maximizing efficiency in microfinance: the path to ......to help microfinance institutions (mfis)...

Maximizing Efficiency in Microfinance: The Path to Enhanced Outreach and

Sustainability

Monica Brand

ACCION International

and

Julie Gerschick Strategic Solutions

September 2000 Washington, DC

iii

TABLE OF CONTENTS

AUTHORS............................................................................................. IX PREFACE .............................................................................................. XI ATTRIBUTIONS ................................................................................... XII APPROACHES TO THE TEXT ...............................................................XIII LIST OF ACRONYMS...........................................................................XIV

Chapter One Efficiency: The New Industry Barrier ..................................................1

HISTORY: OLD TRICKS OF THE TRADE..................................................5 Methodology .....................................................................................5 Markets..............................................................................................8 Impact of the Development Context .................................................9

NEW REALITIES: THE COMMERCIALIZATION OF MICROFINANCE.......11 Methodology ...................................................................................14 Markets............................................................................................20 Impact of the Development Context ...............................................22

THE CALLING: STRATEGIC AND SOCIAL IMPLICATIONS OF EFFICIENCY ....................28

Financial Viability...........................................................................28 Competitive Advantage...................................................................29 Market Penetration ..........................................................................30

OVERVIEW OF THE MONOGRAPH ........................................................30 Chapter Two Understanding and Measuring Efficiency ..........................................33

ANALYZING THE PROBLEM .................................................................36 LEVELS OF ANALYSIS..........................................................................39

Institutional .....................................................................................39 Division ...........................................................................................40 Products and Services......................................................................41 Customer and Customer Types .......................................................43

TYPES OF ANALYSIS............................................................................43 Life Cycle Analysis.........................................................................44 ROA Analysis: The Microfinance Efficiency Ratio .......................47 Portfolio Yield.................................................................................56 Bank Efficiency Ratio .....................................................................57

COST AND REVENUE ALLOCATION .....................................................60 Differentiating Costs .......................................................................61

iv

Degree of Allocation .......................................................................64 Allocation Methodology .................................................................68

BENCHMARKS......................................................................................76 Chapter Three Improving Efficiency: Alignment Theory ...........................................81

ALIGNMENT THEORY ..........................................................................84 Areas of Alignment .........................................................................84 Profitable Delivery of Products and Services..................................85 Centrality of Mission.......................................................................86

OVERARCHING STRATEGY ..................................................................88 Organizational Culture ....................................................................88 Customer Orientation ......................................................................89 Strategy ...........................................................................................94 Leadership .......................................................................................95

TOTAL PRODUCT .................................................................................97 Client-Focused Products .................................................................97 Pricing ...........................................................................................106 Risk Management..........................................................................111 Delivery Channels .........................................................................113

INTERNAL SYSTEMS ..........................................................................116 Guiding Principles.........................................................................117 Organizational Structure ...............................................................122 Processes .......................................................................................126 Human Resources..........................................................................135 Technology....................................................................................141

CONCLUSION .....................................................................................146 Chapter Four Reengineering the MFI .......................................................................147

ACCION NEW YORK........................................................................151 The Pre-Reengineering Scenario...................................................151 The Reengineering ProcessPhase I............................................153 Summary of ResultsPhase I.......................................................158 The Reengineering Process—Phase II ..........................................161

BANCOSOL ........................................................................................162 The Pre-Reengineering Scenario...................................................162 The Reengineering Process ...........................................................164 Summary of Results ......................................................................166

MIBANCO...........................................................................................168 The Pre-Reengineering Scenario...................................................168

v

The Reengineering Process ...........................................................169 Summary of Results ......................................................................173

CONCLUSION .....................................................................................174 Chapter Five Conclusion............................................................................................175

TENETS NO LONGER TRIED AND TRUE .............................................178 Customer Focus.............................................................................178 Average Loan Size ........................................................................178 Differentiated Pricing and Products ..............................................179 Net Contribution............................................................................179 Intentionality .................................................................................180 Redefining Commercialization .....................................................181

REENGINEERING: WHERE TO BEGIN .................................................182 Diagnose the Problem ...................................................................182 Seek Outside Assistance................................................................182 Identify Bold Decision-Makers .....................................................183 Focus on Results............................................................................184

INSTITUTIONAL IMPLICATIONS: LEADERSHIP ...................................184 AREAS FOR FURTHER STUDY ............................................................185

Savings ..........................................................................................185 Marketing ......................................................................................187 Technology....................................................................................188 Institutional Structure....................................................................189 (De)Centralization.........................................................................190 Staff Specialization .......................................................................190 Risk Analysis ................................................................................191

Appendix A Component ROA Analysis..................................................................193

OVERALL RETURN ANALYSIS ...........................................................195 ROE Breakdown ...........................................................................195 Funding Costs and Leverage .........................................................196

ROA: PRODUCTIVE, FINANCIAL, AND NONPRODUCTIVE ASSETS....197 Return on Loan Portfolio...............................................................198 Return on Investments...................................................................198 Return on Nonproductive Assets...................................................198

OPERATING EXPENSE ANALYSIS.......................................................199 Headquarters vs. Branch Expenses ...............................................200 Loan Officer Expense....................................................................201

CONCLUSION .....................................................................................202

vi

Appendix B Process Change Approaches ..............................................................205

CONTINUOUS IMPROVEMENTINCREMENTAL CHANGE..................207 TOTAL QUALITY MANAGEMENTMODERATE CHANGE .................209 PROCESS REENGINEERINGRADICAL CHANGE...............................210 COMPARISON OF BUSINESS IMPROVEMENT APPROACHES................212

Does Business Improvement Equal Job Loss?..............................214 SELECTING AN APPROACH ................................................................214

Pragmatism and Results Orientation .............................................214 Magnitude and Breadth of Change Required ................................216 Impetus for Change .......................................................................217 Organizational Capacity for Change .............................................218 Strength of Leadership ..................................................................219 Time and Resources Available for Change...................................220

Appendix C Reengineering Basics ..........................................................................223

UNDERTAKING ORGANIZATIONAL CHANGE .....................................226 Establishing a Sense of Urgency...................................................226 Forming a Powerful Guiding Coalition.........................................226 Creating a Vision...........................................................................227 Communicating the Vision............................................................227 Defining and Measuring Reengineering Success..........................229 Creating a Successful Analytical Approach..................................229 Empowering Others to Act on the Vision .....................................232 Planning for and Creating Short-Term Wins ................................234 Consolidating Improvements ........................................................235 Institutionalizing New Approaches...............................................235

Bibliography..........................................................................................237

vii

LIST OF TABLES

Table 1: Average Loan Size and Profitability .........................................23 Table 2: Levels and Types of Financial Analysis ...................................38 Table 3: Analysis of Cross-Subsidization and Portfolio Mix (in US$)...42 Table 4: Comparative MFI Efficiency Ratios .........................................59 Table 5: Conventional Cost Objects........................................................61 Table 6: Cost Control vs. Net Profit Contribution ..................................66 Table 7: Common Financial Analysis Systems.......................................74 Table 8: Comparative Financial Cost Analyses – Loan Originations .....75 Table 9: Factors Affecting Performance Levels......................................77 Table 10: Product Differentiation–An Example ...................................101 Table 11: Product Variation and Efficiency Impact..............................102 Table 12: Change in Cash-Flow Analysis.............................................130 Table 13: ACCION New York—Lending Process Changes ................155 Table 14: ACCION New York Phase I Reengineering Results ............159 Table 15: Mibanco’s Standardized Branch Staffing Requirements ......170 Table 16: Mibanco Reengineering Results ...........................................173 Table 17: Asset Composition Analysis .................................................197 Table 18: Margin Breakdown ...............................................................199 Table 19: ROA Efficiency Drivers........................................................202 Table 20: Business Improvement Comparison .....................................213 Table 21: Comparison of Activity-Centered and Results-Driven

Programs ...............................................................................215

viii

LIST OF FIGURES

Figure 1: Cost vs. Risk Trade-Off ...........................................................14 Figure 2: Economies of ScaleACCION Affiliates ..............................24 Figure 3: Economies of ScaleLatin America and Asia .......................27 Figure 4: Life Cycle of a Loan................................................................46 Figure 5: Life Cycle of a Deposit............................................................46 Figure 6: Cross-Country Comparisons of Loan Size ..............................51 Figure 7: Alignment of Key MFI Elements ............................................85 Figure 8: Mission Alignment with Overarching Strategy .......................88 Figure 9: Entity-Wide Customer Orientation..........................................94 Figure 10: Mission Alignment with Total Product .................................97 Figure 11: Mission Alignment with Internal Systems...........................117 Figure 12: Life Cycle of a Loan – Conversion Efficiency ....................127 Figure 13: Credit Scoring Decision Bell Curve ....................................131 Figure 14: ACCION New York Pre-Reengineering

Organizational Chart..........................................................152 Figure 15: ACCION New York Post-Reengineering

Organizational Chart..........................................................158 Figure 16: BancoSol Pre-Reengineering Organizational Chart ............167 Figure 17: BancoSol Post-Reengineering Organizational Chart...........167 Figure 18: Example of Operating Cost Breakdown for an

Efficient MFI .....................................................................200 Figure 19: ROA Analysis......................................................................203 Figure 20: The Process Change Continuum..........................................207 Figure 21: Growth and Infrastructure Gap............................................217 Figure 22: The Clean-Slate Approach...................................................230

ix

AUTHORS

Monica Brand is Senior Director of Research and Development for ACCION International, which focuses on innovations in the field of microfinance. Both her technical assistance work and field research are in the areas of new product development, marketing and business process improvements for commercially oriented microfinance institutions. Prior to joining ACCION, Ms. Brand worked for the Development Fund in San Francisco, helping design and launch a $50 million statewide lending intermediary to finance small business and community facilities. She received her credit training as a loan officer for an environmental fund targeting small businesses in northern California. Ms. Brand’s professional experience also includes work in Cape Town, South Africa, where she founded an entrepreneurial training organization for previously disadvantaged small- and medium-size businesses to prepare them for venture capital investment. This business development work built on Ms. Brand’s experience as a trainer for the Women’s Initiative for Self-Employment (WISE), where she assisted female microentrepreneurs in launching their own businesses. Among the publications Ms. Brand has authored include two technical notes on new product development (USAID Microenterprise Best Practices project, www.mip.org) and numerous case studies she wrote while employed at Harvard Business School (www.hbsp.harvard.edu). Ms. Brand received a Masters of Business Administration (MBA) and a Master of Education (MA Ed) from Stanford University and a Bachelor of Arts degree in Economics from Williams College, where she graduated with honors. Ms. Brand, who is half-Peruvian, works in ACCION’S Washington, DC office and lives in the District community of Mt. Pleasant.

x

Julie A. Gerschick is founder and president of Strategic Solutions, a consulting firm providing a wide range of strategic and operational advisory services to microfinanciers, banks, and insurance companies and their leaders. Her client base includes two large organizations active in microfinance internationally and domestically as well as numerous mid-size financial institutions in the United States, Europe, and the Caribbean. Previously a consulting partner with KPMG, Ms. Gerschick has over 20 years’ experience in the financial institutions industry on both the national and international levels. Her work focuses on issues of process redesign, organizational restructuring, strategic planning, leadership and the use of technology to increase efficiency. Ms. Gerschick also has considerable background in divisional, product and customer profitability at both corporate-wide and business unit levels, and has worked as a Managing Director and as Senior Vice President in community banks. She has played key leadership roles in numerous financial institution mergers and acquisitions, initial and secondary stock offerings, and mutual-to-stock conversions and is well-versed in both the regulatory and financial requirements imposed upon the financial institutions industry. A certified public accountant, Ms. Gerschick has developed a database of community bank “best practices,” co-authored two books on the operational implications of major banking bills and served as a fellow to the Board of The Federal Home Loan Bank at the height of the 1980s bank crisis. She holds a business degree from the University of Michigan’s School of Business and two master’s degrees from Harvard University, where she studied international development and economic ethics. Julie Gerschick resides in Andover, Massachusetts, with her husband and two children to whom she is deeply grateful for their love, support and encouragement during the writing of this monograph.

xi

PREFACE

This monograph addresses strategic and operational approaches to maximizing efficiency—utilizing and organizing resources to maximize outreach and revenue generation while minimizing costs. Maximizing Efficiency provides microfinance management, boards of directors, investors, donors and regulators with a framework for measuring and analyzing efficiency. It also provides a framework (which transcends differences in geography, GNP and wage bases) by which microfinance institutions can analyze their mission, strategy, organizational structure, processes, and human and technological resources from an efficiency point of view. The monograph also provides specific examples of efficiency-enhancing strategies, drawing from a mixture of best practices in the field of microfinance internationally and innovations in lending in the United States. To help microfinance institutions (MFIs) implement these changes, Maximizing Efficiency offers guidance regarding the reengineering of organizational structures, processes, and resources. The examples in the monograph cut across different regions in both industrialized and developing countries, though the focus is primarily on credit operations. This emphasis reflects the fact that the majority of MFIs globally are non-regulated institutions that are not permitted to mobilize savings, limiting the number of efficiency-enhancing microfinance savings models from which to draw. Where possible, Maximizing Efficiency applies efficiency frameworks to savings operations, but this application needs further development.1

1 Illustrative works on savings, including Rutherford’s The Poor and Their

Money and Wright’s Microfinance SystemsDesigning Quality Financial Services for the Poor, were published only as this monograph was being finalized.

xii

ATTRIBUTIONS

This monograph was enabled by the generous support of Wallace Global Fund, the US Agency for International Development, Latin American Bureau, and CGAP (through the MicroFinance Network). In addition, the authors would like to thank Robert Christen (CGAP), Anja Lepp (IPC), Damian von Stauffenberg (PSIC), Anita Campion (MFN) and Maria Otero of ACCION International for their thoughtful review of and comments on this work.2 A special thanks goes to Laura Frederick, CEO of EChange, for her work supporting the research on reengineering and business change processes. Sahra Halpern of the MicroFinance Network, the graduate students of Professor Jonathan Morduch of Princeton’s Woodrow Wilson Graduate School and Alexa Brownell of ACCION International also played significant roles in the initial research of case studies from the field. Last but not least, the authors would like to thank Warren Brown, Isabella Kenfield and Patty Lee of ACCION International for their support in the final editing and production of the monograph. In spite of these valuable contributions, this work is the responsibility of the authors and as such, any errors or omissions are their own.

2 The institutions cited are, in order of appearance, Consultative Group to Assist

the Poorest (CGAP); MicroRate, formerly known as Private Sector Initiative Corporation (PSIC); Internationale Projekt Consult GmbH (IPC); and the MicroFinance Network (MFN).

xiii

APPROACHES TO THE TEXT

The monograph offers readers different options for exploration. Divided into five chapters, the monograph’s first two chapters provide important background information. Chapter One provides an overview of the historical and current approaches to efficiency management, while Chapter Two offers key analytical tools for measuring and understanding efficiency. This groundwork is followed by a discussion in Chapter Three of alignment theory, an analytical framework by which to identify specific sources of inefficiency, which is closely integrated with numerous detailed examples of efficiency enhancements employed in all areas of microfinance operations. Given that the majority of efficiency enhancement projects involve some form of organizational change, or reengineering, the detailed efficiency discussion of Chapter Three is followed by examples of three successful MFI reengineering projects in Chapter Four. Chapter Five concludes with a summary of the major ideas of the monograph and outlines areas for further research. For those readers unfamiliar with financial analytical tools (Chapter Two), efficiency strategies (Chapter Three) and process reengineering (Chapter Four), the monograph can be read in the order written, moving from measurement tools to analytical framework to actual experiences of microfinance reengineering. Those readers familiar with tools employed to measure efficiency, such as the ratio analysis and cost allocation techniques presented in Chapter Two, can either skim the chapter or move directly to Chapter Three for the discussion of an analytical framework and specific techniques used to improve efficiency. Appendix A provides a more in-depth treatment of a particular financial (return on asset) analysis that supplements Chapter Two. For those readers unfamiliar with business improvement techniques, Appendix B provides conceptual background on alternative process change approaches, including reengineering, which is exemplified by the cases in Chapter Four. Appendix C provides guidance to those readers interested in how to best structure and implement a reengineering project for long-lasting efficiency gains.

xiv

LIST OF ACRONYMS

ABA Alexandria Business Association (Egypt) ABC Activity-Based Costing ACH Automated Clearinghouse ABM Activity-Based Management ACP Acción Comunitaria del Perú AIG American International Group, Inc. ASA Association for Social Advancement (Bangladesh) ATM Automated Teller Machine BancoSol Banco Solidario S.A. (of Bolivia) BANRURAL Banco Nacional de Crédito Rural (Mexico) BKD Baden Kredit Desa (Indonesia) BRI Bank Rakyat Indonesia Caja Los Andes Caja de Ahorros y Créditos Los Andes (Bolivia) CAMEL Capital Adequacy, Asset Quality, Management,

Earnings, Liquidity Calpiá Financiera Calpiá, S.A. (El Salvador) CGAP Consultative Group to Assist the Poorest CEO Chief Executive Officer CI Continuous Improvement CMAC Caja Municipal de Ahorros y Crédito de Arequipa

(Perú) Finamerica Financiera América, S.A. (Colombia) FUCAC Federación Uruguaya de Cooperativas de Ahorro y

Crédito GDP Gross Domestic Product GIRAFE Gouvernance et processus de décision; Information et

outils de gestion; Risques et controle interne; Activités et portfeulle de prets; Financement: Dettes et Fonds Propres; Efficacité et rentabilité

GNP Gross National Product IPC Internationale Projekt Consult GmbH IT Information Technology KPI Key Performance Indicator KPOSB Kenya Post Office Savings Bank KUPEDES Kredit Umum Pedesaan LPO Loan Production Office MFI Microfinance Institution MIS Management Information Systems

xv

NIS Newly Industrialized States NGO Nongovernmental Organization PDA Personal Digital Assistant PEARLS Protection, Effective financial structure, Asset quality,

Rates of return and cost, Liquidity, Signs of growth PIC Proceso Integral de Cargo PR Process Reengineering PSIC Private Sector Initiatives Corporation ROA Return on Assets ROE Return of Equity TQM Total Quality Management WAN Wide-Area Network USAID United States Agency for International Development WISE Women’s Initiative for Self-Employment WOCCU World Council of Credit Unions WWB Women’s World Banking

CHAPTER ONE

EFFICIENCY: THE NEW INDUSTRY BARRIER

3

The continued commercialization of the microfinance industry and the market forces it has unleashed are powerfully impacting the field and the priorities of the relevant players. More specifically, increased competition (in terms of number of institutions and range of services provided), discriminating customers, growth and institutional development demands, regulation (ranging from reporting requirements to usury laws) and donor fatigue are placing new pressures on microfinance institutions (MFIs). The number of institutions serving the once-neglected microfinance market is increasing, as is the quantity and sophistication of clients served. Neither competitors nor knowledgeable customers tolerate complacency. So while the majority of MFIs still enjoy oligopoly-like control of their local markets and enthusiastic donor support, the explosive growth of the fieldin terms of existing portfolios, increased competition and new, more demanding stakeholdersis forcing MFIs to think differently about efficiency. Whereas before growth was driven by methodological breakthroughs—including different lending strategies (individual vs. group) and institutional transformation (bank vs. NGO)−continued expansion will require other types of operational and strategic innovations to maximize efficiency—to get more “bang for the buck.” This monograph analyzes how these trends are influencing MFIs and their key stakeholders to better understand costs and their relation to income in order to develop strategies to improve efficiency. MFIs must better leverage their scarce resources to survive—let alone succeed. This pressure is particularly acute for MFIs operating in market sectors that are highly competitive or particularly challenging to reach (such as poorer clients or rural areas). As a result, efficiency—a measure of how well the available resources are utilized (measured by costs) to maximize output (measured by sales, income, or loan portfolio)—is of

4

critical importance to the field. This monograph helps the reader identify and analyze the factors necessary to maximize efficiency. High levels of operating efficiency in microfinance are unfortunately the exception rather than the rule.3 One of the most heavily weighted ratios in ACCION’s CAMEL analysis,4 the efficiency ratio (measured by total administrative or nonfinancial costs over average loan portfolio) consistently ranks the lowest of the performance measures in the CAMEL rating system. The reason is twofold. First, many MFIs have not fully exploited the minimum economies of scale required to improve efficiency. In addition, many MFIs still operate in noncompetitive environments where there are few pressures to improve efficiency, given that high operating costs often can be covered by charging high interest rates. From a social as well as a financial perspective, however, improving efficiency should be of paramount importance to MFIs. Competition and market saturation, which invariably increase over time, will prevent many MFIs from charging undifferentiated, high interest rates in perpetuity. For inefficient MFIs facing these conditions, the only way to maintain self-sufficiency is via larger loans, which are typically not well-suited to lower market segments and thus may conflict with the desired social mission. In short, efficiency is critical for an MFI to remain agile, competitive and responsive to customer needs. Yet in spite of the compelling reasons, most MFIs have not adopted some of the basic operating principles that maximize efficiency. To understand why, MFIs must examine the context within which microfinance originated and within which it is currently operating.

3 ACCION International considers “high” levels of efficiency as operating

expenses (which exclude financial and loan loss expense and include adjustments for inflation and subsidies) that are less than 20% of adjusted average loan portfolio. See Saltzman and Salinger, p. 82.

4 ACCION International conducts CAMEL evaluations (based on a similarly named assessment tool developed by US bank regulators) to assess the financial and managerial soundness of its microfinance affiliates in Latin America.

5

HISTORY: OLD TRICKS OF THE TRADE

A few leading MFIs have mastered some of the elements of efficiency, such as incentive-based pay, streamlined decision-making and automated (or just simplified) lending processes. These best practices are no longer particularly revolutionary and have been well-documented, though perhaps not well-disseminated. The difficulty is that inefficiency has less to do with methodological “breakthroughs” in terms of lending practices than it does with organizational culture and strategic orientation. While there was a compelling, appropriate rationale in the early design of many microfinance methodologies, the landscape within which microfinance was born fostered a governing paradigm that was not commercially oriented toward maximizing revenues and reducing costs. Some of the long adhered-to fundamental truths of microfinance were allowed by the monopoly-like conditions that MFIs faced when they began. While most of these beliefs—such as zero tolerance of risk, undifferentiated lending methodology and pricing, subsidized credit and paternalistic lending practiceswere appropriate for the undeveloped environment, others were based on assumptions about how microfinance markets work that no longer apply. Thus, monopoly-like control of their markets and the cushion of subsidized support shielded MFIs from evidence that might have contradicted these core principles, which are less appropriate (and sometimes invalid) in today’s market conditions. Yet even though the market environment has changed, the old assumptions—related to methodology, markets and development impact−have been retained and ingrained through years of operations.

METHODOLOGY

Early difficulties with efficiency arose in part from rigidities in the methodology. These rigidities were necessary in the beginning, when microfinance was just entering the market. Zero Tolerance of Risks The first MFIs made primarily character-based loans to clients without traditional forms of collateral in markets that lacked centralized information systems for credit analysis. In addition, MFIs were battling the conventionally held belief that the poor were unable or unwilling to

6

repay debt. In response, MFIs were intent on demonstrating the possibility of creating high-quality portfolios in these marginal markets. This demonstration effect was particularly important in response to early, inexperienced MFIs that suffered incredibly high rates of delinquency. In fact, these negative experiences with delinquency demonstrated how dangerous late repayment wasnot only because of the financial and operating costs associated with potential loan loss, but because it was contagious.5 Lax treatment of delinquent borrowers sent signals to otherwise diligent borrowers that there was no downside to late payment, eroding portfolio quality. Accordingly, early microfinance players adopted what Elisabeth Rhyne calls a “zero tolerance” policy towards risk since the loans were unsecured and borrowers lacked credit histories.6 This risk-averse approach required heavy emphasis on detailed credit applications, loan use verification and indiscriminate assiduousness on any delinquency—an approach that increased costs in order to minimize risk. Risk control also led practitioners to focus on financing business needs (such as small equipment or livestock, bulk purchases of raw materials and other working capital) rather than consumption activities, because in the latter case, the loan proceeds did not fund additional capacity to repay. Additionally, this zero tolerance of risk resulted in inflexible loan products and an indiscriminate breadth of underwriting. Inflexible Products The early focus on risk control led to the acceptance among many MFIs of step lending as a key component of most microfinance methodologies, especially group-based methodologies. The premise behind step lending was that loan amounts to first-time borrowers would be kept artificially low (less than the borrower’s capacity or willingness to repay) to minimize exposure to losses. This graduated process was a good way for the MFI to test the borrower’s inclination to repay and for the borrower to become gradually more comfortable managing larger loans. Theoretically, as their enterprises grew, borrowers could take out successively higher loans with prompt repayment of these quickly revolving credits, building in an incentive for timely repayment. In practice, however, loan amounts were defined by methodology and were

5 Stearns, p. 34. 6 “Competition and Regulation: A Critical Interface.”

7

not always directly correlated to the cash-flow capacities of the borrowers. Step lending required a large upfront investment in underwriting costs—which were not typically recouped with revenues on the initial loanin the hopes that this initial shortfall would be made up via the income earned on subsequent loans.7 This loss-leader strategy was based on four important assumptions:

� High retention of clients that allowed for cost recovery over the life

of the relationship. � Cost of renewals that was lower than initial underwriting costs. � High correlation between growth of the microenterprise income and

the loan increments. � A corresponding increase in the financial needs and literacy of the

client.

Little in-depth analysis was done to carefully differentiate the relative costs, risks and the appropriate level of underwriting for each successive loan cycle. To be fair, this standardization of the loan methodology was done to streamline the underwriting process. However, this “one size fits all” approach to microlending left some clients’ financial needs poorly satisfied by the relatively narrow range of products. Undifferentiated Underwriting MFIs adroitly developed underwriting practices appropriate for microenterprises, in response to both the lack of credit information and formal guarantees of most microborrowers and the fungibility of money (the difficulty of linking specific funds to uses). Typical microfinance loan analysis married aspects of consumer lending, with its emphasis on the combined business and household net income, with aspects of business lending and traditional cash-flow analysis, with an enhanced non-quantitative assessment of character. Other aspects of business lending, including reliance on business plans, projected cash flow and collateral were generally abandoned due to a lack of availability. However, many cost-intensive aspects of business underwriting—such as loan use verification and detailed analysis of business income and

7 Many MFIs price based on average vs. marginal costs, assuming a certain

number of repeat loans, meaning that they do not break even until the fourth or fifth loan taken out by a client.

8

expenses—were widely incorporated into microlending methodologies for most, if not all, borrowers, regardless of type of collateral or strength of available guarantees. This union of cash-flow analysis and character-based underwriting, applied fairly consistently to all loans regardless of size or risk or use of funds, significantly increased the costs to underwrite such loans. Even as efficiency pressures began to surface, most MFIs were reluctant to reevaluate the balance between high underwriting costs and tight risk control procedures because of the fear of increased delinquency and losses. Moreover, most MFIs were still looking at their clients unilaterally as “microenterprises,” not differentiating their financial products by type of use (consumer vs. business expense), market segment (market traders vs. manufacturers) or available guarantees (household salaries or jewelry vs. strictly social collateral).

MARKETS

The prioritization of risk over cost was fostered by deeply held beliefs about microfinance markets: namely that in most markets demand was inelastic (not interest-rate sensitive) and that subsidized capital was required for institutional development and expansion.

Inelastic Demand and Interest Rates Inelastic demand implied that the customer was relatively impervious to interest rates charged. To repeat an industry maxim, access to capital rather than the cost of capital was the key issue for microentrepreneurs. Indeed, clients tolerated above-market interest rates and narrow product types—as well as cumbersome applications and bureaucratic approval processes—when they had no choice. Admittedly, most of the thousands of MFIs operating around the world still face little competition, creating what Robert Christen labeled the “yellow pajamas” syndrome. “If an MFI announced that it would offer credit to any microentrepreneurs wearing yellow pajamas, the next morning there would be a line of pajama-wearing borrowers waiting outside its branch.”8 Because demand far exceeded supply, borrowers historically had to comply with whatever products and requirements the MFI put forth. Thus, with monopoly control of markets, early players had little external pressure to control

8 Brand, New Product Development for Microfinance: Evaluation and

Preparation, p. 3.

9

costs because they could cover, literally and figuratively, their inefficiencies with high interest rates. Ongoing Subsidies The abundance of “soft” money from subsidized sources also allowed these inefficiencies to continue by inhibiting competition and hiding organizational bureaucracy. Initially, MFIs used subsidized credit to keep interest rates low to please clients and deter competitors. With little competition and better understanding of their clients’ capacity to pay, MFIs steadily increased interest rates to achieve self-sufficiency. Yet even when MFIs began pricing their products with an eye toward break-even, efficiency did not always improve. With continued access to below-market funds, MFIs could maintain high financial margins (including both interest and fee income) to cover administrative costs. Thus the presence of subsidies—often an implicit signal to conventional banks that the market was not profitable—became a self-fulfilling prophecy for many MFIs in the early years of microfinance. The oft-stated rationale for subsidized funding was (and continues to be) the need to build the institutional capacity required for growth. Though donors initially viewed subsidies as a short-term infusion for capacity-building until an MFI reached self-sufficiency, most MFIs enjoyed ongoing support. The demands of institutional growth served as justification for continuing subsidies, especially for hard-to-reach clients (such as the “poorest of the poor”) and markets (such as rural areas). Because microfinance has been a philanthropic favorite for quite some time, there has been little incentive for MFIs to improve efficiency until the recent onset of competition.

IMPACT OF THE DEVELOPMENT CONTEXT That microfinance was born in a development, rather than a commercial, context helped frame the industry’s priorities. The main goal of practitioners in the late 1970s and early 1980s was to impact the lives of poor people, assisting them to advance out of poverty. Outreach, as measured by scale of operations, emerged as a priority in the late 1980s.9 This goal, however, was to serve as many people as possiblenot cost control. Some MFIs believed (and continue to believe) that it was

9 Otero, Breaking Through, p. 16.

10

inappropriate to measure their success in terms of costs, pointing instead to non-quantifiable gains such as education and empowerment. This mission “frame” meant that most MFIs thought of themselves as development organizations rather than “financial intermediaries.”10 Even when the industry began comparing microfinance to other types of financial intervention in the late 1990s, social indicators, rather than benchmarks used by conventional financial institutions, still carried heavy weight. This socially driven approach resulted in an emphasis on the individual “beneficiary” of small average balance loans, even though they were generally expensive to underwrite. Moreover, the focus on business credit and loan size as proxies of social impact put undue emphasis on methodology and product features, diverting attention from how effectively resources were being used to achieve desired outcomes. “Beneficiaries” vs. Customers Initially, microfinance was treated as one of a host of development-oriented services offered to the poor, rather than a business product offered to a purchasing customer. Early practitioners, almost all of which were philanthropic nongovernmental organizations (NGOs), were interested in helping improve the lives of poor microentrepreneurs. The “beneficiaries” of these programs were the self-employed poor (as distinguished from the subsistence poor) who were offered business credit to build assets, rather than consumer loans, which were believed to deplete a poor person’s economic base.11 Many programs included the provision of both credit and technical assistance because most of the beneficiaries had limited education or vocational training. This training was important to promote client “graduation” from the institution, to promote the self-reliance (vs. dependency) of the beneficiaries and to free the institution (which had limited loan capital) to serve new clients.12 At this early stage of the industry, microfinance was seen as part of a host of services provided to the poor by donor-funded NGOs, staffed by social workers and development experts with no specialization in business or credit, and with only cursory concern for cost control.13

10 Rhyne and Christen, pp. 1-2. 11 Holtmann and Mommartz, p. 15. 12 Otero, The Solidarity Group Concept, p. 55. 13 Drake and Otero, p. 43.

11

Measuring Impact Initially, the focus of the MFI’s attention was on the effect on individual lives. This was measured by the economic and social impact of the programs, as determined by changes in income and asset levels of borrowers, growth of the enterprise, employment generation and qualitative indicators (such as attitudes and family well-being).14 Scale (in terms of number of active clients) was initially resisted, for fear it would dilute the impact on each beneficiary and contradict the ultimate goal of client graduation. Limited client volumes and small average loan sizes were counter to efficiency. As the industry evolved, the focus on impact fueled the push for increased scale in anticipation of broader outreach and lower costs to compensate for the low average loan size. While MFIs were indeed able to take advantage of economies of scale, there were limits to the efficiency gains attainable through growth (as explained in the “Limited Scale Economies” section below). Moreover, for loans that were unprofitable on a stand-alone basis, making more loans did little to improve self-sufficiency. For many MFIs, therefore, this push for scale has actually exacerbated the situation by building upon and reinforcing inefficiencies embedded in the institutions. Today, scale remains the hallmark measure of impact, and as such, portfolio volume is used to justify high cost structures. Many MFIs count on potential sales growth to achieve cost savings that are perceived to be accompanied by economies of scale, and blame inefficiency on a lack of loan volume. Too often, however, the true culprit is not a lack of scale, but rather inefficient processes and systems, high cost structures, and inappropriate delivery channels and products.

NEW REALITIES: THE COMMERCIALIZATION OF MICROFINANCE

The field has evolved considerably since the 1970s, forcing MFIs to reexamine these assumptions and think differently about efficiency. Certainly the microfinance field can boast some success in terms of understanding efficiency and questioning what was once doctrinaire.

