I find it empowering that as a MYC4 investor one can easily get an insight into the appraisal process and other risk mitigation measures undertaken on each loan posted on the platform. One can achieve this by simply clicking on the product tab at the very bottom of the loan they plan to invest in. The old adage that bad loans are actually created at the beginning (before disbursement) holds true with MYC4; and that is why our providers share the steps taken to manage risks before a loan is uploaded.
The purpose of the loan is of absolute importance as it affects repayment capacity, and it is always captured on the profile of a loan. The data captured on the products include pricing parameters, as well as the following risk management information
- Required interaction prior to loan decision.
- Assessment of the client’s affordability of the loan.
- Assessment of client’s stability
- Assessment of client’s reliability/ character
- Securities taken
- Other incentives for timely payment.
Generally speaking, there exists sufficient literature on assessing the credit worthiness of an individual, which is summed up in several C’s. The C’s include character, capacity, capital, collateral, conditions, cash flow, commitment, credit history, computer and even common sense. Essentially the first five C’s are the main ones as they incorporate all the other C’s.
A crucial component of determining credit worthiness is capacity. Determining capacity, in my opinion, should be the priority area as all other factors come to support capacity. Capacity refers to ability to meet the loan obligations. The major variable when determining capacity is the nature of cashflows – In credit, cash is king as loan repayments are made by cash. It follows naturally that capacity to generate revenue and collect all receivables will have a big impact on loan repayment.
In the microfinance industry in Africa, there are challenges in determining capacity due to insufficient or no records. Most micro-entrepreneurs keep rudimentary records, mostly of sales or cash received in a day (and this is also not done consistently). To make good risk decisions, it is highly important that some sort of financial analysis has to be taken. To do this, the loan officers have to reconstruct the records from available data and borrower’s word and generate some financial statements. Other ways used in addition to financial statements analysis include asking the borrowers how much they can comfortably pay in a month (from personally working with this segment, it’s amazing the accuracy with which the entrepreneurs know this figure).
The importance of analyzing bank statements to determine capacity cannot be gainsaid; however, many micro-entrepreneurs do not use the bank in a way that their bank statement gives a good reflection of their business health. MFIs have now incorporated analysis of mobile money transfer (most renown is the MPESA by Safaricom) statements in analysis of capacity. This is because the mobile money transfer has become a common way of settling business transactions and easily recordable (the amount of money that has been introduced into the formal financial market and thus easily factored into economic statistics by mobile money is enormous).
The purpose of the loan directly affects capacity as it determines whether there will be a positive return or not (A major cause of defaults in Africa is deviation of funds from intended purpose to projects that do not bring immediate or sufficient returns such as land, school fees, hospital bills etc.): It is thus crucial when considering a borrower’s capacity to determine sufficiency and practicality of loan amount (Be keen not to over/ under-finance, as these are likely to affect capacity). A borrower’s capacity to overcome setbacks is also very important. Borrowers whose businesses do not require their physical presence and those that have experience in overcoming adverse business conditions are attractive targets.
The loan repayment history represents a good indicator of a person’s repayment capacity. However, a lot of care is required to analyse each application in detail, to justify any increment in subsequent loan amount. A common folly is when MFIs have a graduated loan scheme (increase subsequent loans by certain percentage, especially with group loans) without considering business growth, necessity of funds, adequacy of collateral etc.
The character of an individual is very important in determining suitability to receive credit. There exist borrowers that derive pleasure in pushing the limits to the worst extent. There are many borrowers that can pay but won’t pay, until pushed hard. Determining quality of one’s character is very difficult as it is not an exact science; but there are certain aspects that are used in microfinance industry to make an assessment on character. These include third party reference checks with neighbors, business partners and suppliers.
The stability of an individual is an indicator of a person’s strength of character (MFIs are thus interested in establishing how long a person has been in a particular industry or location). Character can also be assessed by scrutinizing payment patterns for utility bills and other credits (A person who is constantly delayed on settling bills is likely to extend the pattern to loan installments). Analysis of a bank account also reveals bad habits like habitual bouncing of checks and missed loan installments. The loan officers should also be very keen during the appraisal to pick on anything that point towards unethical business practices (for example, some borrowers are very wont to influence the loan officers decisions through various forms of bribes).
The capital in a business is another crucial element. Capital mainly represents owner(s) equity acquired through either fresh injection of funds from own resources or through reinvestment of profits from the business. A borrower should have sufficient stake (Mads would prefer to say skin in the game) in the business for him to strive for the success of business, fully wary that failure would be disastrous personally.
Many of the MFI borrowers believe that the more funds (debt or equity) they have the more the money they will make. It is thus not unusual to find borrowers requesting for loan amounts higher than the total value of assets in the business.
The factors analysed under capital include composition of capital (between debt and equity), level and sufficiency of the working capital, and also the nature of the cashflow.
Collateral also plays a major role in loaning decisions. Collateral represents secondary source of repayment for loan. It is usually the measure of last resort – when all other recovery efforts have failed. The collateral taken should have qualities like have a ready market, be easily transferable, have intrinsic & extrinsic value. The collateral taken must be something the borrower would ordinarily not want to lose, or the loss of which will leave a big void. For group lending, in addition to tangible collateral and forced savings, there exists social pressure for a person to pay, so as to remain of good standing in society.
During appraisal, all the conditions that affect business (and by extension loan) performance should be critically examined. No business operates in a vacuum, and many factors, internal or external, may affect the business (Some factors being beyond control of borrower). Factors to be analyzed here include competition (Borrower’s strategy to deal with competition, borrower’s adaptability to changes in the competitive environment etc). Other factors are effects of legislation, changes in technology, political climate, infrastructure, climatic changes, currency rates, pending legal suits, health of key person etc.
Loan officers rely on information given by borrowers, trade information, industry data etc. to make informed decisions on factors that could affect a borrower; and how effects of such factors can be mitigated. It then goes without saying that the knowledge base of the credit committee should be quite broad and extend way beyond crunching the numbers.