LOGIC Consulting

December 23, 2021


A New Pathway to Financial Inclusion; Credit-Scoring Models

The year 2005 was proclaimed by the United Nations Economic & Social Council as the international year of micro-credit. This was the year right before Muhammad Yunus, founder of Grameen Bank in Bangladesh received his noble peace prize for his work in creating economic & social development. At the time, microfinance was perceived as a strong enabler for people in developing countries to gain access to capital and accordingly achieve a more sustainable improvement in income. This model has proved successful during the 1970 - 80 period in Bangladesh and East Asia at large.

In Europe, a similar model was adopted in the mid – 19th century in the form of cooperative banks. For example, Germany implemented the “Savings Banks” business model, which are small & mid-sized banks that are specialized in local deposits and micro-credits, and are geographically constrained to borrowers within the same administrative district. The banks serving the community have a more personalized relationship with community members and hence more accessible than other larger banks.

In Egypt, the first form of micro-credit was in the 1950’s in the form of agricultural loans that are subsidized by the government to support farmers in need for seasonal capital. In the 1980’s & 1990’s, international donors made substantial investments in microcredit programs. As of June 2008, there were around 280 microfinance programs, offered by both microfinance institutions and banks, serving around 1 million active clients with a total outstanding portfolio of EGP 1.8bn. The market grew rapidly since the early 2000’s till date, leading to a market size of around EGP 18bn in outstanding portfolio that is offered by more than 900 different entities.

Along the journey of microfinance growth in the world and in Egypt, the industry faced numerous challenges that led to the demystification of the success story of microfinance. At the global level, the most notable crisis was the 2010 Andra Pradesh crisis in India, whereby more than 50 microfinance borrowers committed suicide due to failure in committing to debt. Similarly, in Egypt, the industry faced similar tragedies. Currently, there are around 30,000 delinquent microfinance clients that are imprisoned due to failure repay debts.

So, What Went Wrong?
And How Can Microfinance Institutions Overcome its Current Challenges?

One of the biggest challenges faced by the industry is its failure in risk management. Earlier, microfinance institutions were operating at a small-scale, and credit evaluations were largely dependent on the reputation of the client, his/her estimates of their working capital and liquidity at hand. Hence, even though the lending was not backed by collateral, the repayment rate was high reaching 95%-98% as microfinance clients were always keen to maintain their reputation in the area that they are working/living in and credit officers were more familiar with their customer base.
The rise in competition and investment appetite led to the development of a much bigger scale of lending that spanned across much larger geographic areas and customer base. Hence, the personalized relationships between the microfinance institution and the customer diluted, and the subjective scoring used to assess debt capacity became insufficient. Responding to this, microfinance institutions took some measures to improve their credit risk management practices, including;

  • The development of more rigorous credit policies
  • The use of field verifications to support financial evaluation
  • The use of credit history scoring to evaluate the risk of the loan
  • The use of legal collateral documents such as bank cheques and promissory notes

Microfinance institutions further enhanced their legal and collection capacity, which increased the pressure on defaulting clients to repay their loans. Unfortunately, this created the vicious cycle that led to tragedies similar to those that happened in Andra Pradesh and in other areas of the world.
All of these initiatives enhanced portfolios quality, yet remained the problem of insufficient credit risk management prevalent!

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