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  1. 1. Contemporary Concerns Study Financing Small Enterprises by microfinance institutions Final Report Submitted by Divya Ganesan (0411013) Divya Roongta (0411047)Signature_________________________
  2. 2. Financing Small Enterprises by MFIs Table of ContentsNeed for credit for Small Businesses and Enterprises ............................. 3Problems of Credit Supply ........................................................................ 3SAFAL Activities ....................................................................................... 5A Typical Retail Vendor............................................................................ 6Origination of Janalakshmi....................................................................... 6Credit Scoring Literature Survey............................................................... 7Case study I..............................................................................................12Case study 2..............................................................................................15Case study 3..............................................................................................16Product Features ......................................................................................18Interest Rate Determination ....................................................................21Loan Appraisal .........................................................................................23Product Design ........................................................................................24Supplementary Products ..........................................................................26Loan Appraisal .........................................................................................30Credit Scoring Model of Janalakshmi ......................................................32Recommendations for the Credit Scoring Model of Janalakshmi ...........34Annexure I (Loan Application Form) ......................................................35Annexure II (Credit Scoring Model)........................................................39IIMB 2
  3. 3. Financing Small Enterprises by MFIsNeed for credit for Small Businesses and EnterprisesSmall businesses and enterprises in India suffer from a great deal of indebtedness1 and aresubject to exploitation in the credit market through high interest rates and lack of convenientaccess to credit. They need credit to fund their working capital needs on a day-to-day basis aswell as long term needs like emergencies or other income related activities. They need creditto smoothen out seasonal fluctuations in cash flow arising from agricultural activities andconsumer demand. They also need credit as an insurance against minor spikes and troughswith respect to income and expenditure. Since cash flows for the majority of small businesseslike vegetable vendors are small and savings are small as well, they typically tend to rely oncredit for other consumption needs like education, food, housing, household functions etc.And this is exacerbated by the fact that India has no social security net that will take care ofbasic amenities like health, education and so on for the poor. To meet these credit needs theyneed access to financial institutions that can provide them with credit at lower rates and atreasonable terms than the traditional money lender.Problems of Credit SupplyThe main obstacles to the supply of credit arise from the following reasons2. The Credit markets are imperfect and fragmented: Most localities have internal political and economic hierarchies that create market segmentation in the demand and supply of resources, including investment and working capital. For. E.g. The loan requirements of a farmer i.e. its periodicity and its size will considerably differ from those of a vegetable vendor. The farmer would require a substantial size, as he would most probably utilize it for buying seeds or upgrading his machine. A vegetable vendor on the other hand would need a smaller amount to finance his daily needs i.e. to buy vegetables. Supply of formal sector credit is inadequate: The credit is not easily available. Loans from Banks involve a lot of paper work. There is a collateral requirement, which becomes a burden to the borrowers. There are complex legal and operational1 Ramachandran V.K and Madhura Swaminathan, Rural Banking and Landless Labour Households: Institutional Reform andRural Credit Markets in India, Journal of Agrarian Change, Vol. 2, No 4, October 2002, pp. 502-5442 IbidIIMB 3
  4. 4. Financing Small Enterprises by MFIs procedures, which result in delaying the loan disbursal. Hence, credit is not available on time (takes as much as 2 to 18 months). Borrowers are generally assumed to be non credit-worthy and their recovery rate unsatisfactory. Hence monitoring them, getting their credit history for evaluation of loans adds to the transaction costs of the bank. Distribution of formal sector credit is unequal with respect to region, class, gender and caste: There is an enormous concentration of the MFIs (Micro Finance Institutions) in the south of India. This is primarily because of the general dissatisfaction in the economy of the central, eastern and north eastern states, with very little resultant demand for credit among the subsistence poor, and the absence (for historical reasons) of good quality NGOs, that are willing to initiate Microfinance programs in these states (there are a large number of small NGOs but all of them with limited experience and outreach). Informal credit is the main source at high rates of interest and adverse terms and conditions implemented by coercion of different means both economic and non- economic.This problem of credit has been addressed through formal sector lending institutions, directedlending and subsidized credit3. To address this inadequacy, Micro Credit has gainedimportance over the past few years. This has had very good success in countries likeBangladesh, Indonesia and other Asian countries and is gaining ground in India as well.3 Rangarajan, C., 1996 ‘Rural India: The Role of Credit’, Reserve Bank of India Bulletin, May, Bombay: Reserve Bank of IndiaIIMB 4
