RISK ASSESSMENT AND MITIGATION ANALYSIS: MICRO-CREDITS FOR ROMA COMMUNITIES IN HUNGARY

Prepared by Volodymyr Tounytsky, Zoltan Kristof and Alexandra Windisch-Graetz
For UNDP, “Micro-credit programme for disadvantaged groups in Hungary – with a special focus on the Roma population”(Pr.Nr. 00042644)

TABLE OF CONTENTS

1. Executive summary 3

2. Overview of status of micro-lending in general, for vulnerable groups and Roma population in particular 3

2.1 A brief look at the competition: Usury and quick loans in Hungary 7

3. Description of Hungarian microfinance project 11

4. Risk analysis of micro-lending institution and its operations for disadvantaged groups as designed under the Micro-credit program for disadvantaged groups in Hungary and mitigation guidelines 12

4.1 Institution Related 13 4.2 Target Group Related 14 4.3 Product Related 15 4.4 Loan Process 21 4.5 Delinquency and Defaults 27

5. A set of indicators for risk monitoring and portfolio management 30

6. Conclusions and Recommendations 30

Table 1. Risk Areas and Mitigation Approaches 32

Table 2. Characteristics of Client Economic Activities 36

Table 3. Product Specification Sheet: Credit Product 38

Table 4. Loan Analysis Form 39

Table 5. Financial Statements With Loan Loss Provision and Reserve 42

Table 6. Portfolio Management Indicators 43

1. Executive summary

This report has been commissioned by the UNDP, Project Nr. 00042644 “Micro-credit programme for disadvantaged groups in Hungary – with a special focus on the Roma population”. The project is in the start-up phase and undertakes to provide financial services to the Roma population in selected locations in Hungary.

The initiative follows the footsteps of more or less successful Roma microfinance schemes in Bulgaria, Slovakia, Bosnia-Herzegovina, Croatia, Serbia and Montenegro.

The report presents a comprehensive approach to delinquency management based on microfinance good practices. Specifically, it addresses key areas of operations and set-up of the microfinance program (clients, products, processes) from the viewpoint of risk mitigation. Special attention is paid to the loan analysis, which is discussed in detail, tools for reliable loan analysis are provided.

Generally accepted loan portfolio indicators are presented and described. Their applicability is discussed and benchmarks provided where available.

Key areas of risks are presented with recommendations on mitigation measures.

2. Overview of status of micro-lending in general, for vulnerable groups and Roma population in particular

Initiated in the 70-ies of the last century microfinance was a response to economic needs of poor population mainly in the developing countries. It was conceived as a means to overcome poverty and empower wide strata of underprivileged people.

More than a quarter century later, MFIs serve more than 30 million poor people in developing countries with over $7 billion in outstanding microcredit loans. With extensive experience in the provision of financial services (most often loans), the microfinance industry has developed unique methodologies that allow for the extension of credit to previously “unbankable” clients. A general acknowledgement of the importance of microfinance in economic development came in 2004 when the United Nation Organization proclaimed 2005 the Year of Microfinance. One can consider the industry a maturing one.

Microfinance proved a global success due to the following factors: • Finding innovative solutions to loan securitization through non-conventional guarantees and collateral (key to methodology) • Developing efficient, cost-effective ways of service delivery • Designing products that fit the needs of their clients (small, short term, repeat loans)

This success has been largely based on the realization that poor clients can and will repay their debt if provided with quality affordable service and the ability to establish long-term relationships with their micro lenders.

Institutionally, microfinance services are delivered through a wide range of organizational forms – starting from self managed village banks, rural credit and savings associations, NGOs through formal specialized microfinance banks (in 2000 the International Finance Corporation led the way for the creation on 11 microfinance banks in Europe and NIS).

Over years, microfinance institutions demonstrated excellent results in portfolio quality, financial results and efficiency. This allowed the industry, initially donor led, to start moving towards commercial sources of funding (loans and investments). This was accompanied by transformation processes of NGO type institutions into regulated financial intermediaries.

All of the above is true of the microfinance experiences in the developing world, where the main focus of intervention is poverty alleviation. However, recent history shows an increased interest in microlending in the West – including the European Union (both in newly accepted and older member countries). The state of the industry in this region was discussed during the First European Microfinance Conference held in September 2004 in Brussels.

There are a number of specific features of the environment in these countries that have an effect on the shaping of microfinance practice, namely: • Economically developed environment with developed banking sector • Highly active but “invisible” sector of micro and small enterprises • Unemployment as the source of social and economic exclusion • System of social support/welfare • Drastic differences in economically depressed areas

These conditions predetermine the choice of the target population – long term unemployed and self-employed persons. Hence, microfinance service providers’ efforts are concentrated in the area of enterprise development.

Other studies[1] show that the success of microfinance in economically underdeveloped countries cannot be simply replicated in developed areas. The most obvious reason is the mismatch between the size of a loan and its possible impact. For example, the small size of microloans can improve the borrower’s economic situation and be used for boosting productivity in a less developed economy. In the context of a developed economy however, a loan of a hundred or even few hundred dollars is not more than a consumer loan and the most one can do with it is small-scale trading with marginal value added.

Besides specialized government supported agencies, in European countries credit is offered also by NGOs, credit unions, specialized banks (Romania and Bulgaria). As estimated by the European Microfinance Network, currently about 1,5 mln clients are served; the total microfinance portfolio is about $400 mln[2].

While there exists extensive literature on microfinance practice in the developing countries, very little experiences are documented on in the European context. However, some general observations on the sector could be made: • In contrast to traditional microfinance markets, European MFIs are less focused on the issues of sustainability – usually they are heavily subsidized • Productivity and efficiency aspects are of concern • Many institutions lack adequate lending methodologies and staff expertise due to highly competitive labour markets • “Microfinance plus” (financial and business development services bundled) models are much more common • Many MFIs operate under government regulated interest caps • The scale of service provision is rather limited compared to traditional microfinance markets

Experiences in providing microfinance service to niche markets in Europe are rather limited – the best example being lending to refugees and internally displaced persons (IDPs) in the post-war countries of former Yugoslavia (Alter Modus – Montenegro, Prizma, EKI – Bosnia and Herzegovina). In addressing the needs of refugees and IDPs, the MFIs faced some specific challenges conditioned by the following: o The clients they endeavoured to serve were characterized by virtually total lack of assets (including household assets) o Were socially isolated, frequently inhabiting refugee settlements o Frequently showed consequences of deep psychological stress

Faced with these conditions, microfinance institutions approached the implementation of respective projects using an array of methodologies (primarily group guarantee and individual lending), and making their services available to the target and local populations equally. This has led to success both in terms of providing financial services and facilitating the integration of the excluded population into local communities.

These broad approaches should be relevant to the implementation of microfinance programs in other environments where the target population bears certain resemblances[3] in terms of asset base and exclusion status (as is the case with Roma people in Central Europe). In particular, these resemblances are: • no cohesion with the broader community, • weak social ties, • very limited asset base in terms of housing, • strong reliance on direct government assistance.

Ivanov and Tursaliev[4] argue that the reason microfinance institutions were a success in the former Yugoslavia but not particularly among the Roma of Bulgaria or Slovakia was the post-conflict nature of the economic context in Bosnia and Herzegovina, which makes it closer to the traditional developing countries’ environment where microfinance works perfectly.

Additional factors to take into consideration will be: • The status of cohesion and hierarchy observed within the Roma community • Traditional predisposition of Roma to specific activities that have enterprise potential and could be built upon (crafts, services)

Unfortunately, neither of these factors work favourably in the Hungarian context: • Cohesion and hierarchy does work among the Roma themselves, but there are no such ties to the outside world. What this implies is that unless the microfinance institution “builds into” the Roma community, i.e. by employing Roma workers or somehow winning the trust of the leaders, it has little hopes of exploiting this factor. • The vast majority of Roma are unemployed and have been conditioned to rely on grants from the state instead of practicing other crafts or services. This implies two things: • Micro loans can successfully (i.e. with any hopes of them being used for productive means and be paid back) be provided only to those who already have entrepreneurial backgrounds. • Micro loans must be carefully separated from grants in the minds of the targeted people.

At this point, successful large-scale microfinance interventions specifically focusing on the Roma population are virtually non-existent. Limited scale operations (though extremely valuable as pilots) utilizing microfinance good practices are implemented in Hungary[5]. Numerous other projects are heavily supported by the government programs and focus mainly on the provision of direct assistance, lightly experimenting with micro loans.

The project might become, despite it limitations in terms of size, a valuable contribution to the development of new innovative solutions aimed at the improvement of the status of Roma population in Hungary. This experience, if successful, could be easily replicated in other countries in the region with similar environments.

2.1 A brief look at the competition: Usury and quick loans in Hungary

The inaccessibility of commercial banking loan services among the poor and especially the Roma has created a market for usury in Hungary.

