledged if the client does not repay the loan. This sends a message to other borrowers that the MFI is serious about loan repayment. PERSONAL GUARANTEES. While microborrowers themselves do not often have the ability to guarantee their loans, they are sometimes able to enlist friends or family members to provide personal guarantees (sometimes referred to as cosigners). This means that in the event of the inability of the borrower to repay, the person who has provided a personal guarantee is responsible for repaying the loan. Many of the foregoing collateral substitutes and alternative forms of collateral are used in combination with each other. A good example of this is offered by the Association for the Development of Microenterprises (ADEMI) in the Dominican Republic (box 5.1). Loan Pricing Pricing loans is an important aspect of loan product design. A balance must be reached between what clients can afford and what the lending organization needs to earn to cover all of its costs. Generally, microfinance clients are not interest-rate sensitive. That is, microentrepreneurs have not appeared to borrow more or less in reaction to an increase or decrease in interest rates. For the most part, an interest rate far above commercial bank rates is acceptable because the borrowers have such limited access to credit. However, an MFI must ensure that its operations are as efficient as possible so that undue burden is not put on its clients in the form of high interest rates and fees MFIs can determine the interest rate they need to charge on loans based on their cost structure. MFIs incur four different types of costs: Financing costs Operating costs Loan loss provision Cost of capital. Each of these costs are discussed further in part III when adjustments to the financial statements are made and when determining the financial viability of MFIs. For specific information on how to set a sustainable interest rate based on the cost structure of anMFI, see appendix 1.
- 9. In general, an MFI incurs relatively low financing costs if it funds its loan portfolio primarily with donated funds. However, if compulsory savings (discussed above) are used to fund the loan portfolio, they can affect the