14 Otero, A Question of Impact, pp. 32-33.

12

Indeed, almost three-fifths of the more than 100 institutions tracked by the MicroBanking Bulletin15 are financially self-sufficient.16 In fact, the very success of the market leaderswhich have demonstrated that microfinance can make both an impact and a profit—has helped spur the commercialization of the field, characterized by the significant market changes described below.17 � New Players: A combination of sustained returns, large and

untapped market potential, and demonstrated impact has attracted new players onto the microfinance field. In particular, the demonstrated impact has prompted donors, with a desire to serve heretofore undeveloped markets and an increased understanding of the power of microfinance, to create new NGOs, fueling the industry’s growth. In addition, the sustained returns realized by some and the breadth of the untapped market have introduced a distinct new group to the field: conventional financial institutions motivated primarily by profits. Entering the field with established branch infrastructures, surplus resources, brand name recognition and skilled staff, these institutions represent potent competition for even the most commercially oriented MFIs. The universe of conventional financial institutions serving microenterprisesincluding both MFIs that have transformed from NGOs into regulated financial intermediaries and banks moving down-marketis small and is still the exception, rather than the rule. Still, in most microfinance markets, competition is increasing, not decreasing, making efficiency, according to Marguerite Robinson, a critical factor in deciding which institutions will survive.18

� Discriminating Customers: Most MFIs with established track

records have learned from experience and become adept players as they have institutionalized the once informal market for financial

15 The MicroBanking Bulletin is a biannual publication that collects financial

and portfolio data on a broad array of MFIs operating globally, organizing and reporting the data by peer group.

16 MicroBanking Bulletin Issue no. 4, p. 1. The financial (vs. operational) self-sufficiency ratio measures an MFI’s ability to cover its costs with internally generated revenues, adjusting for the impact of subsidized funds and inflation.

17 Brand, New Product Development for Microfinance: Evaluation and Preparation, pp. 1-2. The commercialization of microfinance is taking place in different markets globally, but the trends are most visible in Latin America.

18 Oberdorf, p. 96.

13

services. Similarly, microentrepreneurs have benefited from the continued presence and growth of MFIs and also have gained business savvy as the field has become more formalized. In other words, just as the quality of underwriting improves at some MFIs as their portfolios increase, the financial sophistication and product and service demands of their clients increase as their enterprises grow. Repeat clients have leverage over the MFI because they are valuable in that they typically represent lower costs and high revenues and they have choice due to increased competition. As such, clients of MFIs have become more discerning about product, pricing and servicing demands as they build a credit history.19

� Increased Accountability: The commercialization of the

microfinance market has brought new stakeholders to the tableincluding regulators, more sophisticated investors and market-driven boards of directors—who demand strong financial performance. The transformation of NGOs and the more recent entry of commercial banks into microfinance have led to an increase in formal supervision, with its corresponding increase in regulatory requirements. Some of this regulation—such as usury laws that establish interest rate maximums and consumer protection that makes it difficult to recover payment and collateral from bad debtors—seriously inhibits profitability and makes efficiency all the more crucial. Investors in these regulated MFIs also impose demands for financial soundness and prudent lending practices, especially those who have put their money at risk with the expectation of profitable returns on their investments. For example, investors in ProFund International often require MFIs in its investment portfolio that hold monopoly positions in their respective markets to charge market rates of interest, despite the potential forgone earnings, “because inflated prices attract competitors and can mask operating inefficiencies.”20

The entrance of new entities, more sophisticated borrowers and more demanding stakeholders has altered the microfinance environment and thus, the assumptions under which early practitioners operated. As a result, the market evolution brought about by the commercialization of microfinance requires a shift in how those in the field think about 19 Rhyne and Christen, p. 19. 20 ProFund is a specialized for-profit fund that makes equity investments in

leading MFIs.

14

MFIs

Money- lenders

Underwriting & Collections

Costs

Low

High

High Low Portfolio Risk

efficiency, risk management, lending methodology, product development and pricing, and development impact. Some of this shift has taken place, though the field as a whole still needs to progress further to adopt an “efficiency paradigm,” as described in the Methodology section below.

METHODOLOGY Reanalyzing Risk Tolerance To date, the industry has incurred unlimited collection costs in pursuit of very low loss rates. Maintaining high portfolio quality is critical to an MFI’s viability. Delinquency spreads quickly, eroding an MFI’s asset value and increasing expenses. These expenses include both financial (e.g., provisioning expenses that cover anticipated lost principal, interest and fees in the case of default) and operational (e.g., increased staff effort required for collection). In this respect, there is indeed a strong relationship between cost and risk, especially when compared to moneylenders, as is illustrated in Figure 1.

Figure 1: Cost vs. Risk Trade-Off

MFIs spend more in underwriting because, unlike moneylenders, they are interested in how their loans are used—either for impact reasons or as a source of repayment (productive vs. consumption purposes). As a result, MFIs tolerate less risk than moneylenders, who recover their higher risk and any associated losses through loan volume, streamlined lending operations and very high interest rates.21

21 Christen, What Microenterprise Credit Programs Can Learn From the

Moneylenders, p. 15. Regulated MFIs also have strong delinquency controls imposed upon them by superintendencies, which become very nervous when portfolio quality declines.

15

However, there is strong evidence from both conventional lenders and informal finance that suggests MFIs need to revisit the cost-benefit of this trade-off. First, it is not clear that the marginal costs incurred in assiduous, ongoing follow-up are rewarded dollar for dollar with stellar portfolio quality. For example, a review of 50 CAMELs performed on 11 ACCION affiliates found no correlation between loan delinquency and operating efficiency.22 Part of this finding illustrates that successful MFIs use methods besides stringent loan application procedures and monitoring to control delinquency. For example, that same study found a positive correlation between the rate of client retention and levels of efficiency.23 Client retention strategies, such as differential pricing and targeted services, can reduce delinquency without increasing operating expenses, and sometimes even reduce costs. In addition, many of the best delinquency management strategies are the most cost-effective—such as swift and stern follow-up on the first signs of delinquency, payment incentives (e.g., rebates for on-time repayment) and low-cost, negative reinforcement (e.g., peer pressure or late fees). Still, the delinquency control mechanisms that most MFIs use are blunt and are applied indiscriminately to all clients regardless of their risk profile. For example, most microfinance lending methodologies put a high priority on personal contact and extensive follow-up, for both new clients and repeat borrowers, to control delinquency independent of the costs incurred. While follow-up is critical to maintain pressure on the borrower for on-time repayment, MFIs rarely differentiate the type or target of delinquency controls based on the risk profiles of different clients. Similarly, a few MFIs still verify loan use for borrowers even though its impact, due to the fungibility of money, is unproven in terms of reducing delinquency. As a result, many MFIs have been working harder, but not smarter, in managing risk. Only recently have MFIs begun to thoughtfully analyze which underwriting and delinquency management strategies yield the greatest return on investment.24

22 Saltzman, Rock and Salinger, p. 58. 23 Castello, “ACCION CAMEL: Lessons Learned and Challenges.” 24 These “smarter” (cost-effective) underwriting and delinquency management

strategies are outlined in Chapter Three.

16

Step Lending Revisited Many of the assumptions—including client retention, low-cost renewals, growth of business and needs—that underlay step lending methodologies proved unreliable over time. Part of this increased client desertion was due to mismatches between product types and terms offered and borrower needs, or interruptions in the client’s need for increased funding. This lack of understanding of borrower’s evolving needs and consequent product adjustments often resulted in higher delinquencies, especially in highly competitive markets where over-indebtedness reigned. Moreover, the increase in competitive alternatives as the industry has matured has led to voluntary client desertion, which has disrupted the cost-recovery strategy implicit in step lending. Even those MFIs with high client retention have not recouped their gains in step lending because renewal processes have not yet been reviewed thoroughly for the possibility of further streamlining and thus, further efficiency. Recent activity-based costing studies reveal that the costs of lending are concentrated in the process of repayment, which marginalizes the savings impact of streamlined applications for repeat borrowers.25 These costly renewal processes are not allowing MFIs to exploit the efficiency gains possible through high client retention.26 As a result, the analysis of costs incurred during the loan renewal process and other stages of the life cycle, including payment processing and marketing, provides a key opportunity for efficiency improvements. In other words, careful examination of the life cycle of the loan would suggest that MFIs should streamline the collection process as well as underwriting to realize the best cost savings.27 To be clear, “streamlining” collections refers to less frequent payments for borrowers with strong credit histories—not delayed or lax response to delinquency, which has a significant impact on both efficiency and risk. Moreover, experience with microfinance in the US suggests that efforts to

25 Gheen, Jaramillo and Pazmino, p. 5. 26 MicroRate data reveals a strong correlation both between client retention and

efficiency, as well as desertion and relatively high operating expense ratios. 27 It should be noted that for those MFIs that do not materially differentiate the

application and approval procedures for new loans and renewals, there may very well be efficiency gains to streamlining the underwriting process for repeat clients.

17

streamline underwriting of loan renewals may have actually increased costs because of losses due to insufficient credit analysis.28 To clarify, step lending and other standardized lending methodologies may be very appropriate for MFIs facing new, uncontested markets or serving the smallest, rapidly growing segments where institutional self-sufficiency is predicated on rapid scale-up of operations. However as an MFI matures, step lending, on its own, is typically not a subtle enough methodology to identify and maximize efficiency. Rather, as discussed in depth in Chapter Three, one must differentiate underwriting procedures for different loan products and examine each stage of the loan cycle individually to maximize opportunities for efficiency.

Product Design and Client Segmentation Increasing sophistication regarding the needs and risk profiles of different market niches and client segments has illustrated how undifferentiated underwriting can undermine efficiency. Weak reliability of financial information and the external shocks that regularly disrupt income flows of the poor make in-depth cash-flow analysis imprudent. While it is important for MFIs to determine repayment capacities, especially for first-time borrowers, to help prevent over-indebtedness, this analysis need not be lengthy or expensive. Moreover, for more established clients with assets, many MFIs offer a quick credit product lent primarily on the basis of guarantee type, with only cursory, if any, cash-flow analysis. To meet clients’ demand for a greater range of products for both business (working capital, fixed asset, lines of credit, etc.) and consumer needs (short-term liquidity, education, dowry loans, etc.) while maximizing efficiency, underwriting practices must be more highly differentiated. Traditional means of analyzing microenterprise risk are generally inappropriate for a short-term liquidity loan or any consumer loan.29 As a result, more sophisticated MFIs are beginning to develop distinct prices, collateral requirements and underwriting criteria for different types of

28 In the US context, loan increases called for by step lending methodology did

not always parallel growth in the borrower’s business income or technical (financial) literacy, often resulting in default of the increased loan.

29 A “consumer loan” has next to nothing to do with how the loan is used. A lender of consumer credit cares exclusively about the nature of the collateral, and cares little whether the loan is used for working capital or to buy groceries.

18

credit and market segments. Because of this experience, microlenders are learning that the portfolio risk of consumer credit, primarily because of the nature of collateral taken, is not necessarily significantly greater than for business credit.30 For example, some microfinance consumer loans—such as the pawn loans offered by Caja Municipal de Ahorro y Crédito of Arequipa, Peru or Banco Solidario de Ecuador—have a lower default rate, smaller average loan sizes and lower costs than their products targeted at microenterprises.31 Moreover, as discussed in Chapter Three, MFIs must continue this differentiation of risk at the portfolio level, making sure loans are diversified across industry sectors and geography, to maximize revenue generation while managing the risk of loss. The key point is not that all MFIs should diversify their portfolio just to develop new products, regardless of the specific nature and needs of their target market. Indeed, consumer credit goes haywire if lenders abandon their traditional collateral requirements under the pressure of competition, as illustrated in the Bolivian case example elaborated in the box on the next page.32 Rather, the lesson here is that MFIs must begin to differentiate the analysis of different types of loans and distinct client segments based on the cost/benefit trade-off and risk profile for each.

30 While arrears in consumer credit, which is traditionally considered salary-

based lending, are typically greater than enterprise credit, losses are not higher because the collateral is good and easy to collect.

31 Brand, New Product Development Case Studies, p. 44. It is important to note that pawn loans are a tiny niche of the microcredit market (in terms of portfolio volume, rather than number of loans), and thus it is inappropriate to generalize from the experience with them.

32Consumer lenders are more relaxed than MFIs about late payments, because the penalties they charge for delinquency actually increase their overall returns. The threat of maligned credit histories and potential loss of collateral of the borrower strongly reduce the risk of default for the traditional consumer lender.

19

BOLIVIA: THE COMPETITIVE ASSAULT

Recent microfinance practices in Bolivia provide an example of the destructive effects of shortsighted lending practices poorly tailored to the nature of the target market and the risks of certain types of credit. There, the independent entry into the market of consumer credit companies seeking short-term profits resulted in careless lending practices and the massive extension of excessive indebtedness to microenterprise borrowers. These new commercial entrants did not understand the variable nature of a microenterprise’s household income or the reasons for the low tolerance of delinquency in microfinance. As a result, they began offering products that resembled consumer loans (quick disbursement of credit via cursory underwriting with little regard to the state or quality of the business enterprise) without the requisite stable guarantee (salary, secure assets such as jewelry, etc.). Faced with sudden desertion of their clients to the seemingly more attractive competitive offerings, many MFIs responded by loosening their own underwriting standards, offering credit to already indebted clients without fully accounting for their limited capacity to pay. This perilously easy access to credit eroded asset quality for both the consumer lenders and the microfinance institutions, including the market leaders, BancoSol and Caja Los Andes. The delinquency rates (one day late) of both institutions doubled from year-end 1997 to year-end 1998, as the result of the destructive competitive practices of the inexperienced new players. Previously, all MFIs competed intensely and market share shifted without any significant drop in asset quality.

No MFI can be all things to all clients if it is to maximize efficiency. Client segmentation does not suggest that an MFI develop tailored products differentiated to each specific market niche, unless the added revenues from improved customer service more than offset the costs of product development. Moreover, diversification of products should not be confused with standardization of processes, which is critically important to maximizing efficiency. The main point is that productsincluding their pricing and risk controls—must be designed to take into account the characteristics of the target market segments in order to maximize efficiency.

20

MARKETS Interest Rates Matter Access remains more important than price if the reference point is the microfinance industry as a whole. But the picture changes when one begins to differentiate market segments and contexts in microfinance. New market dynamicsincluding client segmentation, competition, product differentiation and regulationhave had important effects on interest rates that make them relevant to efficiency. These changes, described below, make it more difficult for MFIs to cover inefficient operations with high interest rates. Client Segmentation The importance of interest rates—often described by elasticity of demand, or how sensitive certain customers are to changes in price—varies by client segment. For example, clients who are poor or facing monopoly environments typically have very low elasticities of demand, meaning that changes in interest rates will not significantly impact their borrowing decisions. In contrast, experienced borrowers with competitive alternatives have high elasticities of demand, meaning that small changes in interest rates will typically affect their borrowing actions. So interest rates become relevant when differentiating valuable repeat customers from new clients. The increased financial literacy that comes with experience makes seasoned borrowers less tolerant of high borrowing costs like those disguised behind flat interest rates. This elasticity of demand is especially relevant as new MFIs enter the market. Independent of elasticity, socially oriented MFIs interested in reaching poorer market segments in a viable manner must look more seriously at efficiency, because cost savings can be passed onto the borrower. Competition Price becomes a factor for more seasoned borrowers when they enjoy greater borrowing choice, as often occurs with increased competition. Competition makes access to capital for clients a non-issue. This point is especially acute when conventional financial institutions enter the fray because they often compete on price. Though MFIs do not always meet their new competitors’ price cuts (because they can compete on other core competencies such as speed and customer service), they are usually forced to at least reduce interest rates, which in turn, induces them to cut costs in order to maintain their financial sustainability. The onset of

21

competition in Bolivia, for example, has brought interest rates down so significantly that customers in focus groups cite price as one of their primary motivations for choosing one MFI over another.33 Similarly, MFIs in the crowded Paraguayan microenterprise market have begun using price differences to promote their products.34 In Bangladesh, the most competitive microfinance market outside of Latin America, the Association for Social Advancement (ASA), the country’s fast growing, third largest MFI, reduced its interest rates twice between 1998 and 1999.35 Product Differentiation Competition also induces increasing product differentiation, as MFIs fight to retain repeat clients with product offerings that are better tailored to clients’ needs and preferences. One way to tailor products to specific client segments is through differential interest rates. For example, increased competition from banks forced ACCION Texas to develop a new lending product with a lower interest rate securitized by real estate in order to retain its more sophisticated borrowers. Regardless of competition, differential interest rates are often necessary for new products offered to existing clients. BancoSol, for example, learned that as it moved up-market to serve more established clients, borrowers were much more price sensitive as loan amounts increased because of the overall cost of larger loans. In addition, whether a borrower is a trader with fast turnover or a capital-intensive manufacturer with production equipment plays a role in how tolerant s/he is of high rates. Accordingly, Mibanco offered a lower interest rate on its new fixed asset loan than on its individual loan product because the long-term nature of the capital-intensive business use made the need for financing less urgent. Regulation In both developing country settings (e.g., South Africa) and industrialized settings (e.g., the US), usury laws limit the maximum allowable interest rates an MFI can charge. In fact, there seems to be a trend as regulatory frameworks evolve toward increased consumer protection through usury laws as well as restrictions on collection payment and recovery of collateral. Thus, either existing or potential

33 BancoSol internal market research, 1998-99. 34 Rhyne and Christen, p. 21. According to their study, loan officers in Asunción

must visit 25 prospective clients for each successful credit approval. p. 20. 35 Rhyne and Christen, p. 21.

22

regulatory restrictions cap what MFIs can earn on loans, making efficiency critical to financial self-sufficiency. Subsidized Bureaucracy and Donor Withdrawal Donors have been generous with their support of microfinance, though it is unclear how long their generosity will last. The proliferation of new, donor-driven MFIs, the fatigue that comes with continued funding of a particular institution or donors’ slow withdrawal from the sector as a whole all create the possibility of reduced subsidy for any given MFI. This forced self-reliance is an impetus for a renewed focus on efficiency. Most MFIs have become accustomed to the cushion of continued subsidies, which has fostered bureaucratic institutional structures, unrealistically low prices for products and services, and an organizational culture that was not responsive to market demands. While there are compelling reasons for involvement in the risky, cost-intensive start-up phase of undeveloped markets (where MFIs do not already operate) and at strategic points of expansion, increasingly sophisticated donors understand that ongoing subsidies can hinder market competition and efficiency improvements. As a result, many donors are slowly reducing their unrestricted support.

IMPACT OF THE DEVELOPMENT CONTEXT Poverty Lending and Sustainability Financial self-sufficiency—and ultimately, profitability36—is a core issue that divides microfinance practitioners, but this division is false. The reality is that financial self-sufficiency and impact via small average loan size need not be diametrically opposed. Unfortunately, the popular debate often thwarts creative solutions to the difficulty of efficient lending to the poorest of the poor. Views diverge on how best to achieve widespread impact. For purposes of simplicity, these constituencies can be divided into two camps: those whose priority is reaching the “poorest of the poor” (often termed “poverty lending”) and those whose priority is financial viability or

36 To be financial self-sufficient in its credit operations, an MFI must cover the

following expenses through interest charges and other fee income: operating costs; the cost of funds; and inflation. For commercial viability, it must also yield a risk-adjusted profit to investors. Otero and Rhyne, p. 17.

23

“sustainability” while achieving impact. As Elisabeth Rhyne explains in Conversation with the Experts, “[T]hese two camps are not always opposing; however, there are some practices that push them apart.”37 Many equate low average loan size with financial inefficiency. While it is indeed more difficult to maximize efficiency with lower average loan size, this blanket generalization is misguided, as demonstrated by MFIs such as Compartamos in Mexico, Women’s World Banking (WWB) in Cali and ASA in Bangladesh. These three MFIs have achieved impressive financial results in spite of having low average loan sizes, as demonstrated in the adjacent table with statistics as of June 30, 1999.38

Table 1: Average Loan Size and Profitability AVERAGE LOAN BALANCE

MFI (COUNTRY) 39 ROA US$ AS % OF GNP PER CAPITA40

Compartamos (Mexico) 30.5% 136 3.1%

WWB-Cali (Colombia) 9% 373 16.6%

ASA (Bangladesh) 8% 114 30.8%

Moreover, many MFIs interested in poverty lending compound this fallacy by polarizing mission against financial self-sufficiency, assuming that reaching the poorest and covering costs are mutually exclusive. Those interested in financial viability see impact as directly related but secondary to institutional sustainability. Financial viability implies

37 Oberdorf, p. 97. 38 Return on Assets (ROA), a standard measure of profitability for financial

institutions, is calculated as adjusted net income divided by average total assets. ROA figures for Compartamos are for year-end 1998.

39 Compartamos data is unadjusted for inflation and accruals. Adjusted numbers have not yet been made public. While the adjustments will certainly lower Compartamos’ ROA figure, its adjusted numbers are expected to be in line with ASA and WWB-Cali. WWB-Cali data from MicroBanking Bulletin Issue no. 4, p. 23. ASA data from the MicroFinance Network. All data are 1999.

40 GNP per capita figures taken from the World Bank’s World Development Indicators database, http://www.worldbank.org/data/databytopic/GNPPC.pdf, and are measured using the Atlas method in US dollars. The MicroBanking Bulletin defines a “low end” target market as average loan balance of less than $150 or average loan balance/GNP per capita of less than 20%.

24

permanent, stable access to credit for the poor for the long-term, especially if subsidies diminish over time. Efficiency is a core issue where the two camps converge. Those interested in directly impacting poverty understand that efficiency advances their mission, both by reducing costs (which ultimately can be passed on to the borrower) and increasing outreach. Those who focus on financial viability understand that continual improvements in efficiency will improve profitability and facilitate their ability to raise capital from private sources (either through savings mobilization, bank debt or equity investments from commercial actors), thus ensuring their longevity. Limited Scale Economies As explained above, client volume is in the mutual interest of those who desire impact on the poorest and those concerned with sustainability. However economies of scale in microfinancethe cost savings gained through portfolio growth as measured either in dollars, number of loans, or number of clientsare not automatic. Scale economies imply that costs do not increase as quickly as the portfolio, because of underutilized capacity and efficiency gains that come with size. Yet if an MFI has inefficiency embedded in its organization, costs will often increase along with portfolio growth, significantly reducing returns. Moreover, scale economies in almost all industries are characterized by diminishing marginal returns, meaning that the cost savings gained with each additional unit of output (a client or a loan) are less as business grows.

Figure 2: Economies of ScaleACCION Affiliates

0%

25%

50%

75%

100%

0 10,000 20,000 30,000 40,000

OperatingCosts /

Net Portfolio

Active Clients

Operating Costs Relative to Client Base -11 ACCION Affiliates 1991 - 1995

Source: ACCION CAMEL Studies

25

There are limits to how much MFIs can improve efficiency through economies of scale.41 A review of 11 ACCION affiliates shows that economies of scale produce significant cost savings for young MFIs as they build their client base. However, the efficiency gains to scale diminish greatly once the MFI reaches a certain size, as the theory of diminishing marginal returns would predict and as an analysis of ACCION data confirms. Aggregating data from all ACCION affiliates, it appears that efficiency gains greatly diminish once an MFI has roughly 12,000 clients, as illustrated in Figure 2.42 The MFIs within ACCION’s network that have achieved significant scale (35,000 clients and above) have been left off the graph to better illustrate the more substantial efficiency gains with smaller client bases.43 A review of the MFIs that report to the MicroBanking Bulletin yields similar findings, even when the distortion of loan size is removed.44 (See Figure 3 below.) Looking at all the Latin American MFIs included in the Bulletin, scale economies seem to operate up to 10,000 clients, under current practices. After this point, the cost per borrower, which is a factor that neutralizes the distorting effect of loan size on the ratio of administrative expense to average portfolio, still decreases, but much less dramatically. For Asian MFIs, the point at which economies of scale begin to diminish noticeably is even smaller, partly a result of the higher population density and lower salaries characteristic in some areas of this geographic market. It is also worth noting that, overall, Asian MFIs are

41 Farrington emphasizes that for all that has been made of the assumption that

portfolio size is a primary driver of efficiency, this is true only up to a certain point that he defines as a loan portfolio of approximately US$4 million. Beyond this threshold, “economies of scale do not seem to be a significant factor in determining efficiency.” p. 19.

42 In their article on “Measuring Unit Loan Costs,” Gheen, Jaramillo and Pazmino found that economies of scale “improve steadily until 10,000 loans.” p. 3.

43 The scale economies of MFIs in ACCION’s network with client bases over 40,000 are marginal, as the efficiency gains are less than 1% to 2% better than their smaller peers.

44 The only criterion for participation in the MicroBanking Bulletin is the ability of an MFI to fulfill the “fairly onerous report requirements” established by the publication. However, typically only more established or sophisticated MFIs are able to meet such standards. Indeed, that 60% of the over 100 participating MFIs in the February, 2000 issue of the Bulletin were financially self-sufficient suggests there is a selection bias. Accordingly, these results are probably optimistic regarding the economies due to scale.

26

more efficient (have a lower average cost per client) because of their generally lower compensation expense. As a result, increases in scale have even less dramatic effects on efficiency there, since the Asian starting base is lower than that in Latin America. In both cases the message is straightforward: Those MFIs that have more than 10,000 clients (using the more conservative estimate) have likely exploited a large proportion of the potential economies of scale under existing structures and processes. Put another way, it’s not that economies of scale are exhausted once an institution reaches 10,000 clients, but rather, that further exploiting economies of scale at this client level typically requires major structural changes in operations. The 10,000 to 12,000 client point generally marks the need for an upgrade in infrastructure or processes to efficiently manage the new level of size and growth.45 Therefore, those MFIs with high cost structures that hope to address efficiency problems through portfolio growth alone are waiting for gains that might never materialize. Worse yet, some MFIs are expanding on an inflated infrastructure that can exacerbate the problem of inefficiency. The results of the empirical data suggest that all MFIs can benefit from efficiency analysis—even those with more than 10,000 clients. The difference is that for those MFIs that have achieved significant scale, the changes required may, in fact, be more radical. The call for efficiency reaches to all MFIs—large and small, old and new.

45 This need for an upgrade in infrastructure is consistent with changes required

in organizational structure and processes as organizations grow in size, breadth and sophistication. For an in-depth analysis of changing structural needs as organizations reach various levels of growth, see Churchill, Managing Growth.

Fig

ure

3: E

cono

mie

s of

Sca

le

Lat

in A

mer

ica

and

Asi

a

Cos

tC

lien

(US$

$0

$100

$200

$300

$400

$500

010

,000

20,0

0030

,000

40,0

0050

,000

Act

ive

Clie

nts

Lat

in A

mer

ican

MF

Is 1

997

Sour

ce:

Mic

roB

anki

ng B

ulle

tinN

ote:

Dat

a co

ntro

ls th

e im

pact

of

loan

siz

e by

mea

suri

ng c

osts

per

clie

nt r

athe

r th

an p

er lo

an; o

nly

incl

udes

MFI

s w

ith <

50,

000

clie

nts.

Asi

an M

FIs

199

7 -

1999

Cos

t pe

r C

lient

Rel

ativ

e to

Siz

e of

Act

ive

Clie

nt B

ase

Act

ive

Clie

nts

Cos

t /

Clie

nt(U

S$)

$0$50

$100

$150

$200

010

,000

20,0

0030

,000

40,0

0050

,000

28

THE CALLING: STRATEGIC AND SOCIAL IMPLICATIONS OF EFFICIENCY

As a result of significant market changes summarized above, MFIs must undertake radical reexamination of the way they do business in order to improve efficiency. The concern for efficiency is applicable to both NGOs concerned about better leveraging their resources in terms of their financial and social impact on clients as well as to conventional financial institutions moving down-market. For those MFIs in less competitive markets, market trends are nonetheless focusing attention on costs, including pressure from donors, who would rather see their resources in the hands of the end users than consumed in inefficient processes and swollen bureaucracies. Moreover, efficiency, through its relation to interest rates, impacts what segment of the poor population an MFI can viably reach with its financial services, because there is a limit to what price the market can bear. For socially oriented MFIs with low average loan sizes, efficiency is a key component of success in reaching poorer segments in a viable manner to maximize impact. Efficiency has become an important issue from a commercial as well as a social perspective. For those MFIs that have transformed from NGOs into regulated financial institutions, operational efficiency is a high priority as a result of investor pressure to improve profitability, and regulatory demands. But for all MFIs, regardless of legal structure, continued market penetration and increased competition will make self-sufficiency and profitability more elusive goals without corresponding improvements in efficiency.

FINANCIAL VIABILITY The issue of efficiency is of critical importance because financial sustainability has taken on new meaning in the increasingly competitive world of microfinance. Though most microfinance institutions still enjoy oligopoly-like control of their local markets, there are threats to this seeming stability. New microfinance providers—including existing MFIs looking for new segments to capture, donor-supported start-ups and

29

banks moving down-market—make client desertion a serious threat. Desertion is a particular threat for those MFIs with no or low existing competition that have become complacent or bureaucratic under the cushion of monopoly, or at least oligopoly, profits. The resulting institutional inertia has made these MFIs unprepared to deal with the onslaught of new competition looming on the horizon, as new product development in most markets has not kept pace with the diverse needs of clients. Though some manage to maintain profitability by charging high interest rates, new market entrants are squeezing the financial margins many MFIs now enjoy. In addition, donor money is not a limitless resource, so MFIs will need to adjust to an increase in their current, artificially low, costs. As such, the commercialization of microfinance requires that MFIs rationalize their cost structure and revenue system for sustained economic viability. MFIs that are not yet in the middle of a market crisis, such as that faced in Bolivia [see box insert on page 19], have a window of opportunity to improve their institutions’ efficiency, resiliency and agility in managing unexpected competitive and interest-rate shocks. In this way, maximizing efficiency is not just a question of improving return or defining a new “best practice.” Ultimately, it will be a matter of survival.

COMPETITIVE ADVANTAGE Over and above sustainability, efficiency offers a competitive edge. Some MFIs have used efficiency and customer service as a way to differentiate themselves from new entrants, since streamlined delivery is highly valued by clients. For the typical microfinance client, the transaction and opportunity costs of borrowing are far higher than the financial costs.46 For this reason, ASA, for example, has used quick, efficient customer service to define its position in the competitive Bangladesh market. Similarly, a core component of the methodology employed by MFIs, such as Caja Los Andes (Bolivia) and Calpiá (El Salvador), is an “efficiency orientation,” in which MFIs employ standardized methodology to diligently control costs.47 This efficiency orientation also implies assiduous pursuit of cost savings opportunities and a strategic awareness of how to leverage scarce resources to

46 ACCION estimates that financial costs represent a tiny percentage—typically

between 0.4% and 4% of the total borrowing costs to the borrower. Castello, Stearns and Christen, p. 14.

47 Buchenau, interview.

30

maximize returns. Being cost conscious allows MFIs to be more strategic about setting prices, launching products and opening branches—helping an MFI develop a proactive, rather than reactive competitive stance.

MARKET PENETRATION Faced with the threat of more established competitors and deserting clients, MFIs are trying to increase their portfolio lending to make up the shortfall. This expansion involves increasing both the depth (existing market, new products) and breadth (existing products, new segments) of their reach.48 MFIs deepen their reach by strengthening existing products or developing new ones, often entering into higher risk lending and new areas of financial intermediation (such as insurance). Additionally, some MFIs are broadening their reach by diversifying and expanding into new customer segments, such as small business credits with higher average loan sizes and new geographic markets, including rural areas and adjoining cities. A focus on efficiency can facilitate increased market penetration. For example, a reduction in cost and its corresponding lowering of interest rates allows the MFI to attract microenterprises that previously viewed the price as prohibitive or unattractive. In addition, efficiency allows the MFI to expand quickly, both because of its low-cost service and the agility that usually characterizes lean institutions. The resulting increase in market share can give an MFI a strategic advantage, especially if it has not fully exploited economies of scale. Such MFIs can deter competition by under-pricing new entrants or building consumer loyalty via quick, quality customer service. MFIs that are able to control costs as they grow and exploit these market opportunities will be better positioned to sustain the successes they have achieved to date.

OVERVIEW OF THE MONOGRAPH

Indeed, some industry leaders have already recognized the importance of efficiency to their organizations’ longevity and thus have established organizational cultures and initiatives to institutionalize efficiency.

48 For a fuller discussion of market expansion strategies, see Churchill,

Managing Growth, pp. 23-26.