It is widely known in Hungary that informal money lenders can be found almost in every region, but especially in Roma-populated small settlements. Sometimes these loan sharks are also of the Roma ethnic group.

The topic has been discussed in several periodicals in the course of the past year, e.g. Figyelő (January 2004), HVG (August 2004), Magyar Narancs (February 2005). These articles not only focused on informal money lenders, but also on a (legal) financial company which operates with extortionate (above 225% p.a.) rates of interest.

Generally, the methods of the loan sharks can be summarized as follows:
They provide a quick loan to a low-income person-in-need for a short period, typically for one month or until the debtor receives his/her next instalment of income (which is usually some kind of social aid). The deal is normally for payback of double the original amount. The starting principal of the loan is a very small amount, i.e. between HUF 1,000 and 20,000.

When the time for settlement comes and the debtor appears with the agreed amount, the loan shark either demands a higher amount, referring to inflation, or convinces the debtor to withhold a smaller amount – the double of which he/she may pay back the next month. In either case, the “banker” achieves that some loan remains outstanding, which he can demand in the following month. With this method, the one-time debtor enters into a spiral of increasing loans that he/she must pay for until the end of his/her life. It can also happen that the person defaults and becomes a debt slave who is obliged to work for his creditor just to repay his loans.

“Monitoring” is simple: the “banker” either keeps his records mentally or in a hand-written notebook that contains the calculations from his own viewpoint. The debtors are often illiterate and unable to assess the extent of their indebtedness. Even if they could calculate the amount they owe, they wouldn’t be able to do much about it.

At the first sign of delinquency, the “banker” sends a warning to the debtor in the form of either a relative or a close associate of his, who is in all cases in a physically superior condition compared to the debtor. This method is used extensively in stead of any examination of creditworthiness or the requirement for collateral.

Police is very rarely successful in terminating this illegal business, as the “banker” and his accomplices (physically) intimidate both the debtor and his/her relatives. The rare denunciations are almost always followed by retribution, which prevents the continuing of the investigation by frightening away the witnesses.

The huge market demand for small-amount quick loans is reflected by the success of Provident Financial Rt. The company proudly claims on its home page that it provides “home delivered” financial services in Hungary. The Hungarian company is the subsidiary of Provident Financial Plc of the UK. It is expanding rapidly and currently provides its services to 185,000 clients countrywide. The reported number of clients was around 145,000 a year ago, which is quite remarkable given the fact that the company began its operations only in 2001. The figures at the beginning of 2005 show that the number of clients continues to grow.

Provident Financial Rt approaches its potential customers mainly through flyers thrown into mailboxes and personally through its agents.

Clients with confirmed incomes may be granted amounts between HUF 50,000 and 120,000 by Provident. Under HUF 40,000 no official confirmation is required, it is sufficient if the client presents a bank account statement which shows that he/she has recently received a salary.

There is no bail or collateral required for the loans of Provident Financial Rt. This means that the products of the company are probably sought after by clients who are excluded from “normal” bank loans due to the stricter set of conditions or the lack of information.

Provident Financial Rt’s total credit cost ratio (THM), which includes nominal interest as well as all fees, shows 438% for the 26-week quick loan, 334% for the 39-week one, and 227% for the 52-week one.

These exorbitant rates are justified by the company in terms of its high labour costs, as the provision and handling of credit requires many personal visits. Provident Financial Rt undertakes to evaluate loan requests within 48 hours, deliver the amount to the home of the client, and send an agent to collect repayment personally. This naturally has its advantages: this way, it is more difficult to avoid repayment compared to when e.g. the client would need to wire the amount via postal deposit. Moreover, the personal visit is an opportunity for the Provident employee to quickly assess by looking around in the debtor’s home, whether he/she is likely to be able to repay the loan.

According to last year’s experience, approximately 8 per cent of the British company’s clients default. In the Hungarian subsidiary this ratio is 6-7 per cent.

To summarize, it can be argued that today’s Hungary has hundreds of thousands of low-income, disadvantaged people, many among these Roma citizens, who are in need of quick and easy loans in the amount of HUF 10 - 100,000. Also, these people generally are able and willing to repay loans at very high interest rates.

There is no sufficient amount of data however, regarding the ratio of clients who would require such loans for the financing of investments into their own micro enterprises, instead of immediate consumption.

Nonetheless, the effect of a loan product that is quickly and easily accessible, non-profit based and short-term would surely have a beneficial effect on economic development. Such a loan would at least partially reduce the demand for usury loans and market-based quick loans. The decreasing exploitation of the debtors should increase the chances of successful micro-enterprises appearing.

2.2 Roma entrepreneurs in Hungary[6]

Roma entrepreneurs have a higher level of education and professional qualification compared to the Roma population as a whole. These entrepreneurs were usually active employees before they started their enterprises. While almost half of the whole Roma population lives segregated and one fifth of them lives in ghettos, indicators suggest a better situation in the case of Roma entrepreneurs. Although these Roma entrepreneurs usually live in better circumstances, there exist operating and successful enterprises in ghettos and segregated circumstances as well.

Roma entrepreneurs have significantly higher incomes than the average Roma. Their ability to support their families is higher, but at the same time they shoulder more solidarity with their relatives than the poorer ones. The income conditions with this situation show a shaded situation. Entrepreneurs in the first income decile and the non-entrepreneur family do not differ from each other very much, it can be said that the levels of poverty are different.

Most of the enterprises operate in the construction industry. The second biggest group is commercial companies, the third is the companies operating in other sectors, for example in transportation, education, and other communal service. Only relatively few entrepreneurs work in agriculture.

Family traditions in business are a key factor of economic success. In families where there is a tradition of entrepreneurship, there is a bigger chance of success. These traditions are more important than other qualifications. Entrepreneurship knowledge and practice have real influence when they exist simultaneously with entrepreneur tradition and qualification. A key task therefore, is to create a system where these traditions can be passed to the young generation, as they cannot be learned in other ways.

3. Description of Hungarian microfinance project

The proposed project – “Micro-credit programme for disadvantaged groups on Hungary – with a special focus on the Roma population” – aims at establishing and maintaining a microfinance institution in Hungary. The project is co-funded by UNDP, the Arab Gulf Fund for UN Development Organizations and the Open Society Institute. The Autonomia Foundation was identified as the Implementing Agency based on its considerable experience in the development and implementation of similar programmes.

The programme undertakes to address the problems faced by the disadvantaged groups in the country, primarily Roma, through the provision of access to credit as well as business training and consulting. It is believed, that through these services, the project will contribute to the improvement of the situation of economically active clients, decrease their dependency of the social assistance provided by the government, and promote self-employment.

The choice of microcredit intervention was prompted by the fact that the target group faces special difficulties in accessing formal sources of capital. On the one hand, they represent microbusinesses, on the other, a population traditionally excluded from economic “mainstream”. Though Hungary has a relatively developed banking sector, microbusinesses remain beyond the “radar” of the majority of commercial banks who fail to offer them adequate products because of the associated loan amounts, risks and inability to compensate for them through non-traditional solutions. Also, Roma population, coming from poor depressed regions and possessing lower levels of actual or perceived reliability does not facilitate such access either.

The project, though aiming at the creation of a permanent microfinance institution, is designed as a 3-year pilot. The following objectives are planned to be achieved during this period: • Making operational the new micro-finance institution (completed) • Ensure widespread knowledge of the new micro-finance institution • Increase the business skill levels present within Roma communities • Increase the amount of credit available to micro-enterprises • Support the successful development of micro-enterprises

At this point in the project implementation, a number of tasks were identified which are critical for the future successful operation of the scheme, particularly the following: • Clearly define the so far broadly understood target group • Develop loan products • Develop lending procedures • Develop appropriate strategies for client enrolment and formation of institutional partnerships • Develop business skills development products and decide on how to bundle them with the financial services • Register and open a lending institution (completed)

Mikrohitel Rt is fully compatible with the (modified) Act CXII of 1996 on Credit Institutions and Financial Enterprises. Based on that, it operates as a financial institution and it places loans, but it does not accept deposits.

Mikrohitel Rt. (Micro-credit Economical Development Financial Shareholders' Co.) was founded in 2003, resulting from the co-operation of Open Society Institute, BB Foundation for the Development of Entrepreneurship, Foundation for Autonomy and Autonómia Development Kht.

The managers of Mikrohitel Rt. have decided that the minimum loan they would finance is HUF 300,000. The maximum value can be HUF 1.5 million for the first time financing a client, and HUF 3 million from the second finance of a reliable client.

Act CXII. of 1996 on Credit institutions and Financial Corporations (Banking Act) does not allow foundations to provide loans. For this reason, Mikrohitel Rt was founded as a financial enterprise.

