The Art and Science of Effective Lending
Lending combines the science of obtaining and analysing the facts of a loan request and the art of making judgements about that information, the feasibility of the business, and the credibility of the borrower. Experienced lenders focus on the key business issues quickly, determine what information is needed, and then make prompt decisions based on that information. Developing sound credit judgement takes time and experience; development lending to small businesses “by the book” is difficult and rarely results in a quality loan portfolio.
This section sets out some basic principles for lending. However, it is the implementation of these principles by the right people that brings them alive and makes them work. Investment in people, management and leadership, and a systematic approach to risk are the key elements that allow micro and small business lenders to be effective.
The principles of effective lending presented below reflect the lessons that microlenders have learned through experience and the innovative approaches being used for small business lending today. This does not include a marketing and outreach discussion because demand is assumed to exist if a programme offers the right products and services. The use of technical assistance in loan screening and borrower evaluation is discussed below under the Role of Technical Assistance.
- Know your Borrower:
Understand your market niche and the types of people, and characteristics needed to succeed in the local environment. The best entrepreneurs may be stubborn, without formal education, and blithely unaware of any personal weaknesses, yet they may have the street smarts, resourcefulness, and ability to do one thing well to be successful entrepreneurs. Be aware of their strengths, limitations, and weaknesses, and why you like or dislike them (be careful of borrowers you like because they are similar to you). In other words, lend to the person, not to the idea. Personal commitment to repay is the strongest bond between a microlender and its2 customers. In the United States, microcredit programmes have used small first-time loans and pre-credit training or technical assistance to learn their borrowers potential strengths and weaknesses. Lending in transitional or uncertain environments requires lenders to develop a personal relationship with individual borrowers and the community within which the borrower is doing business.
- Structure Loans to Minimise Risk:
Successful microlenders provide minimal credit amounts at first and then increase the subsequent loan size once a borrower has demonstrated his or her ability and commitment to repay. These “stepping loans” minimise risk to the borrower (particularly start-ups or early stage expansions) and to the lender. In addition to “stepping loans”, other methods for reducing risk to the lender include:
- It is Hard to Fix a Poor Underwriting Decision:
If staff misjudged either the business or the borrower, it is difficult to fix the problem once the loan is made. Loan restructuring and collections take significant staff time and reduce the time available for other borrowers. Careful evaluation of the business viability and borrower character are essential to microlending unless the organisation can rely on (a) collateral, (b) cross-guarantees within a group of borrowers, or (c) social pressure networks. While alternatives to traditional collateral have worked well in certain developing countries, they have worked less well in the individual-oriented culture of the United States. When it comes time to collect, “collateral melts like ice cream in the summer sun.”1 Therefore, prudent judgements of business viability and borrower character are essential.
- Pay Attention to the Details:
Lending is a business of details. Careful information gathering and analysis, loan documentation (as streamlined a possible) and rapid follow-up on any discrepancies all require a focus on details. Although many microcredit programmes learned this the hard way, the most successful programmes now are meticulous in their loan procedures and prompt in their follow-up if any payments or reporting requirements are past due. Collect aggressively to establish market credibility and minimise loan losses.
- Streamline loan administration systems, but stay in close touch with the borrower.
Most of the microlending programmes in operation in CEECs are using direct loans to individual businesses in a manner similar to traditional banking. The key is to stay in close touch with the borrower by (a) requiring frequent payments at the local office and (b) making periodic site visits. A missed payment or disarray at the place of business are immediate signs of trouble. Lending staff must monitor loans for changing economic or market conditions and spot early signs of potential trouble.
- Charge “market” interest rates:
Access to credit is more important than its cost. Because access to credit can dramatically improve the income generation of a microbusiness, most entrepreneurs are less cost-sensitive and more access-driven. Most microcredit organisations charge fees and interest rates that are higher than the conventional finance system and lower than informal moneylenders. Additional margin3 on each loan has a relatively small impact on the borrower (given the small loan amounts and increased income generation) and a huge impact on the programme’s prospects for self-sufficiency.
- Be driven by the deal, not charity:
Despite their development mission, lenders must evaluate each deal on its business merits and the capacity and character of the borrower. Experience gives lenders the ability to recognise those deals that do not make sense and those that might if they were structured differently. If an existing loan suddenly looks precarious, take action swiftly with clear intentions rather than allowing non-payment or problems to continue.
- Collect hard and fast:
Consistent and disciplined loan collection reinforces the business relationship between the lender and borrower, and sends a strong message that delinquency will not be tolerated. Never bluff: do not use the threat of collection actions unless you are prepared to take them.
The key lending principles from international microcredit institutions serving the very poor have been to streamline the loan approval and delivery systems, rely on personal character rather than an analysis of the underlying business, and standardise products and delivery mechanisms to reduce administrative costs. In addition, they have demonstrated that subsidised credit benefits neither the borrower nor the institution in the long run. Within CEECs, however, existing programmes appear to combine the efficiencies of microcredit delivery with the more rigorous assessment of borrower and business that has been used in the United States. Programmes like the Enterprise Credit Corporation in Poland and Opportunity International in Bulgaria and Russia have adapted these development lending principles to serve microbusinesses in these emergent markets with great success. ECC, for example, has drawn on the strengths of both micro and small business lending approaches. Similar to large microcredit organisations, loan products are relatively standard, loans are disbursed near the borrowers (in rural and urban areas), and lenders focus greatly on the capacity and commitment of management. In addition, however, the ECC loan application pushes borrowers to identify their markets, their competition, and their projected cash flows and requires thorough loan write-ups by staff.
- Loan Assessment and Credit Analysis
There is no formula for determining creditworthiness. The loan officer must assemble and evaluate information and then determine what the entire picture looks like. Traditional bank lenders refer to the “Four Cs” of lending: Credit, Capacity, Collateral, and Character. Development lending uses the same rigorous credit assessment principles, but applies them to situations in which the lender must rely on borrower character and cash flow from the business. The loan application and the first meeting with the borrower are the first screen of whether a business is a potential candidate for microcredit. Beginning with the first meeting, the lender must evaluate the quality of the business deal, the fit with the borrower’s experience and capacity, and whether the financing amount and structure is appropriate.
- Source:
- Carperter, Janney and Julia Vindasius (1996), Microcredit in Transitional Economies. Leed Programme. Paris: Organization for Economic Cooperation and Development.
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Hari Srinivas - hsrinivas@gdrc.org
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