31

Among the newer efficiency-oriented initiatives are cost management schemes (profit centers, activity-based costing, etc.), reengineering efforts (the radical redesign of business processes), new product development (group to individual loans, lines of credit, etc.) and creative uses of technology (smart cards, credit scoring, Palm Pilots, etc.). This monograph addresses the more strategic issues of maximizing efficiency (rather than the how-to of managerial accounting), highlighting some of these efficiency-enhancing strategies, as elaborated in the chapter summaries that follow. Chapter Two of the monograph provides a primer on understanding and calculating costs—both operational and administrative, and introduces various ways of measuring efficiency. The chapter includes a discussion of different considerations based on target markets and institutional types, especially as these factors relate to establishing benchmarks for performance. The strengths and limitations of financial analysis for identifying inefficiencies are also discussed. One commonly used tool in microfinance—ROA analysis—is discussed in Chapter Two and elaborated in further depth in Appendix A. Two other financial indicators borrowed from conventional banking—the bank efficiency ratio and yield analysis—are incorporated because they have important implications for analyzing efficiency and self-sufficiency. The chapter ends with a discussion of methods of allocating costs and revenues for deepening efficiency analysis. Chapter Three, the heart of the monograph, reviews strategic and operational approaches to improving efficiency, drawing from the experience of numerous successful MFIs operating in a wide array of contexts. The chapter introduces Alignment Theorya useful framework for increasing efficiency in all MFIs, regardless of context. This framework emphasizes the extent to which organizational efficiency depends on a close alignment among an MFI’s mission, target market, strategy and deployed resources. Product structure and development are discussed in light of mission, strategy, competitive pressures and net profit contribution goals. New developments in underwriting, payment collection and delinquency management that decrease costs are reviewed. Finally, the chapter closes with a section on the use of technology in efficiency enhancement and includes an overview of some of the path-breaking innovations in testing that are anticipated to provide significant opportunities for greater outreach, efficiency and ultimately,

32

sustainability. Detailed examples throughout the chapter illustrate these innovative practices. Successful efficiency enhancement is most often bred within a context of energized but controlled change. Yet for most organizations, change is anything but energized and controlled. Reengineeringthe radical redesign of business processes to dramatically improve efficiency, product quality and customer service—is given particular focus because of the scale and scope of institutional change. Chapter Four provides insight into three successful MFI reengineering projects. For those readers seeking additional information regarding the various types of change processes, Appendix B provides an overview and comparison of continuous improvement, total quality management and process reengineering. It also addresses the conditions under which a significant reengineering is warranted and when alternatives to reengineering are advisable. Appendix C provides readers with greater detail regarding the challenges typically faced in reengineering efforts and specific recommendations and project structure for a process reengineering project. Core requirements that characterize successful reengineering efforts are also described. The monograph concludes with a summary of the key concepts set forth throughout the document, which are fundamental to the long-term viability of the industry. Chapter Five then provides a practical how-to that integrates the financial analysis, efficiency techniques and reengineering protocol discussed in Chapters Two through Four, for those institutions seeking enhanced efficiency. Chapter Five continues with a discussion of the implications of these findings for policy-makers, investors, donors and practitioners in the microfinance industry. The chapter concludes by identifying areas for further study.

CHAPTER TWO

UNDERSTANDING AND MEASURING EFFICIENCY

35

Before elaborating strategies for improving efficiency, it is critical to understand how it is measured and analyzed. This chapter presents the ratios and techniques typically used in microfinance as well as in conventional banking. The main difference is that microfinance equates efficiency with a vigilance on costs, which are only part of the picture. Though conventional banking began its drive for improved efficiency by cutting expenses, its efficiency focus has evolved to a net contribution analysis that considers revenue generation in conjunction with cost control—an approach that has great potential for microfinance. High costs are merely symptoms of problems for which no cure can begin without an accurate diagnosis. This chapter discusses diagnosing efficiency problems from existing financial information (e.g., income statements and balance sheets) and more sophisticated mechanisms such as the “net contribution” model. A variety of options is presented since the most appropriate level of analysis will depend on the type of institution, its stage of development and its strategic vision. This last point goes beyond a discussion of how important financial viability is to the MFI. The amount of resources invested in cost-management systems and the level of sophistication will depend upon how serious the MFI is about self-sufficiency and the extent to which this efficiency orientation pervades the institutional culture. The chapter is divided into two major areas: measuring efficiency and cost diagnosis. The first section discusses different ratios and techniques to measure efficiency—including those commonly used in microfinance and in the conventional banking arena—explaining the strengths and shortcomings of each. The calculation of these ratios reveal that maximizing efficiency requires an analysis of revenues as well as expenses, though most in microfinance focus on the latter. The cost-analysis techniques discussed include both operational (life cycle

36

framework) and financial tools that encompass traditional return on assets (ROA) measures and ratios commonly used in the banking industry. The chapter ends with a discussion of different revenue as well as cost allocation techniques such as activity-based costing (ABC) that can be useful in guiding an MFI’s strategic growth and efficiency efforts. Understanding these approaches for analyzing and measuring provides the first step in developing efficiency benchmarks for different microfinance sectors.

ANALYZING THE PROBLEM

It is critical to understand how revenues and costs are measured so that an MFI can diagnose where deficiencies in expense management lie and opportunities for enhanced revenue generation and efficiency exist. The methodology and measures chosen are a function both of the priorities of the MFI and the capacity of its management information systems (MIS) to track the relevant data. MFIs concerned about efficiency will track these indicators over time in an effort to stretch their resources further and improve results. In addition, with the recent availability of industry data such as provided by the MicroBanking Bulletin49 and MicroRate,50 MFIs can compare their performance with their peers. There are numerous levels and types of analysis that can be employed individually and jointly to evaluate the revenue optimization and cost efficiency of any organization. Each analytical level and type provides distinct insights into the source and nature of inefficiency, though each differs considerably in terms of the depth of sophistication and understanding it can provide. The various methods to analyze efficiency, highlighted in Table 2 and elaborated in this chapter, include: � Level of Analysis: The most general level of analysis is the macro,

institutional level, using information found in standard financial

49 The MicroBanking Bulletin collects, standardizes and presents financial and

portfolio data on leading microfinance institutions to help managers “understand the performance of their institutions in comparison with other MFIs” in their relevant peer groups. MicroBanking Bulletin, Issue no. 3, p. i.

50 MicroRate is a private firm dedicated to establishing a rating tool to analyze the financial performance of MFIs in a standardized way in order to allow peer comparison and facilitate private investment.

37

statements. Analysis at the MFI level is often broken down by division. Even more informative is analysis undertaken at the product or customer level.

� Types of Analysis: The two main types of analysis employed are

financial and operational. The most common efficiency measures are financial, and a variety of ratios that manipulate expenses, income and asset level are discussed in detail.

� Degree of Allocation: The most common and general type of

allocation is of direct costs to a specific unit of analysis, be it a specific division, branch or product. Some institutions have begun employing methodologies that allocate indirect costs to these different units of analysis as well. The most sophisticated analysis that conventional banks have recently begun to employ involves the full allocation of both revenues and expenses, analyzing the net contribution of each unit of analysis (a branch, division, product, customer, etc.).

� Allocation Methodology: The degree of allocation of both costs and

revenues will drive the methodology required. Four common allocation methodologies are covered in this chapter, in order of increasing sophistication and depth of analysis.

These various levels of analysis can be utilized for different purposes. Some more commercially oriented MFIs require that each division, branch, product and service be profitable. Other MFIs employ a cross-subsidization strategy that requires the overall self-sufficiency of the MFI but does not require individual divisions, branches, products and services to be profitable. Rather, profitable units or products are developed to support and subsidize unprofitable units (as in start-up branches) or products. Still other MFIs support a cross-subsidization strategy but do not adhere to a goal of overall MFI self-sufficiency. No matter where an MFI falls on this self-sufficiency spectrum, the ratio or mix of profitable units or products to unprofitable ones is a critical factor in determining the degree of efficiency and self-sufficiency that an MFI attains. The information necessary to monitor this ratio can be gleaned through the various types of analysis set forth below.

Tab

le 2

: L

evel

s an

d T

ypes

of

Fin

anci

al A

naly

sis

Sha

ded

boxe

s re

pres

ent i

ndus

try’

s ge

nera

l lev

el o

f an

alys

is e

mpl

oyed

at t

his

time.

A

rrow

s in

dica

te d

eepe

ning

leve

ls o

f an

alys

is.

Lev

el o

f A

naly

sis

Inst

itutio

nal

D

ivis

ion

Pro

duct

s /

Serv

ices

C

usto

mer

/ Se

gmen

t

T

ypes

of

Ana

lysi

s R

OA

/CA

ME

L

Por

tfol

io Y

ield

B

ank

Eff

icie

ncy

Rat

io

Lif

e C

ycle

F

inan

cial

O

pera

tion

al

D

egre

e of

Cos

t an

d R

even

ue

Allo

cati

on

Dir

ect C

osts

Fu

lly A

lloca

ted

Indi

rect

Cos

t P

artia

lly

All

ocat

ed

Full

Cos

t A

lloca

tion

Net

Con

trib

utio

n (R

even

ue-C

ost)

A

lloca

tion

M

etho

dolo

gy

Bud

geta

ry

Acc

ount

ing

Cos

t A

ccou

ntin

g A

ctiv

ity B

ased

C

ostin

g A

ctiv

ity B

ased

M

anag

emen

t

39

COMMON INSTITUTIONAL PERFORMANCE RATIOS � Volume (number of active clients, loans, accounts or value of portfolio

outstanding). � Delinquency or Portfolio at Risk (balance of loans past due as a

percentage of outstanding portfolio). � Average Loan Size (e.g., average loan balance to GNP per capita). � Organizational Efficiency (typically, total administrative expense to

average loan portfolio). � Profitability (e.g., return on assets, return on equity).

LEVELS OF ANALYSIS

MFIs traditionally gather and interpret information for financial analysis at the institutional level, though the degree of analysis can be broken down by smaller components, including by divisions, products or customers. The deeper the level of financial analysis, the better the quality of information available for identifying efficiency and revenue generation opportunities. The cost to obtain such information must be weighed against the value derived from the additional depth of analysis. Though the appropriate tool and type of analysis will vary by the level chosen, reporting systems need not be overly complicated in order to delve deeper into an MFI’s financial levels.

INSTITUTIONAL The most common level of analysis in microfinance is the “macro” view, which measures the overall performance of the entire organization. Analysis at this institutional level includes the performance ratios that are commonly tracked in microfinance, such as those included in the MicroBanking Bulletin, highlighted in the box below. Typically this

information, such as that included in an MFI’s annual report, is externally oriented—developed for and shared with donors, investors, regulators, stockholders, boards and creditors. This level of analysis provides important information regarding the MFI’s overall performance over time and vis-à-vis its peers, highlighting broad areas for further profitability and efficiency analysis. As such, it is often the first warning

40

sign for an MFI that there are opportunities for improvements in efficiency and revenue generation. Taken alone, however, a return on assets indicator or the organizational efficiency ratio will not provide significant information regarding which of the myriad root sources of operating inefficiency are limiting financial viability. To determine more precisely where inefficiencies reside, analysis at the divisional, product or customer level is required.

DIVISION The second level of analysis examines the efficiency of individual MFI divisions or branches (e.g., lending vs. deposit gathering vs. other services) and is often the basis used for budgeting purposes. This level of analysis measures the degree to which individual divisions or branches contribute or detract from the MFI’s overall profitability. This approach allocates expenses or net profit contribution51 to the various customer-oriented activities of the MFI.52 By providing a breakdown on a division-by-division or branch-by-branch basis, this analysis often highlights those divisions or branches within the MFI that are employing strategies and techniques that lend themselves to enhanced revenue generation, efficiency and thus, replication. In situations where divisions are highly disparate in their operations or branches are uniform in their level of performance, however, division analysis will not typically highlight the sources of inefficiency or missed revenue generation. In these situations, even deeper analysis at the product and service level is often enlightening.

51 As discussed later in this chapter, net profit contribution (or net loss) is the

amount that an individual division or branch contributes to the overall net profitability (or net loss) of the MFI. It is calculated by subtracting all expenses from all revenues allocated to an individual division or branch.

52 Many organizations employing divisional analysis establish each back-office (e.g., information technology, accounting/finance, internal audit) as separate divisions for purposes of monitoring actual costs incurred to budgeted costs. The analysis considered in this discussion moves one step beyond these budgetary considerations to allocate these indirect expenses to the various revenue-generating divisions in order to obtain a clearer picture of the net contribution of an individual revenue division or branch. See the discussion later in the chapter on “Cost and Revenue Allocation”.

41

PRODUCTS AND SERVICES The third level of analysis measures the degree to which individual products and services contribute or detract from the overall self-sufficiency of the MFI. This level of analysis may be a refinement of the division level analysis, as when individual loan products within a lending group are analyzed. Alternatively, this analysis may cut across divisions to aggregate information by product, as when loan products (e.g., village vs. group vs. individual loans) are analyzed individually regardless of the branch through which they are delivered. Thus, short-term liquidity loans might be analyzed independent of mid-term working capital loans independent of long-term capital loans. Alternatively, the net profit contribution of group loans might be compared to loans to individuals. Finally, the cost associated with the delivery of training or other services might be disaggregated from the lending relationships that require such training. This type of breakdown is typically very helpful in identifying sources of inefficiency in the institution, including hidden costs as well as opportunities for additional revenue generation. For example, if a product analysis identifies that loans to start-up organizations are generating significant losses, the MFI can begin to identify the root causes, which may lie in ineffective marketing, poor product design, inadequate delinquency monitoring or some other factor. Another important application of this type of analysis is to highlight the extent of cross-subsidy among products, as illustrated in Table 3. This analysis can help an MFI bring balance to its cross-subsidization strategy for purposes of achieving self-sufficiency. The optimal portfolio allocation by type of product could then be used to guide loan officers in their loan generation objectives.

Tab

le 3

: A

naly

sis

of C

ross

-Sub

sidi

zati

on a

nd P

ortf

olio

Mix

(in

US$

)

TY

PE

OF

LO

AN

N

O. O

F

LO

AN

S

AV

G.

LO

AN

SIZ

E

SHA

RE

OF

LO

AN

P

OR

TF

OL

IO

AV

G.

INT

ER

EST

/YE

AR

AV

G. C

OST

TO

O

RIG

INA

TE

&

MA

INT

AIN

NE

T I

NC

OM

E

(EX

PE

NSE

)

Paw

n 6

50

250

113,

750

14%

5

6,87

5 5

1,95

0 4

,925

Per

sona

l 4

00

500

140,

000

18%

7

0,00

0 5

1,95

0 18

,050

Bus

ines

s <

$1,5

00

750

70

0 37

5,00

0 47

%

93,

750

104,

875

(11,

125)

Bus

ines

s >

$1,5

00

100

2,50

0 17

0,00

0 21

%

42,5

00

33

,963

53

8,53

8

TO

TA

L

1,90

0 42

0 7

98,7

50

100%

26

3,12

5 24

2,73

8 20

,388

A

ssum

ptio

ns:

Cal

cula

tion

ass

umes

int

eres

t ra

te o

f 50

% f

or t

he c

onsu

mer

(pa

wn

and

pers

onal

) an

d 25

% f

or t

he b

usin

ess

(mic

ro a

nd

smal

l) l

oans

and

an

aver

age

term

aft

er r

enew

als

of s

ix m

onth

s, n

ine

mon

ths,

one

yea

r an

d tw

o ye

ars

for

paw

n, p

erso

nal,

busi

ness

<

$5,0

00 a

nd b

usin

ess

>$5

,000

, re

spec

tive

ly.

Any

anc

illa

ry f

ees

that

mig

ht b

e co

llec

ted

(clo

sing

, cr

edit

rep

orti

ng,

deli

nque

ncy

fees

, et

c.)

are

not

incl

uded

. C

alcu

latio

n as

sum

es c

ompe

nsat

ion

of $

20,0

00/y

ear

per

loan

off

icer

and

allo

catio

n of

one

loa

n of

fice

r ea

ch t

o pa

wn

and

pers

onal

loa

ns, 2

.5 l

oan

offi

cers

to

busi

ness

loa

ns <

$1,

500,

and

.5 lo

an o

ffic

ers

to b

usin

ess

loan

s >

$1,

500.

Als

o as

sum

es a

no

n-co

mpe

nsat

ion

base

of

$160

,000

(20

% o

f av

erag

e lo

an p

ortf

olio

) al

loca

ted

to e

ach

prod

uct

base

d on

com

pens

atio

n ra

ther

tha

n th

e av

erag

e lo

an p

ortf

olio

.

53 A

lthou

gh m

any

MFI

s as

sum

e th

at th

e co

sts

to o

rigi

nate

a lo

an w

ill b

e re

cove

red

over

the

aver

age

life

of th

e lo

an, i

n th

is

case

two

year

s, th

e fa

ct th

at n

ew lo

ans

are

cont

inuo

usly

com

ing

on w

ith

high

er c

ost b

ases

res

ults

in a

hig

h ex

pens

e ba

lanc

e in

any

giv

en y

ear.

43

CUSTOMER AND CUSTOMER TYPES The fourth area of organizational analysis, one rarely utilized within microfinance given the difficulty of capturing financial information at the client level, is one that addresses individual customer profitability. This level of analysis is generally appropriate only for those MFIs that are providing multiple products and services to individual customers or those MFIs that segment their portfolios by customer type (e.g., small businesses vs. microenterprises). This form of analysis is particularly helpful when an MFI is faced with competition for certain customer segments or the unprofitability of certain customer types. (Many US banks maintain that 20% or less of their customers actually contribute 100% or more of the net profit generated by the total customer bank. The net contributions from these clients, in essence, subsidize the losses on other portfolio segments.) Customer level analysis, however, is frequently complex and costly to implement—factors that often outweigh the benefit derived from such information.

TYPES OF ANALYSIS There are various types of financial analysis defined through specific ratios and other indicators commonly used to diagnose efficiency. The first tool presented—life cycle analysis—allows for an operational analysis to help pinpoint the source of inefficiency in the lending process. The remainder of the section discusses various financial indicators, beginning with the return on assets (ROA) ratio used in microfinance to measure efficiency since the early 1990s. This approach can provide insight into some key factors—namely, wage rates, average loan size and overall productivity levels—that impact efficiency, though deeper levels of analysis are required to uncover root sources of inefficiency. The final set of financial indicators presented—portfolio yield and the bank efficiency ratio—are commonly employed by conventional financial institutions to analyze these underlying causes of inefficiency, but have only recently been employed in microfinance. By incorporating revenue as well as costs into the efficiency analysis, these tools allow deeper insight into diagnosing and strategically treating inefficiency.

44

LIFE CYCLE ANALYSIS As its name implies, operational analysis focuses on assisting MFIs to operate more efficiently, whether in terms decreased cost, enhanced revenue generation or increased customer service. This level of analysis addresses how and why costs are being incurred in order to ascertain whether they are being optimized in terms of related output. Information gathered at the division level, whether through budgetary or asset-based systems, as described in greater detail later in this chapter, aids management in identifying opportunities for efficiency improvement within the MFI. One particularly important framework used in operational analysis to assess and correct inefficiencies is the life cycle framework—an approach that analyzes operations, revenue and expenses over the life or duration of the product. The life cycle of a loan, which is often used in activity-based and asset-based costing analyses, can be broken down by the different activities, depicted on Figure 4, involved in: � Marketing: the activities undertaken to identify and obtain loan

applications.54 � Underwriting: the activities required to assess, approve or deny and

close a loan, including client intake, application processing, character and financial analysis to determine credit worthiness and capacity to repay, approval (or denial) of the credit and disbursement.

� Maintenance: the activities required to service the loan while outstanding, including payment monitoring, collections, delinquency follow-up, and renewal.

By analyzing the workflow in this manner, MFIs can identify opportunities for greater efficiency, especially in areas that have not been previously emphasized. Thus, a low rate of conversion of possible loan candidates (“contacts”) to applications received may highlight opportunities for changes in marketing techniques. A low rate of applications processed to loans disbursed may indicate the need for stronger borrower pre-screening to minimize the number of disapproved applications. A rapid repayment rate may not provide adequate interest

54 Marketing in the broader sense includes the activities undertaken to better

understanding client needs and build awareness about the MFI and the product.

45

income to cover origination costs (typically the highest component of the entire loan cost structure). Payment processing scattered throughout the month may facilitate collections but may result in significant inefficiency in office operations as a result of fragmented activities. A similar analysis can be provided for savings accounts, as diagramed in Figure 5. Completing any necessary paperwork or process required to “accept” a depositor (when that acceptance is separate from the lending process) may utilize different types and amounts of resources. These resources include those required to collect additional savings on an ongoing basis, post interest earned by the depositor on the account, maintain records and return the proceeds upon withdrawal. By analyzing each major component of the process over the life of the deposit, valuable insight can be gained for efficiency maximization.

F

igur

e 4:

Lif

e C

ycle

of

a L

oan

M

AR

KE

TIN

G

UN

DE

RW

RIT

ING

M

AIN

TE

NA

NC

E

C

onta

ct

App

licat

ion

Loa

n L

oan

Loa

n P

ayof

f/

Id

enti

fied

R

ecei

ved

App

rove

d/

Dis

burs

ed

Serv

iced

R

enew

al

D

enie

d

Fig

ure

5: L

ife

Cyc

le o

f a

Dep

osit

MA

RK

ET

ING

R

EV

IEW

AN

D A

CC

EP

TA

NC

E

MA

INT

EN

AN

CE

Con

tact

Id

enti

fied

/ A

dver

tisi

ng

App

licat

ion

Rec

eive

d55

Acc

ount

O

pene

d D

epos

its/

W

ithd

raw

als/

In

tere

st

Acc

ount

C

lose

d

55 I

n re

gula

ted

envi

ronm

ents

, gov

ernm

ent a

genc

ies

may

req

uire

a c

hara

cter

ass

essm

ent o

f a

depo

sito

r to

ens

ure

that

the

indi

vidu

al is

not

in

volv

ed in

ille

gal a

ctiv

ities

, the

pro

ceed

s of

whi

ch w

ould

be

depo

site

d in

the

bank

.

47

In addition to this operational analytical frame used to identify and evaluate opportunities for increased efficiency and revenue generation, financial forms of analysis are also utilized. Three such financial toolsROA analysis, portfolio yield and bank efficiency ratio—are discussed below.

ROA ANALYSIS: THE MICROFINANCE EFFICIENCY RATIO The most commonly used ratio to measure the efficiency of MFIs is derived from an analysis of return on assets (ROA)—a profitability ratio calculated on an institution-wide basis. To understand the sources of inefficiency, common profitability ratios—namely return on equity (ROE) and ROAcan be broken down into their component parts to analyze sources of inefficiency. (Appendix A provides a graphic analysis and a detailed breakdown of ROE and ROA into their component ratios.) The ROE ratio—measured as net income divided by average equity—is comprised of two fundamental components: ROA and leverage. ROA demonstrates how well an institution generated income from its asset base, while leverage illustrates how the capital structure—the use of debt vs. equity to finance operations—impacted profitability. Because most MFIs still enjoy vast sources of “patient” capital (such as donors and socially motivated investors) and are therefore typically under-leveraged, the majority of the efficiency analysis in microfinance focuses on the ROA.56 As illustrated in the box below, this microfinance efficiency ratio is defined as administrative costs (excluding financial expense, loan loss provision, taxes and extraordinary items) as a percentage of average loan portfolio. The ROA ratio is a core part of ACCION’s CAMEL analysis57 and an indicator tracked by the MicroBanking Bulletin.

56 This monograph does not address the issue of how an MFI can manage its

financing options as way of reducing the cost of capital for efficiency maximization, an area for further study.

57 CAMEL evaluations, explained in footnote 4, analyze the factors reflected in the acronym: Capital adequacy, Asset quality, Management, Earnings, Liquidity.

48

ROA: MICROFINANCE EFFICIENCY RATIO �

Administrative Expenses Average Loan Portfolio

CAMEL’s Supporting Indicators � Total Loan Officer Salary / Average Loan Portfolio � Number of Active Borrowers / Number of Loan Officers � Average Loan Disbursed � Branches’ Total Operating Expenses /Average Loan Portfolio � Head Office Total Operating Expenses /Average Loan Portfolio � Number of Field Personnel / Number of Administrative

Personnel � Personnel Retention Rate � Average Loan Disbursed / Minimum Monthly Wage

An MFI’s efficiency is measured relative to its productive assets (its portfolio) in order to compare costs at different periods of an institution’s growth, as well as against its peers. Leading MFIs in Latin America and Asia have achieved operating efficiencies of 12-16% and 9-12%, respectively.58 This ratio is of critical importance to microfinance because it measures the field’s progress toward achieving operating margins comparable to the formal financial sector. As such, it is one of the most heavily weighted ratios in ACCION’s CAMEL analysis. ACCION’s CAMEL instrument has a number of supporting indicators, listed in the box above, which help dissect the drivers of an organization’s operating efficiency and analyze their impact on earnings.59 Appendix A provides details on all the supporting indicators listed, focusing on the two largest cost items for an MFI: administrative expenses, at both the headquarters and branch levels, and personnel expenses, including total salaries of loan officers and support staff. The discussion below focuses on the most critical drivers of the microfinance

58 Taking all fully sustainable MFIs globally, the ratio of administrative

(nonfinancial) expenses to average loan portfolio jumps to 24%. MicroBanking Bulletin, Issue no. 4, p. 53.

59 It is important to note that almost two-thirds of the indicators used in a CAMEL analysis are qualitative rather than quantitative and that taken together, they determine the majority of the final rating. Saltzman, Rock and Salinger, p. 18.

49

efficiency variable: loan officer salary, including benefit levels; the average loan balance; the productivity levels of loan officers; and the distribution of headquarters vs. branch expenses.

Loan Officer Salary Remuneration of field personnel is often the greatest single expense of most MFIs, typically representing almost half of the total administrative expenses.60 As such, an important indicator of efficiency in microfinance is the ratio of field personnel salaries to average portfolio. A strategic analysis of loan officer salary involves reviewing the alignment between the necessary skill level and experience of the field staff vs. the nature of the product, target market and processes. For example, many MFIs hire college educated staff as credit officers because of the level of financial analysis involved in underwriting loans. However, such skill might not be required for smaller products, those targeted at poorer clients or those supported by credit scoring systems. Still, an issue that sometimes constrains an MFI’s ability to adjust salaries, as discussed in Chapter Three, is that the level of skill, experience and corresponding compensation often affects the productivity levels of staff. Market conditions are an important determinant of salary levels. Accordingly, average loan officer salary is often analyzed in comparison to macroeconomic statistics, such as average GNP per capita or the unemployment rate. For example, ACCION’s Guatemalan affiliate Génesis owes at least part of its enviable efficiency level to the country’s low wage rates and high unemployment. To facilitate regional comparisons, the MicroBanking Bulletin compares total salary, including benefits, as a percentage of GNP per capita, to loan officer productivity and average loan size in a combined indicator it labels the “salary

60 Christen, Banking Services for the Poor, p. 73.

SALARY BURDEN RATIO

Salary Expense (average staff salary/GNP per capita)

Productivity X Average Loan Size (average number of clients (outstanding loan balance per staff member) per client/GNP per capita)

50

burden” ratio,61 as illustrated below. Larger MFIs operating in Asia and smaller ones operating in the southern part of this hemisphere have achieved far greater levels of efficiency, mainly as a result of much lower wage rates and significantly higher productivity levels.62 African MFIs have the worst efficiency performance, a result of high wages, which are greater than any other peer group tracked by the MicroBanking Bulletin, and the cost of finding, hiring and keeping qualified staff in Africa. This salary burden ratio has limitations, however, as local wage rates might differ considerably from GNP per capita depending on how competitive the job market is and the cost of living in the region in which the MFI is operating.63 Most African MFIs, for example, operate in cities, where the cost of living is much higher than in the surrounding villages, so the GNP per capita averages, which incorporate both, are skewed. For example, the cost of staff in Durban is far higher than the GNP per capita for the Republic of South Africa would suggest, and so FINCA adjusts its salaries accordingly.64 Moreover, FINCA’s staff costs in the newly industrialized states (NIS), despite the high education level of its credit officers, are actually much lower than in Africa due to the abundance of educated labor force in the NIS.65 Taking into account these different factors, it is clear that salary is important in maximizing efficiency and thus is dealt with in detail in Chapter Three. Still, the salary indicator by itself cannot isolate the many possible reasons behind an institution’s (in)efficiency. Average Loan Size Average loan size or the average outstanding loan balance per client is calculated by dividing the total amount of credit disbursed by the number of loans. It is often used as a proxy for the market segment an MFI targets, though it is a rough estimate, at best, given the variance of economic factors and loan terms by country, as depicted in Figure 6 below.

61 Christen, “Bulletin Highlights,” p. 42. 62 Christen, “Bulletin Highlights,” p. 45. 63 CAMEL adjusts for inflation before calculating its ratios. Saltzman, Rock and

Salinger, p. 32. 64 Bruett, interview. 65 Bruett, interview. The relative costs would otherwise be surprising because

the GNP per capita of most NIS is higher than that of most African countries.

51

Figure 6: Cross-Country Comparisons of Loan Size

In addition, step lending methodologies employed by many MFIs globally offer increasingly higher loan sizes to clients as they grow, which might inflate the average loan balance of MFIs that are successfully meeting the changing needs of clients that were initially quite poor. Because an MFI’s choice of target population, loan product and underwriting criteria can impact its levels of self-sufficiency, loan size alone is not a strong predictor of efficiency, especially at higher loan sizes. For example, a review of 17 MFIs “recognized as industry leaders in their countries” shows that for average outstanding balances above US$500 to US$600, there is no discernable relationship between loan size and operating efficiency.66 Yet for those MFIs targeting the poorest microenterprise segments, average loan balance can have a strong impact on efficiency. A review of efficiency statistics in the 1999 issue of the MicroBanking Bulletin reveals that the average loan balance of self-sufficient MFIs was twice the size of those that were not (39% vs. 79% of GDP per capita).67 This result does not mean that improved efficiency is out of the reach of those MFIs targeted at the poorest clients. However, for those MFIs with smaller average loan balances, additional vigilance and creativity is required to maximize efficiency, as discussed in Chapter Three.

66 Jansson, p. 2. 67 Christen, “Bulletin Highlights,” p. 42.

Avg. Loan Size/Per

Capita

75% 64%

45%

11%

0%

25%

50%

75%

100%

ABA, Egypt

Bank Rakyat Indonesia (BRI)

Grameen Bank, Bangladesh

ACCION USA

Avg. Loan Size/Per

Capita

Avg Loan Size $695 $234 $160 $3,347

Note: Data for ACCION USA represents averages for the US network

Avg. Loan Size/Per

Capita

75% 64%

45%

11%

0%

25%

50%

75%

100%

ABA, Egypt

Bank Rakyat Indonesia (BRI)

Grameen Bank, Bangladesh

ACCION USA

Avg. Loan Size/Per Capita GNP

Avg. Loan Size $695 $234 $160 $3,347

Note: Data for ACCION USA represents averages for the US network

52

Productivity Levels Of the three factors, the productivity of staff in general, and loan officers in particular, is the most important lever for improving efficiency. To determine target productivity rates—generally measured as active borrowers per person—an MFI can track loan officer productivity over time, comparing its performance to that of competitors or peer averages. MFIs that are just beginning to track productivity sometimes use common sense calculations to set targets. For example, ACCION New York used the average number of hours loan officers spend in the field, geographic dispersion of clients and its historical conversion rate (the number of applications that are approved) among other factors to establish expectations for productivity. When actual performance did not match these expectations, ACCION New York began investigating possible causes of sub-optimal productivity. Low productivity levels by loan officers can be the result of an organizational structure that is “top-heavy” or field staff operating below peak production—both causes of inefficiency. There are a number of factors that influence staff productivity and corresponding ratios that measure these different components of employee effectiveness.

Client Retention Desertion can have deleterious affects on productivity levels, and thus client retention is a key element of efficiency. In general, first loans are more resource intensive due to the client information the loan officer must piece together to mitigate risk. The time and cost of analysis decrease as a client builds a credit history through repeat loans, allowing the loan officer to expand his or her caseload. Institutions with high rates of desertion—both voluntary and forced, through poor portfolio quality—must invest the resources to attract a higher number of new clients and manage the collections and work-out of delinquent loans. For example, clients per loan officer declined sharply in Bolivia in 1999 as MFI staff spent more time going after delinquent clients as a result of the credit crisis described in Chapter One. Not surprisingly, an analysis of ACCION CAMELs revealed a positive correlation between client retention and operating efficiency.68

68 Saltzman, Rock and Salinger, pp. 58-59. Castello, “ACCION Camel.”

53

Staff Retention CAMEL analyzes the retention of staff69 as well as clients, since high employee turnover increases operating costs associated with productivity as well as training. This measure of efficiency is particularly important in the qualitative analysis of CAMEL, since the MFI has control over improving this factor, unlike the macroeconomic variables. Turnover strips an MFI of valuable employee know-how gained with experience on the job, and thus an MFI loses more than just the higher productivity that veteran loan officers typically demonstrate over their newer peers.

Employee Allocation Another supporting indicator CAMEL analyzes is the ratio of field staff to administrative personnel—an indicator of how top-heavy an institution is—to determine how much of salary resources are allocated directly to increased sales. Field staff includes loan officers, collection agents, marketing staff and branch managers, though not the support and back-office staff at the branch.70 The “optimal” ratio of field staff to administrative personnel varies widely by region. Based on repeated applications in Latin America, the CAMEL instrument rates an institution based on a benchmark ratio of 2:1,71 though ASA has fewer than 100 head office staff to support over 4,000 field officers. Another important factor that impacts this ratio is the distribution of lending responsibility in the institution, including the allocation of functions to the front-office (sales) and back-office (processing and support staff). Thus, comparing the loan officer productivity ratio to clients/staff member can be a primary indicator of whether an institution is “top-heavy.”72 To meaningfully compare loan officer productivity ratios among different institutional types, it is useful to review number of staff per branch, taking into consideration the diversity of financial services offered.

