An Analysis on the Low Default Rate in Microfinance
—A Case Study of a Microfinance Program
Wei Lu Bin Sun
School of Management
University of Science and Technology of China, Hefei, P. R. China. 230027
Abstract: Microfinance, in most developing countries, achieves a low default rate on loans to the poverty group that are considered as high risk clients by conventional financial institutions. This paper adopts both comparative and classification analysis methods for an in-depth research on the clients as well as the lending mechanism that the microfinance institution in this study has been using. The results of these analyses validate some of the existing explanations of how the microfinance institutions (MFIs) succeed in achieving low default rates. Factors that contribute to the low default rate on one hand, but might, on the other hand, deviate from the mission of microfinance are also brought to the attentions of readers.
Keywords: Microfinance; Poverty Group; Default Rate; Lending Mechanism
1 Literature Review
According to World Bank’s “microfinance handbook”, microfinance is a kind of financial services,
provided to low-income groups and individual operators by credit institutions. It was born in the 1970s’ in Bangladesh, in order to meet the demand of credit of poverty group. Primary microfinance activities include the followings: (1) small loans, typically serving for the lack of working capital; (2) informal appraisal of borrowers and investments; (3) collateral substitutes, such as group guarantees or compulsory savings; (4) access to recurrent and larger loans, based on repayment performance; (5) streamlined loan disbursement and monitoring; and (6) security savings products .
Since its first step, microfinance has received warmly welcome from poverty group, and quickly spread to the developing countries as an effective way to solve poverty. Previously, the poor were considered as unreliable, and commercial banks usually didn’t like to provide loans for low-income group,
considering the higher operation cost and risk. Microfinance brings in market mechanism, by operated by financial institutions according to the market rules. Compared to the traditional discount loan from government, microfinance has shown great advantage on repayment rate .
Data shows that microfinance programs in China have claimed average repayment rate of above 90%. The group lending mechanism is often considered to be the key to such a success. The creation of joint liability is relied on inducing sanctions which help to discipline borrowers. The sanctions may be fairly subtle, induced by peer pressure from fellow villagers rather than by the direct actions of the programs. The sanctions may involve, for example, the loss of an errant borrower’s reputation in the
community, social isolation, restrictions on access to inputs necessary for business, or, in rare cases, the use of physical force .
Some scholars considered joint-liability contract just as one of the several important factors leading to high repayment rate. Complementary mechanisms include innovative features like weekly repayment schedules, progressive increases in loan sizes, and a focus on female clients . Collateral requirements play an important part in achieving the high repayment rate. In urban, a borrower’s home or business is
typically required as collateral . In addition, research shows that poor people value financial services. They want more of credits, get worried when they don’t have any, but are often frustrated when they do
get them. They know that managing money is important, and that managing money well gives them a better chance to manage their lives and livelihoods well . Some projects were still success at the macroeconomic crisis situation. The main factors are as following: Micro-enterprise could adjust the amortizable amount according to their cash flow model; most of them engaged in the production elements of the domestic trading with little influence from Import and Export; the rural sectors were impacted little by the currency crisis, and at the same term, urban sectors were also impacted by drought with little degree, so the risks of banks are diversified .
2 Analyses of the Contributing Factors to the Low Default Rate
2.1 Analysis of the Trades
The loan receivers in this case study are in a middle sized inland city where the microfinance institution has been operating for three and half years. The majority of these microfinance receivers are engaged in retail, service, and manufacturing trades. These trades are all labor-intensive and create a lot of employments. Another fact is that these three trades have been very steadily growing locally. Most of the loan receivers who are engaged in retail business are buying and selling very basic means of subsistence and low-grade consumables, such as simple dress, daily food, low cost building material, ?cheap home appliance and other small commodities. The following charts demonstrate the distribution
of the trades and commodities.
8.17% 4.74% 29.47% 9.25% 22.24%
5.13% 23.61% 62.40% 19.20% 15.78%
Dress Appliance Manufacture Retail Food Commodities Service Others Building material Others
Chart 1: Distribution of Trades Chart 2: Distribution of Commodities
Interviews with some business operators and local residents reveal that gaining profits from running these businesses mainly rely on high-intensive and overtime work and there is a stable demand among local residents for these commodities and services. These two factors apparently contribute to the low default rate.
2.2 Analysis of the Guarantee Mechanism
The microfinance institution in this study requires their clients to possess some qualifications. Firstly, a client must have a stable business operating in local area for more than one year. The microfinance institution believes this will ensure that client has already gained the basic skills required for operating a business and has a stable target market. Secondly, group lending and counter-guarantee mechanisms are used. Table 1 indicates that very few applicants were granted group lending and the amount granted was also very small. The conclusion can be easily come that repayment rate is not related to the group lending mechanism.