  5. 5. Financing Small Enterprises by MFIsMany microfinance institutions have developed large-scale operations by offering a fewhighly standardized products. Offering “one-size fits all” loan terms and conditions has thefollowing advantages: • Streamlines loan administration • Simplifies decision-making for field staff • Reduces information requirements from clients • Low operational costs • Simplified repayment obligationsHowever, this standardization has its own drawbacks. Many MFIs are reporting high dropoutrates and repeat borrowers do not demand the larger loan sizes assumed in many MFI marketprojections. Also, there are potential clients who refuse to join programs even though theproducts offered were supposedly designed for them.This has led MFIs to re-evaluate their business plans and pay closer attention to productflexibility. Individual need-based loans are more suitable as they can be designed to cater tothe specific requirements of the clients.SAFAL ActivitiesSAFAL is an organization based out of Bangalore that helps in gleaning produce (mainlyfood and vegetables) for the retail vendors as well as the pushcart vendors. It aids the farmersby giving them competent pricing for their yield by eliminating the middlemen in the supplychain. It implements this by openly auctioning the farmer’s products and selling them to theretail vendors. It also helps those retail vendors who have to buy from other vendors and thushave to include the vendor’s margins while repaying them.However the retail vendors who buy the produce from SAFAL have several issues withfinancing their daily needs. They obtain the funds needed to buy the produce from SAFALfrom the local moneylenders. SAFAL also tried to create affinity groups (on the lines of SelfHelp Groups) which brought together people from the same area in order to give them credit.IIMB 5
  6. 6. Financing Small Enterprises by MFIsHowever they concluded that, the strategy did not work as people didn’t seem to have theaffinity for each other when money was involved.A Typical Retail VendorA Retail vendor is usually from the outskirts of the city (“around the area where veerappanresides” is what an ex-official of SAFAL had to say). Due to low rains, arid land and suchsimilar severe conditions he turns to the city for survival. A few of them are also from othersouth Indian cities like Chennai, Hyderabad, etc. Most of them do not even have a pushcart tostart off. Hence they have to source these amenities that they would need everyday fromdifferent lenders. Most of the times the same person lends the money, produce and the pushcart. The vendors pay a huge amount by way of interest. Typically they borrow daily aroundRs.90 and agree to pay back Rs. 100 at the end of the day, which translates, to an exorbitant4056% per annum! Instead of borrowing everyday the vendor also has the option ofborrowing around Rs. 3000 on a monthly basis depending on the kind of resources the lenderhas to wring the money out of the vendor in case he decides to run with the money. In casethe vendor has borrowed the cart he has to pay an extra Rs. 20 daily. This money is takenfrom the lenders the previous night before the market opens which is around 5:00 am in themorning.Origin of JanalakshmiThese issues of financing for the vendors led to the inception of Janalakshmi, an organizationset up as a body of Sanghamithra urban program with the objective to provide credit to urbanvendors. Apart from giving credit to traders on a periodical basis, Janalakshmi has created aCredit Scoring Model that will score every trader who needs credit based on certainparameters that we will look at below. The final score will decide whether the trader shouldbe given credit or not.IIMB 6
  7. 7. Financing Small Enterprises by MFIsCredit Scoring Literature SurveyA potential client’s credit risk level is often evaluated by the bank’s internal credit scoringmodels4. These aim to determine whether an applicant has the capacity to repay by evaluatingthe credit risk of his loan application. This is normally done using historical data andstatistical techniques. Such models offer banks a means for evaluating the risk of their creditportfolio, in a timely manner. Credit scoring has both financial and non-financial aspects. Thedimensions that are analyzed in credit scoring are categorized under five main headingsnamely:(i) Capacity (ability to repay)(ii) Character (willingness to repay)(iii) Capital (wealth of borrower)(iv) Collateral (security if necessary) and(v) Conditions (external and economic)These popular five categories of credit management establish the likelihood that a potential orexisting borrower will successfully meet scheduled interest and principal payments. Based onthe above categories the credit scoring model that we have devised for a vegetable vendor inIndia incorporates these points as follows:4 Ahmet Burak Emel and Muhittin Oral, 2003, A credit scoring approach for the commercial banking sector,IIMB 7
  8. 8. Financing Small Enterprises by MFIsCapacity (ability to repay)We thought of capturing this category through the Trading History parameter. If a client hashad a significant trading record then he would obviously have the capacity to pay his interestand principal repayments in time. Trading history parameter essentially has the following subparameters: Period of trading Frequency of transactions Uniformity in value of transactions (to capture the borrowers stability in his trade)Character (Willingness to repay)This category has been incorporated into the model by way of the number of guarantees theindividual is able to get. Since the guarantors also form the borrower’s immediate neighborsthey would have maximum informal information about the character of the client andwhether he has a stable repayment history. The sub parameters for rating this category are: Number of guarantors in the group Familiarity with guarantors(members/non-members of the MFI) Financial soundness of guarantorsCapital (Wealth of borrower)This information is obtained from the Personal Security and the Business Information of theclient. These would essentially have the following sub parameters:IIMB 8