It should be noted here that the operations of Országos Mikrohitel Alap (National Microfinance Fund), a government-founded microfinance institution are actually excluded from the effects of the Banking Act:

2. § (1) The following are excluded from the force of this Act: [...] h) the money-lending activity of the Hungarian Foundation for the Development of Enterprises through its National Microfinance Fund, as well as the microfinance activities of the foundations for economic development founded by the counties or the capital city.

The Act poses significant administrative and reporting requirements to the companies under its effect, and it would be recommended that the shareholders of Mikrohitel Rt examine the possibilities of becoming legally exempt from such costly duties.

A three-member Board, with the members employed by the company and headed by a Chairman, manages the institution. The Board also acts as the Loan Committee. The members of the board are also employed by the BB Foundation for the Development of Entrepreneurship and the Foundation for Autonomy, but it is not this fact that makes them the board members of Microfinance Rt. The company employs 5 persons altogether, and all core tasks are performed by these. The project is funded by UNDP, its partner from the Hungarian Government is the Ministry of Youth, Family and Equal Opportunities. The Ministry acts as an executing agency, but does not participate in the lending activity itself. It does participate in the monitoring however: it controls the operations of Mikrohitel Rt and only approves of the next instalment of funding from UNDP if it finds everything in order. The funds from the donors (including UNDP) reach Mikrohitel Rt through the Foundation for Autonomy, but it is only Mikrohitel Rt that places loans, financed by the funds provided for it as equity.

The Foundation for Autonomy intends to develop smaller, group guaranteed loans with the newest funds.

4. Risk analysis of micro-lending institution and its operations for disadvantaged groups as designed under the Micro-credit program for disadvantaged groups in Hungary and mitigation guidelines

Risks are associated with the operations of every type of organization. Microfinace institutions face specific types of risks, which arise from the nature of their services – financial intermediation – and, if not properly addressed, might lead to high delinquency resulting in defaults and effective loss of financial assets. Hence, risk mitigation factors need to be built into the institutional set-up, operations and practice, products offered. Risk management systems are highly specific as they are informed by the unique set of variable factors arising from the environment, target client group, products offered etc.

While at this point, according to the UNDP Project Document[7], only general principles of the future operation of the microfinance institution were defined, key areas of the sources of risks could be analyzed and, based on microfinance good practices, recommendations developed that will help the microfinance organization to operate successfully. These are discussed below and summarized in Table 1 in the annex.

4.1 Institution Related

The institutional set up of the MFI is critically important to the success of the program and, if approached correctly, will contribute to the mitigation and, in some cases, elimination of operational risks. The Program Document clearly defines the program management side, while decisions concerning the setting up of the institution in the given context of the target group, existing and future linkages, legal environment etc. have to be addressed. The following areas relating to the institutional set-up were identified as potential sources of increased risk.

Image of the Organization. Given the history of considerable support provided to the Roma community by the government, various local and international donors in the form of grants and free services, an effort should be made to ensure that future beneficiaries understand the nature of loans. An additional difficulty here is the attempt by the program to provide not only loans, but also business development services in the form of training and business plan development.

While the adopted approach of providing integrated services (microfinance plus) might be fully justified, operationally, financial services need to be separated from training and especially from assistance with the development of business plans. This will also help to overcome the projection of Autonomia’s image as a socially oriented institution providing free or subsidized services.

Mikrohitel Rt provides financial services only, whilst Autonomia Foundation provides integrated (training, assistance in business planning, etc.) services separately. This clear separation of microfinance activities should help the institution to overcome perceptions that this is just another assistance program and hence instil appropriate attitude of clients towards loans.

Interaction with the Target Group. The issues connected with a precise definition of the target group will be analyzed separately. Here some broad principles of dealing with ethnically and socially defined focus will be discussed.

The success of the organization greatly depends on how it fosters appropriate linkages to the target group. This could be achieved primarily through close co-operation with Roma organizations – e.g. ensuring their representation on the Loan Committee, using their assistance for client enrolment, and, most importantly, keeping close to the client community. In many cases, organizations make a point of hiring staff from respective communities.

On the other hand, in mixed communities, ethnic focus cannot lead to the exclusion of other nationalities/ethnicities inhabiting the same areas. In case of the proposed project, caution should be exercised to keep the program open to socially disadvantaged individuals irrespective of their ethnic origin in order not to alienate the overall group and not to provoke tensions.

Scope of Operations. The project has been designed as a pilot with a limited budget of $342,000 for 3 years with $139,410 (apart from the staff costs) dedicated to the micro credit activities, the total of $118,410 as loan fund. The latter translates into annual disbursement of about 45 loans averaging $5,000.

This might prompt the program to concentrate geographically in one carefully chosen area. The site of the program intervention should, on the one hand, be representative of the target population, and on the other present certain advantages to the implementers: geographic proximity, convenient communication, relatively strong local groups, relatively high level of economic activities of future clients. This approach will objectively decrease the risks associated with the program start up – lack of staff experience, the need to develop and verify procedures and products, efficiently manage the costs.

For the time being, there is no staff scarcity and there is no such risk either. Later, hopefully there will be a need for more employees, along with the growing number of loans, but the necessary workforce will probably be available.

4.2 Target Group Related

Microcredit has been designed as a development tool for the economically active poor population. It is no “snake oil” – contributing to poverty alleviation, helping overcome social exclusion and improving the economic situation of individuals (and, arguably, local economies) – and has significant limitations. The key word for the definition of the target clients is their economic activities – either existing business or aptitude to start one. This should be borne in mind when defining the target group of clients for the microfinance organization.

In the case of Roma in Hungary, there arise additional difficulties not typical for most traditional microfinance environments. Future borrowers are located in “poverty pockets” inside an economically stable landscape. This poses serious obstacles in terms of demand, market chains and availability of viable business models. These difficulties result in a disproportionately high percentage of bankruptcies in Roma owned/run businesses[8] as well as a very low percentage of target population involved in business activities (only about 7% of loans received by Roma were used for business/trade purposes). While access to credit and a lack of quality business development pose significant obstacles, the program (at least at the start-up period) should concentrate on existing businesses, which will be able to use access to capital in the most efficient way. At a later stage, when the organization acquires necessary experience, it will become able to absorb risks associated with extending credit to new businesses and expand their range of products.

Because of organizational aspects mentioned previously, the idea of making a geographically focused effort might make sense. While choosing the area of operations, preference should be given to Roma communities with higher than average level of the incidence of micro entrepreneurs. Such approach will give the program access to larger numbers of potential borrowers, facilitate enrolment and provide an opportunity to form a higher quality portfolio, hence leaving the necessary “breathing time” to solidify and perfect procedures, improve the products and build the foundations for future expansion and/or replication.

The same purpose of minimizing the risks will be served by the concentration in traditionally successful sectors. These will vary with different locations but should be characterized by some typical features: existence of necessary skills, local or accessible supply sources, and local markets. Table 2 in the annex shows the microfinance client continuum with characteristics specific to different scopes of business activities. It could be used as a template in the process of choosing the specific target group for the micro lending operation.

Based on the program information, it appears worthwhile to concentrate in the areas of Income Generating Activities (IGAs) and Microenterprises (MEs) as these two types of business activities present good opportunities to mitigate objective risks inherent in the broadly defined target group.

4.3 Product Related

The scope of the program does not allow for a fully-fledged product development activity. Nonetheless, based on the current knowledge of the market for the planned services, it could be assumed that at least two main types of loans should be developed and tested – group loans for IGAs and individual loans for MEs.

Main product attributes will be determined based on a thorough analysis of the needs of the two types of clients in specific environment. However, some principles contributing to a better fit between a loan product and the needs of the two types of clients (and hence to successful loan repayments) could be summarized as follows:

|Loan Attributes |Group - IGA |Individual - ME |
|Loan Purpose |Working capital |Working capital, fixed assets |
|Loan Amount |Lower |Higher |
|Loan Period |Short, typically up to 6 months |Longer, typically up to 12 months |
|Loan Interest |Higher |Lower |
|Repayment Frequency |High, frequently weekly repayments |Lower, typically monthly repayments |
|Guarantee |Group guarantee |Collateral, guarantors |
|Incentives to Repay |Access to future loans, rebates, simplified application process for repeat |
| |loans; late payment fees, loss of eligibility to future loans |

Loan Purpose. There are distinct prevailing patterns of loan utilization, stemming from the scale of micro businesses. Typically, what we consider IGAs will have very limited fixed assets, frequently of dual household/business application adequate for the scope of the business. The need for capital in IGAs is limited to the purchase of inventory or raw materials and hence working capital loans prevail. Investment in working capital generates immediate increased sales.

The catch with IGAs is that as their sole purpose is to make enough money for household consumption (see Table 2). We must find a very strong incentive for them to use the loan received for investment into working capital. That is, what is to stop the person from spending all the loan money on the consumption that she was planning to get from her IGA anyway? For this reason, the Character factor of a loan decision for IGAs must be all-decisive i.e., the most important is to focus on an IGA’s willingness to repay, instead of the ability to do so.