Table 1: Group Lending Statistics
Year 2003 2004 2005 2006
No. of loans granted 4 1 5 3
Amount granted RMB47,500 RMB32,000 RMB350,000 RMB193,000
Group lendings/Total lendings 10.00% 1.55% 3.68% 1.88%
Group lending amount/total 8.15% 1.67% 5.14% 2.01% lending amount
2.3 Analysis of Repayment Model
Compared with traditional loans, the innovation of repayment pattern that MFIs have adopted is much shorter installment repayment. That means the borrowers can choose weekly or fortnightly repayment. The microfinance institution in this study also takes two repayment models: bullet repayment or installment and installment all are monthly.
600 Number of accounts Installment 500
400 Bullet 489 490 300
200 248 100 93 100 42 29 27 10 0 0 2003 2004 2005 2006 2007
Chart 3: Installment and Bullet Repayment
2.4 Analysis of the Rate
The rates of the MFI’s loan are primarily constituted of interest charged by commercial banks and
guarantee fees as well as application fee. The guarantee fee is charged lump sum when contact is signed. The loan amount, duration and repayment model all have significant impact on the guarantee fee.
Guarantee fee=Amount*(Duration*Guarantee Rate +Application Fee)
Label?？All data is up to April 2007.
Table 2: Guarantee Fees
Amount of guarantee Rate for bullet repayment Rate for installment
<RMB30,000 0.75% 1.50%
RMB30,000-40,000 0.65% 1.30%
RMB40,000-50,000 0.60% 1.20%
RMB50,000 0.55% 1.10%
Table 3: Application Fees
New clients 1%
Old clients 0.70%
The current commercial loan rate is 6.39；. The rate of this MFI is between 13.69% to 25.39% on
loans of different sizes and durations. But researches found the higher rates have a positive contribution the low default rate. Past experience shows that the government's rate-discount loan often causes to "rent-seeking" behavior and the loans often times couldn’t reach the real target group . Some of those
loan receivers belonging to the target group who actually get the loans treat the loan as poverty relief fund, intentionally or unintentionally. Some of the loan receivers use the loan for consumption instead of production. They do not feel obliged to repay. Those who are not really underprivileged economically and socially would be able to get rate-discount loans. Thus the high rate loans automatically reach the target group. According to the “capacity theory" from Amartya Sen, the poor but capable people are more
courageous to borrow money at a high rate and the possibility of repayment is higher too. In other words, people who are willing to get loans at high rate are the most capable among poverty group, and capacity is the most important factor that ensures repayment.
2.5 Analysis of Gender
Most of the researches on microfinance found that female micro-loan receivers tend to have much higher repayment rate than male. They believed that females are much more conservative, diligent, creditworthy than males and the businesses they operate are associated with low risk. However, in this study, we find that the female proportion has been always less than 40%. The proportion of the loan amount is also less than 40%. Accordingly, the gender of loan receivers has little contribution to the high repayment rate.
Table 4: The Composition of Male and Female Loan Receivers
Year 2003 2004 2005 2006
Number of male 70 165 337 341
Number of female 30 93 179 191
Ratio of female 30.00% 36.05% 34.69% 35.90%
Loan amount to male(RMB) 395,500 1,219,500 4,559,000 6,334,800
Loan amount to female(RMB) 187,500 696,000 2,247,500 3,279,000
Ratio of female’s amount 32.16% 36.34% 33.02% 34.11%
2.6 Analysis of Progressive Increases in Loan Sizes
To grant larger size loans to those applicants who have good record of paying back in time is a common practice of financial institutions of all the kinds and so do MFIs. Chart 4 shows that loan amount of old clients in subsequent loans rises steadily. The progressive loan amount increasing plays a
positive role to the high repayment rate.
0 1st 2nd 3rd 4th 5th 6th 7th 8th round round round round round round round round Average loan amount
Chart 4: Average loan amount of old clients in each round
3. Conclusions and Issues Need Attentions.
This case study reveals that the factors that contribute to the high repayment rate are not group lending mechanism and gender differentiation, but the measures used by conventional banking industry, ie, counter-guarantee, higher rate？sophisticated applicants selection, flexible repayment models and incentives for larger loans to those who repay in time.
The analysis of the data collected from this study and interviews with both loan receivers and local residents also found some issues that need to pay attentions.
Both the total amount and average amount loans rise continuously since it’s the operation of this
MFI in this study. The average amount has risen to RMB 24,508 in 2007, while the figure was just RMB 5,830 in 2003. The annual growth rate is 43.2%. The higher the loan size the less likely for the real poor people to be eligible to get loans.
The revenue of this MFI is mainly from guarantee fee. With the more and more clients and the increase of both amount per loan and duration, the revenue of this MFI has risen from RMB 37,825 in 2003 to RMB 652,202 in 2006. The average guarantee fee per loan has risen from RMB 378 in 2003 to RMB 2,787 in 2007, a growth of 109.4%. It is also less like for the poverty group to be able to get loans.
The average amount per loan increases very rapidly and the loan receivers are gradually becoming no longer poor. The major reason for most of those loan receivers who are still getting loans form this MFI, instead of from conventional commercial bank where they are already eligible to apply, is that borrowing from the MFI is easy and quick. They do not want to spend time and efforts, sometimes, money, to deal with banks. The “no-longer poor” is becoming the major clients of this MFI.
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