  9. 9. Financing Small Enterprises by MFIsBusiness Information Total turnover Total business expenses Total personal expenses Other commitments towards repayment of previous loansPersonal Security Assets owned Assets mortgaged/rented Assets offered as securityCollateral (Security if necessary)Collateral if available would increase the score of a vendor as risk associated with him bothcredit and default is much reduced. He can also operate on a line of credit basis which wehave discussed in one of the previous sections. This information of the client is built-in in theform of the Savings parameter. The sub parameters are: Existing savings deposits Current cash surplus available for saving Expenses of avoidable activities like drinking, movies, etc Interest of client in taking a savings productConditions (External and economic)This category is important as this would determine how the future and the present conditionsif the vendor could affect his payments. E.g., if he has a greater number of young dependentsthen it is likely that his expenses would increase in the future, as his dependents would comeof age. Also if he has an ailing family member, it is probable that it could increase hiseveryday expenditure. Similarly his future prospects play a significant role under thisIIMB 9
  10. 10. Financing Small Enterprises by MFIscategory. If he is into a business that is not much in demand due to seasonal variation orcustomer’s changing tastes, he needs to change his business. The sub parameters for theseare:Individual Demographics Age Number of family members Number of dependents Number of family members in the same businessGrowth Prospects Current scale of operation Interest/possibility of future expansionHowever, there is a potential problem with credit scoring as it is usually done5. The statisticalmodels that are usually used to evaluate applicants are constructed from historical data. Inorder to enter the sample used to build the model, an individual must have already been`accepted. Thus, the model after the initial pilot is a description of some aspect of thebehavior of individuals who have already received loans. The scoring model is to be used toevaluate applicants who are drawn randomly from the entire population. The individualswhose applications were accepted to begin with could have been qualitatively different(difference in credit scoring) from individuals whose applications were rejected. Since, anapplication which arrives randomly at the MFI could be of either type, i.e. the applicationcould be for a client applying for the first time or also for a regular client it is not certain thatthe model being used is appropriate for the population being measured. Hence the mainchallenge of the credit scoring model is to upgrade the model as frequently as possible for theregular customers and have a set standard (e.g., define the score for certain parameters foreligibility) when the client applies for the loan the first time.5 William Greene, 1998, Sample selection in credit-scoring modelsIIMB 10
  11. 11. Financing Small Enterprises by MFIsWe should also remember that Scoring works best for those with a solid individual lendingtechnology and a large database of historical loans6. Even when scoring works, it is only amarked improvement, not a breakthrough. In particular, scoring will not replace loan officersin microcredit completely because much of the risk of the self-employed poor is unrelated tothe information available for use in scoring.6 Mark Schreiner, 2003, Scoring: The Next Breakthrough in Microcredit?IIMB 11
  12. 12. Financing Small Enterprises by MFIsCase study IM. Nagappa is a fruit vendor who sells Apples, Oranges and Sweet Lemon in the crowdedMadivala market. He arrived in Bangalore three years ago from Tamilnadu. His decision tocarry out his daily routine in Bangalore was due to the frustration he experienced inTamilnadu because of the hostility of the local rowdies who asked him a share of his earningsevery day. The police officials were also totally indifferent to the existing conditions there.As it is he was the only earning member in his family. Hence to support his two sisters andhis parents, he turned to Madivala Market in Bangalore where hundreds of vendors get theirpush carts everyday at dawn and feel secure enough to leave their carts at night and departhome.Nagappa and his sisters completed their education upto 12th Standard in Tamil medium. Hiselder sister got married and hence he has four members of his family dependent on him. Hisfamily owns a house Villupuram, a small town in Tamilnadu, in a village called Mutathur.Nagappa does not have a place to live in Bangalore. He spends his nights at his uncle’s shopwhere he doesn’t have to pay rent. Daily routine for Nagappa consists of getting his pushcart(which he bought sometime back) filled by his uncle with fruits and selling them in theMadivala market. The fruits are mainly sourced from certain wholesale markets where hisuncle has been trading for a long time. His cart is filled 2 to 3 times in a week. However italso depends on the season, weather, customer’s taste etc. For this daily activity of Nagappa,his uncle charges him Rs.8500 for 3 months for which he has to repay Rs.10000. Heaccomplishes this by repaying Rs.100/- everyday for 100 days (approximately 3 months)through his everyday sales.IIMB 12