In contrast, with the increase of the sheer size of the business (MEs), the needs of the enterprise expand. Apart from the working capital, support and/or growth of the business requires additional investment in the fixed assets. A frequent difficulty faced by lenders to micro enterprises is the need to balance an increased loan amount for the fixed asset with an additional amount for working capital necessary to ensure the purchase of raw materials/goods. Fixed asset loans usually do not produce a sharp increase in sales, but ensure a long-term effect on the business.

While the principles of microfinance good practices require that the loan use not be restricted, this concept needs clarification. The lack of restrictions in this case means no dictate as to the sources and mechanisms of purchases made utilizing the loan; however, it is the lender’s responsibility to ensure that the borrower’s intentions as to the planned use of the loan are clear and specific. This is critical for the adequate subsequent loan analysis.

Loan Amount and Period. Obviously, the two types of loans (working capital and fixed assets) will differ in prevailing amounts and periods. It is critical that these two loan attributes correspond to the business cycle (period) and the business capacity to absorb the financing (amount) – utilize the loan and produce profit adequate for loan repayment.

The range of loan amounts and periods have to be set based on the analysis of prevailing modes of purchases performed by client businesses (frequency, amounts). A lack of fit between the loan attributes and the realities of borrower business lead to difficulties on repayments. This is especially important in the type of clients microfinance programs deal with – fungibility of funds between the business and the household is a reality. Any excess capital will realistically be used for household needs and harm the client’s ability to repay the loan out of business income. Excessive/too short loan terms might have same effects.

Generally, the types of businesses microfinance programs deal with are characterized by rapid turnover – short business cycles. Hence it could be expected that the range of loan periods indicated in the table (with possible modifications based on client base analysis) should be appropriate for the program. For more on the determination of appropriate loan amounts and loan terms, please see Loan Analysis section in 4.4. Loan Process.

Loan Interest. An organization can approach the issue of pricing in many ways depending on the institutional goals, competition, and characteristics of the target group.

In the case of a pilot project a practical approach could be to start from an analysis of the profitability of typical client businesses. Their margins could serve as an approximation of the absolute upper limit to the interest charged. Typically, micro businesses demonstrate very high levels of profitability, in the range of 40% and up. In conjunction with the levels of cost recovery set by the organization this will allow to make a decision on the pricing of loans.

Obviously, the pricing of the working capital and fixed asset loans will be different as dictated by the different effects on the two types of investment on the immediate profitability of the business. Usually, fixed asset loans are priced significantly below working capital loans. This also corresponds to the inherent risk differences between these two loan types.

Irrespective of the organizational considerations, the loans should not be priced below prevailing market rates. The reasons for that are multiple. Market pricing will allow an organization to: • Select businesses that have a better chance of success • Prevent a situation conducive to fraud and abuse in the selection process • Ensure better chances of the organization for cost recovery

Repayment Frequency. While deciding on the repayment frequency, several aspects need to be taken into consideration: • Repayment frequency will determine the payment amount and hence the business cash flow needs to be taken into consideration • Smaller amounts (and hence more frequent payments) are preferable as they are easier for the client to pay • Frequent repayments keep a client in a closer contact with the organization contributing to the payment discipline

Working capital loans usually are scheduled in equal installments (part of the principal plus interest). This is convenient both for the organization and the client. However, with fixed asset loans additional profit is usually delayed thus calling for a longer or shorter grace period. Bearing in mind that the unpaid principal remains under risk, caution should be exercised when allowing for the grace period. The right balance should be sought between the real needs of the client’s business and risk minimizing measures undertaken by the organization.

It is unusual for microfinance organizations to offer bullet loans. A business activity worth lending to will definitely produce cash inflows adequate for loan repayment prior to maturity. Similar to the grace period, uncollected principal in this case remains under risk for the loan contract period. Besides, earlier repayments will allow for a quicker portfolio turnover and result in more loans disbursed (a factor of extreme importance for cash strapped programs).

Loan Guarantees. Considerations concerning loan guarantees could be started from the analysis of the loan repayment sources. They are:
1. Primary – cash flows from business operations
2. Secondary – other financing (savings, debt – suppliers, other loans)
3. Auxiliary – collateral and guarantees

It is evident that the client’s success in the repayment of the loan depends primarily on the success of their business activities (ability), as well as their intentions (willingness). The microfinance approach to lending is based on the adequate analysis of the client’s business and their character. In contrast to the formal financial sector, a lack of assets, which could be used as “hard collateral” in typical micro enterprises, prompted the development of innovative approaches to loan guarantees.

The most important innovation that allowed lending to previously non-creditworthy clients was the group guarantee. This mechanism consists of mutual guarantees of loan repayment of a group of borrowers. The group guarantee allows a significant decreasing of loan risks of individual borrowers due to multiple cash flows and, in the case of unwillingness to repay, due to peer pressure. In case of the Roma population in Hungary, there need not be any insurmountable barriers to a successful implementation of the group methodology. Even though, as mentioned in some sources, the community cohesion seems to be eroding, a careful approach to the group formation based on mutual longer-term business interests can be effective.

In case of IGAs, the program does not have additional choices because expectations of adequate collateral or reliable guarantors will be unrealistic. However, to reinforce the group guarantee, where possible, additional measures may be adopted to further mitigate the credit risk: household assets accepted as collateral, personal guarantees of individuals.

The Banking Act mentioned above does not restrict the use of group guarantees, i.e. it is a viable approach from the local regulatory viewpoint. However, the legal execution of a group guarantee probably involves several separate guarantee contracts with each of the participants.

Group guarantee is indeed the only possibility in the case of working capital loans. For the leasing of land or other fixed assets, deferred ownership rights transfer is encouraged instead.

In the case of microbusinesses, with larger loan amounts, some kind of formal collateral becomes a necessity. The coverage usually is much lower than that required by the commercial banks and typically constitutes 100% or slightly above the loan amount. In this case, predominantly business assets (including purchases using the loan) are required as collateral. While considering the risk mitigation effect of hard collateral in microfinance, the following should be borne in mind: • The market value and liquidity of assets available for collateralization will be low • Legal aspects of collateral repossession need to be evaluated – if there is a possibility at all. (This is one of the reasons why leasing with deferred ownership rights transfer is advisable.) • The cost of formal collateralization is sometimes rather high. It will either additionally burden the client or diminish the financial results of the organization • In many cases organizations decide to keep the title of the purchased goods/equipment until the loan maturity. This is encouraged by the experience with Roma microfinance in other CEE countries. • When dealing with collateral, title issues need to be verified • On average, repossession and liquidation of collateral, after associated costs, yields 10%-20% of the defaulted loan

Incentives to Repay. The most important aspect of microfinance operations both in the developing world (poverty alleviation focused) and in developed countries (fighting social exclusion) is the provision of reliable and long-term access to financial services to “unbankable” clients. Building operations in a way that send a clear message to clients about a wish and an ability of the organization to build long term relationships might be considered a key incentive for the clients to care about maintaining such relationships and to encourage repayment discipline. This will only work when the organization is able to offer products responding to real client needs.

More technical repayment incentives can and should be built into the product itself. These are divided into positive and negative incentives. As proved by practice, positive incentives possess a much stronger motivational impact. Options to consider: • Gradual increase of the loan amount upon timely repayment of previous loan • Relaxing of group guarantee requirement (e.g. 3 instead of minimum 5 group members • Financial incentives (lower interest rates, abolition of application fee, interest rebate with last installment) • Simplified and quicker application procedure for repeat loans • Ensured access to non-financial services (training, consulting, etc.)

Additionally, negative incentives will further encourage the clients’ repayment discipline: • Late payment fees (as daily percentage of the payment in arrears or outstanding balance) • Forced holidays or total loss of access to subsequent loans

An example of a product specification sheet is presented in Table 3 in the annex and should be used to produce a comprehensive product description (separate for group and individual loans) and ensure that delinquency-mitigating aspects discussed above are built into it.

As shown by the success of loan sharks and Provident Financial Rt described in section 2.1, a personal relationship with the client is key to maintaining appropriate motivations for repayment. Of course loan shark methods for collection are unacceptable, but personal visits and social engagement with debtors should yield positive results. On the other hand, group guarantees only work wherever the clients have something to lose. If their survival depends upon the use of these funds for personal consumption (i.e. medicine, food) there is no amount of peer group pressure that would stop them from spending them in this way. It has been argued in other studies[9] that group guarantees do not work for Roma for this reason.

