Default risk is a critical part of any lending decision and micro-lending is no exception. While micro-lending is trumpeted as having historically high repayment rates, information to support this is limited at best. Of the 260 MFIs that reported their “Portfolio at Risk over 30 days ratio” to the MIX (a World Bank clearinghouse for microfinance information) for 2004, the average rate was 4.76%, with some MFIs reporting up to 63.65% of their portfolio delinquent (200 other MFIs listed on the MIX did not report this delinquency figures). By contrast, consumer credit card loans in the US reported only a 3.99% delinquency rate for Q4 ‘04. Delinquency for Commercial and Industrial loans was lower still, at just 1.83%.
Not surprisingly then, microfinance delinquency figures show an industry that, on average has shown to be riskier than lending in the US. (The star micro-banks beat the above US delinquency benchmarks, but alas, there are few stars),
Compounding default risk, the lender often has limited, if any, courses of action to mitigate damages in the event of default. Poor people lack the assets to back-up their loans, and poor countries lack civil infrastructure, such as adequate court systems, to collect bad debt. Without a safety net for defaulted loans, microcredit portfolios can quickly go bad if borrowers perceive that there are no consequences for loan default.
More often than not, micro-loans are made without collateral; depending on cash flows from the enterprises they fund in order to receive payment. This dependency on cash flow cycles can yield further increased risk in seasonal enterprises that demand loans with longer maturities. Agriculture, in particular, stands out in this regard. Likewise, any trade in goods or services that is highly demand elastic also presents a greater risk.
Further compounding the risks are the harsh environments in which microfinance exists. Impoverished areas lack general infrastructure necessary for day to day business. “The clients of K-Rep, an excellent Kenyan microfinance bank in a small town on the fringes of Nairobi, are a pretty resourceful lot, but when the government stopped repairing roads, picking up rubbish and spraying for malaria, some were at wits’ end. Drainage in the marketplace was plugged by uncollected garbage and customers stopped coming. Maria Njambi, a single mother with a ten-year-old child, used to have a viable business selling fruit and vegetables she bought with credit from K-Rep, but she had to watch her inventory rot and has stopped repaying her loan.” (from “The Hidden Wealth of the Poor,” The Economist)
HIV and AIDS, among other diseases, pose very serious risks in developing nations. Those who become ill, or must take care of the sick, often must divert their time away from work and subsequently default on their loans.
Some micro-lenders have been quite successful in creating social safety nets that help hedge the default risk. Grameen Bank, for instance, one of the largest microfinance institutions with total assets of US$514,718,843 as of 12/31/04, “insists that the [borrowers] be organized into groups of five, with each person in the group committing to guarantee the loan payment of the other members in the group.” (p.2) A number of other mechanisms in this vein exist; including sequential lending, in which borrowers are able to take out increasingly larger loans as they pay off existing debts.
The higher interest rates charged for micro-loans are, in effect, insurance against default, a premium for the added risk. For a more in-depth discussion of how default risk and other factors affect interest rates in developing markets, please see “Credit Rationing in Developing Countries: An Overview of the Theory,” by Parikshit Ghosh, Dilip Mookherjee and Debraj Ray.
Additional Resources
1) Subscription Only: “Bankable Banks,” The Economist: November 3rd, 2005.
2) “Causes of Default in Microcredit Association for Social Advancement,” Association for Social Advancement (ASA), 1997.3) “Credit Rationing in Developing Countries: An Overview of the Theory,” Ghosh, Parikshit, Dilip Mookherjee, and Debraj Ray, December 1999.
4) Subscription Only: “From Charity to Business,” The Economist: November 3rd, 2005.
5) “Grameen Bank Replication: Lessons Learnt,” Mayfield, James B., Choice Humanitarian, Fall 1998, p. 2.
6) Subscription Only: “The Hidden Wealth of the Poor,” The Economist: November 3rd, 2005.
7) “Managing Risks and Designing Products for Agricultural Microfinance: Features of an Emerging Model,” Christen, Robert Peck and Douglas Pearce, CGAP Occasional Paper #11, August 2005.
8) “Response Required: Mitigating Risk in African Credit Unions Serving HIV/AIDS-affected Communities,” Evans, A.C., World Council of Credit Unions, Inc., 2003.
