DETERMINING INTEREST RATE ON LOANS

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Interest rate and its determination is one of the trickiest issues in microfinance. Most people say MFIs are charging too much, and some government agencies are even putting cap on the lending rates of financial institutions.  Mission drift is an increasing phenomenon as more MFIs are shifting to bigger loan sizes and catering to the more “dependable” microenterprises and small and medium enterprises (mMSE) to remain profitable and to satisfy the investors’ expected returns. This mode is being countered with the promotion of responsible finance, that is, delivery of financial services in a transparent, inclusive and equitable fashion (CGAP 2011). It is in this context that determining cost-covering interest rate is relevant. Policy-makers of MFIs should understand how interest rate on loans is determined and how it affects their institutions bottom-line and their clients’ survival and capacity to pay. They can do this by being familiar with the elements of interest rates and develop the skills on how to work on the various elements to come up with the ideal interest rate on their loan products.

Interest rate is generally defined as, the charge for the use of money over time. Several concepts are related to this idea.  The first is opportunity cost which refers to the cost of the missed opportunities.  Second, the time value of money which refers to the earning potential of the money and it future value when invested now. The third is borrowers transaction cost which refers to the expenses and opportunity cost of the clients when transacting business with a financial institution. Most often, this concept is neglected as financial institutions focus only on their cost and their risk management practices.  All the three concepts directly affect cost of doing business for financial institution. These have to be considered in determining interest rates.

In determining cost-covering interest rates, the following core elements should be estimated:

Operating cost.  This refers to all recurring expenses of the MFI including administrative overhead and expenses directly relating to credit management.

Loan losses. Actual written-off loans should be recovered. This can be done by imputing the losses to the interest rate of the succeeding year.  High volume of written-off loans will directly affect the equity of the institution. Loan loss provisioning on the other hand will affect the return on equity and the dividends of the investor.  Controlling defaults and PAR will ensure that this element will not reflect to higher interest rate on loans.

Cost of funds.  Most MFIs leverage their capital. As such, they have to pay for the borrowed funds, whether it is commercial or soft loans from development agencies.  If the MFI has a lot of lenders with varying interest rates, it can be computed on the basis of “weighted average cost of capital”.  Deposits from members and clients with paid interest rate on savings fall in this category.  It is not enough to impute the interest rate on savings as the cost, but rather, to include the opportunity cost of the liquidity reserve set aside as a requirement by the regulatory agency, and the reserve set aside to service withdrawals.

Desired margin. This element refers to the profit or the envisioned income of the institution.

Other than the four core elements, taxes and inflation are also included in the determination of interest rate.  Actual taxes paid can be imputed, while inflation can be determined by looking at the historical trend for the past several years. This will enable the institution to preserve the value of its financial resources.

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CATEGORIZING MICROFINANCE LOAN PRODUCTS

ImageMarket research is now an indispensable tool for MFIs in enhancing their products and services. The emerging trend is now far from the previous one-size-fits-all financial products that has been the cornerstone of microfinance success for several decades.   Group loans are basically reserved for first time borrowers that have yet to establish track record of repayment and those without collateral. For those who have been accessing loans from MFIs for several years, and who were able to move up to the income ladder, financial products that respond to their specific requirement are what they needed.

MFIs should respond to this reality to be able to retain their existing clients and to reach out to other clients. Categorizing products and services will help MFIs rationalize its offering and be able to look at what is lacking.

Loan products can be categorized into two main purposes: for income-generating economic activities and non-income-generating activities. In most Asian countries, the income-generating activities can further be divided into two: enterprises and agricultural production.

Enterprises on one hand, refers to the economic activities of microfinance clients mostly trading in nature. These includes, vending, buy-and-sell, small variety store and the like.  Other economic activities involving simple production skills also fall in this category like handicrafts, preparation of foodstuff and the like.  Activities with growth potentials can be provided not only with loans but also with technical assistance for it to move up from micro-enterprise to small and medium classification, where a more organized and systematic  management skills is needed.

Agricultural production on the other hand, refers to economic activities related to the production of crops, poultry and livestock and even fishery particularly fish culture. The production process from planting to harvesting is the main focus of financing. The risky nature of agricultural production is the reason why banks shy away from this sector.

The non-income-generating needs also known as consumption needs of the clients can also be further categorized into two: life cycle needs and emergency needs.

Life cycle needs refer to the events in one’s life where bigger amount of money is needed. This includes expenses for birth, education, house building or improvement, acquiring assets like land, marriage, old-age pension, death, and other events determined by our tradition and culture.