Said (??) studies recommend a leasing approach instead. The most often mentioned example is the "Land-based Income Generation for Poor Roma Families in South Bulgaria" project initiated by the Creating Effective Grassroots Alternatives (CEGA) Foundation. This initiative, started in 1993, provides a form of farmland leasing for Roma communities, whereby an initial deposit and regular payment of instalments is required, and at the end the ownership of a plot of land is transferred to the Roma in question.

This approach can be replicated for other fixed assets (machinery, etc), and does not have the risks that group guarantees appear to hold. (OK, but how does land leasing apply to providing working capital to micro-enterprises!? I guess you’d have to evaluate your clients in terms of ability AND willingness to repay, “Character factor” pg. 16)

4.4 Loan Process

An appropriately developed and implemented loan process will ensure a reasonable level of delinquency prevention factors. In approaching the design of the future loan process, it should be borne in mind that its complexity and duration have to be adequate to ensure its purpose on the one hand, and be convenient enough for future clients in order not to unnecessarily overburden them. What the organization requires from the clients translates to them into very specific and sometimes considerable cost (necessary documentation, travel costs, time, opportunity costs). Sometimes such costs are comparable with the financial cost of credit.

Typically, a loan process will consist of the following steps:

Application

• Initial Screening for client criteria • Documentation required (ID, licenses and registration, business plan, etc) • Pre-Loan Training (if any) • Loan Review and Analysis • Preparation for Loan Approval • Loan Approval Process • Preparations for Disbursal • Disbursal • Repayment • Follow-Up Monitoring • Preparation of Repeat Loans

While the whole process needs to be harmonized, a special emphasis will be made on the Loan Analysis and Monitoring, as it is critical for successful loan repayment and delinquency prevention.

Application and Initial Screening. The purpose of this step is to efficiently identify potential clients based on clearly defined criteria. The application form needs to be concise enough for clients to be able to fill it in, and informative enough for the staff to be able to efficiently process the applications. Initial screening will save time and effort of applicants and staff, allowing them to concentrate on clients who will be able to ultimately receive the loan.

Documentation Required (ID, licenses and registration, business plan, etc) Required documents have to be limited to those that the organization really needs to make a decision about client enrolment and loan processing. Usually they are limited to ID and residence certification for small groups loans. In this case, micro lenders deal with business that are not officially registered. In case of larger individual loans for legally registered enterprises, business related documentation should be required (registration documentation, necessary licences etc.)

Pre-Loan Training (if any) A careful analysis of the purpose and expected results of training offered should be made. As shown in Table 2 in the annex the needs for training increase with the growth of the sheer size of the business. IGAs are usually involved in business activities that are technologically uncomplicated and based on inherent skills and aptitudes of these entrepreneurs. Hence, training offered could be limited to educating them about the loan process and borrower responsibilities, assistance with the group formation and filling out of necessary documentation.

More sophisticated training could be offered to MEs, including assistance with the development of a mini business plan and financials.

Loan Review and Analysis

This is a critical step in the loan process.

The main difference between IGA and ME loan processes is the emphasis placed on the various factors. While it is important in both cases to see if the business is capable of generating enough funds to repay the loan ie. the ability to repay, this is not very easy to decide in the case of IGAs. Therefore, the focus must be shifted towards the character of the applicant, i.e. his/her willingness to repay. In the ME case there is a history of at least one investment, and the ability to repay can be more readily assessed. Nonetheless, the examination of the applicant’s character should not be ignored in the ME case either.

During the loan review all necessary information for the subsequent loan decision needs to be collected and verified. Based on this information, loan analysis will be performed resulting in the subsequent loan recommendation.

A precondition for a successful and realistic loan analysis is the quality and reliability of information collected. Required borrower information is traditionally grouped in the following 5 areas:

Character: Obtain general information at the home and with neighbours, guarantors, clients and business partners. • Reputation and standing in community, with friends, family, business colleagues • Whether the client is a head of household or secondary contributor to family income • Legal residence status • Total family income • Total family expenses (food, education, housing, clothing, health, public services, transport, incidentals) including outstanding family debts • Type of Housing (ownership, quality, stability, etc.) • Length and Nature of Entrepreneur’s Experience in Business • Credit History. Keep in mind the types of credit open to micro entrepreneurs (moneylenders, family, suppliers, etc.). • Support of Family Members for Loan and Business • Psychological and Emotional Stability

Capacity: Obtain general information on the business at the place of business and possibly with suppliers and major clients. • Age of Business • Characteristic of the Workplace/Sales (owned, rented, location, etc.) • Frequency of Purchases of material and/or merchandise/business cycle • Volume of Purchases • Principal Purchase Sites and Suppliers • Principal Sales Sites • Number and Status of Employees • The different ways of presenting materials and merchandise and the units of measure. • Materials, unit of measure and the amount involved in production or sale of a given product • The Process needed to make a product or provide a service. • The machinery and equipment needed for each area of activity. • The required machine capacity to accomplish production • The average gross profit or profit margin for each area of activity. • Ability to repay a loan of this purpose

Capital • Client’s Financial Resources: personal capital, borrowed capital (suppliers and family loans) • Credit History • Percentage of Sales on Credit • Product Turnover in Days (or Business Cycle – refers to the number of days from the time the client buys the materials and/or merchandise to the day which he recoups the money as a result of sales) • Frequency of Sales • Sales Volume • Records of Accounts (memory or written)

Collateral • Psychological importance of guarantee • Title, ownership of property – if collateral • Ability and realistic resale price of collateral in local market • Condition and security of asset – if collateral • Legal right to resell/repossession • Quality of relationship with guarantors or solidarity group members • Ability to repay of guarantors (sources and stability of income) • Motivation to repay of borrower and guarantors

Conditions: • Competition • Seasonality

There are several aspects of the type and methodology of information collection, particular to microfinance organizations:

• In contrast to banking sector borrowers, microfinance clients frequently do not keep business records or they are of low quality. Hence, it is the staff’s responsibility to collect, verify and organize the necessary information • Microfinance lending is first and foremost character based. Hence, of special importance is character-related information. It is imperative to collect and verify it through home site visit, meetings with suppliers and customers, neighbours and community members • Due to the fact that microfinance clients’ businesses are seldom separated from the households in terms of expenses and possible contribution, it is very important to collect relevant family information through a compulsory home visit. Such visit will also contribute significantly to a better understanding of the client’s character

The examination of the borrower’s character cannot be emphasized enough, especially if group guarantees are used. In our view, group guarantee works marvellously only until a single participant defaults. If there is nothing else to back-up the outstanding debt of the defaulting client besides the group guarantee, the other participants will soon begin to think that they can get away with not repaying their parts, and will attempt to do so.

A typical format for client information presentation format is presented in Table 4 in the annex.

With the planned rather limited scope of operations, attention should be concentrated on the analysis of individual loans. Keeping in mind the character based lending microfinance has adopted, financial analysis of the borrower’s business is a precondition of the loan decision, as business inflows constitute the primary source of the loan repayment. The following is required for a financial analysis[10]:

• Develop the Current Sales Budget • Formulate a Simple Balance sheet • Formulate a Simple Profit and Loss (Income Statement) • Compute 8 Ratios Based on Balance Sheet and Income Statement • Perform Cash Flow Analysis • Create Cash Flow Projections • Interpret Results

The formats for the financial statements, ratios and ratio benchmarks are presented in the Loan Financial Analysis module. There are several specific features in the presented format that reflect the specific nature of micro businesses and address associated specific risks:

Current Sales Budget:

• Is indispensable for the understanding of how the business is doing NOW • Allows to find out the current costs, sales and profit margin • For practical purposes should be calculated on monthly basis • Pitfalls to be aware of: seasonality of the business, changes in demand and general growth/decline of the business

Balance Sheet:

• The format of the proposed balance sheet is not based on formal accounting information but rather observable and verifiable data to be collected from the borrower • Main attention to the assets and liabilities sides – equity is deducted through direct application of the balance sheet equation • Serves the purpose of providing and organizing the necessary information for the loan analysis • Pitfalls to be aware of: - Unclear source of cash - Wrongly assessed receivables - Goods assessed at selling price - Unchecked ownership - Under/overvalued fixed assets - “Wrong” fixed assets included - Payables overlooked - Payables excluded although real - Overlooked other payables (such as moneylenders) - “Old goods” not written off

Income Statement

• Includes family contributions and expenses – reflecting the fact that micro businesses are inseparable from households • If the business is sophisticated, IS needs to be produced for several prior periods • Some pitfalls: - Some family expenses (e.g. family members outside of the household) are overlooked - Chosen period is not representative for the business (consider business cycle and seasonality) - Check for undisclosed discounts and losses

Financial Ratios • Suggested ratios provide information about the business’s liquidity and loan repayment capacity • Computed profit margins give an understanding of acceptable interest rates • Provided benchmarks for individual ratios can be modified based on specific features of environment, types of businesses and risk tolerance of the program

Cash Flow Analysis and Projections • Allows to specify the mode of future loan investment • Critical for the determination of an optimal repayment schedule and loan payment amount

Interpretation of Data • Collectively financial data give adequate information for a loan decision • Loan attributes can be modified to best fit the business’ needs and capacity

Preparation for Loan Approval, Loan Approval Process, Preparations for Disbursal, Disbursal, Repayment

The following aspects should be taken into consideration at the above steps in the Loan Process: • The set of documents submitted to the Loan Committee has to contain a definite recommendation based on a thorough analysis • While the Loan Committee is empowered to approve the loan, it is the responsibility of staff working directly with clients (usually loan officers) to make a recommendation • The process of loan approval, preparation for disbursal and disbursal itself have to comply with generally accepted risk management principles of separation of decision, approval and performance • Templates of all documents supporting these steps (loan contracts, receipts, collateral related documentation, etc.) have to be cleared by legal advisors to ensure their compliance with effective laws • The client has to be supplied with a written repayment schedule

Follow-Up Monitoring and Preparation of Subsequent Loans.