  13. 13. Financing Small Enterprises by MFIsHis other expenses include paying for the following:Expenses Amount (in Rs.)Using the Bathroom 2/-Washing his Face 3/-Food 50/-Bath (He has a bath once in 3 days and 10/-otherwise manages by washing his face asit becomes too expensive to have a batheveryday)Washed and ironed clothes (again once in 3 15/-days)When asked why he didn’t opt for only washing his clothes without ironing he said itcame as a bundled deal.Liquor (especially when sales are 15/-abysmally low)Cigarettes 12/-It becomes very difficult for him to carry out his daily routines without having at least 5-6cigarettes everydayIIMB 13
  14. 14. Financing Small Enterprises by MFIsApart from the above expenses Nagappa is also a sufferer of the ‘vaddi sala’ system which isa highly popular lending practice amongst vendors. In this type of loan the loan payer keepsrepaying the interest till such time he has the whole lumpsum amount (i.e. the principal) torepay the lender.Nagappa borrowed a sum of Rs. 20000/- from money lenders in Tamilnadu for his sister’smarriage and his nephew’s ear piercing ceremony. He has since then (that was around 2 yearsback) been paying interest of Rs.800 per month on the loan. He has to keep paying thisinterest till he collects the amount of Rs. 20000 and repays it back as a whole.From his sales, Nagappa makes a profit of Rs.5/- on an average on all the three types of fruitsthat he sells. Hence in a period of one week he makes around Rs.750 as follows.Refill (in numbers) in a week Profit (in Rs.)90 (for Apples) Rs. 45030 (for Oranges) Rs. 15030 (for Sweet Lemon) Rs. 150Btu the above calculation is subject to vagaries of weather and season to a very large extent.For e.g. the recent heavy downpour of rains in Bangalore led to a huge loss in business for allthe vendors.IIMB 14
  15. 15. Financing Small Enterprises by MFIsCase study 2Perumal, a 19 year old boy educated till 9th standard sells Bananas at Madivala marketeveryday. His family consists of 12 members including his relatives and they altogether havea total of 7 children. His family is well settled in Bangalore having operated in the market formore than ten years now. Perumal hails from Tirupathur which is a village in Tiruchi.His daily routine encompasses getting the produce from their wholesaler and farmer friend inTiruchi for an amount of Rs.20000/-. His source of income remains his sales and the loanamount he occasionally borrows from his relative in Tiruchi which he repays back monthlywithout any interest. He borrows Rs.10000 from him. His family also has a small shop inMadivala market which is mainly used for stocking but they also sell Bananas there.His family’s daily expenses include the following:Expenses Amount (in Rs.)Food 200/-Travel (to and fro) by bus for the members 40/-of the familyElectricity Bill 50Getting the produce from Tiruchi (weekly) 2500Decay due to bad weather or poor sales 500(weekly)Repairing the pushcart i.e. replacing the 50tyre etc (once a month)He manages a yearly profit of around Rs.5000/- which is used for family expenses.IIMB 15
  16. 16. Financing Small Enterprises by MFIsCase study 3Mallesh, a vegetable vendor is a 23 years old man who has had education till 4th Standard andsells his produce in the Vijayanagar area in Bangalore. He arrived in Bangalore 3 years agoleaving his factory Job where he was getting a monthly salary of Rs. 2000. The salary wasnot enough to feed his brother’s family which was fairly large and his own. So he decided tomove to the city.Mallesh starts for work at 7:30am everyday where he buys his produce from the wholesalemarket and sells on the way home. He pushes his cart for one and a half hours on a steepslope and reaches Yashwantpura. He reaches home at 1:00pm and again sets out for sellingwith his pushcart at 4:00pm. However he works only for 4 days a week as it becomes toostrenuous to carry the cart everyday.His daily expenses are as follows:Expenses Amount (in Rs.)Rent 800/-Electricity 150/-Water 100-150/-Kerosene 30/-Miscellaneous expenses (watching a 50movie, occasional drinking etc.)Pushcart Repairs (replacing tyres etc) 1000(once in 3-4 months)IIMB 16
  17. 17. Financing Small Enterprises by MFIsMallesh takes a loan of Rs. 5000 every 3 months to finance his business as well as his dailyneeds. The loan amount that he gets is Rs. 4250 and the amount he repays is Rs. 5000. Herepays Rs. 50 everyday for 100 days. Other than this Mallesh is repaying the loan of hisneighbor for whom he gave guarantee at some point. His neighbor disappeared with aroundRs. 14000/- of which Mallesh repays Rs.750/- every month as a part of the principalrepayment. Mallesh makes a profit of Rs.100 to 150/- everyday to support his daily needs.He tries to save around Rs.50 everyday. From the saved money, he sends his family anamount of Rs.2000 periodically for their requirements.IIMB 17
  18. 18. Financing Small Enterprises by MFIsProduct FeaturesAs inferred from the interviews, most of the pushcart vendors depend on their friends andrelatives for finance. In times of emergency and crisis, they resort to ‘vaddi sala’ from localmoneylenders on which they pay very high rates of interest. The main problems faced by thevendors with the current type of financing can be enumerated as under. • In two of the cases, we found that the vendors take 3-month loans on which they pay an interest of 17.64% quarterly. This amounts to an exorbitant compounded annual rate of 91.52%. • In the case of a ‘vaddi sala’, they borrow a lumpsum amount and then keep paying interest on it till the lumpsum amount is repaid. For instance, one of the vendors has taken a loan of Rs. 10000 and is paying Rs. 500 per month as interest, which amounts to a rate of79.59% annually. The vendors are not in a position to accumulate such a big sum of money. Thus, they keep paying such high interests over a long period of time. • None of the vendors have a bank account, which may pay them some interest on their savings. Therefore, they have little incentive to save and spend their surplus cash on unnecessary activities like drinking, smoking, movies, etc. • Due to non-availability of a collateral security, the moneylenders ask for a guarantee by the vendor’s neighbor who is usually in the same trade and is from the same village as the vendor. This agreement between the vendor and his neighbor is mutual. Therefore, if one person defaults, the entire burden of repayment is shifted to the other person.Considering the afore-mentioned problems, we believe that the following features should beincorporated in an ideal product for the vendors. These will not only help in overcoming thecurrent shortcomings, but will also give the vendors a greater sense of security. • All the vendors prefer short-term loans of about 2-3 months maturity. Therefore, such short-term loans should be available to them but at lower interest rates than the current 17.64% quarterly.IIMB 18