Product Terms Product design—including terms, underwriting requirements, risk levels, etc.—also influences productivity. For example, longer loan terms imply proportionately fewer renewals per year, which allows a credit officer to 69 Personnel retention rate is calculated as personnel at end of period/(personnel

at beginning of period + new hires) 70 Administrative personnel expense is simply the difference between total staff

expense and field staff salaries. 71 Saltzman and Salinger, p. D-4. 72 Churchill, Client-Focused Lending, p. 92.

54

handle a larger caseload because the administrative demands are not as great. On the other hand, products that involve greater risk and resources limit the portfolio size each loan officer can soundly manage. For example, the productivity of loan officers offering rural credit is limited by the difficulty of reaching widely dispersed clients and the seasonality of the business, which is tied to the agricultural cycle.

Target Market Closely tied to product terms in affecting productivity is the market niche the MFI targets. To place the productivity analysis in the context of the market served, CAMEL compares the average credit disbursed with the minimum monthly wage in the given area to determine the impact loan size has on the financial productivity of the loan officer. In Latin America, loan size is typically between five and 10 times the minimum monthly wage.73 Any level below that is an indicator that the MFI is targeting the poorest segments of the market, which could explain lower than average productivity levels if the borrowers are difficult or costly to reach.

Headquarters vs. Branch Expenses Looking at headquarters expenses as a percentage of total costs can reveal if the MFI is top-heavy or bureaucratic, which can negatively impact efficiency in more ways than just lower productivity. If the MFI identifies high headquarters costs as the source of the inefficiency, possible causes include inefficient staff, high administrative salaries, inefficient processes that inflate administrative expenses or (most commonly) a combination of the above. Unusually high branch costs could be an indication of regional difficulties. Most of these efficiency ratios are much more valuable when compared over time within the same institution to analyze trends and track how performance improves with portfolio growth. Nonetheless, the increasing availability of comparative data on peer institutions allows an MFI to begin establishing targets. CAMEL benchmarks for Latin America suggest that in most efficiently run MFIs, administrative expenses are evenly split between the central office and the branches.74 High performing MFIs in Latin America actually exceed this performance and begin to approach the decentralized goals of Asian MFIs, which have a

73 Saltzman and Salinger, p. D-5. 74 Saltzman and Salinger, p. D-4.

55

much smaller proportion of headquarters expense in relation to field operations. It is important to note that operating cost structure will vary according to the products offered, the methodology and the distribution channel. For example, those MFIs that disburse or collect payments through tellers in their branch offices might have higher administrative costs compared with village banking or others that provide on-site product delivery in the field.75 Analyzing the allocation of headquarters and branch expense raises the issue of the “optimal” level of central costs and the relationship to the MFI’s volume of operations. Inefficient institutions try to convince themselves that their high costs are due to an insufficient volume of operations. In order to contextualize this efficiency ratio, other relevant information must be considered, including: � Level of institutional development, usually approximated by portfolio

size. � Market conditions, which are defined regionally and include

macroeconomic indicators such as wage rates. � Target market, typically measured by average loan balance divided

by GNP per capita. � Lending methodology, including types of products offered. � Scope of operations, such as multi-purpose vs. single-service

institution. � Type of institution, including bank/regulated financial institution vs.

NGO. While the CAMEL is a sophisticated analytical tool at the macro level, it has its limitations in terms of diagnosing the cause of institutional inefficiency. The CAMEL ratios aggregate all activities associated with lending—origination, repayment, collections, and renewal or payoff—within the ratios. Thus, these efficiency ratios typically do not break down, for example, the salary and administrative expenses associated with collections activities undertaken by an MFI’s loan officers. Furthermore, CAMEL ratios by themselves cannot isolate exactly which product, customer segment, division or specific process is inefficient. Finally, while CAMEL may identify a small average loan balance as one of the challenges to improved efficiency, it does not differentiate which particular products may be more cost-effective than others or which may

75 Bruett, interview.

56

PORTFOLIO YIELD

Interest Income from Loans Receivable = X% Average Loan Portfolio

generate greater revenues. The portfolio yield indicator assists with this additional level of analysis.

PORTFOLIO YIELD The portfolio yield76 calculation measures the actual, or effective, rate of return being earned on an average loan portfolio. It is calculated as follows: For many MFIs, the portfolio yield is often higher than the stated, or nominal, interest rate because many MFIs charge “flat” rates, stated rates that typically approximate only half of the effective yield. The effective yield may also be higher than the stated rate due to the inclusion of fees or when payments, recorded on a cash basis, are collected more frequently than monthly. 77 For other MFIs, the portfolio yield may be lower than the stated interest rate, a difference that represents lost income to the MFI. This difference often results when MFIs do not charge and collect for delinquent interest additional interest earned on outstanding loan proceeds during the period a borrower is delinquent. Rather than bother with the operational actions required to calculate, track and collect this delinquent interest, many MFIs look to the delinquency charges established to recover this lost interest. Two problems frequently arise with this approach, however, each reducing interest income. First, most MFIs do not regularly analyze the relationship of lost delinquent interest income plus the costs associated with collection of a delinquent loan in comparison to the 76 Given the generally high rate of funding subsidization, the cost of funds is not

considered particularly relevant for efficiency purposes except to identify the extent of economic subsidies that would require coverage if the MFI were required to pay market rates for its funding sources. For the same reasons, this analysis does not calculate the net yield on the loan portfolio—net interest income/average loan portfolio.

77 The cash basis of accounting for interest income mirrors the accrual basis of accounting when the periodicity of income recognition for accounting purposes (usually monthly) is the same as the periodicity of payment collection and the borrower is current.

57

delinquent fee charged. Second, even when an MFI does intentionally predicate the delinquency fee on this type of analysis and establishes a fee structure that compensates the MFI for lost revenue and increased costs, these fees are often waived, especially if the borrower resumes regular payments. Effective, or actual, portfolio yields lower than stated yields may also arise when an MFI records interest income on a cash basis and maintains repayment schedules that are longer than monthly. This difference can also result when MFIs offer discounts to certain clients, or when the delivery channels delays the collection of loan payments – such as when an MFI relies on a bank branch system for collections in remote areas. When MFIs use other entities as collection agents (e.g., post offices or commercial banks) and record loan payments on the day that the collection agent transfers the money to the MFI—the date may be later than when the borrower actually paid the collection agent. Portfolio yield provides insight into efficiency when used comparatively. When the yield is compared to the yield of its competitors or colleagues, an MFI can measure the extent of client-base erosion, and thus, lost profitability. When the yield is compared with an MFI’s operating costs, an MFI can determine the extent to which cash items (e.g., interest expense, salaries and benefits, rent expense and other administrative expenses) and non-cash items (e.g., depreciation, inflationary adjustments and loan loss provisions) consume interest income. Armed with this information, the MFI can then begin a more in-depth analysis of the sources of any cost/income imbalance. For example, FINCA uses this kind of analysis to understand how various expense items consume revenue and when an MFI may reach break-even–i.e., how much the MFI would need to reduce costs or increase portfolio (revenue) to reach set self-sufficiency targets. 78

BANK EFFICIENCY RATIO The bank efficiency ratio analyzes the extent to which total income (net interest and other income before loan loss provision) is consumed by total expenses. The bank efficiency ratio is calculated as follows:

78 Bruett, interview.

58

The majority of US banking institutions have efficiency ratios at or below 55% (total expenses consume 55% of total income) with progressive US financial institutions posting efficiency ratios below 50%. In other words, for every dollar generated, progressive US financial institutions consume 50 to 55 cents worth of resources. Just as this ratio measures operating efficiency, its reciprocal79 measures net profit contribution (before loan loss provision), how many dollars are earned for each dollar spent. Thus, with an efficiency ratio of 55%, a banking institution is spending 55 cents to earn a dollar, leaving 45% of all revenue as net profit contribution. These levels of efficiency are higher than the rates achieved by most self-sufficient of MFIs, as illustrated by the following table.

79 This “reciprocal” is calculated as one minus the bank efficiency ratio.

BANK EFFICIENCY RATIO

Total Expenses (before Taxes)

Net Interest Income (before Provisions) + Other Income

Tab

le 4

: C

ompa

rati

ve M

FI

Eff

icie

ncy

Rat

ios

$U

S 00

0s, a

t exc

hang

e ra

te o

f $U

S =

A

SA

Tak

a 5.

0 B

anco

Sol

Bs

5.98

F

undu

sz M

ikro

FM

4.1

1 A

. Int

eres

t Inc

ome

14,0

48

22,

980

2,50

5

B. (

Inte

rest

Exp

ense

) (2

,082

) (

6,84

9)

-

C

. Oth

er I

ncom

e

547

1,65

9

1,6

11

D. N

et I

nter

est a

nd O

ther

Inc

ome

12,5

13

17,

790

4,11

6

E. O

pera

ting/

Adm

inis

trat

ive

Exp

ense

s 5,

748

(12

,753

) (

3,22

6)

F. N

et O

pera

ting

Inco

me

befo

re P

rovi

sion

s /T

axes

6,

765

5,

037

891

G

. Ave

rage

Net

Por

tfol

io

60,6

61

78,1

71

10,4

49

RO

A R

atio

(E

/G)

9.5%

16

.3%

30

.9%

B

ank

Eff

icie

ncy

Rat

io (

E/D

) 45

.9%

71

.7%

78

.4%

N

et C

ontr

ibut

ion

Rat

io (

1 –

E/D

) 54

.1%

28

.3%

21

.6%

O

pera

tion

al S

elf-

Suff

icie

ncy

Rat

io (

D/E

) 21

7.7%

13

9.5%

12

7.6%

Not

es:

All

fig

ures

are

for

fis

cal

year

-end

199

9. F

inan

cial

inf

orm

atio

n fo

r A

SA c

ourt

esy

of t

he

Mic

roFi

nanc

e N

etw

ork.

Fin

anci

al in

form

atio

n fo

r B

anco

Sol a

nd F

unds

z M

ikro

take

n fr

om th

eir

1999

Ann

ual

Rep

orts

. N

ote

that

the

ope

rati

onal

sel

f-su

ffic

ienc

y ra

tio

wil

l be

sli

ghtl

y di

ffer

ent

than

wha

t the

Mic

roB

anki

ng B

ulle

tin

repo

rts

beca

use

it in

clud

es in

tere

st e

xpen

se a

s a

cost

in th

e de

nom

inat

or o

f th

e ra

tio,

rat

her

than

as

a co

ntra

inc

ome

item

as

calc

ulat

ed a

bove

. Cal

cula

tion

s do

not

incl

ude

adju

stm

ents

for

loss

pro

visi

ons,

tax

expe

nse,

or

fina

ncia

l sub

sidi

es.

60

This ratio has significant value for the microfinance industry. First, this analysis pushes an MFI beyond the singular focus on costs by explicitly incorporating revenue maximization into the efficiency analysis. This shift is important because it redefines the benchmark of efficiency. For example, using the traditional microfinance efficiency ratiowhich measures administrative expenses as a percentage of portfolio BancoSol has achieved high levels of efficiency relative to its peers, as illustrated in Table 4. The bank efficiency ratio, however, illustrates that BancoSol must spend 71 cents for each dollar earned to generate that revenue. Bringing the level of analysis down to the net contribution of each product and service forces a continual focus on how to enhance efficiency. In this way, net contribution analysis allows the MFI to identify the leverage effect—the degree to which every dollar expended generates revenue—on a branch-by-branch or product-by-product or market sector basis. This unit-by-unit analysis allows the MFI to make smart decisions about strategic direction.

COST AND REVENUE ALLOCATION

The ever deepening levels of financial analysis explored here require an MFI to more accurately identify the contributions of individual divisions, product lines, service types and customers to the overall financial position of the MFI. Essential to this analysis are: � The inclusion of all costs—direct and allocated indirect—in

determining net profit contributions among different business units and lending activities.

� The shift away from a solitary emphasis on cost control toward an emphasis on net profit contribution—considering the efficiency opportunities in revenue generation as well as cost containment.

This section discusses each of these points by tracing the progression of allocation methodologies—from costs to net contribution. In managerial accounting terms, costs are resources sacrificed to achieve a specific objective.80 There are many ways to classify costs to help managers understand how they behave and how they can be controlled.

80 Most of the definitions in this section are drawn from Horngren, Foster and

Datar.

61

The classification of costs as direct and indirect describes a cost’s relation to a specific object81 or area of analysis such as a specific product, a customer segment, a department or a branch. The terms fixed vs. variable costs describe the behavior of costs. Table 5 presents a list of conventional cost objects and example corollaries in microfinance.

Table 5: Conventional Cost Objects

COST OBJECTS EXAMPLES IN MICROFINANCE

Product or Service Fixed asset loans, pawn loans, life insurance, savings products.

Project or Program Business development services, health education.

Customer Segment Preferential clients, first-time borrowers.

Brand Category Security vs. high return.

Activity Customer capture, loan underwriting, collections.

Department Sales, human resources, branch.

Branch Rural, urban.

DIFFERENTIATING COSTS Before discussing the methodologies used to assign different costs—and ultimately, revenues—to objects of analysis, MFIs must understand the different types of costs and their implications for efficiency. Fixed vs. Variable Costs The terms variable and fixed costs describe the behavior of costs generated by specific drivers, which are any factors that affect costs such as number of clients, number of inquiries or other inputs. Variable costs, as the name implies, are those which change with the level of the cost driver. For example, the amount of paper and other materials utilized in the loan application process varies with the number of prospective clients. Compensation plans that are performance-based—such as

81 A cost object is anything for which a separate measurement of cost is desired.

Cost objects are not chosen for their own sake, but rather for their assistance in decision-making.

62

salaries based on loan volume and portfolio quality or probation periods for loan officers who fail to meet their sales quotas—also have an important variable cost component. Fixed costs do not change with the level of cost driver within a given range of production and over a given time period. These last two points are important because almost all costs are variable in the long run. For example, loan officer salaries are fixed in any given month because it typically takes at least that long to train a new one. So any additional clients are just added to the caseload of the existing staff, without any increase in total salary costs, until the loan officers reach their maximum productivity level. Over a budget quarter, however, loan officer salary can vary with the launch of a new product or any significant increase in clients, both of which can require hiring additional staff. The distinction between fixed and variable costs has long been regarded as key in the microfinance industry because maximizing efficiency involves increasing productivity of the existing, fixed capacitywhether loan officers, systems or infrastructure. Fixed costs increase in a step fashion or “batches,” whereas variable costs—such as financial expenses—increase one-for-one in a linear fashion with each additional loan disbursed.82 MFIs will try to maximize utilization of existing resources (e.g., a branch or a computer system) to cover fixed costs, until they reach their maximum capacity, at which point they will take on additional capacity to meet the increased levels of demand. Understanding these capacity thresholds and how fixed costs change with different volumes of operations is key to maximizing utilization of these resources (e.g. loan officer productivity) to improve efficiency. For example, it is this state of excess capacity that has allowed many conventional banks to enter the market, often with a competitive edge over existing microfinance institutions. They have an established infrastructure of branches, management information systems and administrative support with excess capacity that can be leveraged in

82 An MFI’s financial expenses include not only interest fee and expense but

inflation and subsidy adjustments as well as provisioning expenses, all of which increase with loan volume. It is important to note, however, that the MFI has some control over provisioning policies and inflation adjustments, as well as some administrative expenses (such as depreciation, amortization, and other non-cash or capitalized expenses) through accounting choices. So, an MFI can choose to control costs by reducing delinquency or (imprudently) adjust provisioning policy.

63

creating and expanding their microfinance portfolio at relatively low marginal costs. Fixed and variable costs are conceptual building blocks that support a cost accounting analysis described in greater detail later in this chapter. However, the microfinance industry’s historical dependence on the fixed and variable cost concepts has, in some situations, hindered support for self-sufficiency. For example, many MFIs argue that high fixed costs are, as the name implies, an immutable fact within the industry and thus are the root of inescapable inefficiency. It is not that their head office is too big, inefficient institutions will argue, but that they have not yet achieved the “right” scale of operations. Therefore they try to address the problem by introducing new products or expanding to new segments to increase average loan size and grow the loan portfolio, without fully understanding—let alone reducing—costs.83 These fallacies become clear in the conceptual construct of direct and indirect costs and ultimately in their allocation. Direct vs. Indirect Costs Direct costs are those that can be specifically traced or assigned to a cost object in a feasible way. For example, loan officer salary expense is a direct cost that can be traced to a specific branch and often, a particular credit product or customer base if there is specialization of labor. Conversely, costs such as general advertising of the MFI (for name recognition), training staff to enhance computer skills, regulatory exams, developing activity-based costing systems (discussed below), certain components of information technology systems,84 and senior management salary and travel all represent expenses that cannot be directly attributable to a given product or office. These indirect expenses must therefore be allocated in a reasonable fashion among different products or branches.

83 This strategy is often unsuccessful because portfolio growth in inefficient

institutions is accompanied by corresponding increases in operating costs, especially if they expand into new product lines and market segments where they have little expertise.

84 While the monthly technology costs to process transactions represent direct costs that can be allocated to individual divisions, branches, products, etc. based upon transaction volumes, other information technology costs (the cost of upgrades, maintenance and repair to IT equipment, etc.) are often considered indirect costs.

64

The difficulty in financial institutions offering multiple products to different client segments is that many costs are heavily interdependent and therefore difficult to link to a specific product or customer.85 To address this reality, there are methods of allocating or assigning both direct and indirect costs to specific objects, as discussed later in this chapter. The ultimate purpose of tracing direct expenses and allocating indirect expenses to specific cost objects (such as branches, departments, activities, products or clients) is to make informed managerial decisions, such as pricing and investment selection. For example, knowing about costs at each branch helps management determine if there are inefficiencies or risks in different geographic areas. Similarly, understanding costs by credit product can provide managers with the extent of cross-subsidies among various loans and savings products and allows appropriate price adjustments. Only when all costs are assigned and allocated to a specific object can management make strategic decisions about how to maximize the utilization of its scarce resources.

DEGREE OF ALLOCATION The distinction between indirect and direct costs becomes important as an MFI begins to allocate costs. Though most MFIs analyze costs at the macro, institutional level, many have moved beyond this macro analysis to categorize expenses on a business unit (or responsibility center) basis. Cost allocation allows an MFI to better understand where and how intensively its different resources are being spent. Still, this level of analysis focuses only on costs without an allocation of the related interest and fee income. Ultimately, as implied in the progression of allocation methods described below, the MFI gains the most valuable information by allocating total business income, interest and fee income, and total expenses, including loan losses, across various units. This consideration of costs and revenues (associated with a product, service or business division) allows what is referred to in conventional banking as net contribution analysis. Both because of its value and the rarity of use in microfinance, net contribution is described in greatest depth in the presentation of allocation methodologies provided below.

85 Allen, p. 33.

65

Direct Allocation The most common methodologies MFIs employ to achieve a more accurate understanding of their expenses are direct cost allocation and partial allocation of indirect costs. Direct cost allocations are commonly found in MFIs and represent the core of expenses typically allocated in MFI budgetary processes. Thus, when MFIs report expenses based upon responsibility center for cost control purposes, the costs typically allocated are those within the direct control of the management of that responsibility center—compensation and benefits for the unit’s staff, rent or depreciation expense, supplies, electricity, etc. Other direct expenses allocated should include the portion of total information technology costs utilized by the division, advertising that is specific to an individual site or responsibility center, and training when it is specific to the individuals within a responsibility center. Partial Indirect Allocation The next level of cost breakdown typically found in financial institutions involves the allocation of all direct costs and easily allocated indirect costs. In this scenario, easily identifiable indirect costs are allocated while others are not. Examples of those indirect costs that might be allocated include the monthly fee paid for information system processing that is not volume-based or payments made to charitable organizations or political parties that benefit a specific division rather than the organization as a whole. Full Cost Allocation Under a full cost allocation, all direct and indirect costs are allocated to each division, product or process, ensuring that each activity under scrutiny carries its share of overhead burden. Thus, the cost of the accounting department, the internal auditors, advertising, public relations, CEO and board would be allocated 100% to the various areas. This full allocation represents a more sophisticated method of analysis and improves the diagnosis and treatment of sources of inefficiency through the implementation of a more accurate cost analysis. The basis for allocation of these indirect costs is often subjective and varies organization by organization. Decisions about the most appropriate allocation unit (at the divisional, branch, product, customer segment, etc. levels), will depend on accuracy, consistency, reliability and availability of relevant information, and the existence of computerized systems (e.g., Excel worksheets) to capture and manipulate the data.

66

PHASE I PHASE II PHASE III COST REVENUE NET PROFIT REDUCTION ENHANCEMENT CONTRIBUTION

Revenues ± Revenues ± Revenues Expenses Expenses Expenses Net Income Net Income Net Income

Net Contribution Confronted with declining net interest-rate margins as a result of deregulation, problematic commercial lending portfolios and periods of economic stagnation, commercial banks in the United States have undertaken a number of initiatives over the last three decades to improve net profitability. As depicted in Table 6, these initiatives began with an emphasis on reduced costs. This reduction in costs—the stage that microfinance is in presently—emphasized an overall reduction in expenses as well as concomitant increases in productivity for expenses incurred. As the ability to decrease costs tapered, the US banking industry turned its attention to revenue generation. This revenue generation orientation—while always a component of banking—emphasized additional sources of income (fee income, insurance sales, brokerage commissions, etc.). This shift led to a significant safeguarding of net income despite the ups and downs of interest rates and the ability to generate new sources of income.

Table 6: Cost Control vs. Net Profit Contribution

As the pursuit of increasing revenue generation matures, leading banks find themselves at their present orientation—the analysis of the net profit contribution. The evolution of these strategies, which is relevant for MFIs concerned about self-sufficiency, culminates in an analysis that looks at revenues and expenses in conjunction, rather than separately. 86 A leverage factor or multiplier effect is inherent in this focus—every unit of expense incurred should generate some multiple of revenue. Through this orientation, expenditures are directly linked to the benefits they generate. Thus, decisions regarding whether to spend marketing dollars on radio, television or bus advertisements are evaluated directly against

86 These costs are typically determined on a fully allocated basis.

67

the revenue to be generated (the multiplier effect or leverage ratio) by each form. This net income emphasis is captured in the bank efficiency ratio described in detail earlier in this chapter. This shift in orientation can be an effective management tool for some MFIs. Most middle management members are given responsibility for cost containment through tight budgetary processes and are expected to meet certain revenue thresholds (usually established at headquarters). Often, however, management feels constrained by ineffective allocations of expenses that they do not believe maximize the return possible on dollars expended. When senior management shifts to a net profit contribution model, middle management is given responsibility for net income and thus a greater flexibility in determining how to allocate expenses to generate desired revenues. Under certain circumstances, this change in orientation and middle management empowerment can generate remarkable results in revenue generation. Net contribution allows the MFI to undertake a strategic analysis that moves beyond operational and financial considerations. In other words, net contribution provides a basis of information upon which to make strategic decisions—decisions about where to set interest rates, which products to offer, which delivery channels to use and where to locate new branches. In this way, net contribution analysis is insightful in formulating strategic decisions, especially for the majority of MFIs trying to meet the twin objectives of mission (serving the poor) and financial sustainability. For example, FINCA uses its Diagnostic Evaluation to analyze profitabilitydefined by net operating margin, return on assets and return on equityper credit officer, and compares this ratio to total loan officer compensation as a percentage of total operating margin. This comparison provides insight on the individual contribution of each credit officer to the bottom line, as well as how much of the burden of the organization the credit officers carry. In calculating and comparing the same ratios for all employees, FINCA determined that credit officers tend to be underpaid compared to administrative and managerial, as the field staff carry a large burden of the expenses of non-income generating employees.

68

ALLOCATION METHODOLOGY There are a number of tools used to allocate costs to provide a richer understanding of business processes and the associated expenses. This section reviews four of these tools with an emphasis on activity-based costing and activity-based management, which have growing relevance to the financial sector. The section ends with a comparison of the different allocation methodologies through examples of practical applications in microfinance. Budgetary Accounting Budgetary accounting is the most frequently used form of financial reporting after preparation of the primary financial statements and ratios. This level of accounting allocates key revenues (e.g., interest income) and core expenses to individual business units, branches or responsibility centers. The most frequent motivators behind these reporting efforts are the need or desire to account for funds with restricted use and the need or desire to hold divisional management accountable for their breadth of expenditures and cost control. Given these driving forces, divisional or unit summaries prepared for budgetary purposes do not generally reflect costs other than those that the unit manager can directly control (e.g., compensation for a specific branch). Thus, overhead expenses, including any fees paid to the board of directors, the compensation of the chief executive officer and the costs of an internal audit department, are typically not reflected in these budgetary reports. At times they do not even include interest income or interest expense associated with various divisions, branches or units—often as a result of an inability to capture this data at that level of reporting. This level of reporting has some advantages for the MFI. It may help individual managers control costs related to their individual business units and may identify variances in actual expenses from previously budgeted expenses. Budgetary accounting also may provide some marginal value when the costs of one division, branch or unit are compared with comparable ones in other parts of the organization. This level of reporting, however, generally does not provide information detailed enough to identify root causes of hidden costs or lost revenue opportunities.

69

Cost Accounting Traditional cost accounting87 accumulates direct costs based upon rates and volumes of productions. Indirect costs (overhead) are allocated to products using these rate- and volume-based measures such as the number of direct labor hours or the amount of labor dollars required to underwrite a loan. Frequently, these cost analyses are one-dimensional—focusing on one segment of an organization while ignoring other relevant areas and costs associated with the delivery of the product. For example, a unidimensional focus to determine the cost to originate a microloan might ignore the component cost drivers, such as the credit officer’s time in lead generation, marketing expenses and the cost of underwriting applications not approved. Rather, a cost is assigned to products produced or services delivered with efficiency measured in terms of variances from the pre-established unit cost, as illustrated in Table 8. Because these units of production may not be the true drivers of how resources are consumed or may not encompass all of the expenses incurred, traditional costing methodologies often misallocate overhead costs.88 When indirect costs are allocated fully, they are often consolidated and then arbitrarily assigned to products. In other words, there is a frequent lack of cause-and-effect relationship between traditional allocation bases and the cost objects to which they are attributed. These distortions often lead to poor decisions regarding expenditure and investments in specific operational activities, products or customers. Activity-Based Costing Like traditional cost accounting, activity-based costing (ABC) is an allocation system that focuses on cost management through the assignment of costs to products produced and services rendered. Unlike traditional cost accounting, however, ABC assigns costs based on the resources (such as employee time or physical space) consumed. In contrast to cost accounting, with its singular focus and emphasis on units of production, the distinctive features of ABC are its focus on activities as fundamental cost objects and its cross-functional orientation.

87 Traditional cost accounting grew out of the manufacturing sector, when

product ranges were limited, technology was fixed and overhead supported the production function.

88 Typically, the traditional approach overloads indirect costs on high-volume products and under-allocates low-output level (volume) products.

70

A description of the ABC process is beyond the scope of this monograph; however, the core of ABC lies in identifying all of the activities performed to complete a certain process or produce or deliver a specific product or service. An activity is any named process, function or task that occurs over time and uses up resources to produce output (products and services). Loan origination, underwriting, approval, disbursements and collections would each represent an “activity” in the lending process.89 ABC requires that costs be allocated for each activity based on resources consumed, such as staff time or physical space. These cost drivers are then aggregated to determine the activity-based cost for the activity being analyzed. ABC tries to allocate overhead in a manner more consistent with the actual costs associated with the production and delivery of products and services, though this process is more an art than a science. For example, an executive director’s time could be allocated to a particular product based upon the percentage that the product represents of the entire portfolio, on the amount of staff time allocated or the percentage of time that the executive director spends marketing certain products in the community. In this way, ABC measures what a company does—how many units of input (a driver) each activity consumes during any given period of time. Applying ABC to MFI loan origination breaks the process down into its incremental steps, activities that might include taking the application, analyzing the application, approving or declining the credit, preparing the loan disbursement documents, and closing the loan. The drivers of these activities are the quantitative results of these activitiesthe number of applications taken, the number of applications analyzed, the number of applications approved and the number of loans disbursed—as illustrated in Table 8. With this greater level of information that an ABC system generates, an MFI can identify hidden costs or the precise cause of high costs and can serve as a critical first step in an MFI’s reengineering efforts.90 Because this approach stretches across divisions

89 Activities are comprised of drivers, the components that define or give rise to

a certain activity or contribute to its expense. For example, the number of loan solicitations is a driver of loan origination, an activity.

90 Reengineering, discussed in depth in Chapter Four, allows managers to identify duplicative or unnecessary activities, pinpoint root causes of waste and formulate focused solutions to improve efficiency.

71

to capture all costs associated with a given process (marketing, lead generation, etc.), ABC creates a stronger basis of direct costs upon which to allocate overhead. Accordingly, ABC helps managers make better-informed decisions about resource utilization by more accurately linking costs with their corresponding drivers.91 For example, the cost of underwriting small loans might seem marginal based on the relatively insignificant financial expense or even loan officer time, if a group methodology is employed. However, the back-office resources employed in processing applications are typically the same regardless of loan size, so fully allocating these administrative expenses provides an MFI with more accurate information for setting interest rates and assigning resources. Moreover, estimating hours spent at key points in the loan underwriting process can help identify bottlenecks and opportunities for revised processes. MFIs can also employ ABC to compare the costs of the same activity for different clients—such as new vs. repeat borrowers—or make decisions about how loan officers should focus their time.92 For example, by defining unit loan costs an MFI could calculate the cost of different stages of the lending process to make strategic decisions about dedicating more time to the screening vs. work-out of delinquent clients.93 Activity-based costing is not, however, without its limitations. ABC requires significant amounts of detailed information (time studies for each task in a given process) that is, at times, difficult to obtain and perceived as excessive and time-consuming. Additionally, ABC requires management information reporting at a level that many MFIs presently lack. The expenses—both in terms of staff time, information gathering and information maintenance—are significant and sometimes do not support the marginal return in information provided over less complex financial analysis methods. This cost-benefit trade-off is especially true if the level of detail produced by an ABC analysis is so specific that staff is

91 BancoSol in Bolivia hired PriceWaterhouseCoopers, a well-known

international accounting firm, to undertake an ABC analysis for its credit processes. BancoSol found the four-month exercise so valuable that it decided to expand the study to encompass all the bank’s business processes.

92 Cost per client is often used instead of unit loan costs because MFIs normally keep reliable data on client levels.

93 Gheen, Jaramillo and Pazmino, p. 6. This study on unit loan costs allocated administrative expenses (not financial costs or loan losses) based on the amount of time spent on the relevant activity.

72

not able to meaningfully apply the information for strategic decision-making. Activity-Based Management Activity-based management (ABM) takes activity-based costing one step further. While ABC focuses on cost management and decision-making around costs, ABM focuses on increasing organizational profits and customer service. It moves beyond the Phase I cost focus of Table 6 to Phase III—the concomitant focus on revenue and cost for strategic planning and decision-making. As a result, it begins with activity-based costing and layers upon this cost structure the applicable revenue generation for each activity.94 ABM looks to product, customer or division profitability for purposes of maximizing value, not simply minimizing costs. Thus, ABM is of particular interest to MFIs expanding their operations or those MFIs operating in competitive environments. For example, by understanding how (un)profitable certain products are, an MFI can make strategic decisions about differential pricing (and cross-subsidization, if appropriate) and expansion or discontinuance of certain product lines or lending methodologies. ABM can also be employed to measure the relative contribution of large vs. smaller loans, thus identifying the extent of any cross-subsidies and helping determine how much staff time to dedicate to different customer segments. ABM is applicable in a myriad of additional ways to MFIs—such as in determining where to expend promotion funds or in intentionally allowing for an increased loss rate when high costs of collection suggest that this loss rate would maximize net profits. Like activity-based costing, the implementation of ABM systems is often limited by the time and expense involved in developing and maintaining such systems. Allocation Methodologies Compared Table 7 highlights key characteristics of each of these four methodologies. It is important to note that the appropriate standard will vary based on target market (e.g., subsistence vs. growing

94 For savings deposits, revenue is typically determined by the return earned

from investing the capital in market investments, such as government bonds. The difference between the cost of funds paid on the deposits (actual interest expense) and the cost of funds that would be paid in the marketplace if the MFI had to procure an alternative funding source could also be considered revenue, as this differential represents an economic benefit to the MFI.

73

microentrepreneurs) and institutional type (e.g., NGO vs. commercial bank). Table 8 highlights the value offered by activity-based costing and activity-based management over functional cost accounting. As the table shows, the functional cost accounting analysis provides data that suggests what the cost to originate each loan should be based upon predetermined levels of time spent originating loans. Thus, costs per loan originated are estimated to be US$122.30; actual costs to originate each loan is much higherUS$177.69. The resulting variance between actual expense per loan originated and the predetermined standard under cost accounting requires significant additional analysis to determine which component of the difference relates to: � Differences between projected and actual origination volumes. � Differences between actual and projected costs (e.g., electricity). � Differences between actual and projected inputs (e.g., the number of

hours for loan officers to originate a loan).

This data is in contrast to the detailed information provided under an activity-based analysis. In this analysis, the actual cost to originate a loan is broken down into individual drivers (done for compensation only in this analysis), thereby providing the MFI valuable information to guide a search for potential cost savings. For example, the 35% of time spent on obtaining a completed application may appear high to many MFIs and thus warrant further analysis for ways to reduce the time spent in this area. Activity-based management analysis takes this ABC data one step further, providing information regarding the net profit contribution of each loan originated. Under this mode of analysis, management has information to guide the further search for cost savings and also information to aid in the pricing of various products.