This step in the loan process is as important in delinquency prevention as is a quality loan analysis. Keeping in close contact with clients during the repayment period ensures that the organization is aware of any possible problems the client’s business may face as well as any non-business issues that might jeopardise the loan.

Technically, loan monitoring is performed through: • Telephone calls prior to the payment date – a friendly reminder • Monthly visits to the clients business (usually unannounced) • Organizing special events where clients can visit the organization and meet the staff

In order to incorporate and effectively implement all of the above described delinquency prevention undertakings, the organization needs to develop an Operational Manual where the loan process is described in detail.

4.5 Delinquency and Defaults

While it could be assumed, that clients are responsible for delinquency and defaults[11], in reality such situations arise mostly due to methodological and procedural mistakes made by the organization. Delinquency does not necessarily mean that a loan will be lost, however it will have a strong adverse effect on the organization in terms of: • Slower portfolio turnover • Delayed income • Irregular cash flow preventing efficient planning • Is detrimental to the image of the organization • Can catch up like “forest fire” across the portfolio • Decreases income through increased loan loss provision • Can ultimately lead to default and loss of a part of the portfolio

In order to effectively manage delinquency prevention activities, the organization needs to formally adopt and comply with delinquency criteria. In most organizations delinquency is understood as a payment or part of it not received on time. This means, that the next day after the payment or part of it was missed, the payment is considered in arrears and the corresponding loan delinquent. Such strict approach will allow an organization to take action on the situation as soon as it arises. The rules, which define delinquency and procedures to deal with it must be formalized and documented in the internal documents (e.g. Delinquency Procedures).

There is a generally accepted approach to the measurement and analysis of delinquency based on the Portfolio Ageing Report:

| |Outstanding |Portfolio |Loan |Loan Loss |
| | Balance |At Risk |Loss Probability|Reserve |
| | |% |% |$ |
|Current |82,000 | |0% | |
|1-30 days past due |8750 |8.75% |10% |875 |
|31 - 60 days past due |5000 |5% |25% |1250 |
|61- 90 days past due |2500 |2.5% |50% |1250 |
|90-120 days past due |1100 |1.1% |75% |825 |
|>120 days past due |650 |.65% |100% |650 |
|TOTAL |100,000 |18% | |4,850 |

The report format helps to disaggregate the total portfolio according to the periods of arrears, or, in other words, the “age” of delinquency. Amounts presented (in money units and percentages of the total portfolio) represent the outstanding balance of loans in arrears. The ageing report also serves as the basis for the calculation of necessary reserves to cover possible loan losses (depending on the likelihood of recovery of loans in individual “delinquency age” groups.

From the point of view of delinquency management, it allows to concentrate on loans carrying more risks. Also important is the accepted levels of reserves – to check against their adequacy to cover eventual loan losses. The procedures of reflecting loan loss reserves and loan loss provisions in the organization’s financial statements are highlighted in Table 5 in the annex for reference[12].

Apart from the delinquency prevention mechanisms that need to be built into the overall organization’s operations, products and procedures, the following aspects are important:

• Delinquency Follow-Up Procedures A clear set of actions needs to be developed and adopted by the organization to be undertaken in case of delinquency. The staff needs to rigidly comply with such requirements. Typical steps should include: - Telephone call with the reminder of the payment past due - An official letter with a request to settle the debt - A visit by staff to the business, delivering another official letter with a threat of legal action - Undertaking of legal steps to repossess the collateral (if any) or execution of guarantee commitments All the steps need to be time related (e.g., days from the missed payment) and be supported by templates of necessary documents.

• Adequate Information Systems As mentioned before, delinquency can be dealt with only if the organization’s information systems provide accurate and timely information about repayment status of the borrowers. In case of limited scope of operations planned for the pilot project, this should not call for major technical problems. Such system could be developed in-house based on generic PC applications (e.g. Excels) and satisfy the practical needs of the portfolio management.

• Staff Incentive systems Another important aspect is the introduction of a staff incentive system that will incorporate portfolio quality indicators. Depending on the situation, this aspect of the system may be allocated higher or lower level of weight.

• Issues of Loan Rescheduling and Refinancing Rescheduling and refinancing, if applied liberally may produce an appealing picture of the portfolio quality hiding at the same time the real situation. In order to eliminate such situations, the following principles should be applied: - Delinquent loans can be rescheduled only under a clearly defined set of circumstances (outside effects beyond the clients’ control – personal crisis, changes in legislation that affect business activities, natural disasters etc.) and require additional levels of approval within the organization - Rescheduled loans should be reported separately in the Portfolio Report with adequate increased levels of reserves - Operationally such loans need additional attention from staff (increased number and frequency of visits, etc).

In summary, it should be underlined that measures aimed at the prevention of delinquency will have to permeate all aspects of the operation’s operations - its image, procedures, product design, information systems, staff qualifications and dedication.

If an MFI has solid delinquency prevention and management mechanisms and principles in place, the loan default rate should be within acceptable limits. However, if a default does occur, the following should be undertaken (depending on the legal and practical context):

• Hard collateral has to be repossessed and liquidated. Oftentimes, fixed business assets purchased under a loan have low liquidity – as an option, these could be offered to other potential borrowers. This is regular business/banking practice in Hungary. • Solid legal support has to be ensured and an attempt made to compensate for the loan using other assets of the borrower. Provided the borrower is a natural person, private contractor (egyéni vállalkozó) or the owner (i.e. at least one of the owners) of a partnership company (betéti társaság) s/he is legally liable to the debts of his/her enterprise with his/her own personal wealth. Most of the targeted enterprises should belong to these legal categories. Therefore, it is “normal practice” for these entrepreneurs to transfer the ownership of any personal/household belongings to spouses or other members of the family. o In case of guarantors or peer group loans payments have to be collected from these sources. Legal clearance of enforcement of guarantees has to be done. • Default loans have to be written off the books with appropriate adjustments of loan loss reserves and portfolio outstanding • Irrespective of accounting and reporting procedures, an organization has to continue efforts to collect defaulted loans • In very infrequent cases of force majeur (circumstances beyond the client’s control) the organization can consider loan rescheduling or, in exceptional cases, loan refinancing (a very careful and objective analysis needed to prevent “throwing good money after bad money”). • Leasing contracts with deferred ownership rights transfers help avoid the need for the act of repossession. The leased object remains in the ownership of the MFI until the debt is fully repaid.

5. A set of indicators for risk monitoring and portfolio management

Apart from Portfolio at Risk as described above, microfinance institutions use a wider set of indicators to monitor the quality of their portfolios and manage associated risks. It should be noted that in order for these indicators to be informative and useful, the following conditions have to be satisfied: • Data used for calculations need to be accurate and based on reliable accounting systems and accepted financial statement formats • Indicators and ratios should be calculated for appropriate periods (e.g. PAR ideally coinciding with the loan payment frequency) and compared between the periods • Chosen indicators should be analyzed in complex; such approach will allow for a deeper insight and remove limitations of individual ratios
While different institutions use different ratios and indicators, a relatively limited number of those should be enough to provide relevant information about the quality of the portfolio. Recommended indicators, methods for their calculation and applicability are summarized in Table 6 in the annex – Portfolio Management Indicators. Microfinance industry benchmarks are provided where available.

6. Conclusions and Recommendations

The format and the focus of the proposed project pose some additional challenges to maintaining an acceptable level of financial risks and loan portfolio quality. These challenges arise from the specific feature of the target group (extreme social exclusion, the history of free assistance provided by the government and development agencies, low levels of education and entrepreneurship), environment (poverty pockets amidst economically developed country), organizational aspects (limited scope of the project and low organizational capacity).

