Understanding Loan Delinquency

Rationale The loan portfolio is considered as the largest income-generating asset of a lending institution. Like any other asset, it has inherent RISKS! One of the biggest risks faced by the bank is non-repayment by clients or delinquency. This risk in the bank portfolio changes as loans are disbursed. Problems with loan delinquency affect not only loan clients but the whole institution and community as well. However, the bank is ultimately responsible for delinquency. Every successful lending institution takes steps to prevent, monitor and control delinquency. After all, its largest income generating asset is the loan portfolio. A loan portfolio though is different from other assets because, even though it belongs to the bank, it’s actually in the hands of the borrowers. Repayment is based on a promise to do something in the future, and that future is a bit uncertain. This is why there is risk inherent in a portfolio. The size and the quality of the portfolio, meaning the amount of risk, change continually as loans are disbursed and payments are made. If delinquency is not properly managed, its effects can be widespread. It affects everybody in the community – starting from the loan client herself, the institution, the depositors, the fund providers and the whole community where the bank operates. That is why delinquency as a problem is primarily the responsibility of the bank. Proceed to next slide.

Session Objectives Understand the basic concepts of zero tolerance and delinquency Learn how to measure delinquency Know the costs and causes associated with delinquency

What is Loan Delinquency? Any loan with a missed amortization of even one day is a delinquent account. Instruction: Before showing the slide, ask the participants how they define loan delinquency. As participants give their answers, write them on the white board. After 5 answers, show slide and ask participants to see if their answers are similar to the one on the slide. The phrase: missed amortization of even one day, must be engrained in the mind of every AO, Supervisor, Branch Manager and the entire bank staff for that matter. This means that AOs and Supervisors should already be alarmed when borrowers miss even one day of their amortization payments. This is a big change from the traditional belief that the bank should only be alarmed when the borrower’s loan has matured and he still hasn’t paid. Next slide.

What is zero tolerance against delinquency ? Zero tolerance means NO LEVEL OF DELINQUENCY IS ACCEPTABLE! It is the attitude of the bank management & staff towards loan delinquency – no level of late payment is acceptable. It is an institutional culture in which late payments are totally unacceptable The bank will aggressively pursue past due clients, whatever the cost, to establish and maintain zero loan delinquency. Before showing the slide, ask the participant what he/she understands of “zero tolerance of delinquent loans,” or by the term zero tolerance. Let them give/encode their answers and then show slide and ask them whether their answers are the same. No level of delinquency is acceptable Zero tolerance means that no level of delinquency is acceptable (emphasize this phrase) which logically means that even one day missed payment is not acceptable and should not be tolerated. Institutional culture The most important factor in developing the culture of zero tolerance lies in the attitude of the bank’s management and staff towards delinquency. For example, if frontliners of the bank (i.e. AOs, Supervisors, collectors, managers) do not consider it a problem that a borrower missed his first amortization payment, then it will send a message that it is alright not make your payment on time. This will result in borrowers not being conscious of paying their subsequent amortizations on time. If the bank personnel’s attitude is to collect from the borrower and not accommodate missed payments, then it will send a signal that the bank is serious in collecting from borrowers and direct them to pay their amortizations on time. The attitude of zero tolerance in our bank must be institutionalized, meaning that each and everyone in the bank share in the belief that zero tolerance must be implemented thereby making it an Institutional Culture. The bank will … With zero tolerance as an institutional culture, the bank will aggressively pursue delinquent and past due clients, whatever the cost. It may be more costly for the bank in the long run if they do not go after clients with low loan balances left. Clients may not start paying the last few amortizations knowing that in the past the bank did not pursue clients with low outstanding balances left. Just imagine if a bank has 200 clients who did not pay their last P500.00 balance, this already amounts to P100,000.00, which could have been lent out again. Zero tolerance simply means an attitude, culture and effort by the bank to make sure that no level of loan delinquency is acceptable. Next Slide

What makes loan delinquency distinct from other problems? The costs of delinquency are hidden. The true level of loan delinquency can be concealed, making it difficult to recognize the true extent of the problem. Lenders tend to attribute delinquency excessively to external factors. Consequently, they do not confront and resolve the causative factors within their control. Delinquency is contagious. It tends to spread and worsen, leading to high levels of default, unless it is aggressively controlled.