Tab

le 7

: C

omm

on F

inan

cial

Ana

lysi

s Sy

stem

s SY

STE

M

OB

JEC

TIV

ES

/ PU

RP

OSE

C

HA

RA

CT

ER

IST

ICS

STR

EN

GT

HS

SHO

RT

CO

MIN

GS

Bud

geta

ry

Acc

ount

ing

Cos

t Man

agem

ent.

Ens

ures

that

tota

l ex

pend

itur

es d

o no

t exc

eed

reso

urce

s bu

dget

ed b

y ar

ea.

Det

ails

var

ianc

es b

etw

een

budg

eted

vs.

act

ual

expe

nditu

res

to tr

ack

exec

utio

n of

bud

gets

.

Rel

ativ

ely

inex

pens

ive.

U

ncom

plic

ated

. E

asy

to m

aint

ain.

Ince

ntiv

e to

ful

ly u

tiliz

e as

sign

ed r

esou

rces

(vs

. im

prov

e ef

fici

ency

) to

en

sure

sim

ilar

futu

re b

udge

t le

vels

. T

radi

tion

al

Cos

t A

ccou

ntin

g

Cos

t Man

agem

ent.

C

aptu

re a

nd a

lloc

ate

cost

s to

out

puts

(pr

oduc

ts a

nd

serv

ices

).

All

ocat

es in

dire

ct c

osts

ac

ross

all

pro

duct

line

s ba

sed

on m

ajor

fac

tors

of

prod

uctio

n: d

irec

t lab

or,

mat

eria

ls a

nd o

verh

ead.

Pro

vide

s a

mea

sure

men

t, al

beit

not

pre

cise

, of

cost

s of

pro

duct

ion

agai

nst

whi

ch th

e M

FI c

an b

egin

to

ben

chm

ark

resu

lts.

Les

s so

phis

ticat

ed a

lloca

tion

(vs.

trac

ing)

of

cost

s to

ou

tput

dis

tort

s tr

ue p

rice

and

ca

n le

ad to

poo

r m

anag

emen

t dec

isio

ns.

Act

ivit

y-B

ased

C

osti

ng

Cos

t Man

agem

ent.

A

ssig

n co

sts

to p

rodu

cts

and

serv

ices

bas

ed o

n th

e re

sour

ces

(tim

e, s

pace

, etc

.)

they

con

sum

e.

All

ocat

es o

verh

ead

base

d on

cos

t dri

vers

inhe

rent

in

wor

k ac

tiviti

es a

nd

proc

ess

flow

s. T

race

s co

sts

of a

ll ac

tiviti

es to

as

soci

ated

pro

duct

s.

Impr

oved

und

erst

andi

ng o

f “r

eal”

cos

ts a

nd s

ourc

es o

f in

effi

cien

cy.

Giv

es p

ictu

re o

f co

sts

attr

ibut

able

to a

par

ticul

ar

prod

uct,

cust

omer

, pro

cess

or

dep

artm

ent.

Mor

e ex

pens

ive,

tim

e-co

nsum

ing

syst

em th

an

trad

ition

al a

ppro

ache

s (t

houg

h in

form

atio

n ge

nera

ted

can

resu

lt in

sa

ving

s th

at f

ar e

xcee

d se

t-up

cos

ts).

No

focu

s on

net

pr

ofit

cont

ribu

tions

. A

ctiv

ity-

Bas

ed

Man

agem

ent

Pro

fit O

ptim

izat

ion.

A

ssig

n re

venu

e an

d co

sts

to

prod

ucts

and

ser

vice

s ba

sed

on th

e re

sour

ces

(tim

e,

spac

e, e

tc.)

they

con

sum

e.

All

ocat

es o

verh

ead

in th

e sa

me

man

ner

as A

BC

. E

nhan

ces

stra

tegi

c pl

anni

ng a

nd d

ecis

ion-

mak

ing.

Impr

oved

und

erst

andi

ng o

f ne

t pro

fit c

ontr

ibut

ions

by

prod

uct,

cust

omer

, pro

cess

or

dep

artm

ent.

Incl

udes

all

sou

rces

of

cost

an

d re

venu

e.

Enh

ance

d de

cisi

on-m

akin

g an

d pl

anni

ng.

Mor

e ex

pens

ive,

tim

e-co

nsum

ing

syst

em th

an

trad

ition

al a

ppro

ache

s (t

houg

h in

form

atio

n ge

nera

ted

can

resu

lt in

sa

ving

s th

at f

ar e

xcee

d se

t-up

cos

ts).

Ada

pted

by

Mon

ica

Bra

nd f

rom

the

Dep

artm

ent

of D

efen

se,

Inte

rnet

Sit

e, w

ww

.dti

c.m

il/c

3i/b

prcd

/020

1c1

(8/

18/9

9)

Table 8: Comparative Financial Cost Analyses – Loan Originations

COST ACCOUNTING

ACTIVITY-BASED

COSTING

ACTIVITY-BASED

MANAGEMENT Variable of analysis:

Costs based on Standards

Actual Costs

Actual Revenue and Costs

Interest and Fee Income

NA NA $525,000

Loan Officer Compensation:

Travel 10% 30,000 10% 30,000 Application 35% 105,000 35% 105,000

Analysis 35% 105,000 35% 105,000 Approvals/

Declines 20% 60,000 20% 60,000

Total 250,000 100% 300,000 100% 300,000

Electricity 8,000 7,500 7,500 Telephones 1,500 1,875 1,875 Stationery, Supplies

1,250 1,000 1,000

Unallocated Overhead

45,000 45,000 45,000

Total Assumed 305,750 NA NA Total Actual 355,375 355,375 355,375 Variance (49,625) NA NA Net Contribution NA NA 169,625 Loan Origination Capacity

2,500

Actual Loan Originations

2,000 2,000 2,000

Notes: There are numerous ways to allocate overhead. For simplicity, overhead has been allocated consistently for each type of analysis on a percentage of total staff basis.

76

BENCHMARKS

The ratios discussed in this chapter and the information captured through different allocation methodologies provide varying levels of insight into the operations and revenue-generating capabilities of an MFI. Whether calculated at the entity-wide level or at more detailed units of analysis (at the divisional, branch, product, customer segment, etc. levels), these ratios and data become even more meaningful when considered in comparison to established benchmarks. These benchmarks may be established internally (a comparison of current performance to previous performance) or externally (a comparison of current performance to peer group comparisons). Moreover, benchmarks can be both quantitative and qualitative, with the latter analyzing accuracy and customer service. For example, how long must a customer wait for loan approval and disbursement of funds? In addition to time, another common benchmark of efficiency is productivity—not only in terms of number of clients per loan officer but number of applications processed or number of corrections made. The targets mentioned thus far are based on generalized performance of mature, well-run institutions around the world. Obviously, each MFI should track its progress over time in an effort to continue improvement based on target goals. Whether in comparison to its peers or to itself based on relative improvement over time, the question remains: What is an appropriate benchmark for a particular MFI? The answer lies in identifying like-kind MFIs, whose characteristics most closely match those of the individual MFI. When comparing performance to its peers, an MFI should seek out institutions with similar characteristics or with characteristics of the type of entity the MFI hopes to become. These key characteristics and the indicators for measuring them are summarized in Table 9 below.

77

Table 9: Factors Affecting Performance Levels CHARACTERISTIC PROXY INDICATORS Institutional Development

Portfolio size and/or savings mobilized, delinquency levels, number of clients, years in operation, number of staff (including front-office vs. back-office), number of branches.

Market Conditions

Country/region, urban/rural/other, wage and employment levels, average household income (and GNP/capita), degree of competition.

Target Market/Customer Characteristics

Portfolio composition by product, lending methodology, degree of product differentiation (including other financial services), average initial loan/deposit size, qualitative indicators (education level, degree of poverty, etc.).

Institutional Type

Bank, NGO, hybrid; size and type of branch network.

Accordingly, one must use benchmarks relevant to the situation of a particular MFI, accounting for differences in: � Scale: Efficiency is a function of scale due to the existence of fixed

costs that can be spread across a higher number of clients as an MFI grows its portfolio. Thus, more mature organizations might have a lower unit cost per product if they can exploit scale economies. Efficiency measures should take into account both the evolution of the MFI (its age and stage of development) and the market (the level of competition and customer awareness, which would impact the MFI’s market penetration).

� Loan Size: An MFI can grow its portfolio either by serving more

clients (“scale”), increasing average loan balance by focusing on repeat clients or targeting higher market segments. In other words, an MFI can improve its efficiency ratio by increasing average loan size, provided that retention rates are positive and the costs of renewal are lower than initial underwriting costs.

� Target Market: As just mentioned, the market segment an MFI chooses to target impacts loan size and other factors that directly affect the standard efficiency ratio. For example, an MFI can segment its market geographically, concentrating its lending operations in areas with certain levels of infrastructure or population

78

density—factors that can directly affect costs, including those associated with marketing, customer identification, loan underwriting costs and branch structure (few vs. many).

� Loan Purpose and Underwriting: The type of lending undertaken

(e.g., group vs. individual, consumer vs. microenterprise) and underwriting methodology employed (e.g., business vs. consumer credit) impacts the efficiency ratio. Typically, operating costs of consumer lenders are much lower than those lenders providing business credit, because the former typically achieve much higher levels of productivity. A review of MicroBanking Bulletin data shows no clear correlation between individual vs. group lending methodology and levels of productivity/efficiency, though as discussed in Chapter Three, tailoring underwriting to the characteristics of the product and target market can heighten efficiency.

� Institutional Type: A regulated financial institution typically incurs

additional costs—such as more robust security and management information systems, staff functions required by regulators (risk management, treasury, etc.) and staff training—that add to its administrative expenses. This increase in costs may be offset by scale economies a regulated financial institution could achieve with its more established infrastructure. Benchmark analysis must take the institutional differences between MFIs and commercial banks into consideration.

These variables emphasize that benchmarking should not be a onetime effort. Rather, an MFI should incorporate benchmarking into a process of continuous improvement for the organization. Benchmarks should be reevaluated periodically to make sure they are relevant and appropriate for an institution’s current business objectives and mission. Among the considerations for establishing relevant benchmarks are: � Importance to customers or business operations. � Consistency with mission or institutional values. � Significance in terms of costs or key nonfinancial indicators.

In addition, standards of best practices can evolve as competition increases and the industry becomes more sophisticated and formalized.

79

Recently, a number of initiatives have been undertaken in the field to develop benchmarks by which an MFI can evaluate its performance. There are rating agencies such as MicroRate and other analytic tools such as ACCION’s CAMEL.95 Peer groups provide comparables, and network organizations operating regionally (such as ACCION International) or globally (such as the Microfinance Network, FINCA International and Women’s World Banking) often amass statistics for purposes of comparison among their members. Donors also contribute to this effort at information gathering for purposes of comparison, such as the CGAP’s sponsorship of the MicroBanking Bulletin.96 The secondary impact of this effort is the creation of de facto standards of performance against which concerned MFIs can track performance. These efforts at developing industry standards reflect the growing interest in performance among more developed MFIs. The standardization of key financial ratios has enabled MFIs to increase the sophistication with which they analyze their operations and identify areas for improvement. The next step is to pinpoint the causes of sub-optimal performance and to formulate strategies to maximize efficiency.

95 Other similar analytical tools not discussed here include FINCA’s Diagnostic

Evaluation, the PEARLS assessment developed by the World Council of Credit Unions, Inc. (WOCCU), and PlaNet Finance’s GIRAFE. All acronyms are listed in the preface, but GIRAFE, when translated, stands for: Governance and decision making; Information and management tools; Risks and internal control; Activities and loan portfolio; Financing: debt and equity; Efficiency and sustainability.

96 The Consultative Group to Assist the Poorest (CGAP) provided three years of initial funding for the MicroBanking Bulletin.

CHAPTER THREE

IMPROVING EFFICIENCY: ALIGNMENT THEORY

83

Understanding and measuring efficiency is a critical part of efficiency maximization, though it is only a first step. The key financial indicators discussed in Chapter Two that the microfinance industry has historically used are generally not detailed enough to highlight the precise sources of inefficiency or lost revenue opportunities that might be uncovered with activity-based costing. Nor are most MFI information systems yet structured to provide the information necessary to implement activity-based costing. This lack of precision in pinpointing sources of inefficiency presents a real challenge for the progressive MFI seeking to optimize net profit contribution. Not only is efficiency optimization limited as a result of this lack of detailed reporting, it is also hampered by the diversity of contexts in which microfinance organizations operate. The industry is rife with methodologies, techniques and practices that have evolved in response to the unceasing quest for broader outreach, increased efficiency or both; however, general application of these “best practices” to increase efficiency is difficult given the disparate conditions under with MFIs operate. For example, technological advancements in data transmission from one location to another that may produce significant cost savings in the United States are worthless in a country whose communication lines are not developed enough to support such technology. Likewise, the benefits derived from the replacement of manual information systems with computerized systems in a country such as Bangladesh are thwarted by the very low-wage base that makes the maintenance of manual information systems cost-effective. Finally, the root causes of operational inefficiency are most frequently multiple and almost always overlap different divisions, products and staffs. Thus, analyzing a given area of an MFI may produce efficiency benefits; however, these efficiency benefits cannot be maximized

84

without an all-encompassing approach that looks at the numerous factors contributing to present inefficiencies. Maximizing efficiency and revenue generation requires looking at the organization holistically—at the way branches interact with headquarters, loan officers interact with support staff, customers interact with loan and savings officers, and employees support or thwart processes. An analytical framework is needed that transcends the diversity of the industry, one that identifies the intertwined root causes of inefficiency and missed revenue opportunities and that can be used in conjunction with traditional financial indicators or activity-based costing.

ALIGNMENT THEORY

AREAS OF ALIGNMENT Alignment theory provides the holistic approach necessary to identify these multiple causes of inefficiency, studying each key component of microfinance organizations individually and in relation to other components, including the mission, in order to identify the myriad ways MFIs unknowingly thwart profit maximization. Alignment theory moves beyond efforts to implement the newest technique or practice, focusing instead on optimizing the manner in which the individual components of a particular MFI conspire to maximize efficiency and self-sufficiency. The key areas of alignment analysis, depicted in Figure 7, are grouped for ease of discussion into three broad areas. They are: � Overarching Strategy: which starts with the mission and includes

customer orientation, strategy, leadership and organizational culture. � Total Product: which includes not only the pricing, terms and

conditions of products and services, but also risk management and delivery channels.

� Internal Systems: which include the organizational structure, human

resources and processes as well as technology, including management information systems, whether automated or manual.

85

Figure 7: Alignment of Key MFI Elements

PROFITABLE DELIVERY OF PRODUCTS AND SERVICES This analytical framework and the efficiency analysis proposed throughout this monograph are premised upon the profitable delivery of loan products and financial services. For some, this profitability focus means that each product or service, when measured over the mid- to long-term, results in a net profit contribution to the MFI.97 The benefit of this strategy is that all of the MFI’s resources are dedicated to activities that contribute to institutional self-sufficiency, relieving the MFI from managing a potential drag on its long-term viability. Many MFIs, however, do not subscribe to this premise. Rather, many cross-subsidize unprofitable products and services with profitable ones for reasons of competitive strategy or social mission. For example, some MFIs will offer a particular product or service on an unprofitable basis to satisfy other competitive goals such as a quick ramp-up in sales to gain

97 Likewise, customer-service levels should be guided by the balance between

the return generated on high-quality service (rapid turnaround for loan applications, products specific to customer needs, etc.) and the cost of providing that service.

HumanResources

MISSION

Organization Structure

Processes

Technology

Culture

Customer Orientation

Strategy

Leadership

Products

Pricing

Risk Management

Delivery Channels

HumanResources

MISSION

Organization Structure

Processes

Technology

Culture


Strategy

Leadership

Products

Pricing

Risk Management

Delivery Channels

86

market share or brand recognition. Other MFIs operate with a “double bottom line,” an explicit strategy that tries to balance the often high cost of social impact with overall self-sufficiency via the intentional cross-subsidization of different products and client segments. For purposes of this analytical framework, self-sufficiency is considered to be an overriding objective for all MFIs, if for no other reason than to enable increased outreach.98

CENTRALITY OF MISSION Whether explicit or implicit, all organizations operate with a mission—a certain vision, a philosophy, a particular operational orientation. As described above, mission, the cornerstone of every organization, answers the questions of who, what, where and how on a macro level by: � Directing the MFI’s focus toward target market niches (e.g., the poor

or the unbankable, women or all individuals above a specific age, certain racial or ethnic populations, etc.).

� Identifying the organization’s overall product and customer-service orientation.

� Identifying the geographic areas to be served. � Establishing certain operational expectations of the MFI (industry

leader, self-sufficiency objectives, etc.) and of its customers (repayment, social impact, etc.).

Many inefficiencies can ultimately be traced back to an MFI’s mission. Thus, mission represents a component of, if not the starting point, for most efficiency analyses. Specifically, inefficiencies involving mission typically result from: � Multiple, competing or polarized missions operating within an MFI. � Missions that do not remain current with industry and market

conditions. � Missions that are unclear or inconsistent with the MFI’s execution of

strategy.

98 Otero and Rhyne, p. 2.

87

Multiple, Competing or Polarized Missions Many MFIs operate with multiple or competing missions, as when “new” management or staff seek to move the organization in a direction actively resisted by “old” management and staff. Competing or polarized missions can also exist when leadership views an MFI as primarily oriented toward the poorest of the poor, which may be in direct conflict with a donor’s insistence upon financial viability.99 Locked in this black and white position, management may take as a given that lending to the poor is unprofitable and may be less likely to develop creative solutions that would allow for a greater balance between a mission to the poor and self-sufficiency. Static or Unclear Missions Missions that ignore changing market realities—such as an increasingly sophisticated customer base, increased competition or the opportunities in rapidly changing operational and technical advancements—are the source of lost efficiency opportunities. Many MFIs struggle with this dynamism when determining whether to limit their services to the poorest of the poor—their traditional starting point—or complement this orientation with services to small enterprise borrowers who have advanced economically because of previously received microfinancing. Likewise, a mission that lacks clarity breeds inefficiencies. An example includes the MFI whose mission targets those “at risk,” a term that management defines by specific client needs, such as emergency loans and savings products, but that the board of directors defines more exhaustively, including health care. In this situation, the board’s pressure on management to expand beyond its current core competencies may decrease efficiency by diverting management and staff into uncharted territory. Inconsistencies Between Mission and Strategy Similarly, inconsistencies between an MFI’s mission and its strategy also diminish efficiency. MFIs whose “stated” mission is to provide business loans to the poor frequently find themselves analyzing credit requests that are really consumer-based. Unwilling to refuse a needy borrower yet limited to a stated mission, some MFIs end up considering these credit requests through the lens of their business underwriting structure—a cash-flow orientation unsuited for a collateral or guarantee-driven loan. 99 Rhyne, p. 97.

88

This mismatch between mission and strategy results in inefficiencies as MFI staff spend time analyzing inapplicable factors in the underwriting process. Alignment between mission and all aspects of an MFI’s operations is essential to optimizing efficiency.

OVERARCHING STRATEGY

Figure 8: Mission Alignment

with Overarching Strategy The overarching strategy that an MFI employs is defined by its mission and serves as the basis for virtually all activity within the MFI. Specifically, the degree to which an MFI’s mission is driven by its cultural and customer orientation and effectively implemented by its leadership is generally a strong indicator of the MFI’s operational efficiency. The higher the degree of alignment between these key elements, the greater the degree of operational efficiency typically found. Likewise, weak or missing synergies between these core elements breed inefficiencies.

ORGANIZATIONAL CULTURE Organizational culture is the intricate pattern of what staff believe in and value, how they treat each other, what management styles are employed, and what behaviors are rewarded and penalized. Every microfinance organization has a dominant culture—an orientation that informs how the organization approaches its customers and the business of microlending.100 Some cultures are innovative; others eschew change and

100 During and after periods of significant change within an MFI, such as a

change in strategy, in customer orientation, in leadership or in processes, it is common for two cultures to exist simultaneously. This cultural dualism (most often seen in the old guard vs. the new guard) is frequently the cause of significant tension within the organization, polarizing the MFI between the

Culture

Leadership


StrategyMISSIONCulture

Leadership


StrategyMISSION

89

innovation, instead relying heavily on historic means of lending and savings. Some are highly cost conscious; others are not. Some MFIs empower staff to make decisions (while coupling this capability with accountability for results), while other MFIs hold decision-making tightly at the top of the organizational structure. Still others are conflict-averse, while their counterparts foster environments where managers or divisions engage in turf battles. However defined, culture is one of the primary driving forces within any MFI and also a primary determinant in how the organization makes decisions and upon what information it will base those decisions. In addition, culture drives how processes will be conceived, staff utilized and technology implemented. Finally, culture informs how the management and staff of the MFI will react to a change in strategy, products or prices. It is one of the primary determinants of efficiency. Establishing an efficiency orientation101 is critical and the driving motivation behind the concept of self-sufficiency at the MFI or product level. This type of organizational culture is unceasing in its search for efficiency enhancements and streamlined procedures, an entrepreneurial orientation that embraces change for the value it creates, encourages critical thinking and maintains a fluid information flow between management and staff. Several MFIs have successfully established such a culture, with the outreach and financial results to prove its importance to efficiency and self-sufficiency, including ASA (Bangladesh), Caja Los Andes (Bolivia), Compartamos (Mexico), Fundusz Mikro (Poland) and WWB-Cali (Colombia). Each of these MFIs emphasizes high-quality customer service within a culture of innovation and a search for increasing levels of efficiency.

CUSTOMER ORIENTATION The degree to which an MFI has a robust customer orientation and the degree to which this orientation is aligned with other key areas of the MFI (product development, processes designed for swift turnaround, etc.) impact the level of efficiency attainable. This customer orientation includes, but is not limited to, three key components:

“old” and “new.” See Campion and White for further discussion on this topic, pp. 34-35.

101 Buchenau, interview.

90

� The degree to which the MFI actively seeks to remain current about

customer issues and needs. � The expected balance of work shared between the customer and the

MFI. � The depth and breadth to which a dynamic customer orientation

permeates the MFI. Deep Customer Knowledge Most MFIs operate under the assumption that they have a clear understanding of their customer profiles and needs. Yet when pressed, they find that this understanding is often anecdotal, inaccurate or obsolete. Moreover, most MFIs do not revisit this customer understanding on a regular basis to assess the degree of match or fit between the customer base, its needs and the products and services required, and the processes required to fill customer needs. Such was the case with BancoSol when it underestimated its clients’ changing demands and increasing financial sophistication, a situation that left the organization vulnerable to client desertion when market competition increased. Products, prices and underwriting processes were not aligned with customer demand, and, as a result, clients deserted until BancoSol took corrective actions. Client-centered strategies are made concrete by market research, critical for the successful product development that is the key to expansion for many institutions. ASA, for example, undertook focused, internally directed customer research to correct a “highly disciplined system . . . [that] paid more attention to guaranteeing the recovery of the loans . . . than to the banking needs and preferences of [its] customers.”102 Interviewing the clients of its primary competitor, ASA found that a large percentage was frustrated by Grameen’s rigid policies and used this information to redesign products to include loans to individuals.103 Simultaneous changes in processes were required, including a transfer of responsibility for routine payment collections from the group borrowers to the loan officer. While this shift may have resulted in an increase in loan officer time, and, thus, a decrease in efficiency, this move must be 102 Rutherford, The Biography of an NGO, p. 133. 103 Some of the product adjustments it made included the elimination of

mandatory, weekly group meetings, variations in the size of groups eligible for a loan and a change in policy that led to loan officers collecting loan payments at the clients’ homes or businesses, Choudhury, p. 27.

91

considered within the context of the net profit contribution of an individual loan. In ASA’s case, the change in policy resulted in higher customer service that, in turn, increased market share and revenue generation. Other MFIs turn to externally available socioeconomic and market research. Bank Rakyat Indonesia (BRI) is using socioeconomic and market research to diversify its product base and enter markets in which moneylenders are the only source of competition. As a result, BRI modified its land-collateralized loan (KUPEDES) to penetrate lower markets that frequently borrow but lack land as collateral. Processes were also modified for the new product (the small-scale KUPEDES), including the implementation of a simple, one-page application, the ability to repay daily rather than monthly and novel payment opportunities to minimize the cost of loan collection, given the increase in frequency of repayment.104 Similarly, ACCION USA,105 operating in a vast and highly heterogeneous country, sought specific statistical data about customer profiles and needs, testing the accuracy of this information against the information gleaned in numerous focus groups held around the country. This information serves as the guiding force for ACCION USA’s marketing campaign, its targeting of certain market sectors, its development of its technology strategy and its plan for additional loan production offices. Another MFI in ACCION’s US network used this information to better understand the cultural preferences of an ethnic group that represented a new market niche and the different product and underwriting requirements applicable to that market segment. Allocation of Responsibility The needs of the customer must always be balanced against the MFI’s goal to effectively deploy its resources to maximize efficiency. For example, the importance of customer service and the need to respond to increased competition does not suggest that an MFI fulfill a customer’s every product or service demand. Nor does customer focus and customer service imply that MFIs must assume responsibility for tasks (the completion of an application, the collection of supporting documents

104 Winaro, pp. 31-32. 105 ACCION USA, a subsidiary of ACCION International, oversees, supports

and facilitates ACCION microfinance activities within the United States.

92

required in underwriting, etc.) that are within the borrower’s realm of technical106 and financial literacy.107 Institutions use various approaches when realigning processes and procedures with customer expectations. In Bolivia, for example, BancoSol’s processes and expectations were revised significantly such that customers no longer visited the branch an average of three times before loan disbursement, waiting a minimum of one hour at each visit before being seen by the loan officer. Instead, underwriting requirements were pared without a negative impact upon credit quality, allowing for a reversal of loan officer/customer dynamics. Under the revised structure, loan officers went to the client’s place of business to obtain information necessary for the underwriting process—a significant improvement in customer service. In contrast to BancoSol, ACCION New York reshaped its customer expectations to return the responsibility for loan preparation to potential clients. As a result of the initial need to build a customer base, ACCION New York had established policies that placed the majority of work necessary for loan origination upon the loan officer, who then spent a considerable amount of time assisting the client to complete the application. As the underwriting process evolved and loan documentation requirements were established, loan officers assumed responsibility for gathering the documentation. In some instances, this assumption of responsibilities resulted in the loan officer meeting with a client several times to collect the information considered necessary to underwrite the loan, which increased the cost to underwrite the loan. As its market base became more established, ACCION New York reclarified the split of responsibilities between the loan officer and

106 Technical literacy is defined herein as core competencies considered

necessary to operate a microenterprise successfully. These vary by country. For example, in the United States these might include skills in basic record-keeping, sales and accounts receivable management.

107 Financial literacy is defined herein as core competencies considered necessary to manage an individual’s personal and business financial responsibilities appropriately. These include an understanding of basic financial concepts such as the importance of timely repayments, the establishment of a strong reputation as a borrower, building a formal credit history in countries where credit monitoring systems exist, and cash management at the household and microenterprise levels.

93

potential client so that customers understood loans could not be processed until all required documents were submitted. ACCION New York simultaneously revisited the number and type of documents required, reducing them to only those considered most salient. In recognition of clients’ financial literacy levels, however, ACCION New York still provided clients with assistance in completing loan applications. By realigning its customer expectations, ACCION New York reduced the time spent underwriting each loan. These two examples represent opposite approaches to a rebalancing of the customer/MFI partnership and increasing efficiency in divergent market situations. Yet, at the core of each solution is the fact that each organization sought increased alignment between key components of its operations which resulted in an improvement in efficiency without a decrease in customer base for ACCION New York and an increase in customer base for BancoSol.108 Entity-Wide Customer Orientation The greater the extent to which a dynamic customer orientation permeates the entire MFI staff, the greater the overall efficiency enjoyed by that organization. True customer focus for the entire MFI includes every department, branch or division that is both externally oriented (e.g., loan and savings officers serving the borrower/depositor) and internally oriented (branch support staff, administrative staff, accountants, information technologists, internal auditors, etc., who serve the loan and savings officers). This focus, illustrated in Figure 8, assumes that all employees are equally oriented toward target customer groups. Unfortunately, however, in the majority of MFIs, customer orientation begins and ends with the loan or savings officers, individuals who are often classified as “front-office” staff. At times, this customer orientation is extended to other individuals in a branch or administrative office, such as those who collect cash payments from customers. Rarely, however, does the concept of customer orientation purposefully extend to the support staff located in the “back-office”, the home office or headquarters. And yet, often it is these individuals, with little direct customer contact and little customer orientation, who constitute the largest percentage of compensation and benefits expense. Worse still is the fact that it is often the individuals with the lowest level of customer

108 Chapter Four includes a more detailed discussion of both of these

reengineering efforts.

94

orientation and those furthest removed from the client who establish the procedures by which loans will be originated and processed. This lack of entity-wide customer orientation is typically the primary driver behind decision processes that place importance upon the preservation of a division, its staff and practices above serving the customer in a profitable manner—also known as the maintenance of internal “silos”.

Figure 9: Entity-Wide Customer Orientation

Each of these problems—the development of processes and products that do not fulfill customer needs and the preservation of silos—coupled with an excessive weighting of administrative staff to loan officers negatively impacts efficiency and revenue generation. The antidote—the inculcation of a dynamic customer orientation throughout the entire organization—serves as the genesis for enhanced customer service and operational efficiency. The inculcation of this entity-wide customer orientation is the motivating factor behind BancoSol’s second phase of reengineering, in which the organization is scrutinizing how administrative resources support can enhance profitable product and service delivery. It is also the motivating factor behind ACCION New York’s development of a loan origination process that closely unites loan officers with support staff in a customer-oriented process.

STRATEGY An MFI’s mission, culture and customer orientation drive its competitive strategy—the guiding framework by which senior management and staff fulfill the mission. Some of the important elements that define an MFI’s methodology include the target markets the MFI seeks to serve, the types of products it provides and the delivery channels109 it uses. Strategy also 109 The term “delivery channel” describes the physical means by which lending

and savings products and services are “delivered”/provided to the customer.

CUSTOMER

Loan / DepositOfficer

Support/Admin.Staff

95

encompasses the numerous processes that an MFI employs, including its lending methodologies, its savings schemes, and its repayment and collection processes. Other key components of strategy include the organizational structure used to fulfill the organization’s mission and the profit and risk management approach implemented. Strategy implies intentionality. It implies an establishment of the desired mix of products and customer types based upon outreach and self-sufficiency objectives, appetite for risk, and the degree to which cross-subsidies are generated or required by each product group. The problem identified most frequently with strategies, and an ultimate cause of inefficiency in MFIs, is a lack of this clarity in strategic mix. ACCION New York’s integration of its mission, strategy and product development is an example of the intentional establishment of portfolio mix. The MFI was faced with a number of applications from business borrowers who lacked sufficient documentation, collateral or co-signers as required for loan approval under its existing processes. Yet ACCION New York believed the borrowers to possess strong character and low credit risk. These business borrowers were encompassed within ACCION New York’s mission but not within its strategy. To rectify this difference, ACCION New York revised its market sector objectives (its strategy) to allow for these character-only loans, limiting its risk by placing a limit on the amount of individual loans and a cap on the percentage of the portfolio this product segment represented.

LEADERSHIP Organizational culture that includes a continual drive for efficiency can be created and cemented by an MFI’s leadership, including not only the chief executive officer or executive director but also the board of directors. As important as this board is, especially in the establishment and fine-tuning of an MFI’s mission, it is the executive director, president or chief executive officer who serves as the key link with the MFI’s employees and its customers. The CEO of an MFI shapes and

Channels can include traveling loan/savings officers, full-service branches (distinguished by the presence of support staff) and loan production offices (distinguished by the lack of support staff). In industrialized settings, delivery channels can also include regional or national call centers, as well as e-commerce through Internet and other telecommunication means.

96

LEADERSHIP TRAITS � Visionary � Ability to Manage Change

Effectively � Ability to Think “Outside the

Box” � Charismatic � Excellent Communication

Skills � Courageous, Risk-Taking � Detailed Grasp of Operations

communicates the vision of the MFI, establishes the culture, develops a team, encourages the exchange of ideas, guides the decision-making, and gives shape to the infrastructure of policies and procedures. Under healthy leadership styles, MFI CEOs inspire the staff to increase loan production aggressively and problem-solve creatively. They demonstrate confidence in staff decision-making ability. Under unhealthy leadership styles, MFI CEOs create insular and/or stagnant institutions, resulting in an environment so controlling that dispirited management and staff leave at higher-than-average turnover rates, or avoid decisions that might not be favored by one or more members of the management team. As a result, revenue generation and cost control suffer. Qualities of successful leaders include vision, commitment, charisma, a strong customer orientation and an ability to build strong infrastructures, all of which are important, even essential, to maximizing efficiency. When striving for the continual enhancement of efficiency and self-sufficiency, the senior executive officer’s ability to establish a culture dedicated to ongoing improvement (change) and to manage that organizational change is critical. As discussed at greater length within the context of reengineering in Appendix C, these leaders must rise above daily management to lead effectively through potential controversy, discomfort and employee resistance. They must be adept at thinking “outside the box.” They must possess a certain level of charisma to induce MFI staff not only to embrace change but also to become agents of change. They must be able to communicate effectively and repeatedly their vision of an entrepreneurial organization, and they must have the courage to make difficult decisions with which middle management may not be in agreement. Often, the ability to make challenging decisions must be rooted in a firm grasp of detailed operations.

