Is 95% A Good Collection Rate?
I still see lots of discussions of microfinance in the press and elsewhere reporting enthusiastically that MFIs get extremely good repayment, as evidenced by collection rates over 90 or even (holy cow!!) 95 percent. But in fact, for most MFIs a collection rate of 95% would be unsustainable: at that level, delinquency will have already spun of control and the institution won’t be around much longer unless drastic action is taken to improve collection quickly.
When we think of a 95 percent repayment rate, most of us tend to assume that this is equivalent to losing just 5 percent of our portfolio a year to loan default. This turns out to be very far off the mark. If an MFI makes 3-month loans repayable weekly, and collects 95 cents of every dollar it lends, it will lose almost 40 percent of its loan portfolio in a year. (Yikes! Can this possibly be right? How?)
Let’s start with the concept of a loan loss rate–the percent of my loan assets that I lose in bad loans each year. As it happens, the maximum sustainable loan loss rate turns out to be about 5 percent of the loan portfolio a year in most microcredit operations. When loan losses go higher than that, they usually spin rapidly out of control unless they are brought down very quickly. Above that level, borrowers seem to notice that lots of other borrowers aren’t paying. They may feel like suckers if they continue to pay. More importantly, their main incentive to repay stems from the MFI’s implicit promise to give them another loan when they want it, and this incentive weakens quickly when borrowers see widespread default and start to worry that the MFI may not around to make future loans. (The borrowers are poor but they’re not dumb.)
Next, we need to look at the relationship between the amount an MFI disburses in loans and the size of its loan portfolio asset. (The discussion gets slightly more complicated here. If you have any trouble following it, you can find a step-by-step explanation in CGAP’s Occasional Paper No. 3 on delinquency measurement.)
If I have $100,000 in cash, how many loans of $100 can I have outstanding? If I make all the loans on the same day, the answer is obvious–1,000 loans. But if, like most MFIs, I spread the disbursement dates of the loans randomly over the months, my $100,000 asset can support almost 2,000 loans at a time, because I can finance some of those loans with repayments I’ve already received on prior loans. At any point in time, some of the borrowers owe me $100, some of them owe me only their final payment, and the rest of them owe me something in between: the average outstanding balance of the loans will be a bit over $50. So if I have $100,000 I can finance almost 2,000 of these loans. The original disbursed amount of these $100 loans totals about $200,000, but the loan portfolio (the total the borrowers now owe me) is only about $100,000. In general, the value of a microloan portfolio tends to be roughly half of the originally disbursed amount of the active loans.
Most of my MFI’s money is in my loan portfolio. Let’s see what happens if I collect 95% of the amount I lend out (i.e., disburse to borrowers). I’ve lent out $200,000 on my present portfolio of loans. If 95% of this eventually gets repaid, then I’ve lost 5% of $200,000, or $10,000. And since I’m repeating this same loan cycle every quarter, I lose $10,000 four times a year, for a total loss of about $40,000, which is about 40% of my $100,000 in loan assets. For 3-month loans, I can keep my annual loan losses below 5% only if I have a collection rate of about 99.3%. Really.
This gives us a useful perspective on how impressively high repayment is at good MFIs. The annual loss rate for MFIs reporting to the MIX Market averages at or below 2.5%. If we assume that the average loan term is six months repayable biweekly, this means that borrowers are repaying over 98.6 cents of every dollar that MFIs lend them. Not bad.