The Need for Individual Lending in Mature MFIs
By Somanadha Babu and Anup Singh | Anup and Somanadha are MSU Associates working with Cashpor on launching individual loans for Cashpor's mature clients. One goal with this project is to help Cashpor continue to meet the needs of its clients within a given geographic region.

The intended outcome of any microfinance program is the improvement in the economic status of its clients. Impact studies have provided mixed results about the actual outcome; however, that at least a considerable section of the clients have graduated from smaller loans to larger loans is unquestionable. This leads one to the stark differences in the loan demand between clients in a single joint liability group. The risk associated in standing guarantee to a loan of Rs. 25,000 is far more than that associated with a loan of Rs. 5,000. So, group guarantee actually builds up a natural threshold on the loan amount within a group. This forces those clients with larger demand to either look for additional sources for credit—which unfortunately still happen to be the money-lenders whom microfinance programs intend to replace—or settle for a status quo in their livelihood status. As such clients are never a majority, even microfinance institutions (MFIs) also find it difficult to cater to the entire loan requirements of these "big-ticket" clients and are forced to put a formal or informal cap on the loan amount that can be disbursed per client. However, as microfinance is entering the mainstream financial services market, product diversification has provided answers to this situation. Mature clients with spotless credit history and with demonstrated business aptitude can now benefit from a new methodology: individual lending. Individual lending is "the provision of credit to individuals who are not members of a group that is jointly responsible for loan repayment" (Ledgerwood, 1999, p.83).

This model provides credit access to individual borrowers who are selected on an individual, discretionary basis and often have at least some small form of fixed assets or income. The Bank Rayat in Indonesia and ADEMI in the Dominican Republic (an ACCION affiliate) are institutions that have adopted this approach successfully. Each loan is specifically tailored to the individual and business involved. This approach tends to work best when used with larger urban businesses or small rural farmers, since collateral is generally required. Also, the personal nature of the relationship between the bank and the borrower often results in repeated transactions over a long period of time. However, the problem of lack of asset collateral still remains unresolved in the case of this product. A novel approach combining the credit history of the client (which includes the experience of the field staff with the clients) and a thorough cash flow analysis of the intended income-generating activity has been adopted to replace the asset collateral. As MFIs are becoming older, there has been an increased need for designing such products for their mature clients. The MFI performs a thorough analysis of every potentially funded business venture. Borrowers receive loans based on past performance, credit histories, viability of business propositions, and references.

To encourage repayment, borrowers provide collateral and/or co-signers. Credit officers have close long-term relationships with clients. The individual approach is most commonly associated with commercial banks. Successful individual micro-lending programs are usually highly modified variants of systems employed by commercial banks. Individual lending has been applied most successfully to urban clientele. Group lending models have found considerable success in serving clients that are just starting very small businesses (typically with no employees but themselves). But the programs tend to impose limits on wealthier borrowers. As a result, both BancoSol and the Grameen Bank have abandoned group lending for their wealthier and most-established borrowers, and this turn toward individual (lender-borrower) contracts represents the leading edge of a growing split within the microfinance movement ¹. The trend is also very clear in Eastern Europe and Russia. For example, Opportunity International's "Trust Banks" for poorer households in Macedonia, Bulgaria, Croatia, Romania, Poland, and Russia remain committed to group lending practices, with clients in this niche typically starting with loans well under $1,000. Opportunity International's programs for the less poor, however (as well as programs supported by the European Bank for Reconstruction and Development (EBRD) in Russia, Kazakhstan, and Bosnia), have embraced individual-lending as a core component of micro-lending ². Uncollateralized loans in this niche begin at about $2,000 and average around $5,000.

The experiences suggest that in areas that are already relatively industrialized, the group lending model may be a poor fit for potential clients. At the same time, the experiences with group lending offer important lessons for the design of individual-based credit contracts even for wealthier clients in transition economies (Morduch & Aghion, 2000). Effective individual lending models across the world have the following characteristics: guarantees of loans by a co-signer or through collateral, screening of borrowers by credit check/character reference, fitting loan size to business needs, increasing loan size over time, average loan amount larger than group loans, close personal relationship with individual clients, frequent, close contact with individual clients, long period of time spent with individual clients, loans largely for production. The ability to secure collateral helps the individual-based programs, and the success of microfinance programs in general (individual programs in particular), is also linked to particular methods of gathering information, monitoring loans, and enforcing contracts (Morduch & Aghion, 2000). With regard to information gathering, the Russian micro-lending program relies heavily on staff visits to applicants' businesses and homes, rather than just relying on business documents (Zeitinger, 1996). In rural Albania, applicants must often obtain a loan guarantee and character reference from a member of the local "village credit committee." Thus, even where group lending is not used, novel mechanisms are in place to generate information. Documentary evidence tends to be deemphasized relative to standard banking practices and local character assessments gain prominence ³. Still, while good information gathering is a necessary condition for the success of microfinance programs, it is not sufficient to ensure contract enforcement and prevent strategic default. Even if loan officers do a good job of eliciting information at the screening stage (before the loan is given) and at the monitoring stage (after the loan is made), loan officers still face the problem of enforcing debt repayments once the returns on borrowers' investments have been realized. To get around the problem of enforcement, nearly all microfinance institutions rely as well on dynamic incentives (Morduch & Aghion, 2000).