97

TOTAL PRODUCT

Figure 10: Mission Alignment with

Total Product An MFI communicates its mission and strategy most clearly through its products and services.110 The “total product” includes all its component parts, including the core product (the benefits—why the customer purchases), the actual product (the specific terms, features and packaging—what the customer buys) and the augmented product (the way it is delivered and serviced—how the customer receives it).111 All the components of the total product must be mutually reinforcing and reflect the institution’s overarching strategy. More specifically, synergy among mission, products, pricing, risk management and delivery channels is essential in order to maximize efficiency and profitability.

CLIENT-FOCUSED PRODUCTS In the early years of microfinance, product development was driven by the need to control and transfer administrative and credit risk costs to borrowers in markets where traditional means of evaluating and collateralizing credit were not viable. Efficiency was thought of in terms of a minimalist underwriting methodology, increased average loan size to reduce costs per dollar lent and product diversification to weather against 110 “Products” include the diverse array of financial services (loans, deposits,

insurance, leasing, money transfers, etc.) MFIs offer their clients. 111 Brand, New Product Development for Microfinance: Evaluation and

Preparation, p. 7. For a savings account, for example, the core product could be financial return or security, while aspects of the actual product would include the interest rates, minimum balance, withdrawal privileges and passbook color. The augmented product would include the wait time to open an account or make a deposit/withdrawal, hours of operation, and branch locations.

Delivery Channels

Risk Management

Products

PricingMISSIONDelivery Channels

Risk Management

Products

PricingMISSION

98

KEY COMPONENTS OF PRODUCT ALIGNMENT

� Customer Needs � Key Customer Characteristics � Loan Purpose � Underwriting Processes � Skill Sets of Loan Officers � Objectives of The MFI

exogenous systemic shocks, minimize the impact of any competitive threats and cross-subsidize costly loans. As microfinance evolves, the cost of client desertion is better understood, competitive pressures increase and clients gain financial understanding (financial literacy), this concept of efficiency is expanding. Defined more broadly as the maximization of outputs (or net contribution) for every dollar spent, products, their design and their terms become an integral part of efficiency management. As a result, more and more MFIs are offering client-focused lending and savings products.112 This client focus has important implications for product design, average loan size and client retention. Product Design “Constructing profiles of clients by occupation, loan use and income level is an important first step”113 in identifying customer needs and aligning them to product design. This client understanding has prodded some MFIs whose methodology was exclusively group-based to add individual lending to their product mixes. ADEMI (Dominican Republic) was unsatisfied with a number of the features of group lending. First, uneven growth in the businesses of group members diversified demand levels and eroded the group’s cohesiveness. In addition, standardized loan terms did not adequately address individual borrowing needs, and thus their group lending methodology did little to democratize credit—a key objective for ADEMI.114 ADEMI’s shift to an individual lending approach in response to these issues presented the MFI with the risk of increased administrative and collection costs borne previously by group members. To remain efficient, ADEMI adopted a series of important structural and procedural changes concomitant with the shift to individual lending, including the implementation of an

112 Brand, New Product Development for Microfinance: Evaluation and

Preparation, p. 11. 113 Morduch, p. 4. 114 Churchill, Client-Focused Lending, p. 14.

99

incentive program for loan officers, improved loan monitoring, additional collections support and higher loan sizes. The evolutionary shift toward client-focused products does not necessarily guarantee high-quality customer service and self-sustaining or profitable products. To optimize efficiency, the total product that an MFI offers must meet (be aligned with) the varied needs of its customers115 and it must do so in a self-sufficient manner. Too often, financial institutions, in their attempts to meet every customer demand without regard to the cost-benefit trade-off, forsake self-sufficiency or profitability for customer service. Limiting the number of products offered, yet tailoring those products to the needs of the borrower in an efficient manner, is essential. Thus, offering loans with terms that closely parallel the needs of a customer (e.g., a loan with seasonal repayment terms for vendors whose sales are holiday-driven) helps to maximize revenue generation and reduce risk of loss. Matching loan maturities with loan purpose and customer wherewithal to repay allows for the proper balance between interest rates and fees charged. In those situations where prepayments are higher than anticipated or desired, explicit incentives, penalties or prepayment moratoriums also help to ensure the duration of revenue generation. Additionally, loan products must be designed considering important borrower characteristics, such as providing alternative products for those without collateral while maximizing efficiency. Many MFIs, such as Caja Los Andes in Bolivia, Caja Municipal de Ahorros y Crédito (CMAC) in Peru, Calpiá in El Salvador and WWB-Cali, have mastered this type of product differentiation, a structure that results in significant underwriting and monitoring efficiencies. To expose this twin accomplishment of customer-friendly and efficient products, a review of underwriting standards is required. Microlenders look to five general areas when assessing lending risk. The first three areas—the strength of the borrower’s character, the cash-flow capacity to repay the loan, and the viability of the business endeavor (including the business acumen of the borrower)—are considered the primary elements of underwriting. Two additional elements, the availability of collateral and of co-signers, co-borrowers or guarantors provide additional insurance against the risk of loss should the borrower 115 See the discussion in Internal Systems below regarding the need to align

differentiated products with processes in order to maximize efficiency.

100

default on the loan. When one of these five variables is weak (e.g., lack of strong collateral), microfinanciers typically seek compensatory risk reduction by relying more heavily on other factors (e.g., strength of character or co-borrowers). How management designs products and evaluative processes to minimize the risk of loss while simultaneously minimizing the underwriting required to grant a loan is critical to efficiency management. Table 10 sets forth an example of a differentiated product structure an MFI might implement. As evidenced by this table, loans for short-term liquidity purposes (pawn loans) are sought by individuals with little business cash flow but some amount of gold jewelry. By shortening the term of the pawn loan, requiring collateral “coverage”116 and taking physical possession of the collateral, this product eliminates involved cash-flow analysis and reduces the time spent underwriting, preparing loan documents and disbursing the loan. The generally high emotional attachment of the borrower to the jewelry typically minimizes the risk of default, thereby reducing the time spent in delinquency monitoring. As a result, one loan officer may be able to maintain a portfolio in excess of 1,000 loans. A similar process underlies the personal loans included in Table 10. The underwriting process for these personal loans is restricted to verifying the borrower’s compensation with the risk of loss mitigated by the garnishment of wages to repay the loan. Again, this product and process design reduces the time spent in underwriting and in monitoring, as the loan repayment is deducted from the borrower’s wages prior to payment of any net wages. Other product variations with positive effects on revenue generation or cost controlboth of which improve efficiency—are found in MFIs ranging from the ABA in Egypt to ACCION Chicago. These product variations are described in Table 11.

116 The coverage is the amount by which the value of the collateral, determined

on an appraised or a wholesale basis, exceeds the amount of the loan.

Tab

le 1

0: P

rodu

ct D

iffe

rent

iati

on–A

n E

xam

ple

L

OA

N T

YP

E

PA

WN

P

ER

SON

AL

B

USI

NE

SS

Cus

tom

er N

eed

Em

erge

ncy.

Tem

pora

ry

hous

ehol

d ne

ed.

Per

sona

l nee

d.

Wor

king

cap

ital

. Fi

xed

asse

ts.

Cre

dit

Ris

k L

ow, a

fter

col

late

ral.

Low

, aft

er s

alar

y de

duct

ion.

M

oder

ate.

L

oan

Ter

ms

T

hree

to s

ix m

onth

s.

Max

imum

loan

—50

% o

f ap

prai

sed

valu

e.

Six

to 1

2 m

onth

s.

Am

ount

s ba

sed

upon

pe

rcen

tage

of

net w

ages

.

Gen

eral

ly <

US$

5,00

0.

Thr

ee to

18

mon

ths.

Col

late

ral

Gol

d or

jew

elry

ret

aine

d at

M

FI d

urin

g du

ratio

n of

loan

. A

ppra

ised

on

site

.

Non

e.

Tie

red

coll

ater

al s

truc

ture

. R

equi

red

for

all l

oans

. Tie

red

publ

ic r

egis

try

requ

irem

ents

. U

nder

wri

ting

C

olla

tera

l dri

ven.

D

ocum

enta

tion

limite

d to

pe

rson

al id

entit

y ca

rd a

nd

sign

ed c

ontr

act.

Rap

id

appr

oval

and

dis

burs

emen

t.

Pro

of o

f pe

rman

ent

empl

oym

ent a

nd r

esid

ence

re

quir

ed. Q

uick

app

rova

l (v

erif

icat

ions

onl

y) a

nd

disb

urse

men

t.

Hou

seho

ld a

nd b

usin

ess

inco

me

anal

yzed

in e

ntir

ety.

C

ash-

flow

bas

ed.

Ong

oing

M

aint

enan

ce

Low

. Int

eres

t and

fee

s co

llec

ted

in a

dvan

ce f

rom

loan

fu

nds.

L

ow d

elin

quen

cies

.

Low

. Pay

men

ts d

educ

ted

from

sa

lary

by

empl

oyer

. C

lient

res

pons

ible

for

mon

thly

pa

ymen

ts a

t des

igna

ted

loca

tions

.

Loa

ns P

er

Loa

n O

ffic

er

1,00

0.

750.

25

0 to

400

.

Cos

t to

O

rigi

nate

&

Mai

ntai

n L

ow.

Low

. Cro

ss-s

ubsi

dize

s th

e or

igin

atio

n co

sts

of b

usin

ess

loan

s.

Med

ium

to h

igh.

Oth

er p

rodu

ct v

aria

tions

with

pos

itive

eff

ects

on

reve

nue

gene

ratio

n or

cos

t co

ntro

lbo

th o

f w

hich

im

prov

e ef

fici

ency

—ar

e fo

und

in M

FIs

rang

ing

from

the

AB

A in

Egy

pt to

AC

CIO

N C

hica

go. T

hese

pro

duct

var

iatio

ns a

re d

escr

ibed

in T

able

11.

Tab

le 1

1: P

rodu

ct V

aria

tion

and

Eff

icie

ncy

Impa

ct

PR

OD

UC

T V

AR

IAT

ION

S K

EY

FE

AT

UR

ES

EF

FIC

IEN

CY

IM

PA

CT

Rep

aym

ent

Pla

ns

Alig

ned

to B

orro

wer

’s

Bus

ines

s C

ycle

Reg

ular

inte

rest

pay

men

ts. P

rinc

ipal

pay

men

ts

duri

ng p

eak

cash

-flo

w p

erio

ds.

Enh

ance

d ef

fici

ency

thro

ugh

redu

ced

coll

ecti

on p

robl

ems.

Lin

es o

f C

redi

t C

lien

t-de

term

ined

loan

dra

ws

(dis

burs

emen

t) a

nd

prin

cipa

l rep

aym

ent.

Reg

ular

inte

rest

pay

men

ts.

Enh

ance

d re

venu

e ge

nera

tion

due

to h

ighe

r cu

stom

er s

ervi

ce

and

incr

ease

d m

atch

of

need

s an

d lo

an te

rms.

Con

trac

tor

Loa

ns

Loa

ns f

or m

ater

ials

req

uire

d in

con

stru

ctio

n di

sbur

sed

dire

ctly

to s

uppl

ier

duri

ng c

onst

ruct

ion.

M

inim

izes

ris

k of

mis

appr

opri

atio

n of

fun

ds.

Mon

thly

vs.

Wee

kly

Rep

aym

ent

Pla

ns

Tra

nsit

ion

to lo

wer

fre

quen

cy r

epay

men

ts f

or lo

w-

risk

bor

row

ers.

D

ecre

ases

the

cost

of

paym

ent p

roce

ssin

g.

Rev

olvi

ng C

redi

ts

Aut

omat

ical

ly r

enew

if k

ey p

reco

ndit

ions

are

met

(e

.g.,

no d

elin

quen

cies

dur

ing

prio

r lo

an).

D

ecre

ases

cos

t of

mar

keti

ng a

nd u

nder

wri

ting

.117

Mul

tipl

e L

oans

to

One

B

orro

wer

In

divi

dual

loan

s ta

ilor

ed to

spe

cifi

c bo

rrow

ing

purp

oses

. In

crea

ses

syne

rgy

betw

een

prod

ucts

and

cus

tom

er n

eed,

re

duci

ng r

isk

of lo

ss a

nd u

nder

wri

ting

.cos

ts

Step

ped

Rep

aym

ent

Loa

ns

Pri

ncip

al r

epay

men

ts in

crea

se a

s th

e in

com

e of

the

busi

ness

incr

ease

s.

Incr

ease

s re

cove

ry o

f un

derw

riti

ng c

osts

thro

ugh

the

decr

ease

in

loan

pre

paym

ents

.

Cre

dit

Car

ds

Min

imiz

es c

usto

mer

s’ n

eed

for

chec

ks a

nd c

ash

on

hand

. Fac

ilit

ates

rec

ord-

keep

ing.

E

nhan

ced

fee

gene

ratio

n fo

r lo

w-r

isk

borr

ower

s.

117 W

illia

m G

heen

and

Gle

nn W

estle

y ar

gue

that

a r

educ

tion

in th

e fr

eque

ncy

of r

epay

men

ts m

ay r

educ

e th

e co

llect

ion

cost

s of

non

-del

inqu

ent a

ccou

nts

by a

s m

uch

as 5

0%, G

heen

and

Wes

tley

, p. 2

5.

103

Offering a variety of savings products is also important for maximizing efficiency and self-sufficiency. Stuart Rutherford notes that savings products must suit the “poor’s capacity to save and their needs for lump sums.”118 Thus, savings accounts that allow for small deposit balances and easy access through withdrawals or loans as necessary are key. Other institutions, such as Caja Municipal de Arequipa (CMAC), offer lower minimum balances and payment orders, which function similarly to checks. Self-Sufficiency Meeting customer needs, however, does not mean being all things to all clients. Rather, customer service must be balanced by an emphasis on the self-sufficient or profitable delivery of goods and services and important social objectives (e.g., the development of customers’ financial literacy). Self-sufficiency may be achieved on a product-by-product basis or an entity-wide basis, as when one product or service cross-subsidizes another. Many MFIs offer a range of loan products, including term loans, lines of credit, contractor loans, short-term liquidity loans, balloon loans and seasonal-pay loans. Many MFIs, such as Financiera Calpiá in El Salvador, cross-subsidize less profitable microloans with higher income loans to more established and dynamic, expansion-oriented businesses.119 Thus, product diversification—in addition to minimizing credit, competitive and economic risk—helps the MFI meet the varying needs of microenterprises and small businesses. For some MFIs operating in markets with high demand, the breadth of portfolio may be appropriate. The proliferation of new products without an intentional strategy regarding the extent of cross-subsidization and portfolio mix, however, often results in portfolios whose revenue generation does not cover the cost to originate and maintain the loans. This scenario is particularly true for those MFIs operating in target markets that demand small average loan balances. Furthermore, a wide product breadth may strain the loan officer pool unless some degree of specialization is instituted—a topic covered at greater length later in this chapter. Thus, to truly maximize efficiency, MFIs need to be more intentional about their portfolio allocation strategies and establish product objectives and limitations, based upon reasonable analyses of profit contributions by loan type.

118 The Poor and Their Money, p. 104. 119 Burnett, p. 11.

104

Average Loan Size Much has been written of the need to increase average loan size to improve the efficiency of microfinance institutions. This recommendation arises from the reality that MFIs with small average loan size often have difficulty covering costs relative to their peers with higher balances. In Latin America, for example, a sampling of medium-size MFIs (defined as having portfolios between US$1 million to US$8 million) with average loan balances of less than US$200 had administrative expense ratios of 38.4%, while their regional peers offering a broader range of loans with higher average balances (approximately US$700) achieved efficiency ratios of 30.5%.120 Examining an admittedly smaller sample, MicroRate reports data that seems to show the importance of larger average loan sizes, noting that Latin American MFIs with average loan balances of less than US$200 have administrative expense ratios around 50%, two-and-a-half times the efficiency ratios of top performers in the region.121 Not surprisingly, some institutions, such as Bolivia’s Caja Los Andes and BancoSol, purposefully embark upon a strategy to improve efficiency and increase average loan size by moving up-market.122 While this strategy of increasing average loan size has been effective for many MFIs in improving efficiency, it is important to note that large average loan balances are not mandatory in order to maximize efficiency. As Elisabeth Rhyne notes, low loan sizes can be the basis for a self-sustaining program, as exemplified by Association for Social Advancement (ASA) in Bangladesh, BKD in Indonesia and Compartamos in Mexico.123 Of course, granting smaller loans does require an explicit efficiency strategy to offset the relatively low leverage multiplier (the amount of revenue generated for each unit of expenditure, as explained in Chapter Two) for lower average balances. The interest rates charged also impact the efficiency levels achieved with low average loan balances. In fact, the success achieved by each of the cases mentioned above is a direct result of the realignment of product terms,

120 MicroBanking Bulletin, Issue no. 4, Tables 1 and 3, pp. 48-49, 52-53. 121 Farrington, p. 19. 122 Farrington, p. 19. 123 Oberdorf, p. 97. In the case of Compartamos, one of ACCION’s affiliates in

Mexico, high efficiency is due to automation of lending process. For ASA, the standardization of manual processes helps maintain efficiency. For BKD, efficiency is a result of low-wage rates.

105

processes, and human resource utilization and compensation, illustrating that a high average loan balance on its own is not a requirement for significant efficiency. Another illustrative example is WWB-Cali. Ignoring conventional wisdom, WWB-Cali lowered its average loan size US$537 to US$376 from mid-1998 to mid-1999 while increasing the size of its portfolio by 65% and increasing the number of loans managed per loan officer to 644—all at a time of high economic stress nationally.124 Portfolio yield reached 54% at June 30, 1999 in comparison to an average 37% for eleven leading Latin American MFIs.125 This revenue achievement, coupled with a reduction in its administrative expense ratio to 16% of average gross portfolio and a decline in the level of portfolio at risk (greater than 30 days) to 1.7%, resulted in WWB-Cali reporting returns on assets and equity of 9% and 21%, respectively, at June 30, 1999.126 Some of the specific strategies WWB-Cali undertook to compensate for its lower average loan balance included: � An increase in productivity levels via incentive pay, thorough

training and motorcycles for each loan officer. � The reduced frequency of loan repayments and loan monitoring to

reduce costs in the maintenance phase of the loan life cycle. � The introduction of specialized job functions and delegated loan

authority that allowed loan officers to manage larger loan portfolios. � The introduction of pricing incentives and streamlined loan renewals

to improve client retention. While these examples clearly illustrate that small average loan balances do not preclude impressive efficiency levels, it should be noted that remarkable performance is a result of deliberate policies like the ones WWB-Cali employed to compensate for the lower than average revenue on a unit basis.

124 Farrington, pp. 21, 23. 125 Farrington, p. 23. 126 Farrington, pp. 22-23.

106

Client Retention Desertion rates vary throughout the microfinance industry; however, rates as high as 50% are not uncommon.127 Recent studies undertaken at individual MFIs suggest that some former clients remove themselves temporarily from the microcredit arena due to low credit needs or other borrowing constraints.128 Another group leaves the microcredit financial sector permanently, perhaps due to the inability to maintain credits, while others are lost to the competition. There is little an MFI can do to reverse desertion rates for those customers who no longer need financing or those who exit the microenterprise arena, other than to continue periodic contact to determine if financial needs have changed. Nonetheless, significant efficiency opportunities exist—including reduced marketing costs and reduced loan origination costs—in increasing retention of those clients who have left because they are dissatisfied with the customer service or products offered by an MFI. These loan origination costs can only be made efficient, however, if processes are modified to reflect the information garnered from a high-performing former customer. In his research on unit costs, Gheen discovered that the decrease in cost incurred during the renewal of loans ranged from only 10% to 39%, or approximately the cost of marketing for new clients incurred.129 In other words, MFIs are not optimizing the efficiency benefits available from client renewals because underwriting processes are not being redesigned adequately to exploit this opportunity.

PRICING The intentional management of revenue is essential to maximizing outputs and thus, profitability and efficiency. As a result, optimizing the pricing on loan and savings products is key. This net revenue management should carefully balance a reasonable rate of return, levels of risk, and compensation of various costs associated with both the origination and ongoing maintenance of the loan or deposit.

127 In very competitive markets where ACCION affiliates operate, desertion

rates can reach a high of 50%; however, these desertion statistics are highly dependent upon the methodology employed to measure desertion. (ABA’s desertion rate ranged by site in 1999 between 28% and 33%. Mokhtar and Makram, interview.)

128 Krutzfeld, p. 25. 129 Gheen, Jaramillo and Pazmino, p. 5.

107

Unfortunately, however, for purposes of decision-making, many MFIs do not have a clear understanding of the cost per product. Many MFIs apply undifferentiated pricing, disregarding the nature of the loan product or service. Still others do not charge for the technical assistance they provide. As a result, potential income is lost and all too frequently, costs are not recovered. Numerous components constitute loan or deposit pricing. These include the interest rate (stated and effective, adjusted for subsidies and inflation), as well as fees for origination, delinquency and technical assistance. From a self-sufficiency perspective, product and service pricing (whether determined on a product-by-product or aggregate product basis) must cover the costs to originate130 the loan. Some institutions have begun employing sophisticated price differentiation strategies to offset these costs.131 Pricing should also compensate the MFI for the cost to maintain its products, covering the costs of borrowing, risk of loss and servicing (payment processing, collections activity, relationship management, etc.) associated with the loan. Delinquency fees should serve as a deterrent for non-payment and should compensate the MFI for staff and legal costs incurred to collect the late payments.132 Finally, costs for technical support should be recovered through the fees charged for such services. To the extent that this technical support is provided through the loan officer’s traditional relationship maintenance with the customer, interest income should recover these costs. These important components of pricing schemesnamely loan terms, delinquency fees, fee for services and a nontraditional pricing mechanismcan help maximize efficiency.

130 The costs to originate a loan include those expenses (staff, administrative,

overhead, etc.) incurred from the time an application is received through credit decision to the point that a loan is disbursed and entered upon the loan accounting system.

131 Fundusz Mikro in Poland, for example, charged differential prices based on solidarity group size and the net contribution of larger groups to its bottom line. Brand, New Product Development in Microfinance: Design, Testing, and Launch, p. 29.

132 Some MFIs that maintain a fixed repayment schedule also use delinquency fees to compensate for interest lost during the delinquency period. Other MFIs charge interest during the delinquent period, thereby reducing their reliance on delinquency fees to compensate for lost interest income.

108

The Importance of Loan Term A too short loan term or high rate of early repayment may result in an inadequate amount of interest income earned to cover costs incurred. Thus, the proper establishment of loan term is critical to optimizing revenue generation and cost coverage on loans. While many MFIs regard early repayment by borrowers as positive (as a sign of credit-worthiness and credit sophistication), this attitude does not necessarily account for the impact such repayments have on efficiency. A detailed analysis of the cause of early repayments within the ACCION USA network identified two scenarios that resulted in early repayments and a loss of income. In the first, a step lending approach was introduced—borrowers in need of US$10,000 and able to support repayment of such via business and household cash flows were limited in the amount they could borrow for their first loan. (This limitation had been established as a risk control measure.) To obtain the full $10,000, borrowers were required to take a series of loans, each one greater than the last until they achieved the $10,000 threshold. Borrowers anxious to obtain financing of $10,000 and capable of supporting such a loan were thus forced to take on three or more different loans, many of which resulted in early repayment in order to advance to the next level, and all of which resulted in added underwriting costs. Given that underwriting actually increased as the loan amount grew, this step-lending approach, in fact, multiplied the degree of inefficiency by not recovering underwriting costs at the various step loan levels. A similar situation arose when granting loans for certain start-up businesses that typically required a high initial investment in fixed assets. After assessing the reasonableness of the business venture, the lender determined the loan term based upon the availability of current cash-flow levels, not the anticipated increases in cash-flows as the business developed. As a result, a large number of loans repaid early, using the increased cash flows generated as the business developed. Given the high costs associated in evaluating start-up ventures, these early repayments frequently did not allow for the recovery of underwriting costs, overhead and a profit margin. To maximize efficiency, step lending was replaced with an underwriting process that based the loan amount upon a thorough analysis of the current and projected cash-flow capacity of the business. (This cash-flow analysis compensated for the borrowers’ lack of formal or strong credit histories—the genesis of step lending.) Loan terms were revisited to

109

better match pricing and product. As a result, the rate of early repayment declined, as did the rate of renewal, without an increase in risk of loss. While this decline in renewals resulted in a reduction in fee income (charged on a per loan basis), the net contribution per loan was thus optimized through enhanced revenue recognition and reduced costs. Delinquency Fees Most MFIs charge delinquency fees as an impetus for prompt payment. For many MFIs, these fees are also intended to offset the costs of collection efforts incurred. For a smaller population of MFIs, these fees are also intended to offset the loss of delinquent interest not typically charged customers.133 To optimize efficiency in this area, MFIs have several options. The first is to periodically assess the full cost of collections against the fees actually charged to ensure that costs are recovered completely.134 “Full” costs include such overlooked items as lost interest, attorney fees and repossession costs. Interest income “earned” during the delinquency period should be recovered either directly (through additional payments made by the borrower) or indirectly (through the delinquency fee). Second, MFIs can undertake an analysis to determine to what extent delinquency charges are waived even when collectable. (This percentage is typically much higher than management might at first estimate.) The third opportunity frequently overlooked is to recover all ancillary costs incurred during collection efforts, including charges for attorneys, asset repossession and disposal, collateral maintenance, etc. This latter opportunity requires an information tracking system to maintain the relevant information and also necessitates that contracts and agreements signed by the borrower at loan origination include language allowing for these charges.

133 Many MFIs record interest income on a cash basis and in accordance with a

predetermined amortization schedule that does not vary even with delinquent payments. Conversely, those MFIs that record interest income on an accrual basis charge customers interest on the additional amounts owed during delinquent periods. This accrual basis of accounting requires a deviation from the amortization schedule established at loan disbursement if the loan is ever delinquent.

134 The frequency of this analysis increases in times of rapidly increasing or decreasing delinquency trends.

110

UPFRONT PAYMENTS Some MFIs employ conservative pricing schemes that collect interest upfront to minimize losses due to delinquency. BRI, for example, actually charges a delinquency fee at the time of origination, which it then returns as a “bonus” to borrowers if they pay on time.135 This pricing scheme not only eliminates the fee collection uncertainty but also creates an incentive for on-time repayment, helping to maximize revenue. Similarly, many pawn loan products, such as the one offered by BancoSolidario de Ecuador, an ACCION affiliate, charge the full interest upfront at the time of disbursement, rather than amortizing over the duration of the typically short loans. The delinquency fees for this product are charged in the traditional wayafter the loan payments are past duebut BancoSolidario is covered in the case of nonpayment because the loan is over-collateralized.136

Fees for Services As stated previously, many MFIs charge for extra services rendered, including technical assistance provided to clients. Others do not, as is the case with the MFI that provides computer education services to some of its clients. The risk in both situations is that the fees earned will not recover the costs incurred, if such fees are captured at all. Several options exist to aid the MFI in maximizing self-sufficiency in this area. First, MFIs should accurately assess the costs associated with the provision of stand-alone services, establishing fees adequate to recover such costs. Second, MFIs can take care to accurately assess the often hidden costs of technical assistance provided by loan officers to clients, for it is this time and expense, often so necessary to the fulfillment of the organization’s mission, that greatly reduce the productivity levels and loan origination volumes of loan officers. Third, MFIs should examine the alternatives and optimize the delivery of such technical services—in-house or through outside vendors. ACCION San Diego “out-sources” such services to other nonprofit or governmental entities equipped to provide high-quality services (personal credit counseling, strategic plan development, marketing skill seminars, purchasing skill seminars, basic

135 Churchill, Client-Focused Lending, p. 38. 136 BancoSolidario will typically only lend up to 60% of the value of raw gold,

allowing it to recoup all costs of loan work-out through the sale of delinquent clients’ jewelry. Brand, New Product Development Case Studies, p. 14.

111

bookkeeping, etc.) in order to provide free or low-cost technical services at virtually no cost to the MFI. Nontraditional Pricing Measures There are other important factors besides cost recovery that an MFI must consider in developing pricing schemes that maximize efficiency. While most MFIs are not limited in the interest rates and fee structures that they can charge clients, some face regulatory and cultural restrictions on full-cost pricing, such as those in the United States, certain Latin American countries and Palestinian territories.137 MFIs operating in competitive markets sometimes cap prices to penetrate new markets or retain their customers and thus ensure preservation (and expansion) of the revenue base. To this end, several MFI institutions, such as the Alexandria Business Association (ABA) in Egypt, are moving beyond traditional pricing to include in “pricing” client perquisites such as access to business support and nonfinancial services, free advertisements in the ABA Newsletter and reduced fees for medical services.138

RISK MANAGEMENT The preceding discussion addressed the need for interest income to compensate for the varying degrees of risk of loss that exist within the portfolio and the cost of recovering such losses. To maximize efficiency, the cost of delinquency oversight and loss recovery must be considered in conjunction with the amounts recovered. More importantly, this cost/benefit analysis must take into consideration not only actual costs, such as the compensation paid to collections officers and the delinquency fees collected, but also the opportunity costs incurred. These costs include the foregone interest and fee income on lowered loan originations that result when loan officers focus on collections rather than loan generation. They also include the increased costs associated with the risk that even a slight loosening in collection practices may result in an increase in delinquencies beyond the calculated increase.

137 Usury laws prevalent in the United States generally limit interest rates to a

maximum of 18% to 21%. Other MFIs, such as Oxfam’s Asala, have difficulty covering costs in some of their Palestinian markets, including Hebron, because of religious strictures in the Koran against charging interest (referred to as haram in Arabic).

138 Mokhtar and Makram, interview.

112

This risk is particularly relevant for those MFIs that rely on psychological factors rather than collateral for full loan recovery. Furthermore, it is highly recommended that risk of loss be considered within the context of the product and market sector inherent in the portfolio. In other words, an MFI must evaluate risk on a portfolio basis as well as an individual basis. Many MFIs evaluate the risk of each loan as applications are received with little consideration of the degree to which the portfolio risk is balanced among loans of high, moderate and low risk. Typically, this sector risk analysis is performed using several different points of classification including risk analysis by industry type, product type, geographic area and collateral type/levels. Establishing maximum percentages of the total loan portfolio for each major market sector and setting at least two different bases of percentages (for industry type and geographic area) aid the MFI in efficiently optimizing the risk-return tradeoff. Historically, the microfinance industry has typically dedicated significant effort to collecting each and every loan made in order to prove to donors, capital markets and regulators that loss rates on microfinance loans could be contained at levels comparable to international banking. In some cases, institutions such as the members of the World Council of Credit Unions (WOCCU) place a “strong emphasis on developing a culture of repayment . . . reward[ing] prompt repayment with a reduction on their interest rate charged on the loan.”139 In other situations, MFIs such as ABA (Egypt) benefit from a strong regulatory environment that imposes heavy penalties upon delinquent borrowers. Other MFIs, such as FINCA Honduras, benefit from the social stigma that collection efforts create within the context of village lending, while still other MFIs manage portfolio risk through diversification. Each of these techniques is important to maintaining a strong repayment culture, especially because the lack of control over delinquencies in microfinance can quickly escalate, leading in the worst of cases to the failure of the MFI.140 “Low” loss levels, however, are rarely considered in a systematic way vis-a-vis the cost/benefit trade-off of lower loan volume, greater operational expense and lost revenue generation. At the simplest levels, MFIs monitor delinquency reports for purposes of follow-up with borrowers. At the more sophisticated levels, some transformed MFIs 139 McDonald, p. 9. 140 Stearns, p. 34.

113

such as Mibanco in Peru have joined their commercial banking peers by dedicating staff to analyze and monitor portfolio risk on an ongoing and thorough basis. No matter what degree of sophistication is employed, individual MFIs should undertake additional analyses on a regular basis to ensure that the low loss rate held in such high esteem within the industry represents the optimal loss rate in terms of collection and underwriting costs and revenue generation. Thus, institutions should analyze the cost of collections (including the cost of internal staff and external agencies and attorneys) against the rate of losses incurred. This analysis should also take into consideration “hidden costs,” such as those associated with the risk that a minimization of collection practices will result in an increase in delinquencies. This analysis should then be considered within the context of maximizing the generally limited human resource talent available in most MFIs. Other practices that seem simple and that enhance efficiency through increased alignment of processes and human resource and technology utilization, yet are frequently lacking in smaller MFIs, include: � Establishing and implementing a standardized valuation process that

addresses not only which credits to strongly pursue and when, but also how to calculate and when to record losses on the general ledger. When recorded irregularly, losses distort delinquencies, default rates and ultimately, any type of cost/benefit analysis based upon either statistic.

� Recognizing that an MFI is responsible for actively overseeing the productivity of outside vendors involved in the collection process (attorneys, collection agents, etc.)—oversight that, when employed, typically increases the rate of recoveries.

� Developing standardized letters (templates), calls and visits that are issued at regular intervals. This standardization allows for greater delegation of collection activity to staff other than loan officers.

� Generating standardized delinquency letters automatically by computer when possible.

DELIVERY CHANNELS The effective, creative use of delivery channels141 can greatly improve efficiency, including revenue generation. Delivery channels traditionally 141 See Footnote 13 for a definition of delivery channels.