Measuring Delinquency Arrears Rate/Past Due Ratio Portfolio at Risk Ratio Annual Loan Loss Rate Now that we have defined important concepts such as delinquency, and zero tolerance against delinquency, the next important question we need to ask ourselves is: how do we determine if we are faced with a delinquency problem? What are various ways in which delinquency is measured? And what is the most applicable measurement tool for delinquency in microfinance loans? There are actually 3 ways of looking at delinquency in an institution. These are: arrears or past due ratio, portfolio-at-risk ratio, and loan loss ratio. The annual loan loss rate is a good complement to portfolio-at-risk rate.

Measuring Delinquency Arrears/Past Due Rate Indicates how commonplace non payment is measures amount of loan principal that is due but unpaid Less rigorous yardstick in measuring portfolio quality Only shows amount of overdue payments Does not reflect portfolio risk Delinquency is often calculated by the amount of payments on loans past due as a percentage of the portfolio. This is called the Arrears or Past Due Rate. Although this measure is frequently used, it understates the risk in a portfolio because it only counts the payments as they become past due. It does not take into account that the entire amount of the outstanding balance of the loan is actually at risk, as well. Amount past due Total Loan Outstanding

Measuring Delinquency Portfolio at Risk Applicable measuring tool use to evaluate portfolio quality of microfinance loans; it considers a loan account with a missed payment of even one (1) day as already a delinquent account more pro-active approach in looking at delinquency problems Unpaid Principal Balance of all loans with missed payments of 1 day or more Outstanding portfolio READ BULLETS

Measuring Delinquency Indicates how much could a bank lose if all late borrowers default Aging of portfolio at risk separates more risky loans from less risky (see next slide) READ BULLETS

Measuring Delinquency PAR Aging Level of Risk Current Loans with no miss payments and therefore LOW RISK PAR 1 – 7 Days Loans that are MINOR RISK BUT NEED WATCHING PAR 8 – 30 Days MODERATE RISK PAR 31 – 60 Days Increasingly SERIOUS RISK PAR 61 90 Days LOW CHANCE OF REPAYMENT, lots of collection effort PAR over 91 Days LOSS This tabular matrix shows how PAR Aging Report can be interpreted in terms of the level of RISK the bank is faced with.

Measuring Delinquency DELINQUENCY INDICATORS OVERDUE 1 – 30 DAYS 31 – 90 DAYS 91+ DAYS TOTAL OVERDUE ON MATURED LOANS Value of Late Payments As % of Outstanding Portfolio (=161,119) 12,904 8.0% 6,583 4.1% 6,094 3.8% 25,581 15.9% 5,462 3.4% Unpaid Balance 39,119 24.3% 30,095 18.7% 20,314 12.6% 89,557 55.6% - Number of late borrowers As % of total active borrowers (=40) 8 20% 7 17.5% 5 12.5% 20 50% Between the 2 measurement tools – arrears/past due rate and portfolio-at-risk rate – the latter is the most superior. This can be gleamed from the example shown in this table. Proceed to discuss the content of the table emphasizing the percentages representing the possible loss/es to the bank.

Measuring Delinquency Loan Loss Rate Shows how much of the portfolio has been lost; annual cost of default, which must be balanced by higher interest income Measures the amount written off as a percentage of average outstanding portfolio Provides a complement to PAR No Write off Policy INFLATES ASSETS Quick write offs underestimate portfolio health While Delinquency rates show how much of a portfolio is a risk or in danger of being lost, Loan Loss Rates show how much has already been lost. Loan Loss Rate measures the amount the bank has declared non-recoverable or written-off, as a percentage of the average outstanding portfolio for the period. Loan Loss Rate is an essential complement to the PAR Rate and you must know both calculations to accurately assess the viability of an MFI. Sometimes, high delinquency in a portfolio can be caused by lack of a write-off policy. If loans are not written off they will still be in the portfolio and reflected in the delinquency rate. The banks’ assets will be inflated in the Balance Sheet. On the other hand, an operation might show a very low delinquency rate by writing off loans soon after they become delinquent. Quick write-offs underestimate the health of the portfolio. As we have seen Loan Loss is a high cost to the bank.

