NOTE 9: (CONTINUED)

NOTE 9: ON MICROCREDITS (Continued):

Continuing with the theme on Microcredit, upon which much has been written, I would like to add my general concept of credit risk linked to the credit in general terms, which includes the Microcredit. We suffered a worrying global recession, in which we have already 7 years of crisis. Countries show a varied response to the crisis, with few countries with a trend towards recovery, many under worse conditions than in 2008, which led me to wonder: What caused the credit bubble crisis?. There is no single answer to explain it, but having given it track before the crisis, there are four elements that stand out as potential generators of this situation: (1) initially it happened in developed countries and then it had a domino effect in the rest of the World; (2) it was caused when there was an effort to try to massify credit, calculating risk based on statistical models, (3) Automating  the approval process, and (4) it was assumed that on rising rates of riskier loans, the total risk was compensated, In short: Countries with a mature financial markets, complex mathematical-statistical models, the application of a risk-rate equation and automation of the credit approval. I am a psychologist, perhaps by my training and work in marketing and sales of financial services, I am a "financial Psychologist" and learned from my beginnings in this profession how difficult, perhaps impossible it is to predict theoretically, the human behaviour, an issue that Stephen Hawking raised years back in Black Holes and Baby Universes and Other Essays – 1993, quote: " The real reason why we cannot predict human behaviour is that it is just too difficult" and "So although we know the fundamental equations that govern the brain, we are quite unable to use them to predict human behaviour ". Credit is a situation in which the financial risk must be predict based on the human behaviour that produces it (To pay or not the instalments), so it is very difficult to determine a priori, what will be the future payment behaviour of any debtor. It is known that 70% of delays can occur during the life of the loan and 30% of it in qualifying. I am a believer of statistics and in the information and communications technology, but I seriously doubt if this can bring a lot of light to the future behaviour of an individual debtor.

I wondered which was the basis by which bankers of Florence in 1379 lent their money. Evidently they had neither the mathematical knowledge nor technology of today: However, they assumed, as today, the same risks for the recovery of the loans as we do today. But other aspects have changed that make the credit risk a critical issue nowadays: Today banks and chartered social financial institutions lend the money of the deposits from the public, but that money, unlike the days of the Medici, is not of the property of the financial institutions, so both the financial and moral responsibility for the institutions is complete.

I ask myself: Why it was assumed the use of mathematics to develop theoretical models for the prediction of human financial behaviour?. Perhaps it was because: (1) The financial aspect of it, is the actuarial science; but actuaries predict what is basically the probability of global risks based on consistent laws; some are natural laws (Life expectancy), others on collective behaviour (accidents, fires, etc.) that serve to determine the individual cost of insurance premiums; but in any case these do not refer to predicting patterns of individual behaviour; (2) In the science of the economy, here things are significantly more complicated because economic theories do not always apply to the micro level, as was observed with the failure of Long-term Capital Management LP (LTCM) in 1998. (3) The momentum of the great development in information and communications has us spellbound and it seems to be the answer to all our problems in our day to day. This led to the creation of tools that came to replace the traditional authority of the Credit Officer and were not able to detect NINJAS (no job/no income). These automatically and in many cases by phone granted loans based only on the data in the Credit Bureaus and using "Credit Scoring" systems. The support with mortgage guarantees, which finally did not, were as warrantable as it was considered. The aim of all this ideas was to give credit massively, automating a product that is by definition selective. It seems that the combination of increasing income by pricing rates according to the risk and massively spreading the credit, was the norm in 2007 and back, and unfortunately, is still done today, but this led to the credit bubble in 2008 which many countries have not yet recovered.

How do I think it should be a sound loan portfolio?: I do not think the statistical analysis is the answer. I believe in the information and communications technologies (ICT): In fact I am using it in an innovatively way: The last year and a half I have been developing training and consulting models using the Internet, you will receive more information on this issue. But I do not think that ICT are the best, much less the only answer to all problems, these must be used wisely to be effective. The fact that these facilitate and accelerate statistical calculations and manage information does not mean that the results are realistic. To me a healthy and productive credit portfolio, is nothing else but the sum of well awarded and monitored loans which are constantly observed and react fast to paying delays: This has always been the focus of Microcredit in Latin America where very important MFIs; such as BancoSol (Gross loan portfolio USD1.106 millions, underperforming loans 1.06% - 6/2015) and Banco FIE (Gross loan portfolio USD 1.048 millions, underperforming loans 1.46% - 6/2015) have shown undoubtedly, that MFIs can operate in the sector with a low risk level of underperforming loans.

But; To the end, what is a credit?: A credit is nothing more than an act of confidence in a debtor by a creditor: Can you statistically measure trust in a person?. The obvious answer would be that the Credit Bureaus are for that purpose; but is that really, can we consider today, that anyone who has paid very well before will do so in the future?. The crisis has shown us that excellent payers stopped being so with the world recession.