114

serve two primary roles in microfinance: as the vehicles by which loans, deposits and services are delivered to customers and, conversely, as the vehicles by which customers provide payment and communicate with the MFI. In determining the optimal selection and use of delivery channels, MFIs need to align available delivery channel options with a number of factors, including: � Geographic dispersion of the borrowing base. � Availability of reliable transportation. � Average travel distances and times. � Average wages. � Competitive practices. � Customer service expectations.

To maximize efficiency, the choice of delivery channels should be as inexpensive as possible while still balancing the need for reasonable customer service levels. For example, ASA’s decision to locate the majority of customer/MFI contact with the loan officer (the delivery channel) is predicated upon three factors: � The high degree of competition in Bangladesh, which requires a

“high-touch” customer-service approach.142 � The wide geographic dispersion of its customer base, which

precludes multiple ASA officers calling upon the same borrower due to expense.

� The low wages prevalent in the country, which makes a “high-touch” approach cost-effective.

To implement this policy, ASA provides its loan officers with affordably financed motorcycles. This delivery channel selection differs from that of Pride Africa, for example, which initially had its solidarity groups meet at company headquarters in Nairobi rather than in the field. The reason for the centralized delivery mechanism was the greater ease in administering training components from headquarters that were part of

142 “High-touch” refers to a high degree of customer contact including but not

limited to assisting the client complete a loan application and visiting the client repeatedly after loan disbursement, even if not delinquent. This is in contrast to the low degree of customer contact that pervades pawn lending and credit card issuance in the United States and Europe.

115

Pride Africa’s lending methodology. Similarly, ACCION’s affiliate in Venezuela, BanGente, which is not a cash-handling institution, out-sources various of its bank functions to its partner, Banco del Caribe, including withdrawals and deposits, accounting reports for regulatory authorities, on-line client services and payment management.143 Other sources of low-cost delivery channels include the loan production offices being established by ACCION USA,144 “weekly or bi-weekly points of attention in public places such as markets [and] community group alliances.”145

Partnerships In pursuit of increased loan generation at low costs, microfinance organizations have developed partnerships with local organizations to identify loan prospects. Federation Uruguaya de Cooperativas de Ahorro y Credito’s (FUCAC) “credit delivery system includes service agreements to provide loans to members of trade associations, . . . [a] relationship [that] reduces risks (known borrowers, recourse through the association) and increases efficiency (prepared financial statements).”146 ACCION New Mexico has taken partnering one step further, actually using banks to take applications and close loans. In this case, local banks, motivated by regulatory requirements to support lending to the poor, provide a variety of functions for their partner MFI, including: � Funneling their credit rejections to ACCION New Mexico, providing

the MFI with loan referrals. � Providing ACCION New Mexico with assistance in evaluating

certain credits, a significant benefit given that distances between the MFI and the prospective borrower can be as great as four hours travel time by car.

� Closing the loans on ACCION New Mexico’s behalf. � Serving as payment depositories for borrowers.

Kenya Post Office Savings Bank, as its name implies, uses the nationwide network of post offices in addition to its own stand-alone

143 BanGente, or “Bank of the People,” is formally named Banco de la Gente

Emprendedora. Lok, p. 21. 144 ACCION USA is establishing loan production offices (LPOs), small offices

with a limited number of loan officers, supported by a centralized office for underwriting and loan processing.

145 Lok, p. 21. 146 Farrington, p. 22.

116

branches to mobilize savings. Several MFIs, including ADEMI in the Dominican Republic, also partner with local banks that serve as repayment centers on behalf of the microfinance institution. In villages with an existing MFI with a solid local borrower base, ASA forms a partnership with the institution to provide wholesale lending (direct lending to microfinanciers that, in turn, lend to microborrowers) and technical assistance to the MFI.147 Other MFIs partner with institutions to diversify their product offering without assuming the capacity-building costs often required. For example, FINCA Uganda formed a partnership with a formal insurance company in which the company assumed all the actuarial analysis and risk pooling, while the MFI provided the delivery channel to offer life insurance to indigent borrowers in the informal sector.148 In each of these situations, costs were decreased and in many cases, portfolio balances increased through the use of partnerships as alternative delivery channels. Technological Advancements In those countries where technology is cutting edge, there is an expanding array of delivery channels that will soon be available to MFIs and their clients. These delivery channels are discussed at greater length in the technology section at the end of this chapter.

INTERNAL SYSTEMS

How successfully a product is delivered and clients’ needs are met depends on the alignment of an MFI’s internal processes and systems. The main elements of an MFI’s internal systems are its organizational structure, its processes, its human resources and its level of automation.

147 Choudhury, p. 27. 148 Brown and Churchill, pp. 23-24 and 85. In this win-win alliance, FINCA

Uganda was able to offer its clients an enhanced product by incorporating the life insurance premium directly into the regular monthly loan payments. From American International Group, Inc.’s (AIG) perspective, they now have low-cost access to a new market they would otherwise have had difficulty reaching in a profitable way.

117

Figure 11: Mission Alignment with Internal Systems

All of these components must be aligned with each other, with the MFI’s mission and customer orientation and the MFI’s products in order to maximize efficiency. Each of the elements is discussed at great length below, following a review of the guiding principles, which, if strategically applied, can enhance efficiency throughout the entire product life cycle.

GUIDING PRINCIPLES In addition to the application of an alignment framework to evaluate opportunities for increased efficiency, five principles provide valuable aid. These techniques—the standardization of procedures and processes, increased specialization of staff, the delegation of tasks to lower-paid staff, simplification of processes and increased automationare discussed in turn below. Standardization Standardization is one of the most effective tools available for increasing the efficiency of various processes. Familiar examples include the creation of templates for letters, agreements and other documentation issued by MFI offices and the establishment of prescribed time frames for certain processes (e.g., the issuance of delinquency letters at standard points in a loan’s delinquency rather than as arbitrarily determined). Where standardization brings perhaps the greatest benefit, however, is in those areas long considered too subjective to be standardized. An example includes the standardization of underwriting criteria used for assessing the credit-worthiness of a client and his/her business. It has long been assumed that the assessment of character is so intangible and so varied that it cannot be codified, and to some extent, this assumption is accurate. Nonetheless, new loan officers are somehow indoctrinated into the assessment culture of an organization, sometimes without the benefit of any readily available, standardized framework by which to

Technolog

Processe

Organizational Structur

Human ResourceMISSION Technology

Processes

Organizational Structure

Human Resources MISSION

118

assess a client’s character. The fact that an MFI’s approach to credit assessment is communicated through established training or more informally from loan officer to loan officer provides concrete evidence that this information can be codified, measured and documented in a systematic manner. As a result, large portions of the previously “subjective” underwriting process can be assumed by staff with lower wage bases, reducing underwriting costs and freeing loan officers to pursue a greater volume of loan originations. Perhaps no other microfinance organization is as famous for its degree of standardization as ASA. Operating in a low technology environment with a relatively low wage base, ASA has taken standardization to new levels. This standardization encompasses not only the traditional areas, such as forms and processes, but also all components of branch expansion, including the organizational structure and staff size at various lending volume thresholds as well as procedures for ordering the most elementary supplies. The result for ASA has been the ability to manage over 800 offices and rapid growth while achieving high levels of efficiency and self-sufficiency. Furthermore, because of the level of standardization, ASA staff are easily transferred to other locations with virtually no loss in efficiency. Yet standardization is not an unqualified recipe for success. For as important as standardization is to efficiency, especially in MFIs managing growth, it is important that standardization not evolve into inflexibility or bureaucracy that ultimately increases, rather than decreases, inefficiency and costs.

Staff Specialization There are instances in which adding responsibilities to a given job function enhances efficiency, as when branches or loan officers are given the additional responsibility to make certain credit decisions in order to streamline the underwriting process and enhance customer service. In many other situations, functional specialization of staff can greatly enhance efficiency: � Through the development or acquisition of expertise in given

markets or products, tasks or processes. � By decreasing the breadth of tasks performed by a staff person,

which is often a source of significant inefficiency. � Through the enhanced alignment of skill sets and responsibilities.

119

Such is the case when an individual experienced in collection techniques is hired to relieve loan officers of a portion of their responsibilities for follow-up on very delinquent clients. Other examples include the hiring of a jewelry appraiser, as Caja Los Andes did, to value (almost by sight) the collateral for pawn loans, 149 or the employment of a risk management specialist, as did Mibanco, to monitor and track the portfolios of loans originated by others. There are at least four factors that determine the relevance of specialization in enhancing efficiency, including: � Volume of Operations: An MFI must consider whether activity

volumes are large enough to support the cost benefits in specialization. For example, when application volumes reach a certain level, an MFI can support employing an individual to perform the more routine components of the underwriting process (file creation, reference checks, data entry, etc.).

� Skill Sets of Employees: Sometimes staff specialization results in a better match of responsibilities and skill sets. Many MFIs have wrestled with finding the right type of loan officer, one who is highly personable, skilled in sales and steeped in common sense or the “street smarts” necessary for evaluating the character and business prospects in this nontraditional lending form. Yet loan officers are also expected to possess strong financial and analytical skills. Often this wide-ranging set of skills is difficult to find. Segregating the “sales” and human relationship component of the job from the financial analysis component as ACCION New York and ACCION Texas have (through the use of an underwriter who analyzes the financial viability of individual credits) may offer greater opportunities for increased application production and thus, enhanced revenue generation.

� Uniqueness of Products: Some markets or products are so unique or

particular that specialization is required. For example, rural lending, as a result of the variable nature of agricultural economies, often requires loan officers with experience working in this field, as Calpiá in El Salvador discovered. Other times, such specialization enhances efficiency because of the unique underwriting involved (e.g., the segregation of a lending portfolio and loan officers into consumer and business portfolios).

149 Farrington, p. 21.

120

� Cross-Selling Opportunities: Sometimes specialization by product may detract from efficiency if there is overlap in the respective target markets. In these cases, specialization may diminish an MFI’s cross-selling efforts.

Delegation Standardization and specialization are further enhanced by delegation. Numerous studies, including the semi-annual industry statistics published in the MicroBanking Bulletin and in MicroRates’ fact sheets, highlight the generally high levels of compensation as a percentage of total operating expenses (with Asian MFIs the general exception due to their low-wage bases). Delegation helps to maximize the productivity for every dollar of compensation incurred by analyzing every task and its associated responsibility assignment to ensure that each task has been assigned to the individual with the lowest compensation level capable of performing it well. This delegation principle is one of the primary motivators behind ACCION New York’s and ACCION Texas’ decisions to transfer a significant portion of the underwriting procedures (e.g., landlord and employer reference verification, household and business financial analysis) and collection process (collection efforts required after the 10th day of delinquency) from loan officers in order to improve their productivity. Similarly, institutions such as CMAC in Arequipa have established a tiered credit approval process that delegates credit decisions for a majority of loans to loan officers or the managers to whom they report. Calpiá in El Salvador employs the concept of delegation when it shifts responsibility for loan portfolio management post-closing from the originating loan officers to portfolio managers. Simplification The standardization of tasks often results in their simplification; however, this standardization does not automatically lead to a simplification of processes. Simplification, by itself, is a concept that can be applied to all aspects of the MFI from the mission and strategy of the organization to the organizational structure (e.g., flatter organizational structures typically enhance communication and decision-making) to the processes followed. Processes, especially those that have evolved over time, are frequently plagued by redundancy, circuitous work or information flows, or an excessive number of internal controls and thus often benefit from simplification. Such was the case with BancoSol’s and WWB-Cali’s underwriting processes before each organization

121

significantly pared the number of documents required and financial ratios analyzed. Simplification is also applicable to internal controls in that the benefit of reduced risks of loss must be balanced against the increased cost to prevent such losses. Thus, when assessing the multiple layers of internal controls that many risk-control oriented institutions implement, basic cost-benefit analysis must be applied in order to ensure that “risk avoidance [is not] more costly than risk exposure.”150 This analysis should include the opportunity costs of the internal controls—“the lost revenue as a result of avoiding or mitigating risk”151—as well as the direct expenses. For example, in gradually and selectively relaxing its “zero tolerance for arrears” policy, ABA provided a second chance to some clients to repay their loans, thereby increasing client retention and its overall profitability. It is important to note that internal control does not necessarily have to be at odds with efficiency maximization. In fact, the internal control verification carried out by Mibanco’s internal auditors not only provides assurance that client and bank records are consistent, the verification process also adds value through the simultaneous solicitation of feedback from clients about how the MFI could better serve their needs. This customer service emphasis puts the client at ease and saves Mibanco the cost of separate visits to conduct market research.152

Automation In many situations, the automation of manual processes can enhance efficiency, although the benefits of this technique must be considered in conjunction with the cost of automating and the savings to be achieved. Automation encompasses the use of calculators and time clocks as well as computers. Several uses of automation have been cited already, including standardized templates for the recurring issuance of certain documents such as delinquency letters. The automation of these letters can reduce the time required to prepare them, especially if names and addresses can be entered from existing computer files. Automation can also be employed to speed the calculation of certain cash-flow information (returns on assets and equity, gross profit on sales, debt to

150 Campion, p. 18. 151 Campion, p. 18. 152 Campion, p. 59.

122

cash-flow ratios, etc.) and maintain manually-prepared lists (e.g., of loans maturing in the next month).

ORGANIZATIONAL STRUCTURE Organizational structures that facilitate rapid, responsive decision-making and maintain a keen awareness of customer and competitive issues are essential in maximizing efficiency, maximizing customer service and minimizing the threat of competitive pressures. Thus, the manner in which an organization is structured—the degree of centralization vs. decentralization of staff and functions, and the ratio of front-office to back-office staff—plays a significant role in overall efficiency. To optimize efficiency, this organizational structure must be aligned with other critical factors, including the MFI’s customer orientation, market competition, the extent of geographic dispersion, the cost of its local wage base and the degree to which tasks can be consolidated and transferred to lower-paid staff. Of primary significance when analyzing the efficiency of an MFI’s organizational structure is the degree to which the structure promotes the lowest possible number of staff and the lowest cost of buildings and equipment while simultaneously maximizing customer service and minimizing the risk of loss.

Decentralization To date, conventional wisdom has argued that successful programs, “without exception, administer their microfinance services through a decentralized, performance based, modular, operational structure.”153 Organizations that embody a decentralized structure—characterized by standardized retail units (branches) located in close proximity to the client base, empowered with a high degree of operational autonomy in all but the largest of lending decisions, and accountable for the quantity and quality of their production—include ABA, ASA, BRI’s desa unit system and Finamerica (an ACCION affiliate in Colombia). While their staff sizes and structures vary, these branch offices are responsible for the majority of loan generation, loan payment processing, loan collection and savings mobilization and often include some number of administrative staff whose tasks may range from accepting deposits and payments to data entry to accounting and computer maintenance. These

153 Christen, p. 191.

123

branches are, in turn, supported by a centralized staff (often labeled as headquarters) who provide the organization with overall computer, accounting, information technology and marketing support. While a decentralized organizational structure may bring loan officers closer to the clients, it does not, however, guarantee efficient operations or high levels of customer service. As Todd Farrington notes, “The ratio of loan officers to total staff is a proxy for the institution’s ability to allocate resources to its core business: lending. Remarkably, even in the most efficient institutions fewer than half of staff members are loan officers. In fact, the ratio seems to decrease as microfinance institutions mature, suggesting an increase in middle management that may not bode well for further efficiency enhancements.”154 Thus, the ratio of staff located in an MFI’s “headquarters” to total staff plays an important role. The availability of affordable, reliable technology is also a critical determinant in maximizing the efficiency of decentralized organizational structures. The degree to which the lending methodology is standardized is also significant.

To assess the degree to which the organizational structure contributes or detracts from the efficiency of the organization and customer service, the analysis of the structure must closely examine a number of factors, including: � Cultural orientation toward customer service. � Assignment of job responsibilities. � Lending methodology. � Degree of automation.

The key to efficiency maximization is to search for opportunities to eliminate operational redundancy and speed information analysis, as BancoSol did in its reengineering effort.

Models As described in greater detail in Chapter Four, BancoSol’s reengineering effort had two main goals: increasing the efficiency of its already decentralized branch operations and improving customer service. In analyzing the split of job responsibilities, BancoSol discovered that the heavy involvement of the loan officers in a number of mundane tasks

154 p. 18.

124

(data entry, payment collections, etc.) skewed the loan officers’ time toward administrative processing rather than loan generation. This skew was further exacerbated by an underwriting process that overly compensated for risk assessment through extensive financial analysis and that required loan officers to be present throughout the entire local credit committee process. Furthermore, a low regard for the value of prospective clients’ time resulted in long waits and poor customer service. BancoSol has spent considerable energy and effort redesigning processes and reassigning job responsibilities to optimize its decentralized organizational structure. Thus, in its initial phase of reengineering (discussed in greater detail in Chapter Four), a number of routine tasks were transferred to administrative support within the branch, thus freeing up loan officers to spend the majority of their time in loan generation activities. In advancing to this point, BancoSol has moved closer to the ideal decentralized structure as currently envisioned within microfinance literature. This first phase of restructuring, however, did little to address the size and efficiency of BancoSol’s large central administration—a staff complement in the headquarters and regional offices that represented 23% of total staff. It is this area that represents a large portion of the second phase of BancoSol’s reengineering focus.

An alternative to this decentralized branch model is one currently being employed by various sites within ACCION USA—a model necessitated by the geographic dispersion of clients and facilitated by the technological infrastructure of an industrialized country. Adapted from the residential lending sector of US banking, this model maintains local loan production offices (or LPOs)—thinly staffed branch offices described earlier in this chapter—while all administrative staff are housed centrally. Only loan officers reside within these local offices with primary responsibility for loan application generation, the initial assessment of loan applicants, maintenance of client relationships and any necessary collection efforts during the first 10 days of delinquency. While at first glance, this approach appears to be a step backward in decentralization, heavy reliance upon relatively inexpensive technology allows for the easy transfer of data and documentation. Underwriting processes that have been standardized, simplified and automated allow for the transfer of many underwriting responsibilities to the administrative staff155 (known as the loan processing staff within the

155The loan processing staff’s responsibilities include components of character

assessment through reference verifications, the majority of financial analysis

125

service center). This delegation of loan authority coupled with an increasing reliance upon credit scoring in the decision process affords rapid turnaround on loan applications. Strong computer links between the loan production offices and the central office allow loan officers access to application status. (The underwriting processes and automation of data are discussed at greater length below.) By centralizing administrative staff directly involved in the lending and loan maintenance processes, this organizational model eliminates the administrative redundancy of the branch structure, as exists at many MFIs. Not only does the number of administrative staff members required decline, efficiency also benefits from the enhanced standardization that centralization affords.156

As at ASA, BRI and other MFIs, optimizing the efficiency of a decentralized organizational structure requires that internal barriers to a dynamic, entity-wide customer orientation be eliminated. In this respect, administrative staff, whether located in the branch, headquarters or the service center, work not to protect their own business unit but rather to ensure the swift processing of loan applications and payments regardless of business unit assignment. Similarly, accountability and timely access to information are key requirements for the success of these decentralized models. Each local office should serve as a stand-alone unit for purposes of measuring the quantity and quality of production as well as the efficiency of operations and revenue generation. To this end, access to timely information—about individual clients, about the unit’s performance and the performance of its peers (internally and externally)—is integral. The loan production office model requires the clear establishment of benchmarks for all employees involved. Some of the more commonly tracked benchmarks include: � Number of loan applications generated. � Quality of applications submitted (measured via the loan approval

rate, the percentage completion of the application upon submission for review, etc.).

after data input into automated spreadsheets and other evaluative assessments based upon the nature of documentation received.

156 This model is the precursor to the development of call center and Internet technologies that will allow prospective clients to complete loan applications over the phone or via the Internet and, in many instances, receive lending decisions within one day of receipt of application.

126

� Number of loan officers supported by each loan processor (and by default, the number of loan applications processed per loan processor).

� Number of loan processors supported by one underwriter, etc.

PROCESSES The key processes involved in any product or service can be segregated into three areas correlating to the three primary components of the life of a product or service. These areas, highlighted in Figure 11, are the: � Marketing phase (the identification of prospective customers). � Product or service origination phase (the assessment of the

prospective client and the subsequent issuance, if acceptable, of the product or service).

� Maintenance phase (the maintenance of the client after initial product or service delivery).

Opportunities for inefficiency and thus efficiency enhancement are numerous in each of these areas. As discussed at length in Chapter Two, this inefficiency can be best measured through an analysis of the costs (and net profit contribution or utilization) associated with each product or service on a fully allocated basis. An important consideration in this detailed financial analysis is the conversion rate, a ratio used in conventional banking to measure the rate at which the MFI is successful in converting potential clients into long-lived customers of the organization. Maximizing conversion rates, or as William Gheen phrases it, “minimizing attrition rates”,157 is an important component of efficient organizations. Each in Figure 12 represents a point at which prospective or existing clients may exit the system. Gheen notes that “the earlier the non-qualified borrower is eliminated from the process, the cheaper the cost of attrition. Attrition rates between steps provide management with insight into where to look for changes in procedures and marketing in order to lower costs.”158

157 p. 26. 158 p. 26.

127

Figure 12: Life Cycle of a Loan – Conversion Efficiency

MARKETING UNDERWRITING MAINTENANCE CONTACT Application Loan Loan Loan Payoff/

IDENTIFIED Received Approved Disbursed Serviced Renewal

Conversion Opportunity

Through a series of practices discussed at greater length in the sections that follow, the conversion rate for applications to disbursed loans can approach 75%. This achievement means that for every four loans underwritten, three will generate revenue for the organization and will bear the costs associated with the one declined application. With the cost of underwriting often high on a per loan basis, this represents a significant efficiency savings over the MFI whose application to disbursement conversion ratio is only 50%. Similarly, increasing the rate at which an MFI is able to convert a maturing loan into a new loan should also reduce costs and increase efficiency, if only in the form of marketing efforts not required. Marketing Marketing is the process of building awareness and ultimately allegiance among potential customers regarding the particular identity of an institution, as defined by its products, brand image, competitive position and target market. The concept of alignment applies strongly to marketing, as an institution’s products, competitive strategy and overall image must be strongly linked to the needs of its target market in order to be successful. The more closely customers identify with an institution’s brandthe concept that links an MFI’s products to its overall strategythe stronger the customer satisfaction and overall client retention, which in turn enhances efficiency. For example, Caja Los Andes’ brand is defined by its individual (vs. group) lending products and streamlined delivery. Its agile lending system, which involves fewer guarantees and simpler application process than most of its competitors, reinforces this brand image so much that Caja Los Andes actually spends relatively little on explicit promotions. As a result, its conversion rate for individual loans has been higher than that of its competitors, as has its client retention. Not surprisingly, its efficiency ratio is stronger than that of most of its competitors.

128

Conversely, in markets such as the United States, despite huge unmet demands for microfinance,159 significant marketing costs are required to establish name recognition and overcome the disbelief that often permeates cultures that have been disenfranchised from traditional lending sources. In such cases, efficiency in marketing is enhanced when the marketing costs (whether word-of-mouth, loan officer outreach or formal print or electronic advertising) generate a “steady stream of referrals”160 with a high conversion rate of potential customers into active clients.

To optimize the revenue-generating potential of any advertising and marketing efforts undertaken, whether formal or informal, it is important that MFIs track the results of individual marketing activities, analyze these results against strategic objectives, product structure and processes, revising areas that require realignment as necessary. To this end, some client-driven MFIs have begun to incorporate the collection of valuable marketing information into their regular lending practices in order to more directly align customer needs with product enhancements. For example, BancoSol is incorporating a borrower classification system into its regular application process so that it can build a more detailed, dynamic profile of different market segments and tailor its product terms accordingly. Other MFIs have begun standardizing interviews of departing clients so that the institution can identify opportunities for greater product and customer service enhancement. In both cases, incorporating marketing more directly into the normal lending process allows MFIs to track customer satisfaction in a more robust way, allowing for preemptive product refinements that translate into increased revenues at minimal costsefficiency maximization.

Underwriting Underwriting can be compartmentalized into four discrete components—prescreening, loan analysis, credit approval and loan disbursement.

Prescreening Strong prescreening enhances efficiency by preventing applications with the high risk of a negative credit decision from consuming underwriting

159 Research undertaken for ACCION USA by the Roslow Research Group

suggests that there are over 13.8 million microentrepreneurs in the United States.

160 Churchill, Client-Focused Lending, p. 45.

129

resources. While this prescreening need not be as stringent for groups as for individuals, given the cross-guarantee inherent in group loans, MFIs such as ACCION New York have limited but effective prescreening criteria that, if unmet, will preclude an application from being processed further. (ACCION New York maintains a list of those clients screened out at this juncture but who may be eligible at a later date for follow-up by loan officers.) Key factors analyzed at this juncture can include proof of residence, the status of any bankruptcies or significant, unexplained loan defaults and whether the business type falls outside the industries allowed by the MFI. Loan Analysis Certain opportunities for significantly increased efficiency, such as the standardization of procedures and forms, the assignment of underwriting responsibilities based upon delegation and areas of specialization, and the increased use of automation in the underwriting process, are discussed above. Other opportunities to reduce the level of documentation and analysis required during the underwriting process have also been presented, so that MFIs “[r]ather than spend[ing] time and resources on technical analysis of the borrower’s repayment capacity . . . base their repayment assessment on prior credit performance . . .”161 Elemental to this discussion was the concept of a tiered underwriting process for loans with varying degrees of risk. (See Figure 10 highlighting a sample product differentiation model.) In one MFI, lending staff made recommendations regarding loan amounts based upon the ratio of net cash-flow available, calculated on a combined household and business basis, to the ensuing debt payment, usually at a multiple of net excess cash flow to debt payments. See Table 12 for two examples of income-to-debt ratios. A careful review of the cash-flow analysis performed on household and business income revealed that the income components of the cash-flow analysis could be verified with a high degree of comfort (e.g., through confirmation of wages paid with secondary employers and through an analytical review of gross profit margin on goods produced in the business). This in-depth analysis of the underwriting process, however, indicated that the MFI had little ability to verify either household or business expenses against

161 Gonzalez-Vega, p. 190.

130

third-party sources.162 Yet they nonetheless spent approximately three hours gathering and analyzing this expense data.

Table 12: Change in Cash-Flow Analysis CASH-FLOW ANALYSIS

BEFORE REVISION AFTER REVISION HOUSEHOLD BUSINESS COMBINED COMBINED

Wages Sales Other Income Cost of Goods Sold Gross Income Gross Profit Gross Inc/Profit Gross Inc/Profit Household Expenses

Business Expenses Total Expenses

Net Income Net Income Net Income

Net Income-to-Debt Ratio = Minimum of 2:1

Gross Income-to-Debt Ratio = Minimum of 5:1

The benefit of this intensive information gathering was not outweighed by the added value such work created in terms of reduced underwriting risk. As a result, the MFI is testing a revised underwriting process—one that virtually eliminates any analysis of expenses, concentrating instead on those areas of cash flow that can be verified (income from wages and gross profit from sales of goods and services). To compensate for the inability to test and rely upon the expense information, the MFI changed the ratio of cash flow to debt required to no less than 5:1. This shift in emphasis, highlighted in Table 12, resulted in a savings of three hours per loan application. Where available, employing national credit bureau data can significantly enhance underwriting efficiency by providing third-party information regarding a potential borrower’s credit history, debt levels, legal filings and legal status. FUCAC in Uruguay is one institution using such data. In some of these cases, this national credit bureau data has been linked to sophisticated mathematical algorithms that compute “credit scores”—computations that indicate the relative probability of a potential borrower’s debt repayment. At its simplest level, credit scoring analyzes myriad data in an attempt to identify key characteristics that correlate with (and thus are indicators of)

162 Expense receipts were unavailable and little benchmarked data existed

against which to compare average rent or utilities, etc.

131

payment performance. In so doing, credit scoring seeks to identify those potential borrowers whose scores (representing the probability of repayment) are so low or so high that the MFI will spend little or no time rejecting or approving the applicant for a loan. These credit scores are plotted along a “bell curve,” as depicted in Figure 13, with the outer extremities of the curve representing the high and low probabilities of repayment. MFIs can then theoretically narrow their underwriting efforts to those potential borrowers who fall within the midsection of the curvethose whose likelihood of repayment requires greater in-depth analysis.

Figure 13: Credit Scoring Decision Bell Curve

When credit scoring does not exist or lacks specific data for an MFI’s client base, some microfinance institutions are undertaking detailed assessments of their historical underwriting processes in conjunction with historical loan performance to determine key criteria that might better identify loan applicants with extremely high success or failure rates. BancoSol and Finamerica, ACCION’s affiliates in Bolivia and Colombia, respectively, have undertaken such an analysis, as has ACCION’s Peruvian affiliate Mibanco, the results of which are described in Chapter Four. When these key criteria can be identified, the extent of underwriting can be reduced for those loans with high rates of success or failure, thereby allowing for the redirection of staff resources to those applications lacking clear-cut indicators and requiring increased analysis and judgment. Seeking creative ways to minimize the number of visits to an applicant and the associated travel time is another way in which MFIs can shave costly time from the underwriting process. For example, while loan use

Automatic Denials

# of Potential Clients

Riskiness of Potential Clients

High Low

Automatic Approvals

Applications Requiring More In-Depth Underwriting

132

verification used to be a standard component of many of ACCION’s microfinance affiliates, all have abandoned the practice for a couple of reasons. First, the fungibility of money complicated the accuracy and reliability of loan use verification. Second, the cost of the follow-up outweighed the benefit, as ACCION’s reengineering efforts could not robustly identify a direct impact on the probability of loan delinquency.163 Important efficiency gains have also been reaped in the underwriting process by the implementation of such basic procedures as: � Grouping all staff meetings into one day or afternoon, thereby

reducing the number of hours lost to commuting to the office. � Establishing specific time blocks during each week for marketing,

client visits and loan analysis and administrative work. � Establishing (and maintaining) clear timelines for submission of

complete applications for loan consideration. � Organizing client visits by geographic area to minimize or eliminate

wasted travel time. � Maintaining alternative work on hand at all times for action while

waiting for a client, using public transportation, etc. � Allowing customers to provide copies rather than originals of

documents.164 � Placing the burden of documentation gathering on the client rather

than the loan officer. � Developing a standard loan recommendation form that summarizes

the most pertinent data, including primary strengths, weaknesses and mitigating factors underlying the loan recommendation.

Credit Approval Process The primary techniques of efficient credit approval are practiced widely by a number of MFIs. These include limiting the type and number of loans going through the formal credit committee process by delegating

163 It should be noted that some MFIs still favor loan use verification because the

end use of the funds can be important for social as well as financial reasons, or as a means of remaining in contact with the borrower.

164 The risk of potential fraud in obtaining copies of documents rather than originals must be weighed against the cost of collecting originals. For example, accepting copies of key identification documents, such as passports, carries a high degree of fraud risk. Alternatively, the risk of fraud is typically low when obtaining copies of utility bills.

133

authority for most loan approvals to loan officers, branch management and the head of the credit department. When loans are small, two loan officer signatures may prove adequate for approval. Limiting attendance at the credit committee meetings to only those individuals whose credits are being presented is another way to maximize the efficiency of the approval process. To further minimize the time spent in credit committee meetings, many MFIs do not submit credits that were not recommended for loan approval. Changing other simple factors, such as the time when credit committee meetings are held, can also improve efficiency. Mibanco realized a significant efficiency gain during its reengineering by systematizing the loan officer’s workday so that client visits (as well as collections and promotions) were conducted in the morning, and the afternoon was dedicated to credit committee and other office functions. Previously, the loan committee meeting took place in the morning and invariably ran over, negatively impacting loan officer productivity.

Loan Disbursement Efficiency in disbursement involves two components: the preparation of loan documents and the actual disbursement of loan proceeds. The most efficient processes are those where standardized loan documents are automatically generated by computer-based data previously input in the application process, not requiring duplicative input of basic information such as name, address, loan amount and terms, etc. Automating disbursements (computer-generated checks by an accounts payable system, loan proceeds automatically deposited into a customer’s account via electronic payments, etc.) is also an inexpensive way to increase efficiency. Similarly, the grouping of loan disbursements into fixed time slots is a simple way to improve efficiency by reducing the length of time spent with clients and away from other revenue-generating activities. Another technique to increase efficiency is the verification of the client’s desire for loan proceeds to minimize the preparation of documents and disbursals for borrowers who never close on the loan. Loan Maintenance Like underwriting, loan maintenance can be broken down into certain core functions, including payment processing, collections and loan renewals, to identify opportunities for efficiency improvements.

Payment Processing Payment processing represents a significant time expenditure, one that increases as the frequency of repayment increases. MFIs have instituted a

134

variety of techniques to enhance the efficiency of payment processing, including using partners (such as banks or post offices) to collect payments and the implementation of electronic means to capture and transfer loan payment information directly into the loan system. These electronic forms of payment include payments made via direct salary reductions, smart cards and ACH transfers.165 Compressing repayment dates to two or three dates during a month (commonly referred to as “cycle dates”), while potentially increasing the pressure on collection staff, greatly reduces the time spent in payment processing due to concentration in discrete time periods. Obviously, the choice of cycle dates must balance processing savings with customer convenience.

Collection Efforts Practices widely employed to increase the efficiency of collection efforts have also been discussed above, including: � Use of standardized templates for delinquency letters, calls and

visits. � Establishment of standardized points in the collection process at

which certain actions will automatically take place (first phone call, issuance of first letter, first visit, call to co-borrower or guarantor regarding loan status, etc.).