Measuring Delinquency Loan Loss Rate Complements the portfolio at risk rate (PAR) Compare over time to see if write offs are increasing Loan loss rates over 4% are dangerous – best kept under 3% MFI should continue efforts to recover loans that are written off Amount declared unrecoverable Average outstanding portfolio How is loan loss rate computed? Read the formula in the slide.

Is collection rate a tool for measuring delinquency? Collection/ Repayment Rate Frequently misused to report portfolio quality Measures amount repaid as % of amount expected to be repaid Does not reflect portfolio risk Used to: Predict and plan cash flow Analyze repayment trends Examine collection performance Amount received in a given period From cash flow Amount due during the period From portfolio report Some lending institutions give their collection rate when asked about their portfolio quality. Is collection or repayment rate a tool for measuring delinquency? No! The Repayment Rate is frequently misused to report portfolio quality. Repayment Rates measure the amount that has been repaid as a percentage of the total amount that is expected to be repaid during a given period. The Repayment Rate is not a measure of portfolio quality and does not reflect portfolio risk. In fact, the outstanding portfolio is not even part of the equation. However, the Repayment Rate is useful in predicting and planning cash flow, analyzing repayment trends and examining collection performance over time.

Is a 95% collection rate good? 95% collection rate (amounts received/amounts due) Total amount disbursed = P500,000 500 loans: P 1,000 principal disbursed, repaid in 10 weekly installments of P100 each. Loans renewed every 3 months Let us go back to the use of the Repayment/Collection Rate as a tool used by some MFIs for measuring delinquency. But is it really a good tool for measuring delinquency? Remember, how we defined the actual use of the Repayment Rate? Let us see what it really tells us through an example… (CLICK TO THE NEXT SLIDE)

Implication of 95% CR P 500,000 Loan Disbursement (LD) - 475,000 Recovered amount ( LD x 95%) 25,000 lost PER LOAN CYCLE x 4 cycles per year 100,000 Total amount lost for 4 cycles/ 1 year 100, 000/ Total amount lost for 4 cycles/1 year 500,000 Original amount of Loanable Funds = 20% of portfolio lost in effect every year EXPLAIN HOW THE FIGURES WERE DERIVED What this presentation shows you is that a bank that is able to collect only 95% of the portfolio it disbursed, on an annual basis (assuming 4 loan cycles) loses the chance to rotate/rel-end 20 % of the same portfolio due to loan delinquency. This shows you how delinquency affects the funds management of the bank and how even higher levels of loan delinquency could lead to more serious liquidity problems in the long-run. Do not simply assume that a repayment rate 95% is good. Delinquency hurts because it eats away the amount of money you have to lend to other borrowers.

Why is delinquency not acceptable? What makes delinquency such a big problems for banks and why should it not be an acceptable state of its lending operations?

Why is delinquency not acceptable? It reduces profitability; It reduces the bank’s competitiveness; It affects the bank’s image in the community negatively BANK FAILURE!!! can lead to: READ BULLETS

Impact of Delinquency PROFITABILITY SUFFERS THROUGH: Direct Costs Indirect Costs How does delinquency affect the bank’s profitability? Delinquency entail costs. We have Direct Cost (which are easily measured and discernable), and we have Indirect Costs (which are harder to establish and often have far-reaching impact).

DIRECT COSTS Expenses Income PROVISIONING Higher Loan Loss Provisions LEGAL FEES for pursuing most serious cases COLLECTION Loan Officers/ Management spend more time on it Delinquency result in diminished profitability postures. Delinquency result in increased expenses (READ EACH EXPENSE ARROW AND EXPOUND) Delinquency likewise results in decreased income (READ EACH INCOME ARROW AND EXPOUND) DELAYED INTEREST Negative Impact on Cash Flow SLOWER PORTFOLIO ROTATION Less Interest and fewer fees SLOWED PORTFOLIO EXPANSION Less Interest and fewer fees