All this has led me to try to address the credit risk issue from a psychological perspective; because after all, a credit is nothing more than an agreement between people: A debtor and one or more representatives of a financial institution.
Based on these ideas, there are some points that I recommended in my consultancies and I hope it will also be useful to you:

1.      It is important to give empowerment to the Loan Officers to assume the consequences of a bad credit granted. That is usual in Microfinance by punishing the production bonuses of the Loan Officers according to the level of underperformance of their credit portfolio; this has not been the case in traditional banks. This reduces the moral risk of passing to others (Collection departments) who become responsible for recovering loans that the latter did not approve.

2.      Practice has proved that it should be assume that all loan applicants may be potential defaulters. If their payment behaviour is correct, nothing happens and if they show a pattern of improper payment the institution will be ready to act in time to control it. In fact, the crisis demonstrated that defaults near to 100% can happen.

3.      The situation of a credit application is something punctual that reflects the financial realities of the applicant at the moment, so it is essential to monitor and observe the behaviour of the payments during the term of the loan, reacting fast and firm to the slightest delay to prevent It getting worse. Each delay in payment is casuistic and must be solved individually; I hardly found a common denominator or solution to all the defaulters in a credit portfolio other than going to Court, which is the end of the road.

4.      A credit applicant who is distrusted by a Credit Officer should not have the loan approved. This would imply a high moral risk for the financial institution and a source of future conflicts.

5.      The loans have two distinct phases, in which the borrowers show different patterns of behaviour: (a) The application phase: In it, the applicant is willing to give and gives all the information requested and (b) The payout phase: At this stage if the debtor defaults payments, stays away from the financial institution even evading it. Given this, it must be ensured in the first phase that all the information needed to press the debtor to come forward and/or take the case to Court has been collected, if the need arises. Again, too much information does not cause any harm to a good payer.

6.      The Credit Bureaus are important filters to detect "professional debtors" as those are present on a regular and systematic basis in them. This "professional" debtor wants to have access to a lifestyle that can not pay, so tries that be paid by the financial institution. This behaviour must be acknowledged and prevented.

7.      I cannot conceive of the approval of credit without interviewing the applicant personally, this comes in conflict with the mass given credit, which has been the practice for many years back, with the consequences we know. Credit interviews are ideal to detect inconsistencies and contradictions in the information of applicants. The differences between what an applicant says in the contacts with the Loan Officer in various moments and the documents can be an indicator of lack of transparency and therefore a warning of caution.

8.      No one can approve a loan based only on papers, either being given by a person or company, because this last is managed by people. There is a tendency to turn to the risk departments to revise, approve or veto the loans, without seeing personally the applicants, which is a riskier practice than the possible mistake of Credit Officer. Risk Departments should design and promote policies that reduce risks but cannot take executive decisions based on papers, this is the job of those who deal with applicants and must assume the primary responsibility of the credits and hence their recovery.

9.      Trust is very critical, because half of trust implies another half of distrust. The problem is that no one knows for sure which of the two will be applied to the financial institution. Trust is a yes or a no situation, not halfway. When in doubt it is better not to risk approval, because of the financial implications and conflicts that can be generated.

10.  Only the observation of a trained person is able to detect what the credit applicant thinks and how it thinks, there are no statistical methods to determine the sincerity; this can only be perceived by observing the behaviour of the person. The interview is an art and a science; it must be learned and mastered by the Loan Officers.

11.  As you have to sell the credit professionally, to show to the potential debtors that the financial institution is their best choice against the competition, it must also de sold to the debtor the idea that the payment delay can result in a limitation to enjoy future benefits and loans from the financial institution where the loan was made.

12.  It is the duty of any financial institution to give financial education to the debtors, to show them what their responsibilities and consequences are in a loan. Very few institutions do it. Debtors usually see themselves as the weakest link against the institutions, largely because they ignore where the money lent comes from in the financial intermediation equation. They assume that the money is a property of the institution itself and not from depositors, that give it in trust and/or creditors that lend it to the institution. Ask yourself: How many debtor read the loan contract?.

Many have asked me: Is it possible to mass sell the credit?, it is a marketing issue and the answer is yes, but not in the way that was been done and is being done today. The problem of mass credit lies in the saturation of branches, but if  the applicants are filtered using mass media (Call Center and/or Web sites), determining its presence in the Credit Bureaus and the net repayment capacity, this eliminates over 80% of applicants, because either they not qualify for being in the Credit Bureaus or are not interested in the maximum amount of credit that can receive based on their paying capacity and if all of them were been attended in offices, it would be a lost of time and money due to those that do not qualify. By filtering the applicants, it is easier to meet the 20% who qualify; either because these do not appear in the Credit Bureaus or have accepted a loan amount according to their paying capacity. Obviously, those who pass the filter must be sent to a Branch and will have to present all the documentation required to process the loan request as required by the financial institution.