However, there are no serious obstacles for a successful implementation of the project and minimization of the effect of those factors, provided that:

1. The project builds in risk minimization factors into the project set-up and procedures, especially into the products offered and loan underwriting process 2. Special attention is paid to ensure that the products offered fit the needs and the potential of the target group – at least two loan products are recommended for implementation 3. Loan analysis follows good practices with ensured staff skills and qualifications 4. Depending on the specifics of the environment, effective ways to implement two key types of loan securitization (group guarantee and collateral) are developed 5. A set of commonly accepted and informative portfolio quality indicators is utilized based on accurate timely information 6. Geographic focus is applied to the project implementation (at least at the initial stage)

Annex

Table 1. Risk Areas and Mitigation Approaches

|Area |Situation |Associated Risks |Mitigation Suggestions |
|Institutional Aspects |Integrated program offering financial and |Clients perceive services as assistance – no need to repay |Run loan program separately from other services offered |
| |non financial services |They do not distinguish between subsidized services (Business|Make a special effort to educate clients about loans |
| |Organization with a history of |Development Services) and financial services |Ensure linkages with local Roma organizations and community activists – enrol |
| |grant-making and free service provision |Because the organization is an outsider it is ok not to pay |Roma staff whenever possible to work or provide services for the project |
| |“Outsider organization with weak presence |back | |
| |in the community | | |
| | | | |
| |Limited capacity and scope of operations |Inability to manage activities in multiple locations |Concentrate activities (at least initially) in one targeted location |
| | |Low repayment discipline | |
|Target Group Aspects |Broad definition of the target group |Low efficiency of the program |Define the target group clearly. Concentrate in the IGA and MB areas |
| |High levels of micro business bankruptcies|Difficulties in enrolling clients |Focus on traditionally typical business activities |
| | |Difficulties in maintaining an adequate portfolio quality |Focus (at least initially) on existing business activities; consider moving to |
| | | |start-up later when main project components and processes are well established |
| |Low levels of entrepreneurship |Difficulties in client enrolment |Start operations in the location with higher than average levels of business |
| | | |activities |
| | | |Choose location that has good access for client markets |
| |Extreme social exclusion of the target |Hostile attitudes from non-Roma population |Make services available to non-Roma population |
| |group |Clients fail because of limited access to supply and delivery|Encourage business linkages between Roma and non-Roma businesses |
| | |markets | |
|Product Related |Possible discrepancy between the business |Client repayment failures |Design products that correspond to the clients business needs – ensure their |
| |needs of the clients and products offered |Low portfolio quality |correspondence to their business cycles |
| | |Losses of financial assets |Develop at least two products – individual and groups guarantee loans |
| | | |Keep loans customized to individual needs of the borrower |
| |Low probability of the availability of |Loan losses in case of client’s failure |Use non-conventional loan security – group guarantee |
| |“hard collateral” | |For individual loans – guarantors and innovative approaches to “hard collateral” |
| | | |(lower coverage, inventory, contract purchases) |
| |Affordability of loans |Interest rates could be prohibitive for successful |Compared interest charged to profit margins of client businesses |
| | |development of clients’ business |Set interest rates according to project cost recovery targets (including loan |
| | |Interest rates inadequate for project viability |loss provision) |
|Process Related |Duration of the Loan Process |Considerable non-financial costs to the borrower |Loan process needs to be designed in a way that it is adequate for the purposes |
| |Documentation Required | |of loan underwriting and yet be short enough not to overburden the borrower |
| | | |Different sets of documentation need to be required at different stages of the |
| | | |loan process |
| |Application and Client Screening |Unqualified clients get into the process thus decreasing the |Clear client criteria set |
| | |efficiency and reducing the quality of the process |Simple initial questionnaires to support the step |
| |Loan Review and Analysis |Loan analysis does not ensure quality client selection thus |Introduce comprehensive loan analysis procedures focusing on the borrower’s |
| | |leading to repayment problems and poor portfolio quality |character and financial analysis |
| | | |Ensure objective and complete client information collection |
| | | |Develop and adopt formal Loan Procedure to ensure compliance and accuracy |
| |Loan Approval and Disbursement |Internal fraud risks |Design the process I compliance with the principle of separation of decision, |
| | | |approval and implementation/recording |
| |Follow-Up and Loan Monitoring |Low client repayment discipline |Design appropriate loan monitoring procedures involving regular contacts with |
| | |Late reaction to repayment problems |clients and site visits |
| | | |Produce loan repayment schedules – ensure clients understand them |
|Delinquency and |Delinquency and Portfolio Quality |Delayed or lost income |Introduce an adequate system of loan portfolio reporting |
|Defaults |Indicators |Loss of financial assets |Introduce a set of portfolio quality indicators to be monitored regularly |
| | |Irregular cash flow |Ensure timely and accurate information flows |
| |Additional DQ Prevention Measures | |Ensure client repayment incentives are built into the loan product (amount and |
| | | |period increase for subsequent loans, interest rebates, simplified procedures for|
| | | |follow up loans |
| | | |Promote long term relationship with clients – not single loans but ensured access|
| | | |to credit |
| | | |Introduce staff incentive system incorporating portfolio quality indicators |
| | | |Formalize delinquency follow- up procedures |

Table 2. Characteristics of Client Economic Activities

|Type of Business: |Income Generating Activity |Microenterprise |Small Enterprise |
|Profit Used for: |Household consumption |Household consumption & reinvestment in enterprise |Reinvestment in enterprise |
|Strategy: |Diversification to decrease risk/increase |Specialization to increase household income |Specialization to increase profits |
| |income | | |
|Number of Employees: |0 to 2 |0 to 5 |5 to 50 |
|Examples: |Market vendors, small-scale livestock raising|Retail boutiques, tailors, auto mechanics |Furniture making, garment assembly, |
| | | |construction |
|Need for Credit: |High |High |High |
|Need for Business Training |Low |Medium |High |

Table 3. Product Specification Sheet: Credit Product

|PRODUCT CHARACTERISTICS |CREDIT PRODUCT |
|1. PRODUCT NAME | |
|2. PURPOSE/FOCUS | |
|Loan Use | |
|Client Profile | |
|Location(s) | |
|3. AMOUNT | |
|Minimum Loan Amount | |
|Maximum Loan amount | |
|Average Loan Amount | |
|4. PRE-CONDITIONS | |
|Collateral Requirements (including compulsory savings) | |
|Collateral Type | |
|Control of collateral | |
|Collateral Amount | |
|Collateral Basis (flat amount, % of loan, % of payment) | |
| | |
|Other Requirements | |
|Group Membership | |
| | |
|5. PRICING | |
|Interest rate | |
|Interest rate method | |
|Commissions and Fees | |
|Timing/Frequency: Upfront, ongoing | |
|Basis: Fixed amount or % of loan amount or % of monthly principal payments | |
|Loans indexed to inflation rate | |
|Penalties | |
|6. DISBURSEMENT | |
|Loan disbursement timing | |
|Wait period between loans | |
|7. REPAYMENT CONDITIONS | |
|Repayment frequency | |
|Effective loan term | |
|Grace period | |

Table 4. Loan Analysis Form

|LOAN ANALYSIS FORM |
|Client Name: |Amount Loan Requested: |
|Loan Officer: |Term Requested: |
|Date(s) of Site Visit: |Business Cycle: |
|Business Description: |Mark-up (verbal): % |
| |Mark-up (verified): % |
|M |T |W |T |F |Sat |Sun |Daily Sales: |
| | |
|Number work places retained (after loan): |Number work places created (after loan): |
|Product or service Quality |Low |Middle Range |Good |Excellent |
|Working Capital |Analysis of purchases and sales |
|Own capital: |Where do you sell? |
|Borrowed capital: |How often do you sell? |
|Commission: |Where do you buy? |
|Other |How often do you buy? |
|Total: |How many sales outlets? |
|Fixed Assets |Employees |Workplace |
|Qty |Description |Condition |Value |Amount Owed |No. |paid relatives |Own: |
| | | | | | |Y N Y N | |
| | | | | | Male | |Rent: |
| | | | | | Female | |Other: |
| | | | | |Credit History |
| | | | | |Type of Creditor amount date rate result |
| | | | | |Lender |
| | | | | |Relative |
| | | | | |Financial Inst. |
|+++ |Total |+++++++ | | |Suppliers |
|Assets |Liabilities |Use of Loan |
|Cash & Banks | |Short-Term Liabilities | |Product (service) |Cost |
| | | | | | |
|Account receivables | |Accounts payable | | | |
|Goods in process | |Long-Term Liab. | | | |
|Finished goods | |Other Liabilities | | | |
|Fixed Assets | |B. Total Liab. | | | |
|А. Total Assets | |Equity (A-B) | |Total invested from loan | |
| | | | |Total invested | |
|Income Statement/Cash Flow Data |Monthly Family Expenses |
| |Before loan |After loan |Type |Amount |
|Businesses Sales | | | | |
|Purchases | | |Health | |
|Expenses | | |Education | |
|Rent | | |Rent | |
|Equipment | | |Food | |
|Labor | | |Clothing | |
|Utilities | | |Savings | |
|Other | | |Transportation | |
|Other | | |Outside Family Support | |
|Total Expenses | | |Other | |
|Monthly Profit | | |Total Expenses: | |
|Family Contributions: |

|Form of Loan Guarantee |
|Guarantors |Collateral |Solidarity Group |
|Information from Guarantors or Solidarity Group Members |
|1. Name ID: |
|Address/Telephone: Place of Employment/Position: |
|Relationship to Borrower: |
|2. Name ID: |
|Address/Telephone: Place of Employment/Position: |
|Relationship to Borrower: |
|3. Name ID: |
|Address/Telephone: Place of Employment/Position: |
|Relationship to Borrower: |
|4. Name ID: |
|Address/Telephone: Place of Employment/Position: |
|Relationship to Borrower: |
|Description and Evaluation of Collateral |
|Description: |Current Market Value: |Condition: |Location: |Current Usage: |
| | | | | |
| | | | | |
| | | | | |
| | | | | |
|Special Notes and Risk Factors: |
|Character of borrower and motivation to repay: |
|Market and Competition: |
| |
|Guarantee Quality: |
| |
|Other: |