  19. 19. Financing Small Enterprises by MFIs • To overcome the problem of non-saving, the following 2 features can be considered o A person who has taken a loan can be encouraged to deposit his/her monthly savings. This savings amount can be used to settle against the outstanding loan amount leading to early repayment and thereby lower interest rates on the outstanding balance. o A separate savings product can be offered to the vendors where the vendors can deposit their monthly savings on which the MFI can pay them some amount of interest. This would also help the vendors to accumulate a lumpsum amount, which they can withdraw in times of emergency or need. • The MFI can adopt the joint liability model to overcome the problem of default in repayment by any of the members in the affinity group. The loans in the group can be given on individual basis whereas the group can share the liability of default. This will prevent the problem of burdening a single person due to his neighbor’s inability to repay. However, while creating the affinity groups, the MFI should ensure that all the individuals in the group require a similar amount of loan such that the burden created due to any member’s default is the same.For implementing the savings schemes, the regulatory framework for banks and NBFCs mustbe considered. As per the regulations, any institution requires a minimum equity capital ofRs. 2 billion to be able to accept deposits. To acquire the status of an NBFC, an institutionrequires a minimum equity capital of Rs. 20 million but it cannot accept deposits from itsclients. Therefore, to facilitate the savings products, the MFI can try to collaborate with bankssuch as ICICI, which also works in the micro-lending space.If the MFI collaborates with a private bank for sourcing of funds, there are primarily threekinds of structures possible. • Portfolio Buyout Structure: The existing assets of the MFI can be assigned to the bank in return of a purchase consideration. • On-tap Securitization: The MFI can continually source loans from the bank and can assign the receivables under such loans to the bank under a mutually agreed arrangement wherein sourcing criteria and operational guidelines are stipulated. • Partnership Model: The MFI can source loans directly in the books of the Bank, and continue to monitor and recover loans thus disbursed.IIMB 19
  20. 20. Financing Small Enterprises by MFIsHowever, all collaborations with any private banks would work best when the terms on usingthe money are not dictated but left to the MFI to decide on and all relevant information isdisclosed and transactions are as transparent as possible.IIMB 20
  21. 21. Financing Small Enterprises by MFIsInterest Rate DeterminationThe interest rates charged by the MFIs are high essentially due to the high costs of bringingmicro-finance products and services to the poor. In addition, there are the costs of creatingdelivery mechanisms at the community level (which are not included in determining theinterest rates). Then there is the cost of creating and setting the client base for micro-financeproducts and services. These costs are difficult to integrate into the calculations of interestrates. Hence each of these issues must be considered while determining interest rates in orderto avoid any operational difficulties in future. Apart from this recruiting, training andmonitoring staff is a key constraint. Monitoring of operations and transactions using IT basedsystems is a must. All these will add up to the transactional cost and hence an increase in theinterest ratesIf an MFI has to be sustainable, covering costs of funds, and transaction costs, than interestrates have to be high. Talking about interest rates as a percentage on loans of Rs 2000 or5000 might not be the most accurate method of expressing them. The transaction costs - offinding a borrower, appraising her, disbursing money to her doorstep and then collecting itback over 52 weeks or twelve months in small installments, is nearly fixed irrespective ofloan size. So if the cost is Rs 500 per loan, then the cost can amount to as high as 25% for Rs2000 loan and will appear to be as low as 5% for Rs 10,000 loan. Thus interest rates of 24%per annum charged by most MFIs are barely enough to cover their costs. We could specify aminimum rate of 12% per annum on a declining balance, and a maximum of 25% per annum.The lower interests if for people who might borrow in groups or have guarantee given byothers as our transaction costs would be lower there. E.g., for lending a large sum of Rs 2lakh to a group of 10 vendors who might want to start a shop, we would charge 12%. Butwhere we have to give an individual loan of Rs 5000 to a marginal vendor, there thetransaction cost is high and hence we would charge 25%. In any case that would be far lessthan the interest charged by moneylenders on a yearly basis.It is only through competition that the interest rates can come down. It can happen if there area many MFI’s offering similar products to the retail vendors differentiating only on interestrates and that would be good for the customer as well as for the business. The GoI and RBIshould encourage hundreds of institutions to come into this field, innovate and bring downIIMB 21