José Linares Fontela

jlinaresf@gmail.com

NOTE 8

NOTE 8: ON MICROCREDITS

I will address the issue of credit and Microcredit in this and the following Notes, but keeping in mind that the Microcredit is a sensitive issue, which requires focusing on many facets and due to the social and poverty alleviation view given to the matter. I do not intend to create controversy, just express my personal views.

Microcredit was born from Dr. Muhammad Yunus hands in 1976, without doubt, that made him to deserved the Nobel Prize in 2006. The model has spread worldwide since the creation of the Grameen Bank. The basis of the model were: (1) The poor need small loans to generate income to overcome poverty; (2) Poor people respond by returning the borrowed money and (3) This will have a significant positive impact on poverty reduction. These concepts distanced the Grameen model from the financial grounds, taking it mainly to the social supportive field; that, in my opinion, has shown to be unrealistic and less likely to be a relief to global poverty. BEWARE: I'm not saying the Microcredit is not useful, necessary and important, what I say is that the focus has been a repeated myth, more than a proven fact; which was demonstrated as time passed and many successful MFIs that initially assumed this model have modified it, to bring it closer to the financial reality of their own sustainability and academic studies have conclusively shown that there is not a clear relationship between Microcredits and poverty reduction. As time passes and lived my experiences, without resting value to the merit of its pioneer; Dr. Yunus, I became distanced from the traditional Microcredit model that has shown a number of aspects that seem to threaten its sustainability, because: (1) Only a minority of people are able to generate income and assets from money lent; (2) A loan is a liability for the debtor and is a risk; both for their family’s economy, and their mental health; (3) Not all people want to borrow for fear of not being able to return the loan; (4) All persons are sensitive to saving money to meet the unforeseen, even when they are not using a financial institution; (5) A loan creates obligations; if these are not met, debtors suffer pressures, threats and aggressiveness from creditors; (6) A loan, regardless of its size, will always be a financial transaction, impacting the revenue and sustainability of the creditor; (7) All people have a credit capacity and have physical or fiduciary collaterals, regardless of their economic status; (8) Everyone has a payment capacity according to their income: (9) The risk of default has a double probability to occur during the term of the loan, than over the initial qualification of the loan applicant; (10) The credit risk of a portfolio is the sum of the quality of each loan, not an overall probability of the portfolio; due to the complexity of the combination of debtors and the particular situation of each of them; (11) The defaults must be attended objectively and early, taking in account the situation of the debtor that is causing them and (12) Credit is a psychological situation more than a financial issue, because the wiliness and the financial knowledge can influence more the payment of the debtor, than the financial capacity, since this last can change suddenly. The only exceptions to this last point are the massive crises that lead a country into a deep recession, due to the way it has been managed its economy, of what the ordinary citizen has no responsibility, but has to pay the broken glasses (Europe) and the exceptional nature’s disasters that are uncontrollable; as in the case of floods in Bangladesh in 1998. But the exceptional situations are not permanent, so the provisional lending policies are an exception, these do not function as permanent policies. It must be assumed a period of recovery adapting the lending policies to the circumstances and once reached the normality, there must be a return to the appropriate prudential financial policies, because otherwise inappropriate payment behaviors and loose expectations are encouraged; and this is a very dangerous moral hazard. This leads me to share with you some thoughts and concepts on lending that have been developed during my long career and it also apply to Microcredit. I will summarize these concepts in this first Note:

1.      Regardless of the purpose or application of credit, all; poor or non poor have a payment capacity, so there should never be denied credit to anyone; what has to be done is to lend the maximum amount according to their paying capacity, stability and not what the applicant aspires to get. Therefore, a person with a payment capacity of US $ 4.00 a week, at one-year term and with 20% interest rate, could only receive a maximum loan of US $ 100.00, to be able to pay it back without difficulty. That is about the average amount of an ordinary loan in the Grameen Bank.

2.      Everyone has an income; either in monetary form or in providing services or goods for use and/or consumption, the last two can become liquid by selling them.

3.      A Microcredit is exactly like any traditional financial credit transaction: it implies: A voluntary agreement to receive money, to be returned in equal installments over a given period of time, at a rate or commission and that, under normal conditions, the debtor will pay back properly.

4.      Each loan has a price (Interest rate or commission) that can be fixed or variable; calculated on the debtor’s outstanding balance or calculated on the total amount and deducted from the loan (Flat), as is the case of Islamic finance. But is not the same interest rate if calculated on the outstanding balance, that when it is calculated on the total loan, the second method generates a much higher rate. In fact; these are two completely different interest rates, due to the gradual depreciation of the capital, when calculated on the loan’s period balance.

