230 Mark Schreiner • Formal savings account o Date opened o Passbook and/or time deposit • Frequency of receipt of remittances Business “Demographics” • Sector (manufacturing, services, trade, agriculture, other) • Specific type of business (construct a list of 30–50 context-specific) • Year started • Formalisation • Tenure status of place of business (owned, rented, other) • Person-months of full-time-equivalent workers per year o Applicant o Family members (excluding applicant) o Non-family members Business Financial Flows (Monthly) • Sales • Expenses • Installments on other debts (business and household) Business Financial Stocks • Cash and savings-account balances • Inventory • Fixed assets • Debts o Formal o Informal Repayment Record for Each Scheduled Installment • Date due • Date paid-off Can Credit Scoring Help Attract Profit-Minded Investors to Microcredit? 231 Aspects of the Loan Contract • Date application submitted • Date loan disbursed • Date paid-off • Amount disbursed • Amount of average installment • Number of installments • Frequency of installments • Refinanced status • Type of guarantee • Value of guarantee • Identity of cosigner Identity of the Lender • Branch • Loan officer CHAPTER 13: Credit Scoring: Why Scepticism Is Justified Christoph Freytag Managing Director, IPC GmbH Providing loans to micro and small businesses has been at the heart of IPC’s ac- tivities for more than 20 years. In 2005, ProCredit Banks in Eastern Europe, Af- rica and Latin America disbursed more than 60,000 business loans per month. The ProCredit Banks achieved a return on equity of 15% in 2005. IPC also advises private commercial partner banks on behalf of international fi- nancial institutions (IFIs) in “downscaling” projects, which are designed to build capacity in MSE (micro and small enterprise) lending. These banks disburse 75,000 MSE loans per month. An indicator of the profitability of the partner banks in the downscaling projects is that only about 15% of their combined MSE loan portfolio is being funded by IFIs. The remaining 85% is financed with resources these banks have mobilised in their domestic markets. The levels of profitability implied by these figures are being achieved because the lending methodology – or “credit technology” – which the banks use is effi- cient and keeps credit risk under control. A recent in-depth vintage analysis of bad loans within the ProCredit Group revealed that only 0.5% of all loans disbursed were not recovered. From this analysis, we also learned – once again – that in the vast majority of cases, loan defaults are triggered not by the borrower’s “individ- ual” inability to repay the amount outstanding, but rather by an unwillingness to repay or by an inability to fulfil payment obligations brought about by events such as crises, natural catastrophes, civil unrest or fraud. Another type of risk – “opera- tional risk” – that can contribute to loan delinquency is a lack of institutional dis- cipline, which in most cases is a result of insufficient management attention, spe- cifically on the part of middle management staff. Credit scoring will not protect lenders against these risks. That is something that only conscientious, well-qualified employees can do. Accordingly, IPC and the ProCredit Group are investing on an increasing scale in staff and management training at all levels – as evidenced by the creation of training centres in the indi- vidual banks, regional middle management academies and a central academy for senior management training. We strongly believe that investments in people are of paramount importance in identifying and managing risk. Trying to “revolutionise” 234 Christoph Freytag microfinance through credit scoring is an attempt to shift attention away from people and focus instead on systems and procedures. It is easy to understand why, at first glance, credit scoring is appealing to mi- crolenders. Scoring is generally applicable to mass-market lending products with a high degree of standardisation, including rather uniform terms and conditions, which are sold to clients whose incomes and financial behaviour patterns are usu- ally stable and predictable. Scoring requires the lender to compile large databases containing information on “good” and “bad” borrowers as well as applicants whose loans have been rejected. Ideally, if scoring is to be effective in assessing risk, credit information should be easily obtainable and simple to verify. If these conditions with regard to the availability and quality of the underlying information have been met, scoring can result in higher efficiency, faster loan processing, less dependence on staff and consistent, explicit risk assessment, which in turn makes risk-based pricing feasible. All of this makes scoring even more attractive for banks: They usually have large databases and strong IT support. Banks that serve corporate and retail cus- tomers are usually very centralised and, as a rule, their procedures are highly stan- dardised. A traditional microfinance approach, however, requires decentralisation, which conventional bankers are afraid of. Credit scoring, a radically centralised and standardised loan approval system, therefore fits perfectly into the kind of corporate culture that is characteristic of large, mainstream banks. A thorough analysis of the borrower’s repayment capacity and his or her will- ingness to pay are at the heart of IPC’s credit technology. This is due not only to reduce risk-related costs, but also to a fundamental desire to implement socially responsible lending practices. We must not forget that credit – a loan from the banker’s point of view – is a debt for the borrower. Lending that leads to the over-indebtedness of clients must be avoided: especially for those who might have limited skills in financial planning and tend to overestimate their repay- ment capacity. Credit scoring creates a temptation for the lender to take a different approach: By replacing the well-trained, expensive loan officer with a machine, costs amounting