FROM THE MARGINS

Bad debts are called non-performing loans (NPL) in the financial industry. It describes a loan that has not been repaid in accordance with the agreed upon terms for a specified period, usually around 90 days. An NPL may involve missed installment payments or complete failure to make a single payment, and is thus assessed as unlikely to be fully repaid in the future.

Managing NPL is a major challenge for the lending industry, but especially for digital banks which mainly leverage mobile technology and artificial intelligence to serve clients, including those with untested credit profiles. However, all types of lenders, including traditional banks and microfinance institutions (MFIs), need to reduce their NPL ratio both to meet regulatory requirements and to ensure profitability.

Overcoming the NPL challenge comes down to prevention and three key factors: understanding borrowers on a deeper level, adopting better solutions for accessing customer data, and implementing measures to mitigate risks.

MFI advantage

According to the BSP, digital banks’ NPL in April accounted for 17.69 percent of the sector’s total loan book. This is lower than the 25.33 percent NPL ratio in March, but still higher than the 3.45 percent NPL ratio of the entire banking industry.

MFIs seem to be doing better, with an average portfolio-at-risk (PAR) of 9.3 percent, according to Allan Robert Sicat, Microfinance Council of the Philippines executive director. Interestingly, while they cater to the poor and informal sectors, most MFIs’ loan repayment rate has always been high, ranging from 92-99 percent.

The following factors account for MFIs’ good repayment rate:

1. High-touch approach - MFIs have a personalized relationship with clients, with account officers who build trust and confidence in the communities where they operate.

2. Regular center meetings - MFIs conduct weekly meetings with clients not only to collect dues and disburse loans, but also to provide training, monitor clients’ microenterprises, among others. The Center facilitates loan collection, with members providing peer support.

3. Close client monitoring – MFIs’ account officers personally visit and monitor their clients’ status, checking not only their businesses but their family’s socio-economic situation. MFIs know their clients – their names, what they look like, where they live, and their circumstances. This enables them to identify at-risk clients and intervene before reaching the point of loan default.

4. Responsive products and services – MFIs design financial products and services tailor-fitted to clients. Their understanding of the local situation allows them to better assess credit risk and adjust their lending practices.

5. Small loan, small repayments. MFIs allow flexible repayment terms based on clients’ capacity to pay. Loans are paid in small amounts weekly and require no collateral. Interest rates are reasonable. The clients’ character and behavior are the key to loan access, which empowers and protects client dignity.

Since MFIs cater to the financially-excluded population with little access to credit, they value their relationship with their MFIs. They strive to maintain their good standing by repaying their loans. Digital banks lack this level of personal interaction, localized knowledge, and community pressure. They also tend to rely on credit scoring models which do not always capture the nuances of each borrower's situation.

Recovery strategies

What strategies can MFIs and other lenders adopt to improve loan recovery?

1. Invest in staff training/retraining. As the saying goes, there are no bad borrowers – only bad lending decisions. Therefore, it is important to strengthen staff in client targeting, loan monitoring, and evaluation of clients’ business proposals.

2. Intensify financial literacy training. Clients must be trained on financial management, bookkeeping, and enterprise development to help them succeed.

3. Review/redesign loan products. Loan products must be responsive to clients’ needs, with enough flexibility in loan terms and repayment terms.

4. Use data analytics – MFIs have collected tons of data over the years. With digitalization, they can now use technology to mitigate risks, not only in identifying potential defaults but also how much and what type of loans can be given to clients.

5. Implement loan rehabilitation and recovery. Since MFIs are in the business of poverty eradication, there are no “bad clients.” The approach should be loan rehabilitation. They extend “recovery loan” and give support to distressed clients so they can repay.

6. Restructure loans. Borrowers experiencing financial difficulties due to business failures or calamities (e.g., pandemic) should be given temporary relief by easing their repayment schedules.

7. Reward field staff – It is important to provide incentives, especially to loan officers doing the collection of bad loans as this requires more time and effort.

8. Instill credit discipline. MFIs must teach credit discipline, and take legal action against recalcitrant and willful defaulters.
Effective management of bad debts can significantly boost loan repayment while alleviating client vulnerability. The key lies in proactive measures to identify at-risk customers and helping them before they reach the point of loan default.

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“All loans, in the eyes of honest borrowers, must eventually be repaid.” – Henry Hazlitt

(Dr. Jaime Aristotle B. Alip is a poverty eradication advocate. He is the founder of the Center for Agriculture and Rural Development Mutually-Reinforcing Institutions (CARD MRI).)