These mechanisms complement the use of social sanctions in China and of collateral requirements in Russia and Albania. Dynamic incentives boil down to the threat not to refinance a borrower who defaults on her debt obligations. The threat is enhanced by promising to extend steadily larger loans over time to good customers. Because borrowers typically desire larger and larger loans, the promised increases enhance the borrowers' loss from being cut off. However, when there are multiple lenders in the same geography, this practice of dynamic incentives may not have its intended outcome. In India, the preferred form of micro-finance loan is group lending. According to a study by Sa-dhan (Industry Association of Community Development Finance Institutions in India), only 7 per cent of micro-finance loans in India is to individuals. Many of the large micro-finance institutions provide individual loans to clients who have a track record and have improved their economic status; the provision of individual loans to first-time borrowers is not common. How can lenders give collateral-free loans in the absence of group lending? One approach is to take non-traditional collateral. For example, the lender may accept the borrower's degree certificate, driver's license, marriage certificate and such other documents as collateral. The logic here is that what matters most is the value the borrower attaches to losing the item than what the lender expects to recover from selling them. Bank Rakyat Indonesia, a leading name in micro-finance, uses this technique effectively. Another way of reducing credit risk in the absence of collateral is to insist that borrowers demonstrate habitual savings for a certain period before a loan is sanctioned. The SHG-Bank Linkage model, India's homegrown micro-finance model, uses this technique in conjunction with group lending. In the case of MFIs using the JLG or Grameen model, legal structures (eg: NBFCs) enforce a ban on collecting savings. However, innovations like the Banking Correspondent model provide options for MFIs to collect savings under the principal-agent model with MFIs collecting fees for delivering the services of savings. The financial and legal implications of becoming a Banking Correspondent need to be fully understood from certain organizations that have taken up this agency role before making it a widely acceptable model. Individual and group methodologies require different operational and financial structures. The choice of structure is based on organizational goals, profitability objectives, and risk tolerance. Individual lending and group lending have different cost structures.

For instance, because of the increase in loan amount per client, some of the administrative costs on a per client basis would be lower; however, due to increase in the due diligence and monitoring costs which get translated into decreased case load per loan officer, costs on personnel might increase. Individual lending requires careful analysis on behalf of the lending institution prior to fund disbursement. Evaluating the loan proposal and defining the terms for each particular client, which may take considerable amount of time, is costly to the MFI. Add to this the increase in risk for the MFI, there would be an increase in the Loan Loss Provisioning resulting in reduced profitability. Even from the strength of the social capital perspective, empirical results (Paal & Wiseman, 2006) have shown that lenders can earn higher profits by offering joint liability contracts as compared to individual liability contracts. The main challenges in the Indian context for individual lending happen to be introducing non-traditional collateral mechanisms, training the field officers in the skills required for a cash-flow-based business appraisal and designing appropriate cost structures to make such new products into sustainable revenue models. Even operational models would be very different for different contexts. For instance, an MFI operating in a relatively poorer and entirely rural geography might not have the numbers to operate separate branches for group loans and for individual loans whereas, an MFI operating in a semi-urban or a densely populated area can have separate branches for group loans and individual loans. Despite the challenges for individual loans in the Indian context, the need for such a product seems to be higher amongst the mature clients. The entire mature clientele may not require individual loans, but even if only a quarter of such mature clients graduate to individual loans, which normally are double in amounts to group loans, it would be a good business proposition for the MFI. If the objective of microfinance is to provide financial services to those not within the reach of the mainstream financial system, then individual lending might become important for MFIs as even these relatively bigger ticket loans cannot be provided by the mainstream institutions because of their lack of reach to the individual client level.

References

1.Aghion, B. A., & Morduch, J. (2000). Microfinance Beyond Group Lending. Economics of Transition, 8(2)

2.Bansal. H. (2006) Penny wise: Bankable Poor. Retrieved from the website http://us.oneworld.net/article/view/78399

3. Ito, Sanae (1998) "The Grameen Bank and Peer Monitoring: A Sociological Perspective," paper presented at the Workshop on Recent Research on Microfinance, University of Sussex, 13 February, 1998.

4. Ledgerwood, J. (1999). Microfinance handbook: An institutional and financial perspective. World Bank: Washington, D.C.

5. Paal, B., & Wisemann, T. (2006). Group insurance and lending with endogenous social collateral. Retrieved from the website of Department of Economics at the University of Texas.

6. Shankar, S. (2006) Micro-credit: Looking beyond group lending. Retrieved [URL]

7. Zeitinger, Claus-Peter (1996), "Micro-lending in the Russian Federation," in Levitsky, J. (ed.), Small Business in Transition Economies. London, pp. 85—94.