Credit Risk Measurement in MFIs

The credit risk measurement systems in MFIs need to evolve substantially in order to sustainably provide collateral-less loans to poor clients. While lending through the group guarantee mechanism has ensured sound portfolio quality for long periods of time, we have in the recent past witnessed situations when there has been a rapid decline in portfolio quality. At times, these have happened without any warning primarily catching the MFI management unaware. The present system of risk monitoring relies heavily on the Portfolio At Risk (PAR) indicator. This is inadequate because of two important reasons discussed below:

Firstly, making an assessment of credit risk inherent in the portfolio on the basis of Portfolio Age reports and PAR is necessary but not sufficient. This is so because potentially all the outstanding amounts with the groups which have hidden delinquency can be lost as within the microfinance sector, there is significant evidence to show that delinquency can rapidly spread from one member of a group to the entire group. Hence it is also important for MFIs to collect data regarding the number of groups that have delinquent clients and the amounts outstanding with them

Secondly, under the group guarantee mechanism, in case an individual is unable to pay her loan installments, other members of the group pool monies and pay up on the individual’s behalf.  As a result the individual’s installment is paid and her loan shows up as being regular, hiding delinquency. This constitutes a risk event for the MFI as a borrower had not been able to pay her installment and guarantee mechanisms had to be enforced in order to make up for the shortfall. However, the MIS of MFIs today do not catch data pertaining to such events. This results in Hidden Delinquency. Therefore, a system is required to correctly capture and classify incidence of hidden delinquency. This should form part of the regular reports generated by MFIs.

Thus, instead of generating only the PAR report portfolio age, there is a need to broaden the analysis to include data on groups which show manifest and hidden delinquency as well as the amounts outstanding with them.