  22. 22. Financing Small Enterprises by MFIsthe costs. But even then the interest rate might not come down to 8 or 10% because the costof lending small loans is intrinsically highAlso interest rates would not be the same way across all the products that we offer; it wouldnot be same even in the same location for different types of customers because along with thetransaction cost of disbursing the loan, the risk cost has to be kept in mind. We would do arisk based pricing of the loan based on a credit-scoring model, which would rate the customeron different parameters. If there is a class like a particular region, a particular activity or acategory of people where the default rate is 5% instead of 2% then the 3% has to be built intothe pricing because unlike in public sector banks, there is no government that would write offloans and then recapitalize lending institutions.IIMB 22
  23. 23. Financing Small Enterprises by MFIsLoan AppraisalLoan appraisal for micro lending has a number of complexities. Complexities arise due tolack of data validation, high risk lending, financial constraints of the MFI, high transactioncosts, etc. for assessing the credit worthiness of clients, MFIs have two options: individualcase by case basis of evaluation by a loan officer or use of a standardized credit scoringmodel.In the individual case-by-case method, a loan officer collects all relevant information for eachclient and then decides on the credit worthiness of the client. This method offers theadvantages of greater accuracy of information and better decisions about the disbursement ofloans. However, it involves very high transaction cost, higher loan processing time and veryhighly skilled staff. Also, the loan appraisal decision is completely dependent on thejudgment of the loan officer.Using a standardized credit-scoring model is simpler and less time-consuming. With a credit-scoring model, a less qualified person can also assess the client’s credit worthiness and take asuitable decision. The transaction costs and operating costs are reduced significantly.However, it suffers from the problem of absence of on-site data validation giving rise togreater risk of default by the clients.IIMB 23
  24. 24. Financing Small Enterprises by MFIsProduct DesignWe will segment all our clients, based on the purpose of their loan, into the following: Loan for everyday (income generation) activities or Working capital Loans Loans for Micro enterprise Loans for Small Enterprise Working Capital Loans implies full-time, often seasonal economic activities undertaken for subsistence. At times several family members simultaneously engage themselves in a wide array of such activities, in order to diversify the income sources of the household. Similarly small enterprises are the entrepreneurs primary source of income but they reinvest the profits of the enterprise to further its growth. Microenterprise bridges the gap between the loans for daily activities and those for Small enterprise.Definitions:We define Microenterprise activities as any individual or group of borrowers havingcombined assets (to be offered as collateral) less than Rs. 10,000. Similarly we define SmallEnterprise activities as any owner having assets less than Rs.100,000. For Income Generationor working Capital loans there need not be any collateral.With working capital loans, the need is for loans for which borrowers are willing to payreasonably high interest rates, which would obviously be considerably lesser than what theypay the moneylenders. However Microenterprises would need more flexible financialproducts, which are more customized. Microenterprises might also require working capitalloans, but initially when they are about to set up their business or when they are about toexpand they would need fixed asset investment loans. Such investments require access tolarger loan amounts for longer periods of time, and as a consequence, borrowers can affordinterest rates significantly lower than those affordable by the working capital borrowers yethigher than the commercial bank rate. Finally, Small enterprises have very different creditneeds, almost matching the credit conditions of the commercial banking loan sizes and termsspecifically matched to the investment and repayment capacity of the business, for which theborrower is able to offer sufficient collateral, but can only afford commercial interest rates.IIMB 24
  25. 25. Financing Small Enterprises by MFIs Characteristic Daily Activity ME SEUse of loan Working Cap Working Cap + Working Cap + Fixed Assets Fixed Assets + Infrastructure for expansionLoan term 1 week - 3 4 months – 1.5 1 - 5 years months yearsLoan size Rs. 500 – 10000 Rs. 10000 – Rs. 10000 – 100000 100000Collateral Requirement None Low HighInterest Rates 25% - 40% 15% - 25% 5% - 15%Repayment Daily Daily for a month Monthly + Weekly after thatCollection By collecting At the nearest At the nearest agents at the branch of the MFI branch of the MFI specified marketsFor all Loan products, the Clients are required to acquire guarantee of atleast threeindependent parties forming a joint liability group. Each of the parties in the group guaranteeseach other’s default. The individuals in the groups are from the same neighbourhood, as theywould have maximum information about the neighbour’s activities.IIMB 25
  26. 26. Financing Small Enterprises by MFIsSupplementary Products Education Loan Savings Product Remittance Product Microinsurance Products Microentrepreneurs Products Emergency Loan Mutual Benefit ProductIIMB 26
