Best practice MFOs have successfully introduced process and product innovations within a given legal and regulatory framework to achieve high levels of outreach on a sustainable basis. This has enabled these institutions to shift the production possibilities frontier outward through fmancial innovation (Gonzalez-Vega, 1993; Meyer and Nagarajan, 1997). Process and product innovations have occurred in several different ways and have enabled MFOs to effectively service different niche markets (Navajas, 1999). The most notable innovations have been in the area of loan applicant screening and loan contract enforcement. Numerous examples exist in Bolivia, Bangladesh and Indonesia where MFOs have cost-effectively reduced the problem of asymmetric information and divergent incentives between borrower and lender (Christen et al., 1994; Yaron, 1994; Chaves and Gonzalez-Vega, 1996; Gonzalez- Vega et at., 1997).
In this study, the evaluation framework will document financial technologies used by KZN MFOs, and how these technologies have changed over time to make a qualitative assessment of their relative success. Section 4.4 briefly outlines some of the aspects covered in the analysis of MFO financial technologies.
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Providing both savings and loans facilities improves both clients' and lenders' individuals' decision-making options and thus contributes to improved rural financial intermediation.
Traditional development-orientated MFOs may provide fmancial and non-financial services which may negatively influence their financial self-sustainability. Development-orientated MFOs may also not set fmancial self-sustainability as their objective. The number of years of operation influences the MFOs' ability to achieve a large scale of operations, which may improve outreach and reduce operating costs (fixed costs are spread over a greater number of clients) (Riley, 1996). The number of branches and areas of operation influence the accessibility of financial services and hence outreach, and the geographic portfolio diversification of lenders, which improves lender risk management (Yaronet al., 1997).
Quality financial services do not only facilitate the intermediation of funds between surplus and deficit units, but also provide funds for consumption smoothing and act as a store of value. In addition, transaction costs can be a high proportion of the rural individual's total costs of accessing and using fmancial services. As shown in Chapter 2, borrower transaction costs include out-of-pocket costs to access financial services, legal fees and opportunity costs of time. The ability of lenders to minimise these costs is a key feature of quality fmancial services (Rhyne, 1994). Lenders also incur transaction costs in providing loans and savings facilities, such as the processing and monitoring of loans, information gathering and screening of loan applicants, loan contract enforcement and mobilising and servicing voluntary savings. Controlling these transaction costs can improve lender financial self- sustainability (Yaron, 1994). The evaluation framework thus documents how the loan technologies accommodate the client's financial management process and overcome information asymmetries and contract enforcement problems while containing both borrower and lender transaction costs.
Table 4.1 Evaluation Framework for Financial Technologies
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2.2
2.3
3
General Characteristics of Study Rural Finance Institutions Years of operation
Objectives Type of institution Ownership
Financial services offered Target clientele
Number of staff
Number of branches (main and satellite branches) Loan Technologies
Client-Service Relationship Types of activities fmanced Loan size
Lending to groups - Group size - Group formation Place of loan application Loan application process
Loan application processing times - First time borrowers - Repeat borrowers Loan approval process
Decentralisation of decision-making power to branches Loan disbursal
Loan repayment frequency Loan collection
Staff incentives
Management information system
Client Screening, Incentive and Loan Contract Enforcement Technologies Loan applicant screening teclmologies
- Use oflocal individuals or leaders in loan approval - Client self-selection
- Use of formal credit scoring models Supervision and monitoring of loans
Client incentives and penalties Collateral
- Borrower collateralisation costs - Collateral specific risks - Asset appropriability - Asset marketability Loan Interest Rates
Nominal quoted annual interest rate Effective annual interest rate Savings Technologies
Voluntary or compulsory savings Typesofsavingsproducffi Accessibility
- Ease of withdrawal - Restrictions on use Interest rates
Source. Adapted from Yaron (1992), ChrIstenet al., (1994), Yaron (1994), Gurgand et al., (1994)
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For loan products such technologies include flexibility of loan sizes and loan repayment terms, eligibility and collateral requirements. Flexible loan sizes and loan repayment terms permit a wide variety of agricultural, non-agricultural and consumption activities to be financed which improve the individual's fmancial management decision-making process (Table 4.1). They also enable MFOs to better manage risk through portfolio diversification across sectors (Gonzalez-Vega, 1994). Some best practice MFOs (e.g. Grameen Bank, BAAC), however, have introduced fixed repayment structures to promote regular lender- borrower contact that promotes borrower discipline and loan repayment amongst small, relatively uneducated borrowers. Flexible loan products may also impose higher administration costs on lenders.