to at least 3-4% of the portfolio can easily be saved. The temptation is to allow higher losses in order to gain a larger market share and lending volume. Nobody today would deny that over-indebtedness of households due to aggressive credit card, consumer, car and mortgage lending is a social problem in Western markets. In most cases, the rapid expansion of these types of lending has been based on the use of scoring techniques, often in conjunction with nontransparent pricing prac- tices and aggressive marketing. This has caused traditional lenders to be crowded out of traditional credit markets. In certain emerging and transition economies, similar trends can already be observed. In Turkey, for example, credit card and consumer debt increased by 800% between 2001 and 2004 and the NPL (nonper- forming loan) level reached 9%. As Schreiner rightly notes in the preceding chap- ter, such practices can have – and indeed have had – a disastrous impact on micro- finance markets, as is shown by the example of Bolivia. Credit Scoring: Why Scepticism Is Justified 235 It is clear that the aggressive use of credit scoring will have severe negative im- pacts in the long run and hinder the development of a healthy credit culture. One could argue that the answer is simply to fine-tune the scoring system by applying more rigid criteria. But even if this is done, the temptation inherent in credit scor- ing, as described above, will continue to exist as long as advocates of shareholder value continue to seek to maximise profits regardless of the social costs involved. It is interesting to note that a conservative lender, a major Austrian bank, has re- cently adopted a policy designed to facilitate micro-lending using a rather rigid scoring system. This system requires data from tax declarations and information on bank transactions, and automatically rejects businesses that have existed for less than two years. 1 We do not believe that such approaches are in any way compatible with the de- velopment goals which microfinance pursues. Almost invariably, the more rigid the criteria and rules which are applied, the sooner a microfinance provider will end up lending in the “comfort zone”, where lending staff can rely primarily on narrowly defined systems to assess creditworthiness, without having to assume responsibility for analysing borderline cases. As a consequence, a large number of low-income clients that would be able to repay loans tailored to their personal repayment capacity will be denied access to credit. In essence, microfinance is about building relationships between finance providers and clients among the low- income target group. Abandoning this type of relationship banking for the sake of potentially more efficient banking transactions will neither be beneficial for indi- vidual microfinance providers nor in terms of the sound development of microfi- nance markets. For all of these reasons, we cannot see why credit scoring would be a worthwhile activity for donors to support. Schreiner and others do not advocate a complete shift from the traditional mi- crofinance credit technology to credit scoring. Rather, credit scoring is seen as a tool which would supplement and refine the traditional credit technology by add- ing a “third voice” to the credit committee and making credit risk management more explicit and consistent. In principle, we agree. Learning from statistical evi- dence, drawing lessons from practical lending experience and implementing grad- ual improvements to the credit technology must be an ongoing process. Thus, credit scoring offers very little that is really new, given that the truly useful as- pects of this approach are already being applied by a substantial number of micro- finance providers in various parts of the world. A new buzzword is certainly not necessary in order to drive institutional development in microlending. 1 This is in line with the bank’s strategy, as expressed by its CEO, who wants to “select the cream of the cream of customers”. See: “Expansionist where others fear to tread”, interview with Raiffeisen International’s Chairman Herbert Stepic, The Banker, Feb. 5, 2006. PART III Partnerships to Mobilise Savings and Manage Risk Introduction to Part III Two topics are presented in part III. While they may seem quite different, they have in common the management of risk where risks are relatively high and where transaction costs are also high, at least at early stages of development. Microinsur- ance and micropensions, at the bottom end of the market, is one member of this odd couple. At the top end of the market is structured finance and securitisation, the other part of this odd couple. In each case the motivation is to increase access at the bottom end of the pyramid. In each case the initiatives are innovative and complex, involve coordination by many different parties for successful execution, have the potential to serve very large numbers of clients, and create new structures with the capacity to achieve far-reaching developmental effects. Stuart Rutherford in Chapter 14 explores the challenges of security in old age among the poor, and the ameliorating role that microfinance can play. His insights rely in part on “financial diaries” of poor people that he and his team have re- corded over years of research in South Asia. This empirical basis makes it clear that poor people do want to save, but that facilitating formal institutions are not yet sufficiently in place to meet demand. A tremendous market for micropensions could be built, but many challenges must first be overcome. Rutherford describes these issues and lessons from attempts at institutional development, and suggests what might be done to create a market. In Chapter 15 a team of authors describe the ins and outs of finance and old age in Sub-Saharan Africa. Demographic and other changes add a sense of urgency to the challenges of maintaining or improving safety nets as populations age. Unfor- tunately, low-income Africans rarely plan for old age. Very few attractive