Cost of Delinquency To see a better picture of how delinquency impacts on the bank’s bottomline, let us compare two banks that are both doing microfinance – one with a high delinquency rate and one with a low delinquency rate. (EXPLAIN COMPARATIVE FINANCIAL STATEMENT AND HIGHLIGHT THE INCREASED COST ON LOAN LOSS PROVISION FOR THE HIGH DELINQUENCY RB AND THE DECREASED INCOME GENERATION OF CAPABILITY OF ITS PORTFOLIO) (

Cost of Delinquency RB Loan Data: Loan Amount P 15,000 Interest 3% per month Term 3 months(12 weeks) Assumptions: The loan has become a problem account. After receiving only 5 full payments of principal and interest, the borrower has fled the municipality. The total payment amount due per week on this loan is P1,362.50 Assume that cost per loan for the RB has been calculated at P150. Requirement: Calculate for the following: a) lost interest income, b) lost principal, c) net revenue per loan, d) number of loans required to earn the lost principal and interest.

Cost of Delinquency Initial Loan Amount 15,000 Interest (9% flat) 1,350 16,350 Loan Term Weeks 12 Weekly PRINCIPAL Repayment 1,250 Weekly INTEREST Repayment 112.50 TOTAL Weekly Repayment 1,362.50 Payments Received 5 6,812.50 (Total Weekly Repayment x 5) Payments Missed 7 Lost Interest Income 787.50 (Weekly Interest Repayment x 7) Lost principal 8,750.00 (Weekly Principal Repayment x 7) Total LOST Principal & Interest Income 9,537.50 (Total Weekly Repayment x 7) EXPLAIN HOW FIGURES ARE DERIVED

Cost of Delinquency Expected Actual Revenue earned (15,000 loan@ 12 weeks) 1,350 562.50 Cost per Loan (assumed@10% of loan) 150 Net Revenue per Loan 1,200 412.50 Number of Loans Required to Earn Lost Principal Lost Principal/net revenue per 15,000 loan 8,750/1,200 7 loans of P15,000 Number of Loans Required to Earn Lost Interest & Principal Lost Interest & Principal/net revenue per 15,000 loan 9537.50/1,200 8 loans of P15,000 Therefore, this example clearly illustrates that when we allow a loan to become delinquent, we need to generate almost almost 10x the number of loans just to compensate for the lost revenue from one loan.

INDIRECT COSTS Breakdown of credit discipline; Reduced staff morale; Reduced access to fund sources Quantifiable costs show a direct impact on the bank and the delinquent borrower. However, what a lot of MFIs fail to recognize is the even more damaging and long-term effects of Non-quantifiable costs of delinquency. On the Bank While low levels of delinquency engender pride on the part of the MFU staff, high levels of delinquency create a sense of frustration and even futility, especially when attempts to control delinquency do not succeed. The AO who have continual personal contact with the clients, are the most directly affected, and they can infect the morale of the entire staff. Not only do clients lose respect for an institution with repayment problems, but so do other institutions, limiting a program’s ability to expand. Local and international sources of capital are less likely to support a credit program that has trouble getting loans repaid. Increase in delinquency could result in higher past due ratios and a downgrade by BSP of the bank’s CAMELS rating, thus, adversely affecting access to rediscounting facilities of BSP and other lending institutions (e.g. Land Bank, PCFC, etc.) On the Community Just as many credit programs are promoted rapidly by word of mouth, word of repayment problems travel quickly. Clients within the same area tend to hear about who pays loans back on time, who does not, and what happens to those who do not. Communication among borrowers make delinquency extremely contagious. When this happens, development process in the community (i.e. increasing access to capital of microenterprise operations the redound to increases in household income and job creation, that further results to increase in the purchasing power of residents of the community thereby promoting economic activity) will be hampered. On the Microenterprise Operator/Industry A bad loan can ruin a microentrepreneur, bankrupt an enterprise and plunge an entire family into desperate financial situation.

Delinquency hurts! Conclusion It hurts the bank where it matters most –PROFITABILITY AND IMAGE IN THE COMMUNITY.

Conclusion There is a direct link between an increase in delinquency and decrease in the bank’s profitability and sustainability. There is also a direct reduction in staff productivity when delinquency increases. The bank ultimately loses the opportunity to fulfill its business objectives – that of making a profit and providing credit access to the community – as it either runs out of money, or focuses too much time on chasing delinquent loans.