Stringent collateral requirements may also negatively influence the accessibility of credit for small, low wealth rural borrowers (Yaron, 1994). While the use of group loans may alleviate the collateral problem, they necessarily impose high transaction costs on both lenders and borrowers, depending on how the group formation costs are divided between the two contracting parties. Lenders may impose all the group formation costs on borrowers. Group homogeneity, group size and proximity of members may reduce borrower trahsaction costs in group formation and peer monitoring (Graham and von Pischke, 1994).
Financial services should also consider geographic, time, mobility, literacy and numeracy constraints. A poorly-developed branch network, complicated loan application procedures and contract documents, and social constraints (such as rural women married under communal law) may impose high transaction costs on borrowers in accessing fmancial services (Yaron et aI., 1998). Quality financial services should take the constraints faced by potential clients into account and make the services as accessible as possible. However,
establishing branches may come at a considerable cost to the lender. A suitable balance should be maintained between information required from individuals to make appropriate decisions on loan risk, and the cost of the additional information.
Streamlining the paperwork involved in loan applications and loan disbursals may reduce administrative costs for fmancial intermediaries, while reducing loan application times for borrowers (Gonzalez-Vega, 1984; Riley, 1996). Centralised and bureaucratic decision- making structures contribute to long loan approval times. Opportunities for which clients borrow are frequently time sensitive, increasing transaction costs in accessing loans.
Decentralised decision-making structures, possibly including local leadership in the decision making process, may reduce loan approval times and cut the time taken to gather information from loan applicants, reducing borrower and lender transaction costs (Chaves and Gonzalez- Vega, 1996). In-kind loan disbursals through input suppliers necessarily increase borrower transaction costs (increased time required to access the loan), while reducing flexibility of loan products (borrowers may require loans for consumption smoothing purposes).
Borrowers may thus find cash loan disbursals more desirable.
Information is critical to the functioning and viability of MFOs. If key data are maintained are not manipulated and presented coherently as information on which decisions can be based, the information will remain just data. A good management information system can effectively manipulate data and present useful and coherent information in the form of reports. Mainhart (1999) provides a detailed framework for analyzing management information systems (MIS), and outlines several important categories for the evaluation of an MIS. As far as possible these will be documented in this study with specific focus on the first
three categories: functionality and expandability, usability, reporting, standards and compliance, and administrative support and technical specifications.
Functionality measures the extent to which a software product meets the requirements of different types of micro-fmance programmes, and whether the software has the capacity to expand as the MFO evolves. This forms the heart of the MIS and can often constrain the expansion of the organisation in many ways. Usability refers to the extent to which users are able to perform daily tasks effectively using the system, while reporting examines the extent to which 'built-in' reports cover management and operational requirements (Mainhart, 1999).
The assessment in this study will provide some indication of the suitability of the MIS used by the four KZN study lenders.
Most challenges in rural financial intermediation anse from the promISSOry and inter- temporal nature of financial contracts. As Chapter 2 shows, asymmetric information between borrower and lender (adverse selection and moral hazard), and loan contract enforcement problems in rural financial markets, have frequently led to poor rural individuals being rationed out of formal credit markets (Hoff and Stiglitz, 1990). Hence, successful rural financial intermediation not only requires lending technologies that reduce both borrower and lender transaction costs, but which are also able to reduce information asymmetries between borrowers and lenders and also provide the necessary incentives for borrowers to repay loans (Carter, 1988; Gonzalez-Vegaet al., 1997).