5.      The characteristics of a Microcredit in a MFI are the same as that of a credit in any financial intermediary. The credits are fully linked to the results of the institution, which makes the recovery a prerequisite for sustainability, regardless of the level of wealth or the poverty of its debtors.

6.      A Microcredit is not a subsidy, but may become so if it is not recovered, being initially affected the Microfinance Institution (MFI), which is no longer sustainable and must close. However, the main victims are the customers as they lose access to credit, that was available before.

7.      The Microcredit is not a realistic solution for poverty reduction, for several reasons:

a.      Poverty is a very complex situation, which requires multi and interdisciplinary actions and an appropriate national economic environment that is driven to avoid or reduce poverty. The Microcredit is just a grain of sand on the poverty beach.

b.      Not all the people are able to successfully become Microentrepreneurs, this includes poor people and those who are not, so that only a minority has the features and innate personality to undertake and therefore to convert a liability in revenues and create assets.

c.      Poor people can also choose to receive Microcredit to solve specific unpredictable situations, but provided they are able to return it comfortably.

8.      Not necessarily all people have access to financial services; In part by the high amounts demanded, the minimum balances required, the maintenance charges, the high lending rates and largely by the attitudes and the treatment of the personnel in some institutions, which inhibits many people from going to these institutions. This requires providing everyone the possibility of using Microfinances, with a menu of options for savings and lending tailored to the needs of each segment of the population, this has been proven socially possible and financially sustainable.

9.      I have no objective evidence that the high number and low balances of the accounts and loans affects the cost of Microfinances, but the successful way to manage these is costlier, because it is a completely different form of financial intermediation, based not on operations, but centered on the customers: Perhaps this is product of its roots in the NGOs that were created to help people. I may be too simplistic in my analysis, but I would like someone to explain me how the greatest number and low balances of the accounts and loans increases today the operative expenses: Disposing of information technology and communications resources at very low cost and with increasing capacity and speed; with the payrolls of employees varying little (Many times reduced in the branches) despite customer growth; with the utilities, leases or depreciation of the premises being fixed expenses and being the variable expenses representing a minor part. As an illustration of my argument the case of the costs of the two Bolivian most efficient Microfinance Banks, as published by Mixmarket 2014. "100 best MFIs in Latin America" (BANCOSOL and Banco FIE) will be cited and comparing their average costs with those of the largest Multiple Banks (Commercial) in the country. The average operative costs of the Microfinance Banks in 2014 represented 59.1% of the revenues and in the Multiple Banks it was 62.0% (A 2,9% difference), the financial costs of the first were 30.5% and that of the second was 32,7% (A 2,2% difference) and the other expenses rose to 10.5% in the first and 5.3% (A 5,2% difference) in the second. Compared to the Multiple Banks, the Microfinance Banks duplicate the other expenses, due to the way that Microfinances must be managed, having to maintain a force of Financial Advisers in the field, in permanent contact with the debtors and promoting savings person to person, unlike the passivity of the traditional Multiple Banks.

10.  As shown, Microfinance is a very different and more expensive system to operate than the traditional bank’s finances because:

a.      The loan approval requires the visit and review of expenses, income and compromises of both; the households and the businesses and/or work of the applicants, to determine the real paying capacity.

b.      Credit monitoring, debt collection and recovery of portfolios is continuous, personalized and to detect potential problems and solve them early, which involves visiting the customer in their premises..

c.      There is a limited access of MFIs in many countries to bank Credit Bureaus. The Bureaus of Banking Authorities take much time to actualize the data and there is a lack of Microfinance’s Bureaus, this increases risks, due to over indebtness; so some Latin American countries has led to distance the Microfinance from the banking sector, opening the Supportive Institutions Banking Authorities and creating new local legal figures for Non Banking financial intermediation, allowing them to receive deposits from the public and monitored by the new financial authorities.

d.      The high costs and traumatic process of regularizing MFIs as full Microfinance Banks; applying to these the same requirements as those applied to universal banks, despite having a national jurisdiction; the high cost implied in the reporting and the disproportionate levels of demanded capital, made this industry to become restricted and jeopardize its sustainability. Experiences like the Delegated Regulation of the Non Bank sector, reporting directly to the Banking Authorities, by federations, unions and chambers, with independent units whose cost is borne by those organizations and have proved in Latin America to be an effective solution that has strengthened the Microfinance sector, enhancing transparency and avoiding its disappearance.

In the next Note I will continue with my analysis of Microcredit.

José Linares Fontela

jlinaresf@gmail.com

Suggested reading: "Microfinance and Poverty: Questioning Conventional Wisdom" (Microfinance and Poverty, questioning conventional wisdom), Hege Gulli 1998 http://www.amazon.com/Microfinance-Poverty-Questioning-Conventional-Wisdom/dp/1886938458