  27. 27. Financing Small Enterprises by MFIsEducation LoanThis will be given for education of the immediate family members of the client. Maximumloan would be decided based on the segment to which the client belongs.Savings ProductWe would have the following features in the Savings product that we would offer:Product Minimum Balance Term of Amount and Interest for withdrawal deposit frequency of depositRegular 1000 or 10% of his 4 months Weekly 8% current balance deposit of 1% whichever is higher of the loan amountCombined (for None Anytime Monthly 6%non borrowers) deposit ofLong term 50000 or 5% of 1-5 years Monthly 8% the current balance deposit of 5% whichever is higher of the loan amountThe amount that would be obtainable would be reduced if the amount is withdrawn before theexpiry of the term.IIMB 27
  28. 28. Financing Small Enterprises by MFIsRemittance ProductFor a client like Nagappa who sends most of his earnings to his family back in Tamilnadu, itwill be highly convenient if a product is devised for him wherein we will pay his family on amonthly basis and charge the repayment from Nagappa. This will however include thetransaction costs in sending the amount to Nagappa’s village which he anyways would end uppaying himself. This would fall under the income generation activities and the rates will becharged accordingly.Microinsurance ProductDisastrous losses such as those caused by fire, theft, or natural disasters can be disturbing forany business owner. To help mitigate these catastrophic losses, we will offer an insuranceproduct to our clients. Since we are largely looking at a client base that consists of vendorswho would want everyday finance for their income generation activities, we are not planningto get into Life insurance at this stage. We would provide insurance for the vendor’s pushcartfor instance. Other insurances products would be insurance against calamities and seasonalitychanges where we could relax the repayments cycle for our clients at a higher interest or takea premium from them every month and repay a lumpsum amount during the calamity.Microentrepreneurs’ ProductMicroentrepreneurs’ would be financed for fixed assets or for infrastructure and the interestswould be charged as given in the above Table based on the purposes that the client needs theloan.Emergency LoanThis loan will be given in case of unforeseen emergencies. E.g., accidents, for performing thelast rites of a person, etc. This loan is different from Microinsurance in the sense that theamount for this loan will be decided based on the savings the client has or his repaymenthistory or his cash flows. The client would not have to pay any premium on a periodical basisfor this type of product.Mutual Benefit ProductIIMB 28
  29. 29. Financing Small Enterprises by MFIsThis product is applicable only to working capital loans. Here the client can combine aregular savings scheme with the basic working capital loan. He can achieve this by depositinga percentage of his daily earnings in his account every evening. He can then withdraw acertain amount based on his daily working capital needs everyday and keep repaying theamount along with interest that evening. In essence the borrower would get to operate on aline of credit. The interest rates on his deposit could be increased or his repayment interestrates could be reduced if client additionally wants to save a portion of his daily earnings.IIMB 29
  30. 30. Financing Small Enterprises by MFIsLoan AppraisalApplication form (Refer Annexure I for the actual application form)For the purpose of loan application, we are using a standardized application form. Theapplication form will provide information pertaining to the following, which will help inassessing the credit worthiness of the applicant by using the credit scoring model. • Personal details • Financial information (business and personal) • Personal security • Product details • Details of guarantorsVerificationsThe application form will be filled by a loan officer by visiting the residence of the applicant.This will enable verification of various information provided by him/her. Due to the lack ofadequate security, the verification process becomes very important to avoid incorrect data.The following key information requires thorough investigation and verification. • Location of residence • Place of business (fixed/mobile) • Bank details • Details of guarantorsVerification of guarantor details is most important, as they are the only source of securityprovided by the applicants. This is the reason for carrying out the application form fillingprocess at the residence of the vendor as the loan officer can visit the neighbours who havegiven guarantee and verify their details. It is especially necessary to ensure that theguarantors do not belong to the same family or are closely related in order to diversify therisk of default.Monitoring and collectionIIMB 30
  31. 31. Financing Small Enterprises by MFIsFor keeping a periodic check on the business of the vendors, we will assign one person ineach region to carry out the process of form filling, monitoring and collection. Since the sameperson will carry out filling and monitoring, a better understanding between the client and theofficer will be established which will provide better access to their operational information.Fixed pushcart vendors can repay their daily/weekly loans to their area in charge whilemobile pushcart vendors can choose their place of repayment based on their convenience.ApprovalWhile the form filling will be carried out by the area in charge, the approval of the loans andadjustments in the repayment requested by the vendors will be done by a superior, in chargeof a number of areas. Therefore, the area in charge can be less skilled and his task willbecome simpler. Also, it will help in keeping a checking on the performance of the area incharge.IIMB 31
  32. 32. Financing Small Enterprises by MFIsCredit Scoring Model of JanalakshmiThe Credit Scoring Model of Janalakshmi rates the traders according to the followingparameters with their respective weights:Parameters WeightsTrading History 30Success of Data Validation 20Financial Viability 15Credit officer’s Recommendation 10Feedback from neighborhood 10Cross-sell Opportunity 10Security 5Saving’s History 0 (as of now)Total 100IIMB 32