Reducing default risk through careful client screening, and providing adequate incentives, will also assist the financial intermediary in achieving financial self-sustainability and facilitate the transfer of resources to productive investment (Gonzalez-Vega, 1994). The
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aAevaluation framework, therefore, focuses on the technologies used to screen loan applicants and enforce loan contracts. The ease and accuracy with which screening technologies reduce geographic, cultural and occupational distances between borrower and lender influence the length, detail and cost of the loan applicant screening procedure. Long and complicated screening procedures may increase loan approval and borrower waiting times, while the use of local individuals (prominent village leaders as in the case of the Indonesian MFOs or self- selection in group loans) and loan applicant scoring models may improve the accuracy and speed of the screening process (Chaves and Gonzalez-Vega, 1996).
The use of joint liability groups and loan officers who make detailed personal and fmancial evaluations of individual loan applicants and their homes, businesses and collateral (relying on the loan officer's localized knowledge) have been important mechanisms by which MFOs have reduced information asymmetries (Schreiner, 2001). However, not many MFOs have used statistical scoring models on the scale that commercial fmance institutions do, mainly because of the lack of suitable data required to build such models. Credit scoring models work on the premise that the past predicts the future. Statistical models (such as logistic regression) use historic information on loan applicants to predict a future outcome (mostly the probability of the loan applicant repaying the loan) (Bailey, 2001). Scoring models have many applications within the lending industry of which the most important are first-time loan application and behavioural credit scoring models.
A first-time loan application scoring model is used to predict the risk of a first-time loan applicant defaulting at future point in time while a behavioural scoring model is used to predict the risk of an existing borrower applying to take a repeat loan. Schreiner (1999; 200 I) has explored the application of scoring in microfinance and concludes that while credit
scoring will not replace the important function of loan officers in the screening process, it can expand the fmancial technology frontier of those MFOs who can use it. A scoring model that predicts loan repayment risk relatively accurately can be an important tool in the loan granting decision process. Better credit granting decision result in fewer borrowers defaulting which improves loan collections and reduces costs associated with loan default (Schreiner, 2001). The evaluation framework will review the screening technologies used by the four KZN MFOs focusing on the mechanisms used to screen loan applicants and how these have evolved over time. Specific focus will be given to the adoption of scoring models and how these have helped the study MFOs to improve the credit granting process.
The evaluation framework will also document the degree to which lenders monitor borrowers' activities. The cost and quality of information obtained from monitoring depends on the resources committed to monitoring and the monitoring technology. Geographic dispersion of rural clients and the seasonal nature of agricultural loan repayments reduce borrower and lender contact while making monitoring costly. More densely populated urban areas and more frequent incomes of micro-entrepreneurs and employed individuals promote frequent borrower-lender contact, thereby improving loan monitoring. Using local individuals in loan approval procedures, as is done by best practice lenders, may also be a cost-effective way to monitoring borrowers, since information is a by-product of living in the area. Well- developed MISs capable of tracking loan repayment performance are also important in borrower monitoring to allow early identification of problem loans. The MISs may also reduce the administrative burden of loan tracking, potentially lowering lender transaction costs (Chaves and Gonzalez-Vega, 1996; Yaronet al., 1998).
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Collateral is also an important incentive and contract enforcement device. To act as an enforcement device collateral should reduce the lender's default loss and/or make it costly for the borrower to default (borrower must incur collateralisation costs in pledging collateral).
This requires that collateral assets have well-established and transferable property rights, and a legal environment that facilitates loan contract enforcement such that the lender can foreclose and attach the collateral (good appropriability). Asset liquidation costs should also be low, and marketability good, to enable the lender to recover sufficient funds from liquidating the collateral to cover loan losses (Barro, 1976; Nagarajan and Meyer, 1995).
Collateral assets should also not be prone to high collateral specific risks such as theft, damage by fire or accident and poor maintenance (Binswanger and Rosenzweig, 1986).
Borrower collateralisation costs include potential loss of pledged assets if the investment fails, costs incurred in pledging the collateral (such as group formation costs and legal costs) and foregone opportunities to use the collateral to secure additional debt. Although excessive borrower collateralisation costs may discourage borrowers from using formal financial services, these costs are important if collateral is to be as an effective enforcement device (Chan and Kanatas, 1985; Federet al., 1988).