formal financial practices, instruments and institutions are close at hand for the majority, whether urban or rural, who live on a dollar or two a day. However, informal and non-financial activities provide support in emergencies, more young people are becoming aware of problems they are likely to face as they grow older, and incen- tives are strong. In Chapter 16 Michael McCord explores risk management possibilities in low- income insurance markets. He foresees a large potential market that will enable people of modest means to manage the risks they and their families face, offering greater security and protection against catastrophic risks. His scope includes health, accident and life coverage. His structure is based on coverage, premiums, delivery channels, terms and benefits. Examples from Ghana, Georgia, India, Mexico, the Philippines, Uganda and elsewhere are provided, offering lessons for further development and opportunities for development assistance. 240 Introduction to Part III Two chapters by KfW authors round out this book. Each deals with structured finance and securitisation as innovative means of overcoming barriers or features that constrain access to global capital markets. Harald Hüttenrauch and Claudia Schneider provide a road map for securitisation in Chapter 17, specifically target- ing its application to microfinance. The mechanics of this relatively new tool are explained, and its complexity is sorted out. These aspects include explanation of the roles of all parties concerned plus legal and data requirements. Pioneering deals are described. In the final chapter, Klaus Glaubitt, Hanns Martin Hagen, Johannes Feist, and Monika Beck discuss structured finance as a means of promoting microfinance, specifically through mechanisms that attract more private funds. Diversifying, broadening and deepening the supply of funds can be achieved by reducing barri- ers and constraints in capital markets. Construction of an enabling framework for securitisation and structured investment funds in emerging markets is essential for massive outreach. Regulatory issues are a critical factor in facilitating securitisa- tion, while potential benefits reach far beyond specific deals because they create new structures with longer time horizons. The mechanics and advantages of struc- tured investment funds are illustrated by the example of the European Fund for Southeast Europe, in which KfW has an important role. CHAPTER 14: Micropensions: Old Age Security for the Poor? Stuart Rutherford Chairman, SafeSave, and Senior Visiting Fellow, Institute for Development Policy and Management, University of Manchester, UK How can microfinance be expanded to include approaches to the problems facing poor and very poor people in developing countries when they become too old to support themselves? Microfinance clients have long been signalling their demand for such services by doing their best to use current microfinance products, such as microcredit, in ways that create assets that can help protect them in old age. How- ever, “micropensions” will not, at least at first, look like miniature versions of developed-country private pensions, because most would-be clients are not for- mally employed and do not “retire.” The most promising platform for developing suitable products can be found in medium term “commitment savings” plans for the poor that are now growing in popularity and scale in a number of countries. This chapter describes the challenges that face the microfinance industry as it strives to scale up these financial instruments and to make them ever more appro- priate for their users and potential users. A Framework for Micropensions Pensions are generally understood as a regular flow of receipts from retirement to death. They became common in the rich world as industrialisation advanced and formal employment replaced casual or self-employment as the main source of income for most people. Pensions are therefore coupled with the notion of “re- tirement.” Rich-world pensions answer the question “what happens after I retire and stop earning?” To the extent that formal employment has grown in the developing world – where microfinance has its main focus – employment-based and private pensions resemble those in advanced economies. Government and private sector formal employees are usually enrolled in retirement pension schemes, and some workers buy private annuities. But in many developing countries formal employment is not the norm. Most poor people in villages and slums patch their livelihoods together from a mix of 242 Stuart Rutherford self-employment, casual employment, or low-grade formal employment – full- time, part-time or intermittent. To them, the idea of “retirement” is foreign. The question they raise about their old age is “what happens when I can no longer support myself?” Two forms of pension provision can help them answer that question. The first is the public or “social” pension, where the state raises revenue (sometimes from general taxation, sometimes through dedicated contributions) and redistributes it to citizens when they reach a stipulated age in order to guarantee them a dignified life. Such schemes command huge public support from taxpayers (and pension- ers), are virtually universal in the developed world, and are spreading to develop- ing countries. And, the debate on how to fund them is fierce in both the developed and developing worlds. The Case for Social Pensions … Some of what we know about pension use and impact on poor people comes from groups that lobby for social pensions. The NGO HelpAge International, for exam- ple, estimates that 80% of the old people in developing countries have no regular income and that 100 million old people live on less than a dollar a day. By 2050 the number of over-60s in the developing world may jump to 1.5 billion from 375 million today. As life expectancy rises, the accumulation of funds that will be needed to deal with pensions grows steadily greater. HelpAge has studied the impact of social pensions