PRODUCT DEVELOPMENT - LOANS MABS PROJECT February 21, 2000

MABS-M Chemonics International 2 Course Audience & Objective Course Audience Bank staff responsible for designing and implementing microfinance loan products Objective At the end of this session you will know how to design a successful microfinance loan product

MABS-M Chemonics International 3 Micro- entrepreneurs have needs that differ from other bank clients... Loan products must be developed / modified to suit client needs Introduction Micro-entrepreneurs are typically not well served by conventional bank loan products Typical bank loans are designed for clients with credit history, assets for collateral and a demonstrated understanding of general banking procedures

MABS-M Chemonics International 4 Loan Design Process Designing a micro-enterprise loan product is a two- step process: Evaluate borrower’s needs D e si g n s ui t a bl e lo a n p r o d u ct Cash patterns Debt capacity Loan purpose Loan amount Loan term Payment frequency Loan collateral Loan pricing Repayment incentive Step Considerations

MABS-M Chemonics International 5 Cash Pattern Analysis For the period of the proposed loan, identify timing and quantity of expected inflows and outflows Loan should match expected cash patterns to ensure repayment without undue hardship to borrower Cash Inflows Wages Sales revenues Loans Gifts Cash Outflows Business expenses Household purchases Evaluate borrower’s needs Design suitable loan productDesign suitable loan product

MABS-M Chemonics International 6 Debt Capacity Total net cash flow for the duration of the proposed loan period equals maximum risk free debt capacity An allowance should be made for the risk associated with the total net cash flow, including: –reasonable expectations about adverse conditions affecting the micro-enterprise –other claims that may come before repayment to the micro- enterprise loan provider Maximum risk free debt capacity... … less micro enterprise risk allowance... … less total net cash flow risk allowance... … equals effective debt capacity Evaluate borrower’s needs Design suitable loan productDesign suitable loan product

MABS-M Chemonics International 7 Loan Purpose For current expenditures that occur in the normal course of business For the purchase of assets that are used over time in the business Working CapitalFixed Asset Loan Loan Type Purpose Match loan terms to cash-to-cash gap (typical range: 2 mos. to 1 yr.) Longer term = Higher risk to microfinance institution Considerations Borrower’s capacity for repayment is more important than purpose of the loan (a.k.a. impact of fungibility of money) Caveat Evaluate borrower’s needs Design suitable loan productDesign suitable loan product

MABS-M Chemonics International 8 Loan Amount Loan amount should be designed to reflect the debt capacity and cash patterns of borrower Evaluate borrower’s needs D e si g n s ui ta bl e lo a n p r o d u ct Guiding PrincipleRationale Bank should not finance 100% of micro-enterprise activity Borrower should have a vested interest in enterprise’s success Look for reasons to lend less than the requested amount Borrowers generally ask for larger amounts than they need and can afford Increase subsequent loan amounts only after successful repayments Borrower is rewarded for respecting bank agreement

MABS-M Chemonics International 9 Loan Term The term of the loan product needs to be tailored to the micro- enterprise’s business cycle Loan term matches business cycle Revenues provide for loan repayment and business income Loan term shorter than business cycle Revenues provide for loan repayment but no business income Loan term longer than business cycle Inability to renew loan ”on cycle” leads to inefficiency and/or end of term defaults due to lack of cash BankBorrower Win ( short term) Lose ScenarioResult Evaluate borrower’s needs D e si g n s ui ta bl e lo a n p r o d u ct

MABS-M Chemonics International 10 Payment Frequency Loan payment frequency can range from “daily” to “lump sum at the end of term” The costs and risks of the of the payment frequency must be assessed and a balance sought Transaction costs increases with the frequency of payments Risk of default through poor cash management increases with infrequent repayment Daily payments (Eg/ Market Vendors) Lump sum at end of term (Eg/ Harvesting Activities) Payment Frequency Evaluate borrower’s needs D e si g n s ui ta bl e lo a n p r o d u ct

MABS-M Chemonics International 11 Loan Collateral Alternatives In lieu of assets of equal value, microfinance loans can be collateralized through alternative methods: Compulsory Savings Chattel Mortgages Personal Guarantees (Co-Maker) Evaluate borrower’s needs D e si g n s ui ta bl e lo a n p r o d u ct

MABS-M Chemonics International 12 Loan Collateral Substitutes If no collateral is available to secure the loan, intangible substitutes can still be arranged. The following collateral substitutes have been successfully used by microfinance institutions around the world: Group Guarantees Frequent Visits by Credit Officer Character Based Lending Risk of Public Embarrassment Risk of Jail or Legal Action Evaluate borrower’s needs D e si g n s ui ta bl e lo a n p r o d u ct

MABS-M Chemonics International 13 Loan Pricing Revenue generated by loans includes: –interest rates –service fees Costs incurred by microfinance institution include: Financing Cost Operating Cost Loan Loss Provision Cost of Capital + = Cost of Loan Evaluate borrower’s needs D e si g n s ui ta bl e lo a n p r o d u ct Loans must be priced to ensure loan revenues equal cost recovery plus a profit

MABS-M Chemonics International 14 Repayment Incentives Successful loan design encourages the borrower’s sustained participation and desire for further loans: Evaluate borrower’s needs D e si g n s ui ta bl e lo a n p r o d u ct promise of another, larger loan rebate/discount late penalty fees contractual savings requirements

MABS-M Chemonics International 15 Summary When designing a loan product: –Always start by analyzing the potential borrower’s true needs and available assets –Ask yourself: How can I help the borrower to be a successful repeat customer of the bank? –Ensure all risks to the bank are accounted for and all needs of the borrower met in the design of the loan product