Financial intermediaries involved in rural and micro-business finance often face high transaction costs in liquidating collateral due to the often poor condition of the assets, institutional constraints (such as title to land not secure and transferable), the geographic dispersion of borrowers, poor rural infrastructure, low-wealth borrowers unable to pledge suitable collateral, and a costly and/or ineffective legal system (Nagarajan and Meyer, 1995).
Rural fmancial intermediaries have thus resorted to using collateral substitutes such as group loans, savings, guarantee funds, reputational capital and interlinked contracts.
While these collateral substitutes may alleviate the problem of suitable collateral, they are also subject to borrower collateralisation and lender transaction costs, potentially reducing their efficacy (collateral use may, therefore, differ for lenders operating in different markets subject to borrower transaction costs, liquidation costs, collateral-specific risks and institutional arrangements. The evaluation framework will thus document the collateral types used by the four KZN study lenders and qualitatively assess the efficacy of the different collateral types based on borrower collateralisation costs, collateral-specific risks, asset appropriabiliy and marketability (Table 4.1). Staff remuneration incentives linked to loan collections is also important in reducing default rates since loan officers take more effort in granting loans to credit worthy borrowers where the probability of loan repayment is high.
Remuneration linked to loan collections will also incentives loan staff to rigorously follow-up those borrowers whose loan repayments are in arrears.
Collateral may also serve as a signaling device. However, to determine the use of collateral as a signaling device, information on collateralisation costs of low-risk relative to high-risk borrowers is required. Low-risk borrowers must also have suitable assets to pledge as collateral (Bester, 1985). Since rural individuals frequently do not have sufficient collateralisable wealth, and information on the relative costs of collateralisation for high- and low-risk borrowers is difficult to obtain, the evaluation framework will only focus on the enforcement properties of collateral types used by the four KZN study lenders.
Interest rates charged by lenders as noted in Chapter 2, affect the ability to cover operational costs and loan losses. Achieving a suitable interest rate spread combined with improved operating efficiency can reduce dependence on subsidies (Yaron, 1994). Both quoted
nominal and effective annual interest rates will be documented in the evaluation framework
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to qualify the study MFOs' ability to achieve fmancial self-sustainability. The annual effective interest rates are all computed on the remaining-balance method to facilitate interest rate comparability between institutions (Rosenberg, 1999).
Access to fmancial services allow individuals to protect themselves against income shocks by accumulating monetary reserves, synchronise income-generating and consumption activities, and use funds for productive investment. Both savings and credit can fulfill these functions.
Individuals may prefer to save rather than to borrow. Thus savings mobilisation in rural financial markets is potentially more important than the provision of credit (Rhyne, 1994).
Since savings can facilitate investment decisions, and consumption smoothing, it is important that quality savings services are provided that improve the individual's decision-making options (Rhyne, 1994).
Ready access to savings may hence be important both in terms of a well-distributed lender branch network, and ease of depositing and withdrawal of funds. In addition, savings should allow the individual to use those savings to satisfy consumption and investment decisions (Yaron, 1994). Savings can also serve as a form of collateral and information on potential borrowers. It is thus important that savings form part of multi-function financial intermediaries offering both savings and credit facilities. Accessing both services at one lender can help to reduce borrower transaction costs.
This study also aims to determine whether these savmgs facilities are voluntary or compulsory, as compulsory savings are less flexible in use and are more difficult to access, serving as a form of collateral or contingency fund when individuals do not repay loans. For
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group loans this avoids the use of peer pressure, which may generate hostility amongst group members (Yaron et aI., 1998). Savings mobilisation may also reduce lenders' reliance on donor funds, improving fmancial self-sustainability. While real, positive interest rates offered by deposit accounts do affect individual's decisions to save, it is less clear whether an increase in the interest is the only motivating factor, which encourages savings mobilisation (Meyer, 1989). Evidence suggests that rural individuals tend to value access to savings higWy (Gurgandet aI., 1994). Rural finance institutions may offer both savings and loan products.It is, however, important that these savings are accessible and flexible in use. The evaluation framework will thus document the type of savings products, access to savings and interest rates paid.