Emergency needs refer to unexpected expenses brought about by natural calamities like typhoons, floods, earthquakes and even man-made calamities and personal emergencies like sickness, accidents and the like.

These general categories rationalize an MFI’s list of products and services. Providing the clients with wide array of products that can cover their specific needs will surely develop client loyalty. It will ensure not only the sustainability of the institution but the improvement of standard of living of the client as well.

Developing Agri-Microfinance (AMF) Loan Product

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Developing agricultural microfinance (AMF) addresses two main issues in development finance: first, to ensure that small farmers have access to credit for production expenses; and second, to address the risks involved in agricultural production. Risks is agricultural production  is so high that most formal financial institution do not venture in the agricultural sector, leaving  government  banks and the informal money lenders to serve this sector. Developing AMF products involved several activities:

  •  The Market Study includes market-understanding research to determine the features of the loan products. It will also provide information of the specific agricultural commodities that can be financed. It also includes a risk profile identifying various risks related to the commodities and the coping mechanisms to address the risks.
  •  During the Product Development Workshop,  information from the market study are used to develop the “product architecture” – the features of the loan product fit to the needs of the clients and the production cycle of the  commodities identified for financing. It shall also review of the loan process.
  •  The Pilot testing is the phase where the product prototype designed during product development workshop will be implemented in a limited scale, say a branch, to check its applicability. Monitoring and coaching sessions are done during this period to check the development, the variance in the features and processes and other observations that will enhance the product.  Refinements in the features and the process can be done during this phase.
  •  The final phase is the Mainstreaming where the tested products will be installed in all operating units of the financial institution.

Based on our experience, AMF loan products are appreciated by the farmers because the loan term is fit to the production period and the harvest season, and they understand the production cost of each agricultural commodity. On the part of the credit staff, the commodity profile assisted them in speeding up the loan appraisal process. It became easier for them to determine loan amount based on the production activities in the commodity profile.

In mainstreaming AMF, there are several pointers that have to be strictly observed.  Agricultural production should be treated as a separate economic activity that requires a specific loan product. Agribusiness or enterprises that are not directly related to the production process like trading, provision of inputs and the like should be categorized under enterprise or business loan and not as part of AMF. Portfolio management should prescribe percentage allocated for AMF, taking into consideration the suitability of the area to agriculture (irrigated or not), the frequency of natural calamities and other factors.

Cambodia MFIs: At the forefront of agricultural finance

The government of Cambodia is in full-swing mobilizing resources to upgrade the country’s infrastructure in support of agricultural development. Roads, ports, irrigation and other support facilities are fast-tracked to reach the target of making Cambodia one of the main rice-exporting countries in the region, in the league with neighboring Thailand and Vietnam. Resources for these upgrading projects are sourced from a mix of loans from bilateral and multilateral agencies and from private investments.

In the absence of a massive government financing program for agriculture, resources for the production phase remains with the informal moneylenders and the microfinance institutions. For small farmers, these two sources are the most accessible and relevant to their needs. Of the 32 MFIs licensed by the National Bank of Cambodia (NBC), almost half has loan products for agricultural production. It is estimated that more than half of the $732 million outstanding loan portfolio of the microfinance industry is invested in agricultural production and other agriculture-related economic activities, benefitting 1.1 million clients nationwide.

The MFIs have also started re-designing their loan products. Most are still having the traditional group or individual loans, but some have already fine-tuned their products, infusing features that fit to the needs of the farmers. In a project funded by European Union (EU) and the Agence Francais de Developpement (AFD), MFIs are assisted to develop agricultural-microfinance (AMF) loan product. The loan product will specifically be used for agricultural production and agriculture-related economic activities.

The contribution of the MFIs in the development of agriculture is also part of the poverty reduction goals of these institutions. While most MFIs started as non-government organizations and projects of development agencies, social mission is considered as the ultimate mandate even as commercial investors are gradually becoming the main source of funds.

The situation in Cambodia where the private sector is the main providers of funds is better compared to other countries where the government is heavily involved through special government-owned banks. With a subsidized lending program, inefficiencies are shouldered by the taxpayers and also developed dependency among the farmers.

6 Features of Effective Financial Literacy Materials

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Financial literacy is considered as one of the main tools to prevent over-indebtedness that has plagued many microfinance borrowers.  A consistent and effective financial literacy program will ensure that borrowers receiving loan funds will use them for its intended purpose and will not divert it for non-productive purposes.