on health, longevity and child-care (many old people live in multi-generational households where grandparents care for the young). These surveys and case studies have been conducted in poor countries that have advanced social pensions provision, such as Brazil and South Africa. Research results make a good case that even low-value pensions can make a big difference to household welfare (Gorman 2004). But these figures point in two directions. While they make a strong case for ex- tending and improving social pensions, they raise doubt about whether state reve- nues will be able to manage such a massive task. … and for Micropensions So it looks as if there is plenty of room for micropensions – pensions for poor and very poor people. But formal employment and formal retirement are rare among this group. This requires a search for a broad understanding of the purpose of mi- cropensions: to help poor and very poor people answer the question – “what hap- pens when I can no longer support myself?” Microfinance clients have long been signalling their demand for micropensions. Early microfinance was almost exclusively microcredit. Loans could be invested in microenterprises (as most lenders insisted) and some of the resulting businesses have contributed to income and asset growth and thus to improved security in old [...]... of reinvestment in a financial asset that produces a flow of income: either interest income, or perhaps by the purchase of an annuity, which is the financial product that specialises in maximising income streams Microfinance and Micropensions How far has microfinance travelled on the road to micropensions? At first glance not far – if in early 2005 you had typed “micropensions” into the search engines... managing money for old age These products will consist principally of medium- to long-term saving schemes that produce capital for reinvestment in real, human, social or financial assets that can create a flow of income to support the non-working elderly In some cases the reinvestment will be in real property for rental, or in the businesses or education of family members in exchange for future income... Rutherford (2000) points out that saving and borrowing are simply alternative ways of converting saving capacity into usefully large lump sums, and that when poor people have restricted access to safe ways of “saving up” they will find ingenious ways of “saving down” (borrowing) to satisfy their most pressing money-management goals As Todd’s example shows, these cases include security in old age Micropension... accounts into a “red GPS” (a low-value one that satisfies the borrowing requirement) and a “green GPS” (the balance of large-denomination accounts, or additional accounts) SafeSave in Dhaka abandoned the mandatory link between borrowing and long-term savings after a three year trial Bearing in mind what was said above about savers’ preference for accessing their capital in some way during the saving term,... Bangladeshi mothers -in- law wise to recommend continuous saving to the next generation? Maybe, since in South Asia inflation has not been rampant Besides, inflation-caused losses in bank deposits, as work by MicroSave in Africa has shown (Wright et al 2001) may still be less severe than losses in other savings vehicles such as livestock, home-saving or on-lending Nevertheless, as the terms of savings plans lengthen,... Medium-term commitment savings plans Huge potential, now rapidly growing These plans allow clients to amass financial assets over time in rhythm with their own savings capacity Matured sums can be reinvested in real or social assets, or can be retained as financial assets producing income streams for the elderly in the form of interest income (or even as fixed-term annuities) Fund management: where these... micropensions Monthly payments of interest plus returned capital over ten years would be relatively easy to calculate and price The resulting increase in the size of the income may make such a product attractive to some poor people in certain situations – such as waiting for an offspring to finish her education and start earning, perhaps We do not yet know Testing is required The fact remains that most GPS holders... insurance into a savings plan) In southern India research found that of all informal savings devices, local “burial funds” attracted the biggest proportion of the very poorest (Rutherford and Arora 1997) In northern India and Bangladesh desperately poor people are sometimes found, after death, to have tied surprisingly large sums of money into their saris and loincloths to secure a proper funeral In. .. assistance In the last six months of 1994 this office assisted 157 rural people with insurance policies (Roth 1995) In the vast majority of cases, agents had misrepresented the nature of the policy to their clients Agents frequently misled buyers into believing that they were purchasing a simple savings plan, when in fact they were being sold a hybrid of savings and insurance In other cases, clients were insufficiently... savers • savings for a specific purpose (such as marriage) may spur a greater effort to save • being able to tap the savings – even if through relatively expensive borrowing – helps foster confidence, and helps to avoid conflicts between long-term savings goals and current liquidity needs as well as financing the interest paid on the savings In the Philippines, Dean S Karlan and his team from Princeton . believe that investments in people are of paramount importance in identifying and managing risk. Trying to “revolutionise” 23 4 Christoph Freytag microfinance through credit scoring is an attempt. of income to support the non-working elderly. In some cases the reinvestment will be in real property for rental, or in the businesses or education of family members in exchange for future income. long-term savings goals and current liquidity needs as well as financing the interest paid on the savings In the Philippines, Dean S Karlan and his team from Princeton University (Karlan 20 04) ran