  33. 33. Financing Small Enterprises by MFIs Trading History: This parameter establishes the familiarity of the trader with SAFAL. This parameter as the highest score as the higher a trader the greater are the chances that he will execute his repayment. The following sub-parameters are used to measure the parameter o Period of trading o Frequency of transactions o Consistency in value of transactions o Familiarity of SAFAL representative Success of Data Validation: The data that has been entered in the appropriate forms by the vendor is verified by the officer. Based on the accuracy of that information this parameter is scored. Financial Viability: This decides whether the vendor has any means of financial capability. To score this parameter the cash flows of the vendors are considered after deducting all business expenses which include equipment expenses like replacing damaged tyres etc. Feedback from neighborhood: This parameter is scored by gaining feedback from neighbors and business community. Cross-Sell Opportunity: This parameter is scored depending on the number of products the vendor would be able to afford i.e. Educational Loan, General purpose Loan, Enterprise Loan, Education Loan. The more the number of products the vendor is interested in the higher the score he gets. Security: This parameter is scored based on the savings of the vendor which is highly unlikely; hence the lowest weights are given to this parameter.IIMB 33
  34. 34. Financing Small Enterprises by MFIsRecommendations for the Credit Scoring Model of Janalakshmi Trading History: This parameter has been given the highest weights i.e. 30. Hence it becomes really important. Since SAFAL is an organization that came into being only 1.5- 2 years ago, this parameter will be able to capture only the recent past of the trader. Instead of familiarity with SAFAL the Trading History should look at the familiarity of the trader with the trade itself i.e. the parameter should capture how long he has been in the trade instead of how long he has been with SAFAL. Financial capability should be given the lowest weight (similar to the Security parameter) because it is extremely difficult to establish the cash flows of a pushcart vendor. Also, if the vendor would have a stable cash flow he would be eligible for a loan in the commercial bank instead of a microfinance institution. For a pushcart vendor losing a 15 weight would mean a huge loss and that would be judged only on his cash flow. There should be some way of capturing the reason why the trader has come to Bangalore. This is essential because if the trader has come here for survival it is highly likely that he would stick around for a longer time than a trader who has come here to expand his business, etc. Most vendors seek out a way to protect their families who usually stay in the villages amidst their dry and barren lands. Hence, these traders are more trustworthy as they would not easily leave their source of income once settled. There needs to be a parameter to capture the movement of a vendor within the city because how frequently the vendor changes his market would provide some indication about how long he might stick to SAFAL and since Janalakshmi is initially targeting SAFAL customers, it would also give them an idea about how long the customer would have a registered information at SAFAL to be traceable.IIMB 34
  35. 35. Financing Small Enterprises by MFIsAnnexure I (Loan Application Form) PERSONAL INFORMATION 1) First Name 2) Middle Name 3) Last Name 4) Address 5) Telephone: Residence 6) Age 7) Sex: 8) No. Of Family Members 9) No Of Earning Members 10) No. Of Dependents 11) Education Qualifications if anyIIMB 35
  36. 36. Financing Small Enterprises by MFIs FINANCIAL INFORMATION (Monthly)PersonalTotal ExpenditureExpenditure on house rentExpenditure on FoodExpenditure on CommissionExpenditure on EducationExpenditure on UtilitiesExpenditure on MiscellaneousBusinessNature of BusinessSpecify TurnoverSpecify Cost of RentSpecify Cost of TransportationSpecify Cost of ElectricityMiscellaneous CostsIIMB 36
  37. 37. Financing Small Enterprises by MFIs PERSONAL SECURITY & PRODUCT DETAILS 1) Details of Bank Accounts held Bank Name Bank Account number 2) Sources of income other than business 3) Assets Savings Immovable Properties Others 4) Amount repaid Routinely to Pay of Other Loans (Specify time period and amount) 5) Source of Loans 6) Purpose of Loans Taken 7) Details of Loan Taken (Amount, Term & Interest) Money Lenders Friends & Relatives Banks Others (specify)IIMB 37
  38. 38. Financing Small Enterprises by MFIs PRODUCT DETAILS 1) Type of product applied for Scheme of product 2) Amount 3) Preference of Repayment Duration Location CollateralDETAILS OF GUARANTORS 1) Name 2) Address 3) Relationship with client 4) Specify for each member whether he/she is our clientIIMB 38
  39. 39. Financing Small Enterprises by MFIsAnnexure II (Credit Scoring Model)Parameters with their weights Sub parameters Existing savings deposits Current cash surplus available for savingSavings (20%) Expenses of avoidable activities like drinking, movies, etc. Interest of client in taking a savings product Assets ownedPersonal security (20%) Assets mortgaged/rented Assets offered as security Number of guarantors in the groupNumber of Guarantees (15%) Familiarity with guarantors (members/non-members) Financial soundness of guarantors Total turnover Total business expensesBusiness information (15%) Total personal expenses Other commitments towards repayment of previous loans Period of tradingTrading History (15%) Frequency of transactions Consistency in value of transactions Age Number of family membersDemographics (10%) Number of dependents Number of family members in the same business Current scale of operationGrowth prospects (5%) Interest/possibility of future expansionIIMB 39