One main concern however is the perception that financial literacy is an added burden both for the borrower and the loan staff.  On one hand, ineffective financial literacy methodologies are viewed by clients as time consuming, taking away precious time from their income-generating activities. On the other hand, most loan staff has   a notion that doing financial literacy activities reduces their level of performance. It does not contribute to the attainment of their targets and their main functions of generating borrowers and collecting repayments.

When done properly, financial literacy will develop the capacity of the clients to become prudent managers of funds and responsible borrowers.   This in turn will lower the cost of providing services by the MFIs.  Applicable methodologies should be the main consideration in the design of FinLit  materials.  Among the key features that can help make the materials effective are the following:

  1. The AUDIENCE of the sessions should primarily be the current clients, but it should also encourage non-clients as well.  Efforts should be made to reach as much audience as possible.
  2. The materials should use VISUALS to reinforce verbal presentations.  Structured-learning activities (SLAs) are applied in sessions where it is applicable. Texts in the visuals should be minimal so as not to intimidate clients who cannot read.
  3. The MATERIAL should be designed as a “discussion-starter” and should be able to generate interest and participation among the audience.
  4. The loan staff shall be the FACILITATOR in the conduct of the learning sessions.  The sessions shall be interfaced with her/his regular field activities like loan assessment, collection and monitoring activities.
  5. The SESSION should be conducted in the field whenever possible, as often as possible to cover as many topics as possible.  The session should not be made as a requirement for loan release.
  6. The material should be PARTICIPATORY and INTERACTIVE, so that maximum participation from the clients can be expected and encouraged.

Social Performance Management (SPM) Training for Microfinance Institutions

Social Performance Management (SPM) is a management tool used to translate the mission statement of microfinance institutions into reality and be able to keep track on how they perform in line with the internationally and socially accepted indicators. This will ensure that MFIs will continue to serve the poor, despite the issue of commercialization and moving towards bigger borrowers.

A training of trainers will be conducted in Cambodia and Vietnam for selected MFIs to re-enforce the capacities of the respective SPM point persons in providing guidance as mentors in the process of SPM institutionalization. The training activities are slated on August 13-17 in Phnom Penh, Cambodia; and August 20-24 in Hanoi, Vietnam.  The topics covered in the training are coaching and mentoring skills, social performance standards and client protection principles.

The training is expected to develop in-house pool of capable SPM point persons whose major role is to ensure that SPM is in-place in their respective MFIs.  The knowledge transfer gained out of this effort will pave the way to disseminate and expand SPM adaptation among other MFIs in the two countries.  The entire process of SPM institutionalization is part of the various  technical assistance provided by PlaNet Finance, in partnership with the Cambodia Microfinance Association (CMA) and the Vietnam Microfinance Working Group (MFG)  to strengthen their  over-all institutional  capacities, under the project “Improving Financial Inclusion and Social Impact Towards Food Security in Southeast Asia” (FinInc Asia).

How to prevent MFIs to be channels of money laundering

Microfinance institutions providing financial intermediation functions can be used as conduits of money laundering and terrorism financing. With MFIs, it is even harder to track down since transfer of money in small amounts through a non-profit “charitable” institutions may not be monitored effectively.

Deterring people with motives to use MFIs as a channel of their illegal activities should be part of the risk management efforts of the institution. It should be the lookout of MFIs to ensure that they will not be part of money laundering and terrorism financing. Among the basic steps that should be done are the following:

1. Anti-money laundering policies. Microfinance institutions should establish policies against money laundering and terrorism financing. Implementing procedures for these policies should immediately be cascaded down to the frontline staff.

2. Know your client (KYC). The first thing to determine is the origin. Inflows deposit, money transfer and even grants should be scrutinized. From where is the money coming from? The individual owner of the fund must be determined. A grant coming from a foreign foundation is to be highly appreciated, but it is more important to determine who are the people behind the foundation. The ultimate beneficial owner (UBO) must be identified to make sure that it is not just a front for a terrorist-supporting organization.

3. Another KYC effort is to know the destination of the money. Who is the final receiver and user of the money? Is the money being deposited to the institution only for a short time, to be withdrawn immediately? Or is the money invested to be used only for a certain group without expectations of being repaid? Answers to these questions will reveal the intention of the destination.

It is surprising that in the series of anti-money laundering seminars we have conducted, most microfinance institutions are not aware of the possibility that their institution may be used. Appropriate policies and mechanism and vigilance are the answers to ensure that your institution will not be used by people with criminal intention.