Managing Credit Risk in Rural Financial Institutions in Latin America

Mark Wenner

Rural Finance Research Conference

March 19, 2007

Rome, Italy

Outline

Types of Risks Financial Institutions Face Significance of Credit Risk Ways of Evaluating Creditworthiness Common Portfolio Credit Risk Management

Techniques Results from Survey of 42 Latin American RFIs Highlights of Four Case Studies Conclusions and Recommendations

Types of RF Institutional Risks

Credit Liquidity Interest Rate Foreign Exchange Technological

Operational Product Innovation Reputational Regulatory

Two Most Important Risks

CreditCredit Interest Rate

Focus is on credit risk because majority of rural finance institutions are non-deposit taking. Many smaller institutions are dependent on concessional funds.

Note: a liquidity crisis is the culmination of other risks and is the immediate cause of insolvency and failure.

Forms of Evaluating Creditworthiness

Repayment Capacity Analysis Human Based Expert Systems Mathematical Models

Credit Scoring (discriminant analysis & logit/probit)Programming Hybrids (computation, estimation, and plus

simulation)

Asset-backed Analysis

Figure 1: Credit Analysis Process Flow

Does the borrower have a repayment strategy

Why does the firm need to borrow?

Is the risk-reward ratio acceptable to the

lender?

Source: Adapted from Caoutte et al, 1998

Strategy Review: Does the firm have a clear sense of direction and

how to get there?

1. Management Analysis: Competence, Integrity 2. Financial Analysis: Balance Sheet and Cash Flow Analysis - projections 3. Sector Analysis: Position in Industry, Price Trends, Competition, Suppliers, Labor Situation, Transport and Marketing Issues, Importance of Quality and Differentiation 4. Qualitative Factors-Environmental Due Dilligence 5. Financial Simulations: Stress Testing, Breakeven Analysis 6. Risk Rating/Legal Opinion

1. Loan Administration: Set up, Funding Schedule, Entry into Data, Management System 2. Negotiations/ Credit Approval 3. Loan Documentation/Closing

Common Portfolio Credit Risk Management Techniques

Geographic Diversification

Sectoral Diversification Crop Diversification Loan Size Limits Minimal Enterprise Size

Limits Over collateralization Joint Liability Contracts

Graduated Lending Exclusion Lists Linking Savings to

Credit Approval Guarantee Funds Donor Trust Funds Credit Insurance Portfolio Securitization

Survey Methodology

Methodology: Web-based survey instrument with was sent to 226 financial institutions in Latin America. The survey asked about perceived risks in rural lending and in particular agricultural lending; techniques used to manage credit risk; and basic information on the institution (size, age, loan products, interest rates charged, guarantees required, profitability, delinquency, staff profile, etc.)

42 institutions responded.

Table 3: Rural Financial Institutions in LAC by Country

BOLIVIA

BRAZIL

COLUMBIA

COSTA

RICA

ECUADOR

EL SALVADOR

GUATEMALA

HONDURAS

MEXICO

PARAGUAY

PERU

TOTAL

Regulated 1 2 0 0 1 1 0 1 1 1 9 17

Commercial Banks 1 1 2

Non-bank Financial Institution

1 1 1 8 11

Credit Unions 1 1 1 1 4

Nonregulated (NGOs) 7 0 2 2 1 1 3 1 1 0 7 25

Total 8 2 2 2 2 2 3 2 2 1 16 42

Source: IDB Survey to Rural Financial Institutions – 2006.

Survey Results

Ranking of Perceived Risks Political Interference 74% Climatic Risks 71% Price Risk 59% Lack of guarantees 56% Regulatory and Legal 36% Weak Contract Enforcement

36% Operational risk, lack of

information (tied) 33% High cost of funds 31%

Credit Evaluation Techniques Used

Majority use human-based expert system

One used credit scoring Guarantees were not seen as

vital due to scarcity and high cost of enforcement.

Survey Results

Index of Credit Technology constructed consisting of reported use

Financial and Character-based Information

Requirements Decentralized decision-

making Monitoring Guarantees

Sharp differences between regulated and non-regulated

50% of regulated entities require a sales contract versus 11% of non-regulated (requirements)

39% of regulated entities required that client be part of a value chain

Better performing entities monitored more, gathered less but more pertinent information.

Regulated entities had more requirements as per law.

Survey Results Cont.

Keys Policies Used to Reduce Credit Risks Staff Incentives (60% used, bonuses amount to approx.

50% of base salary) Loan size limits (94%) Additional Requirements about a Threshold (91%) Loan Provisioning (88%) Client Repayment Incentives (84%) Use of Credit Bureaus (81%)

Survey Results Cont.

Institutions that had a higher share of agricultural lending had higher PAR>30

There seems to be minimum scale required to obtain strong financial results.

Figure 2: Agricultural Portfolio Share vs. PAR (>30 days) Source: IDB Survey to Rural Financial Institutions – 2006.

