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1 MicroSave market -led solutions for financial services Offices across Africa, Asia and Latin America toolkit for loan portfolio assessment of micro finance Institutions Graham Wright, Ramesh S Arunachalam, Manoj Sharma and Madhurantika Moulick micro - finance Consulting Group August 2006 toolkit for loan portfolio assessment of micro finance Institutions MicroSave market -led solutions for financial services 2 Acknowledgements MicroSave acknowledges the contributions of Sonal Mishra and S Narayanan in preparing this toolkit . This toolkit needs comments from trainers to provide additional training tips, examples and ideas!

2 Your thoughts and comments are anticipated and welcomed for the next version. toolkit for loan portfolio assessment of micro finance Institutions MicroSave market -led solutions for financial services 3 Table of Contents 1 OBJECTIVES OF A loan portfolio assessment .. 4 2 BASIC METHODOLOGY FOR CONDUCTING A loan portfolio assessment .. 6 3 CHECKLIST TOOLS FOR USE IN THE loan portfolio 9 CHECKLIST FOR loan portfolio assessment IN MFIS/BANKS .. 9 EXPLANATION FOR CHECKLIST .. 26 CHECKLIST FOR assessment OF RECORDS .. 71 COMPARATIVE ANALYSIS OF KEY portfolio QUALITY INDICATORS .. 72 SUMMARY REPORT ON loan portfolio assessment .

3 72 ANNEX 1 BEST PRACTICES portfolio REPORT .. 73 ANNEX BEST PRACTICES portfolio REPORT .. 73 ANNEX BEST PRACTICES COMPARTIVE portfolio REPORT .. 74 ANNEX 2 - ASSET QUALITY INDICATORS .. 77 ANNEX 3 HOW TO AGE A loan portfolio AND CALCULATE portfolio QUALITY INDICATORS? .. 102 AGEING OF LOANS, EXAMPLE USING THE CORRECT METHODOLOGICAL APPROACH .. 106 WHY SHOULD THE INSTALLMENT METHOD OF AGEING NOT BE USED? .. 119 DISCUSSION .. 131 OTHER ISSUES OF IMPORTANCE .. 133 ANNEX 4 - CALCULATION AND INTERPRETATION OF BEST PRACTICES loan portfolio MANAGEMENT INDICATORS .. 137 portfolio AT RISK - CALCULATION AND 137 ARREARS RATE - CALCULATION AND INTERPRETATION.

4 140 loan LOSS RESERVE RATIO - CALCULATION AND INTERPRETATION .. 142 loan LOSS RATIO - CALCULATION AND INTERPRETATION .. 144 ANNEX 5 ACCOUNTING PROCESS AND TRANSACTION SUMMARY FOR loan portfolio MANAGEMENT AND micro - finance .. 148 ACCOUNTING PROCESS FOR loan portfolio MANAGEMENT .. 149 micro - finance TRANSACTION SUMMARY .. 151 ANNEX 6 - GLOSSARY OF FINANCIAL TERMS FOR micro - finance loan portfolio assessment .. 200 toolkit for loan portfolio assessment of micro finance Institutions MicroSave market -led solutions for financial services 4 How to conduct a loan portfolio assessment A Best Practices toolkit for Microfinance Institutions 1 OBJECTIVES OF A loan portfolio assessment The loan portfolio is the primary income generating asset for an MFI1 and it is most commonly subject to material misstatements.

5 Most MFI failures stem from the deterioration in the quality of the loan portfolio . An assessment of the risks and inadequacies inherent in an MFI s portfolio therefore assumes tremendous importance and this is the most important objective of a loan portfolio assessment . MFI credit (lending) operations have unique characteristics that portfolio assessors must first understand. Several aspects that need attention include: Difficulty in maintaining portfolio information - MFIs grant a large number of small loans, and process a very large number of (repetitive) tiny payments. Their operations often tend to be dispersed over a wide geographic area.

6 As a result, MFIs utilize streamlined and decentralized operating structures in order to be efficient. These factors make it a challenge to maintain effective portfolio information and management systems. Lack of portfolio information is a serious aspect which could result in lower portfolio quality - bad loans not being identified and followed up. Decentralization could cause deviation from prescribed credit policy and result in fraud, error or manipulation - Decentralization implies that relatively few staff members are involved in approving, disbursing, monitoring, and collecting each loan . This structure increases the opportunity for deviation from approved policies, and for fraud, as well as increases the risk of error or manipulation when branches transfer information to headquarters.

7 Mandate of efficiency may result in lesser controls/procedures/information/supervis ion - To handle small and repetitive transactions efficiently, MFIs come under great pressure to cut costs, sometimes, even at the expense of adequate portfolio controls. Lack of adequate information flow, as well as insufficient supervision of clients and loan officers could in the long time affect portfolio quality. Burgeoning growth of portfolio could result in failures of established systems - Many MFI portfolios are growing rapidly. This growth puts pressure on systems and if capacities to manage the increased volumes do not exist, portfolio quality will get affected in the medium / long term.

8 Secondly, a rapidly growing portfolio has a larger percentage of loans in the early stages of repayment. Delinquency problems often occur in the later stages of the repayment cycle or in the third / fourth loan cycles when loan amounts are relatively large. Also, an increasing outstanding may not reflect increased delinquency ratios even though absolute volumes may be high. Pressure from donor / lending agencies, lopsided incentive structures and at times the mindless number game can all lead to quick disbursal of loans sometimes, even without demand this is clearly a recipe for disaster. This pressure can also create an environment for fraud.

9 Restructuring (rescheduling and refinancing) of delinquent loans is an often-used strategy to camouflage portfolio quality - MFIs generally dislike provisioning for problem loans or writing them off. They want to maintain a good image in the eyes of outsiders, especially donors. This sometimes leads to restructuring or refinancing as a tool to hide delinquency. Weak information systems may not even permit MFIs to recognize delinquency - MFI information systems are often inadequate and systems for operational loan tracking are seldom integrated with their accounting systems. The lack of appropriate systems may mean that MFIs may not even recognize delinquency in their portfolio and consequently may not make any efforts to tackle it.

10 1 The term MFI is broadly used and includes micro finance Institutions, Commercial Banks, Non Banking finance Companies / Institutions, Cooperatives / Credit Unions and other such entities involved in delivering financial services to low income people toolkit for loan portfolio assessment of micro finance Institutions MicroSave market -led solutions for financial services 5 These issues, among others, make the loan portfolio assessment a very crucial but rather complicated and time consuming exercise. Assessors will need to allocate significant effort in the review of the loan portfolio and to carry out field visits.