by Hio Kyeng Lee - Regulation -

MICROFINANCE PAPER WRAP UP – CGAP Due Diligence Guidelines For The Review Of Microcredit Loan Portfolios, by Robert Peck Christen and Mark Flaming

Written by Robert Peck Christen and Mark Flaming of CGAP (Consultative Group to Assist the Poor), published by the World Bank Group in December 2009, 58 pages, available at: http://www.cgap.org/gm/document-1.9.36521/DueDiligence_TechGuide_ENG.pdf

The purpose of this paper is to provide a method of acquiring an understanding of the underlying quality of the loan portfolio of an microfinance institution (MFI) for banking regulators, donor agencies, and potential investors.It provides “a comprehensive checklist of what to analyze, some instruction about appraisal technique, and very little guidance about how to interpret the results.”  The authors emphasize that “This is not a training manual for aspiring analysts; it is a checklist for an analyst with extensive experience in evaluating MFIs.”

The authors argue that as the microfinance industry grows, MFIs have become more integrated into regulated financial systems and now operate more like commercial banks by taking deposits and leveraging commercial sources of funding.  Also, it has become increasingly clear that conventional methods fail to properly detect the underlying portfolio quality of microfinance institutions (MFIs), which can lead to liquidity crises for MFIs.  According to this paper, conventional methods, such as “external audits, ratings, evaluations, and even [direct] supervision, too often fail to identify the primary risk — the inaccurate representation of portfolio quality.” Based on the existence of an audit report, conventional appraisal methods typically assume that the information reported about an MFI’s portfolio quality is correct.

The paper guides the analyst through a three-tiered approach for assessing how well an MFI’s loan portfolio is performing and how well it is managed. At the end of the three-tired approach, an analyst should be able to evaluate, with statistical precision, the accuracy of accounting and performance reports about the portfolio, as well as an MFI’s compliance with its own portfolio management policies.

Tier I
This is a five-day review of the MFI’s basic policies, procedures, and systems for managing and reporting on its loan portfolio. The primary objective of this review is to determine if the MFI has adequate policies, operating systems and management capacity to support portfolio quality. The Tier I assessment is based largely on the following: (1) on-site interviews with senior management about portfolio trends and (2) the policies, procedures, and systems for managing the loan portfolio. The analyst will collect documents and reports, such as audited financial statements, accounting policy manuals, credit policies and procedures manuals, loan portfolio reports and policy manuals to manage third-party agents who are contracted to conduct external audits. In addition, the field visit provides the analyst with an opportunity to check for consistency between MFI policy and management’s understanding of those policies.  Ultimately, the analyst should be able to form an opinion about senior management capacity. The field visit also provides an opportunity to gather missing information and ask clarifying questions about policy documents or reports.

Tier II
This is a ten to fourteen day assessment of “whether MFI operational practices are consistent with policies and procedures and with standards of best practice in microcredit portfolio management.” The essential question of the Tier II assessment is whether the policies and procedures are reflected in the daily practice of business at the operational level and whether those practices are sound.  The analyst consults with several departments to confirm how transactions are recorded, how reports are generated, and how all loan management procedures are actually carried out. At least three full days should be spent with the loan officers, away from senior management, to capture the reality of field operations. A Tier II review is a minimum requirement for donors, investors, and rating agencies that evaluate MFIs for potential investment because this level provides more robust evidence of actual performance. 

Tier III
This is a three to four week exercise that includes “detailed testing of transactions to confirm the portfolio quality through a sampling of loan files, accounting files, and the loan tracking management information system (MIS).” The Tier III assessment uses statistical sampling methods about real arrears levels and the risks related to accounting practices and credit policy. This level of assessment is recommended for investors or regulators that need a quantitative and statistically certain measure of portfolio performance and management.

Additional Resources:
[1] There are assessment tools, such as ACCIÓN International’s CAMEL, World Counceil of Credit Unions’ (WOCCU) PEARLS, and CGAP’s Technical Tool for appraising MFIs; assessments by rating agencies (MicroRate, M-CRIL, Microfinanza, CRISIL, and PlaNet Finance); credit ratings by credit rating agencies (Standard and Poor’s, Fitch, Apoyo, Class, Pacific Credit Rating, and Equilibrium); guides for analysts, including the Technical Guide of the Inter-American Development Bank, CGAP’s external audit manual, and minimum disclosure guidelines for MFI financial statements.”

[2] “There are existing sources of peer group analysis, such as the MicroBanking Bulletin (MBB). MBB tracks the financial performance of over 700 MFIs worldwide (www.mixmbb.org). Although individual program results are confidential, MBB displays results for peer groups of similar institutions that the analyst can use as a guide to determine where the performance of given institutions fall. Also, an analyst can look at the performance of other individual MFIs in the country at MIX Market (www.mixmarket.org).”

[3] Several publications explain the indicators commonly used in the microfinance industry: See Tillman Bruett, ed., Measuring Performance of Micro-finance Institutions: A Framework for Reporting, Analysis, and Monitoring, SEEP and ACT (Washington, D.C.: USAID/Accelerated Microfinance Advancement Project, forthcoming); see also “Selected Definitions of Financial Terms, Ratios and Adjustments for Microfinance,” published by CGAP, Microfinance Consensus Guidelines (Washington, D.C.: CGAP, 2003); see Joanna Ledgerwood, “Sustainable Banking with the Poor” in Microfinance Handbook: An Institutional and Financial Perspective (Washington, D.C.: IBRD/The World Bank, 1998); see Richard Rosenberg, “Measuring Microcredit Delinquency,” published by CGAP, Occasional Paper 3. (Washington, D.C.: CGAP, 1999)
 

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