0

0.2

0.4

0.6

0.8

1

1.2

0 5 10 15 20 25 30 35

PAR>30 days

Ag

ricu

ltu

ral

Port

foli

o S

hare

(%

)

Diversification Effect

Scale Effect

Mean

Mean

Table 9: Scale Effects – Ranked by Total Portfolio Size

   

Share of Agricultural Credit (%)

Agricultural Delinquency – PAR>30 days (%)

Total Portfolio

Delinquency -

PAR>30 days (%)

ROA (%) ROE (%)

Quartile 1

0.53 4.11 10.60 1.72 0.08

Median 0.61 2.50 3.50 5.0 7.75

Quartile 4

0.25 4.56 5.87 2.57 14.65

Median 0.25 0.25 5.00 2.00 7.00

Total Portfolio - Correlation Coefficient -0.308* -0.009 -0.152 0.0238 0.295*

Source: IDB Survey to Rural Financial Institutions – 2006.Note: Due to it significant different size, data from BancoCooperativo SICREDI was not included in this calculation.(*) Significant of at least 10 % level ( cut-off corresponds to is 0.296).

* Significant difference of at least 10 % level.

Case Studies

Banrural SA-Guatemala Fundación para el Desarrollo Empresarial y

Agrícola (FUNDEA) Caja Municipal de Ahorro y Crédito (CMAC)

Sullana-Perú Entidad de Desarrollo para la Pequeña y Micro

Empresa (EDPYME) Confianza

General Indicators

Banrural Sullana Confianza FUNDEA

Regulated Yes Yes Yes No

Ownership Mixed Public Private Private

Branches 323 20 10 19

Loans $673.8m $69.5m $21m $6.2m

Clients 195,822 58,301 26,258 12,213

PAR >30 days 0.9% 5.1% 3.5% 0.9%

ROA 2.1% 5.7% 3.7% 12%

ROE 38.7% 38.2% 21.3% 14.8%

Efficiency Ratio 11.4% 11.4% 15.2% 23.5%Source: Trivelli and Tarazona, 2007

Agricultural Indicators Table 11: Agricultural Portfolio as of December 2005 Banural S.A. CMAC Sullana EDYPME

Confianza FUNDEA

Agricultural Portfolio

US$81.7 million US$11.6 million US$3.1 million US$3.0 million

Number of Loans 28, 810 5,850 3,501 4,275 Average Loan Size

US$2,839 US$1,982 US$894 US$694

Annual Interest Rate

16% 51.1% 57% 29%

Delinquency (PAR>30 days)

1% 2.3% 9.6% 1%

Guarantees Normally Requested and/or Accepted

Trust Funds Liens

Title in Custody (no mortgage)

Liens Group Joint Liability Co-signers

Trust Funds Co-signers, Liens

Typical Client Profile

Diversified Farmer cultivating 2-3 different crops in the year. No minimum farm size.

Specialized Farms with high margin crops or livestock. Minimum farm size 1 ha

Rural Households with diversified income stream. Minimum Farm Size 1 ha.

Diversified Farmer cultivating 2-3 different crops in the year. Minimum .4 ha.

Source: Trivelli and Tarazona (2007).

Key Elements in Credit Technology and Risk Management

Specialized staff Staff incentives Information gathered on

character, managerial ability, reputation for repayment, and financial viability

Cash flow and sensitivity analysis

Client repayment incentives Preference for households with

diversified income streams Regular monitoring

Diversification Geographic Sectoral Commodity

Portfolio exposure limit for agriculture (20-45%)

Limits financing for or refusing to finance basic grains.

Excessive provisioning (121% -260%)

Technology Risk Management

Conclusions and Recommendations

Leading institutions are using information-intensive appraisal systems and rely on well-prepared and motivated staff. Real guarantees are not important.

Repayment incentives are commonplace. RFIs seek to build long term relationships.

Diversification, portfolio limits, and provisioning are principal means of managing agricultural credit risk

Transfer instruments (guarantee funds, insurance, securitization etc.) not widely used or available.

Continued

Some minimal economies of scale seem to be necessary in absence of more modern risk transfer instruments. Implications Smaller institutions with rural vocation have to grow

rapidly, emphasizing non-farm lending. Mergers of small rural institutions should be encouraged. Donors and policymakers should target larger institutions to

provide rural financial services. Will be difficult entice urban institutions due to high perceived risks, lack of robust risk mgmt. instruments, lack of appropriately trained staff, and and more attractive risk-return profile of the consumer lending market.

Continued

Agricultural microfinance has expanded the frontier but is limited.

Longer term options needed and desired. Interest rates are very high probably surpassing average rates for

more agricultural activities. Specialized and more commercially–oriented small and medium sized

agricultural producers seem to be disadvantaged due to lender preference for diversified households. However, they could benefit if the lender adopts a value chain approach.

Need to introduce more project-centered, yet economical, types of loan appraisal appropriate for larger sized agricultural loans.

Urgently need to introduce more robust and modern risk management instruments combined with delivery systems that lower operational costs.