Table 5. Financial Statements With Loan Loss Provision and Reserve

| |INCOME STATEMENT |Dec-04 | | | |
| | |(Thousand) | | | |
|OPERATING INCOME | | | | |
|1. |Interest and fee income from loans | | | | |
|2. |Income from other finance related services | | | | |
|3. |Income from investments | | | | |
|4. |Total Operating Income | | | | |
|OPERATING EXPENSES | | | | |
|5. |Interest and fee expense | | | | |
|6. |Loan loss provision expense | | | | |
|7. |Personnel expense | | | | |
|8. |Other administrative expenses | | | | |
|9. |Total Operating Expenses | | | | |
|10. |NET OPERATING PROFIT (LOSS) | | | | |
|NON-OPERATIONAL INCOME | | | | |
|11. |Cash donations | | | | |
|12. |Other non-operational income | | | | |
|13. |Total non-operational expenses | | | | |
|14. |TOTAL SURPLUS/DEFICIT | | | | |
| | | | | | |
| |BALANCE SHEET |Dec-04 |Dec-o3 |
| | |(Thousand) |(Thousand) |
| | | | |
|ASSETS | | |
|15. |Cash and due from banks | | |
|16. |Investments | | |
|17. |Total loan portfolio | | |
|18. |(Loan loss reserve) | | |
|19. |Other short-term assets | | |
|20. |Net Fixed assets | | |
|21. TOTAL ASSETS | | |
|LIABILITIES | | |
|22. |Member savings (forced or voluntary) | | |
|23. |Loans: commercial banks | | |
|24. |Loans: subsidized | | |
|25. |Other liabilities | | |
|26. TOTAL LIABILITIES | | |
|EQUITY | | |
|27. |Paid-in equity from shareholders | | |
|28. |Donated equity -- prior years | | |
|29. |Donated equity -- current year | | |
|30. |Prior year's retained earnings/losses | | |
|31. |Current year retained earnings/loss | | |
|32. TOTAL EQUITY | | |
|33. TOTAL EQUITY AND LIABILITIES | | |

Table 6. Portfolio Management Indicators

|INDICATOR |RATIO |MEASUREMENT |BENCHMARKS** |
|Portfolio at Risk |Unpaid Principal Balance of all loans with |The most accepted measure of portfolio quality. Portfolio at risk is the outstanding |1.1% over 30 days |
|PAR |payments at least 1, 30, or more days past due |principal amount of all loans that have one or more instalments of principal past due by a |0.4% over 90 days |
|By Age* |Outstanding Portfolio |certain number of days. | |
| | | | |
| | |When referring to PAR, the MFI should always specify the number of days. | |
| | | | |
| | |MFIs should indicate whether restructured loans are included in their calculation. Some MFIs | |
| | |automatically include restructured loans in their portfolio at risk. This practice reflects | |
| | |the belief that restructured loans have higher risk than current loans | |
| | |The indicator shows the percentage of portfolio an MFI stands to lose should ALL delinquents | |
| | |loans default | |
|Arrears Rate |Amount past due |Measures amount of loan principal that is due but not paid. Is informative for the cash flow | |
|Past Due Rate |Outstanding Portfolio |planning of the organization. | |
|Repayment Rate |Amount received (current and past due) less |Shows amount paid compared to amount due/expected during a specific period. | |
| |prepayments |Does not provide useful information about the performance of the outstanding portfolio but can| |
| |Total amount due this period + amounts past due|be useful for cash flow planning | |
| |from previous periods | | |
|Risk Coverage Ratio* |Loan loss reserve |Shows how much of the portfolio at risk is covered by the MFI’s loan loss reserve. It is a |3.6 PAR over 30 days |
| |Portfolio at risk > X days |rough indicator of how prepared an institution is to absorb loan losses in the worst-case | |
| | |scenario. MFIs should provision according to the aging of their portfolio at risk: the older| |
| | |the delinquent loan, the higher the loan loss reserve. | |
| | | | |
| | |For example, a ratio for PAR > 90 days may be close to 100%, whereas the ratio for PAR > 30 | |
| | |days is likely to be significantly less. | |
|Annual Loan Loss Rate* |Amount of loans written off as unrecoverable |Represents the percentage of the MFI’s loans that have been removed from the balance of the | |
| |Average Outstanding Portfolio |gross loan portfolio because they are unlikely to be repaid. A high ratio may indicate a | |
| | |problem in the MFI’s collection efforts. | |
| | |Depends on MFIs write off policies. Typically loans over 180 days overdue are written off | |

*CGAP recommended
**Benchmark data for MFIs in Central, Eastern Europe and NIS for 2004
-----------------------
[1] Andrey Ivanov, Sanjar Tursaliev: Microlending for Roma Communities: opportunities and constraints for poverty alleviation. United Nations Development Programme (UNDP) Regional Centre, Europe and the CIS, Bratislava
[2] This results in ca. HUF 50,000 per client as microcredit value, which is actually about half of initially disbursed amounts. Besides, many programs include clients that are using other services, e.g. BDS after/before they received a loan or after repayment. Hence, an average loan at disbursement could be safely estimated at about HUF 100,000.

[3] Several studies from numerous viewpoint on Roma issue are available on the Internet. Some addresses: http://www.irb-cisr.gc.ca/en/research/ndp/ref/index_e.htm?cid=105 http://www.osi.hu/eumap/minhu.htm
[4] Microlending for Roma Communities: a “silver bullet” or part of “multiple therapy”? Andrey Ivanov, Sanjar Tursaliev, United Nations Development Programme (UNDP) Regional Centre, Europe and the CIS, Bratislava
[5] Notably Autonomia Foundation in Hungary
[6] This chapter is based on the research conducted by Éva Bulátkó
[7] PROJECT DOCUMENT, Government of Hungary, United Nations Development Programme, Micro-credit programme for disadvantaged groups in Hungary with a special focus on the Roma population.

[8] “Education and employment opportunities for Roma”, Andrey Ivanov, Sanjar Tursaliev, United Nations Development Programme (UNDP) Regional Centre, Europe and the CIS, Bratislava

[9] Khilola Shukurova: Research on Microfinance Tools Applicability - Case of Roma. September 2004
[10] It is not the responsibility of the client to have this information. It is the duty of the lender to collect, format and analyze it. The difficulty here indeed, is a frequent lack of formal financial data in clients’ businesses – an additional challenge to microfinance staff.
[11] Delinquency is a situation when loan payments are past due. Loans with payments part due are referred to as delinquent loans. Delinquency may lead (if not acted upon) to default – a situation when the organization is no longer expects the loan to be repaid.
[12] Sometimes for managerial purposed organization[pic] |^˜¶·Á< = > ? @ R S g h i j … † ‡ ˆ œ ? ž · ìäÙÐÅÐä¹äÐä©Ð?ä?‰ypy^‰ypPpjhTWÁU[pic]mHnHu[pic]#[13]?j[pic]hTWÁ>*[pic]U[pic]mHnHu[pic]hTWÁmHnHu[pic]-hTWÁ0JB*mHnHphÿu[pic]'jhTWÁ0JB*U[pic]mHnHphÿu[pic]jhTWÁOJ[14]QJ[15]U[pic]hTWÁ5?;?OJ[16]QJ[17]mHnHu[pic]hTWÁOJQJmH sH hTWÁ5?OJ[18]QJ[19]^J[20]hTWÁ5s decide to adopt internal report formats since those required by regulators do not fully serve the purpose. Things to watch out for: - reserve amounts (are those required by regulators adequate for the actual risk coverage?) - write off policies - separation of operational (financial) and other sources of income