� Delegating collection activities to a loan officer after a predetermined period of delinquency (e.g., 10 days delinquent).166

� Close monitoring and management of outside entities (attorneys, collection agencies, etc.) to whom seriously delinquent accounts have been transferred for action.

� Limitation of client visits, typically a cornerstone of client relationship maintenance, to only those showing signs of trouble or in industries or economic sectors experiencing difficulty.

Additional efficiency-enhancing practices include an interesting application of the credit-scoring model under development by ACCION

165 ACH stands for automated clearinghouse, the functional entity in many

countries that tracks, clears and balances payments between financial institutions.

166 Some MFIs, BancoSol and ABA, for example, still tie a portion of the loan officer’s performance-based pay to the ultimate recovery of the loan, to provide incentives for solid underwriting initially and diligent follow-up in the early days of delinquency, when there is the greatest probability of recovery.

135

in Banco de Pinchincha in Ecuador167 that actually rates the likelihood of ultimate recovery based on the profile of the delinquent loan (number of days late, credit history of borrower, etc.). In this way, the MFI can quantify the cost/benefit of each loan collection so that it concentrates resources disproportionately on those credits that have the highest probably of recovery. This improved resource utilization results in a direct increase in institutional efficiency. Loan Renewals As stated previously, Gheen notes that MFIs’ managers frequently expect that the cost of loans to “repeat borrowers in good standing would be between one-half to one-tenth the cost of first time borrowers.”168 Unfortunately, the results of his research contradicted these expectations, revealing that most “microlenders made few, if any changes in the subsequent loan screening and processing stages, and none in the loan disbursement and repayment stages between new and repeat borrowers.”169 As a result, little financial efficiency is gained through this renewal process. Calpiá represents an example of an MFI that has restructured its renewal to maximize efficiency and reduce costs by providing “automatic credit . . . instant credit . . . only available to applicants who maintain the top credit rating for at least a year.”170 This rating, determined by a loan officer, and based upon a site visit, allows clients to borrow up to three loans simultaneously or consecutively, within an established limit.

HUMAN RESOURCES Human resources is typically the single largest cost item of any MFI. Therefore, in spite of significant enhancements in technology and advancements in microfinance underwriting that reduce reliance upon office personnel, human resources constitutes one of the most important areas of efficiency management for any organization. Human resource management is interrelated with every aspect of the organization, from the mission, culture and customer orientation of the MFI to the products

167 Banco de Pinchincha, the third largest commercial bank in Ecuador,

approached ACCION for help in expanding its operations down-market to serve microentrepreneurs.

168 Gheen, Jaramillo and Pazmino, p. 3. 169 Gheen and Westley, p. 5. 170 Churchill, Client-Focused Lending, p. 90.

136

delivered and delivery channels used to the organizational structure, processes and technology employed in operations. To manage human resource deployment effectively, the MFI must have the capacity to: � Maintain a staff (in terms of numbers and skill sets) that coincides

with the demand for the MFI’s services. � Train and deploy staff efficiently. � Manage and motivate staff within the context of varying wage

markets, different levels of education and prior job experience, and competitiveness within the labor market.

The Match of Skill Sets, Staff Size and Needs MFIs vary widely in how they define the optimal skill sets of a loan officer. Some, such as ASA, prefer individuals without college educations. Others, such as Financiera Calpiá, pride themselves on the depth of professionalism among their staff. Still others, such as the ACCION USA affiliates, eschew hiring individuals with significant lending or underwriting experience, having found that this experience is frequently at odds with the manner in which ACCION evaluates loans for credit-worthiness or that they lack the requisite sales skills. While there is no one right profile, the clarification of specific skill set requirements for major staff and management positions enhances the chance that skill sets and job requirements will mesh. Many MFIs maintain such skill set and job requirement definitions. Efficiency declines markedly, however, when: � These definitions are not reviewed and updated on a periodic basis.

As MFIs grow, the nature of their operations changes, as do their human resource needs. The relatively unsophisticated employee who filled the MFI’s needs two years ago may not possess the skill sets necessary to manage a diversified portfolio or an increasingly competitive environment.

� The organization does not periodically reassess the degree of

alignment between the requirements of key job functions and the individuals filling those positions. This misalignment is often a significant but overlooked source of inefficiency in organizations—one that is avoided for fear of having to terminate an employee when often what is necessary is a shift in responsibilities for renewed alignment.

137

There are many well-documented ways in which MFIs can and do evaluate the appropriateness of staff size and ongoing competency. Traditional measures usually are defined in terms of productivity, such as assets or loans managed per staff member or loan officer. ACCION’s organizational development area employs a tool called PIC (Processo Integral de Cargos)171 to align job functions with actual skills profiles of MFI staff. Institutions such as ASA and BancoSol that establish relational staff size objectives, as in the optimal complement of branch staff depending upon age, size and location of the office, bring a new dimension to efficiency analysis and monitoring. Some, such as ACCION New York, take this relational analysis one step further by establishing staff complements among the number of loan officers, loan processors and underwriters based upon anticipated production objectives at each level and the split of responsibilities among them. Thus, every processing clerk is expected to process the loans originated by three loan officers and each underwriter is expected to review the work of three loan processors, or nine loan officers. Recruitment, Training and Retention Perhaps no other component of the human resource function is as essential to efficiency maximization as the recruitment and retention of the appropriate type and number of individuals. Given the high cost to train staff, and loan officers in particular, and the length of time before they reach peak loan production, it is essential that the recruitment process be as well-planned as possible. As simplistic as it appears, the administration of tests to determine the true extent of computer, communication, letter-writing, and financial skills may avoid the pitfalls associated with individuals who falsify or exaggerate their capabilities during the interview process. ASA has found the use of written exams and group interviews to be very effective in fostering lower turnover rates and higher levels of loan officer success in its new recruits.172

Staff efficiency is also greatly enhanced by ongoing training. For example, opportunities to acquire even the most basic of skills (e.g., introductory courses in word processing and financial spreadsheet programs) are often of important and immediate benefit to operational efficiency. Too often, staff is trained only once, usually at the onset of

171 Literally translated, Integral Processes of Responsibility, is an evaluative tool

that analyzes responsibilities and job assignments. 172 Muhit, interview.

138

new responsibilities or the introduction of new systems. As a result, MFIs may maintain computer systems with a wide range of functionality that goes largely unutilized due to low user skills. Recent literature on how adults learn supports the need for ongoing training to reinforce and extend previous training to achieve maximum results.173

Retention also plays an important role in the efficient operation of an MFI, reducing recruitment and training costs and minimizing the lost opportunity costs generally associated with the first few months of a staff person’s employment. MFIs use a variety of techniques to boost retention, including compensatory incentives, the development of interesting career opportunities and involvement in special projects, and additional benefits packages (e.g., inclusion in retirement or savings plans). Other MFIs, such as Calpiá, use disincentives, including the requirement that officers repay training expenses if they leave before working for two years.174

Productivity and Incentives To foster efficiency, MFIs must establish reasonable performance objectives, effectively communicated and owned, supported by transparent tracking systems, and linked to compensation and reward systems.175 Numerous MFIs implement some form of productivity objectives and a reward system, including ADEMI and BRI176 as well as ABA177 and Centenary Rural Development Bank in Uganda. The timely availability of individual performance data to all staff is essential to the staff’s ability to monitor and successfully manage their behavior and outcomes. There is also a motivational advantage to efficiency in the motivating “lift” that peer pressure often provides. Additionally, some MFIs establish collective as well as individual incentives (such as BRI’s

173 Harbison. 174 Navajas and Gonzalez-Vega, p. 14. 175 This section primarily addresses linked compensation systems, what the

students of the Woodrow Wilson School of Public and International Affairs at Princeton University characterize as “high-powered” incentives. As they rightly noted, these should not replace, but rather complement, the use of “low-powered” incentives, which “are only loosely tied to specific metrics of performance,” such as gradual promotions to higher ranks, good working conditions, attractive vacation packages and opportunities for additional training. Woodrow Wilson School, p. 21.

176 Rhyne and Rotblatt, pp. 56-58. 177 El Shami, p. 41.

139

profit sharing plan) so that performance competition among staff does not undermine any cohesiveness or collaborative culture the MFI is trying to maintain.178

In order to maximize efficiency by establishing and monitoring performance objectives and subsequently rewarding success, the incentive system must: � Include Quantitative and Qualitative179 Performance

Objectives:180 All too often, MFIs establish quantitative objectives (the number of loans originated per month, the number of active clients managed, the conversion rate for loan applications, etc.), limiting qualitative performance objectives to levels of delinquent or loss loans. Certainly, portfolio quality is essential to self-sufficiency and efficiency maximization. Yet it is the poor quality and incomplete nature of tasks performed that create so much inefficiency in organizations. This inefficiency includes, for example, the erroneous input of data into general ledger systems or mortgage systems that requires correction and reentry as well as the submission of incomplete or inaccurate loan applications for analysis that sends loan processors in search of phone numbers. Even simple errors, such as the inaccurate spelling of a borrower’s name, can cause great inefficiencies, when they require the re-issuance of loan documents and disbursement checks.

� Establish Performance Goals at All Levels and Throughout All

Divisions of the MFI: In many MFIs, the establishment of performance objectives begins and ends with the loan officers and branch managers. Yet the creation of a dynamic, enthusiastic team that intentionally and routinely seeks out efficiency opportunities and maintains a vibrant culture requires motivation at all levels. Such motivation is also integral for reducing the impact of “silos” within an organization and inculcating an entity-wide enthusiasm for high-quality, efficient operations and customer service. In fact, Christen

178 Brand, New Product Development: Design, Testing, Launch, p. 35. 179 Qualitative performance objectives are defined herein not as “subjective”

objectives but rather as those factors affecting the quality of the work performed. Thus, the accuracy and completion of information gathered or input is considered a qualitative measurement.

180 These quantitative and qualitative performance objectives are often known as “key performance indicators” or KPIs.

140

suggests that most “financially successful programs have designed incentive systems that tie between 15% and 50% of total operational staff remuneration to the results they obtain with clients.”181 Thus, the receptionist who greets clients and takes loan payments can be motivated and evaluated based upon the number of payments processed, the number of inquiries handled without referral to another party and the level of customer service provided clients. So, too, can the accounting clerk in the Finance Department be motivated by the number of bank reconciliations performed monthly or the number of general ledger entries recorded (accurately) on a monthly basis or the dollars of assets under supervision. ABA has successfully extended its incentive compensation plan to include employees in the legal, management information systems, accounting and personnel departments.182

� Be Under the Employee’s Control: Senior management at

ACCION New York spent considerable time with loan officers and staff responsible for supporting loan underwriting to ensure that the performance objectives established for each group of individuals could be attained. Thus, requirements for the submission of only complete and accurate applications were established for the loan officers so that loan processors did not waste time with incomplete applications. This ensured that loan processors would not be thwarted in their efforts to meet their goals. Likewise, turnaround times were established in the processing area that guaranteed loan officers the prompt and swift processing of applicants. This ensured that loan officers would not be thwarted in their efforts to meet loan origination targets.

� Be Easy to Understand and Aligned with the Desired Objectives:

The incentive plan of CRECER—a Bolivian MFI which evaluates credit officers based on individual (rather than group) performance for loan originations and levels of delinquent loans—is straightforward and focused on the key indicators by which the institution measures success. In contrast, CorpoSol of Colombia instituted volume-based goals for its loan officers that had inadequate controls over delinquency, leading to disastrous results.183

181 Keys to Financial Sustainability, p. 192. 182 El Shami, “ABA’s Staff Incentive Scheme,” p. 39. 183 Brand, New Product Development: Design, Testing, Launch, p. 34.

141

The results of successful incentive plans can be impressive. As Farrington notes, the attention of loan officers at Caja Los Andes “is focused by the fact that up to 40% of their pay is determined by these indicators,” a factor that he believes directly contributes to their ability to manage an average of 505 clients, after adjusting for gold-guaranteed pawn loans.184 Establishing such incentive programs is not without risk, however. If not carefully created, incentive systems may result in the aggressive pursuit of one objective (e.g., loan growth) at the expense of another (e.g., a failure to fulfill an MFI’s mission to serve the poorest of the poor) as CRECER experienced.185 Additionally, consideration should be given to the simultaneous use of incentives (set forth herein) and disincentives (e.g., salary penalties), a dualistic structure implemented by ABA to reverse its turnover rate, which was in excess of 30%.186

TECHNOLOGY In microfinance as in the conventional business sector, technological advancements offer radical opportunities for improving efficiency, enhancing customer service levels and extending client outreach.187 The computerization of manual processes, the expansion of delivery channels through electronic means and the facilitation of data (loan applications, client information, etc.) from the field into the branch or central office and back are the key areas in which these efficiencies are realized. Technology is typically expensive, however, and many business organizations have not reaped the level of efficiency benefits expected from its implementation. Equally important in optimizing technology is assuring the synergy of technology with three important criteria—namely, the needs, processes and users—as described in turn below.

Technology and Needs Technology should meet the needs and constraints of the organization and have the capacity to grow with the institution. In certain geographic areas, especially those with low-wage population bases, manual systems may be more efficient than computers. Such is the case in Bangladesh,

184 Farrington, p. 20. 185 Farrington, p. 21. 186 Mokhtar and Makram, interview. 187 The microfinance field has only just begun to exploit the potential of

technology, so established track records backed by empirical results are not yet available.

142

where ASA has only recently embarked upon greater computer use, having been able to operate very efficiently with highly standardized, manual systems maintained by individuals with relatively low wages. Conversely, the relatively inexpensive availability of much technological equipment in the United States, coupled with the willingness of many donors to fund technological enhancements, creates significant opportunities to increase efficiency. In deciding to employ new or enhanced technology, several considerations are key, including: � The degree to which a given location can support technology (the

availability of hardware and viable software). � The strength of available modes of connectivity.188 � The availability of competent technicians to support the technology

installation within the local labor pool. � The overall skill sets of the loan officers and administrative staff who

will use the systems.

Technology and Processes To optimize the typically high cost of technology, processes must be closely linked to technology. Too often, technology is implemented but the processes “replaced” by the technology are maintained (e.g., the manual posting of individual components of a loan payment when the loan accounting module is capable of automatically allocating the payment among principal, interest and fees). Alternatively, the simple implementation of key Excel spreadsheets or delinquency letters in template form is often overlooked because staff cannot carve time from their daily work to use the technology to increase procedural efficiency. Finally, layering technology on top of inefficient procedures generally will not enhance efficiency.189

188 Connectivity refers to the communication lines and equipment that allow one

office to communicate with another. This includes the communication modes—such as telephone lines and wireless communication—to support wide-area networks (WANs) that connect two or more offices together.

189 Sometimes the overlap is necessary until staff get accustomed to the new technology. For example, Compartamos, ACCION’s affiliate in Mexico, trained only select, younger loan officers in its new Palm Pilot technology to ease the transition from manual paper to electronic client intake. Even so, the Palm Pilot team allowed the newly trained officers initially to bring pad and paper with them at their request, until they became comfortable with using the personal digital assistants (PDAs).

143

Accordingly, the degree to which different systems can be integrated with each other seamlessly to avoid duplication of effort is an important component of efficiency. (Most MFIs continue to enter the same data repeated times in computer systems or onto a number of manually prepared forms.) The interface of computer systems—ranging from the simple interface between a loan system and a system used to generate delinquency letters to the complex interface that allows payments received through electronic transfer to be automatically recorded on the MFI’s loan system—is integral to the efficiency of automated processes.

Technology and Staff Optimizing the systems employed requires that staff be both knowledgeable and comfortable with the technology and have ready access to computer systems. Thus, they must be able not only to post entries (usually a rote activity) but also be able to generate special reports from the system (manipulate data and the reporting mechanisms). They should also be able to identify situations when data are not being processed or reported correctly. All too often, staff trained initially in the use of various databases receive little or no follow-up training at either the introductory or expert levels of software use. As a result, user functionality levels are often far below those necessary to gain full utilization of the installed systems.

Access to information is a critical component in enhancing operations. Technology can facilitate this access, as exemplified by the use of the Palm Pilots at Compartamos in Mexico, BancoSolidario in Ecuador, both ACCION affiliates, and, soon, within ACCION USA to connect loan officers in the field with their branches or home offices. While initially used as an electronic tool upon which to capture loan applications and other pertinent client data for transmission into the MFIs’ primary computer systems (inbound communication), these personal digital assistants (PDAs) are now employed at BancoSolidario for both inbound and outbound communication. Thus, not only can loan officers transmit applications from the field for prompt processing in the branch or administrative offices, they can now also receive essential data from their home offices, including information regarding delinquent loans requiring attention, clients awaiting return calls and potential clients awaiting interviews or site visits. ACCION USA expects to push even further in its use of PDAs in 2000, incorporating key worksheets used in the underwriting process and downloading important data received by the

144

loan officer from national credit bureaus into the loan application. This expanded use of the Palm Pilot, coupled with other advances in technology (e.g., “j-fax” capabilities, which transmit scanned documents such as a lease or utility bill via email at exceedingly low costs), will greatly increase a loan officer’s productivity by: � Eliminating the administrative and logistical hassles involved in

transmitting loan files and loan information to other offices for evaluation.

� Increasing the organization of key actions required through

centralization and rapid availability, by providing an individualized list every morning identifying the various meetings scheduled for that day and actions required (e.g., delinquency calls, calls to schedule site visits, calls to track missing information, etc.).

� Providing loan officers with immediate access to negative credit

bureau information, which will allow the loan officer to terminate or defer discussions with a potential client if the likelihood of loan approval is remote.

Additionally, the ability to transmit key documents and information rapidly and efficiently further supports the transfer to, and centralization of, key components of the underwriting process within a service center environment. This centralization is discussed at greater length in Chapter Four as part of the analysis of ACCION New York’s reengineering.

Other Technological Developments There are several other technological advancements under review by a few leading MFIs for their possible impact on operational efficiency and ability to reach even broader market sectors. These include: � The use of technology to allow for the development of a centralized

call center that would manage loan inquiries from across a broad geographical area, as is under consideration by ACCION USA.

� The employment of credit-scoring technology to identify those loan

applications requiring little or no further underwriting analysis (as a result of the high or low quality of historical credit patterns and strength or weakness of predictive indicators).

145

� The use of loan kiosks190 and Internet technology to provide initial information to potential customers (including downloaded loan applications) and ultimately, allow for the assessment and granting of credit on-line. Presently, BANRURAL in Mexico is allowing potential borrowers to view their account balances on-line.191 Pride Africa and ACCION USA are exploring the use of the Internet for submission of applications on-line.

� The use of advances in financial technology such as smart cards192 to

enhance the efficiency of loan disbursements and loan repayments as employed by Swaziland Business Trust and FINCOMUN in Mexico.193

� The use of televisions, cellular phones, PDAs and smart chips that

allow wireless delivery of information and credit to remote locations, often in partnership with raw material suppliers and retail distributors, as is the case with BancoSolidario de Ecuador and Financiera Trisan in Costa Rica194 and Grameen Bank in Bangladesh.

190Loan kiosks look very much like automated teller machines (ATMs). Rather

than accept and dispense cash from savings accounts, customers can complete and submit simple loan applications at these kiosks, check balances, make payments, and often receive loan approval and loan proceeds.

191 Lok, p. 31. 192Similar to credit or ATM cards in appearance, these cards store the value of

money on them. MFIs can use these cards to store the amount of the loan made. The borrower, in turn, can “disburse” the loan as needed through the withdrawal of funds using the smart card. Likewise, borrowers can transfer money to these cards and then use them as a means of electronically transferring loan payments to the MFI. Theft is reduced, customer service increased and operational efficiency enhanced through these direct transfers.

193 Lok, p. 28. 194 Brand, New Product Development Case Studies, pp. 21-2. Wenner and

Quiros, p. 20.

146

CONCLUSION

This chapter has provided an analytical framework and numerous examples of techniques implemented within the microfinance industry to increase operational efficiency and revenue generation. All of these techniques have been predicated upon developing a high degree of synergy, or alignment, among the MFI’s strategy, its total product and its internal systems. For many microfinance institutions, this type of alignment analysis may seem like a daunting task. Chapter Four, however, offers tangible examples as to how MFIs can employ process reengineering to improve efficiency as their institutions grow.

CHAPTER FOUR

REENGINEERING THE MFI

149

The strategies outlined in the previous chapter—with the possible exception of the technological innovations—do not represent startling discoveries for most well-run MFIs. They reflect sound, straightforward strategies, structures and processes that often seem obvious when reviewed. Yet as most people who work in reengineering will attest, what seems obvious is often far from common practice. This adage is especially true for institutions that have operated in environments that are noncompetitive or that have been distorted by “non-market” forces (government intervention, donor subsidies etc.). Accordingly, maximizing efficiency requires not only understanding the principles and practices that drive well-run, cost-conscious institutions but also understanding how to implement them on a long-lasting basis. In other words, efficiency maximization for most MFIs requires a fundamentally new approach to doing business and a significant change in orientation, not just doing the same things at lower cost or in better ways. Reengineering can be defined as the redesign of business processes to improve efficiency. In the US corporate setting, reengineering has changed the landscape of many companies facing an onslaught of new competitors spawned by the dismantling of regulatory apparatus, privatization of industry and globalization of trade. The field of microfinance is facing similar seismic shifts as conventional banks move down-market, NGOs transform into regulated financial institutions and customers become more sophisticated. The reasons to overhaul an MFI’s functional processes are varied. They include the need to increase profitability, enhance customer satisfaction, boost client retention, expand an existing client base, or venture profitably in new markets and products. Three business improvement strategies have served as the basis for the majority of process changes

150

wrought in western-based corporations. They are continuous improvement, total quality management and process reengineering. The least disruptive of the three change processes, continuous improvement (CI) seeks incremental levels of efficiency enhancement for business processes within the context of an organization’s existing strategy. It is typically carried out by the employees and middle management of the organization. Total quality management (TQM) is ultimately oriented toward achieving high levels of customer satisfaction through the implementation of continuous change processes. It typically involves statistical monitoring and an emphasis on the active participation of management in the change process. Process reengineering (PR) is the most radical of the three approaches, seeking significant improvements in efficiency. Readers seeking a deeper understanding of the differences in and comparison among these business change processes are referred to Appendix B. Appendix C looks more closely at process reengineering, the most radical of the three business change approaches and the one that typically generates the greatest change. Key elements of successful reengineering efforts are highlighted in Appendix C, including management techniques and approaches to affecting organizational change in a positive manner. Three microfinance institutions, faced with the need for additional outreach and the lending structure to support that expansion, the challenges of increased competition or the need to dramatically improve efficiency, have recently sought the breadth of change at the root of process reengineering. The reengineering experiences of these three MFIs are described in detail herein and illuminate the challenges and possible successes of reengineering efforts. They include: � ACCION New York: which sought to establish an infrastructure

that would allow for a significant expansion of lending operations and a dramatic increase in a self-sufficiency ratio of 46%.

� BancoSol: which sought to retain its customer base and market dominance through enhanced operations and customer service.

� Mibanco: which sought to improve its operating efficiency, consistent with the expectations of clients and investors of this recently transformed commercial bank.

151

ACCION NEW YORK

THE PRE-REENGINEERING SCENARIO In 1999, ACCION New York realized three important things. First, ACCION New York confronted the fact that the demand for microfinance in New York City and environs was enormous, yet the organization’s penetration in that market was almost imperceptible. Second, ACCION New York faced the fact that its highly subjective underwriting process lacked a necessary degree of quantitative analysis and was unable to support rapid loan growth. Third, ACCION New York’s lower-than-desired self-sufficiency rate precluded any significant progress in its expansion into the New York market. Loan officers were simply too involved in the origination of existing loan applications to even consider proactively soliciting new sales much less efficiently processing those applications once generated. In June 1999, ACCION New York operated from one office and had approximately 340 active loans with outstanding loan balances of US$1.153 million,195 a self-sufficiency ratio of 46%, a delinquency rate of 7.2% and seven employees, of which two were loan officers. The organizational structure was simple. Loan officers were responsible for all aspects of loan origination and loan collections. The loan application, required for all loans regardless of size or complexity, was eight pages in length. With little formal marketing effort in place and loan officers largely office-bound, every application received was pursued with vigor as ACCION New York sought to increase loan originations. As a result, the underwriting process was skewed heavily toward the client, with ACCION New York assuming significant responsibility for completing loan applications, collecting missing documentation, allowing for the late submission of information, etc.

195 Its corresponding average loan size of $3,391 was equal to 11.6% of per

capita GNP, low by international standards, as discussed in Chapter Two.

152

Figure 14: ACCION New York Pre-Reengineering Organizational Chart

Loans, as a percentage of dollars, were almost equally distributed between group loans and individual loans. (ACCION New York did not make personal loans.) Changing demographics and increasing levels of financial literacy, however, suggested that borrowers were increasingly interested in individual loans over group loans and were disenchanted with ACCION New York’s insistence upon co-signors. (ACCION New York relied heavily upon co-signors for individual loans as compensation for the borrowers’ general lack of collateral.) In June 1999, ACCION New York loan officers averaged a minimum of 14 hours in taking and underwriting each loan application. Loan officers provided significant assistance to potential borrowers in completing the application, tracking missing documents required in the loan underwriting process, visiting the client’s business site, reviewing financial information and supporting documentation, and verifying personal and rent references. Loan officers understood well how to analyze character for underwriting purposes. The parameters guiding financial analysis were less complete. Financial analysis, which focused heavily on an analysis of income and expenses for both the household and the business, did not extensively analyze sales and cost of goods sold. (There is a high degree of commingled household and business revenues and expenses amongst ACCION New York clients, like most microentrepreneurs internationally.) Neither set of criteria (character or financial), however, was systematized nor documented in a manner that facilitated consistent and easy transmission to other loan officers. ACCION New York held credit committee meetings once a week on Thursdays with disbursements for loans approved the following Friday. The underwriting process was heavily client-driven, with potential borrowers often bringing documents essential to the underwriting process (including loan applications) to the office as late as the afternoon before

L o a n O ffice r I

L o a n O ffice r II

L o a n Sup po rt

M arke tin g B oo kke e p e r R e c e p tion ist

C E O

153

the committee meeting. Receiving data so late in the underwriting process created stress and chaos as loan officers attempted to move every loan application into the Credit Committee. More importantly, a high number of the loans reviewed by the Credit Committee were approved pending significant additional underwriting (e.g., the borrower’s obtainment of and ACCION New York’s review of a co-signor).

THE REENGINEERING PROCESSPHASE I196 ACCION New York’s CEO sought to increase the number of loans issued significantly (funding not being a constraint) but knew that existing processes did not support this expansion or a sustainable rate of self-sufficiency. She suspected that the degree of change necessary to expand its lending base to 1,700 loans and beyond and improve its self-sufficiency rate to 100% was significant. She also knew that the internal staff, stressed by existing processes, lacked both the time and expertise to lead the reengineering effort required. ACCION New York looked externally for a consultant to lead the efforts, reporting to the CEO, supported by internal staff and financially backed by ACCION USA. After an initial review of the loan origination process, the following issues were identified: � The criteria employed by loan officers to analyze credits were sound

but undocumented and, thus, difficult to transfer to new loan officers. � Loan officers relied upon borrowers to generate applications. The

loan officers were generally office-based. Their preference for this orientation and the manner in which loan applications were processed provided little opportunity for any change in this office-based orientation. Compensation was not linked to the number of loans generated or processed.

� Loan officers, the most highly paid staff in the New York office, were performing all steps in the loan underwriting process, including file creation, reference inquiries, financial analysis and final recommendation.

196 Julie Gerschick of Strategic Solutions led the technical team that supported

the reengineering efforts of ACCION New York, with the financial support from ACCION USA.

154

� There was little differentiation in product and no differentiation in loan underwriting. All loans followed the same process. All forms and the entire underwriting process were manual.

� Financial analysis focused heavily on operating expenses at both the household and business level. Little time was spent analyzing the reasonableness of sales and cost of goods sold.

To create a process that addressed the issues identified, ACCION undertook a four-pronged reengineering process that involved: � Strengthening and then streamlining its underwriting processes. � Restructuring its organizational structure to align with the redesigned

processes and support the planned expansion. � Redesigning its post-loan disbursement processing. � Differentiating its product base and loan terms. The first two of these four components were encompassed in Phase I of ACCION New York’s reengineering and are discussed in detail below. Redesigning the Underwriting Process ACCION New York chose to adapt, rather than adopt, an underwriting model prevalent in residential and consumer lending in the United States. This lending model views loan officers as application generators (sales officers) with virtually no underwriting responsibility, supported by loan underwriters and processors centralized in a back-office who shepherd the application through the underwriting and approval processes. Highly impersonal and heavily reliant upon credit-scoring and strong collateral, this lending model required adaptation to a microlending environment where credit bureau reports are available for only 50% of potential borrowers, often with blemished borrowing histories. Adaptation was also required to ensure that “manual” character assessments remained a significant component of the underwriting process and to preserve the personal relationship between loan officers and borrowers, which was considered critical to prompt loan repayment. To adapt this methodology for success in microfinance, ACCION New York thoroughly analyzed existing processes and the new model, closely scrutinizing each component for value added to the ultimate lending process. Table 13 summarizes the analysis of the lending process, highlighting which components were abandoned, which were retained, and which were adopted or are in the process of adoption.

155

Table 13: ACCION New York—Lending Process Changes

ABANDONED RETAINED ADOPTED/IN PROCESS Client-driven deadlines and processing schedules. Belief that customer service meant assuming responsibility for the borrower’s application.

A balanced degree of helpfulness for customers completing loan applications.

Cultural orientation that locates responsibility for the completed loan application with the potential borrower, not with the loan officer or loan processor.

Loan officer as primary relationship holder with borrower.

Loan officer as sales agent, with an incentive plan designed to reward changes in orientation.

Loan officer responsible for all aspects of loan origination.

Loan officer with partial responsibility for character assessment, limited responsibility for financial assessment.

Loan processors responsible for file creation, credit bureau review, documentation review, reference checks and initial financial review.

All loan staff Credit Committee approval process (average length—four hours weekly).

External Credit Committee review of large or exceptional applications.

Adoption of tiered individual loan approval authorities (in process).

Totally manual process. Significant automation of underwriting process, including financial analysis.

Pre-screening criteria to stop an application with a low rate of potential approval.

Standardized underwriting criteria.

Underwriting processes differentiated by type of loan and streamlined in terms of supporting documentation required (in process).

Loan underwriter responsible for thorough financial analysis and loan officer recommendation.

156

Phase I of the reengineering project lasted approximately nine months and consisted of: � Standardizing and documenting the underwriting criteria in an

automated format that facilitated the final loan recommendation process.

� Separating loan underwriting functions from loan application generation functions.

� Establishing performance expectations (the number of approved loans per loan officer per month, the number of applications processed per loan processor per month, etc.) and staff ratios (e.g., the number of loan processors to loan underwriter to loan officers).

� Standardizing and documenting the functions that loan officers and loan processors performed. This step included standardizing and automating forms for credit references and letter generation, and the reordering of loan processing steps.

� Strengthening pre-screening processes to minimize time spent on applications with a low probability of approval. (A targeted 75% conversion ratioloan application to disbursed loanwas established.)

� Strengthening the level of financial analysis performed. This involved an improvement in the manner in which sales and cost of goods sold are analyzed, a de-emphasis on household and detailed business expense,197 and the establishment of benchmarks for key expense categories such as rent and monthly taxi driver expenses. (For example, a New York taxi cab driver typically spends US$500 to US$700 on gasoline and maintenance monthly. Any significant deviation from this amount on an application required a greater level of inquiry during the underwriting process.)

� Reeducating existing loan officers about their changed responsibilities and orientation on two levels. First, loan officers were provided greater clarity regarding the degree to which borrowers were responsible for the submission of a completed loan application. Second, the reengineering effort involved consistently (and persistently) redirecting loan officer efforts away from detailed involvement in the underwriting process outward to loan application generation.

� The hiring of several new loan officers. 197 These detailed expenses were typically difficult to verify due to lack of

receipts and checks and virtually impossible to benchmark given the wide variation in household structures.

157

� Training new loan officers and loan processors regarding their split of responsibilities.

� The implementation of an incentive-based compensation plan that rewarded loan officers based on the number of approved loans generated and loan processors on the number of loans processed in a timely and accurate fashion. (These incentive plans were both quantitatively and qualitatively driven.)

� The automation of virtually all aspects of the revised underwriting process including:

− The establishment of a tracking system accessible by both itinerant loan officers and centralized Service Center198 staff that enabled involved employees to track the status of every application.

− The automated links between financial analysis and the final loan recommendation.

� Consolidating all office meetings (credit committee, office staff, etc.) into one day of the week to reduce the amount of travel to the main office required.

� Blocking two time frames a week during which loans would be disbursed in order to standardize the disbursement process and reduce interruptions to the staff.

� Establishing clear delivery and turnaround guidelines (e.g., completed loan applications submitted to the Servicing Center by Monday at 5:00 p.m. would have final loan recommendations no later than Friday at noon).

Restructuring the Organization for Growth In order to support the planned expansion, ACCION New York is establishing five satellite offices. These offices are staffed by loan officers only, with all administrative support for the processing of loan applications centralized in ACCION New York’s newly established Service Center. Technological enhancements, including the introduction of electronic faxing, wide-area networks and Palm Pilots, are intended to greatly facilitate data and document transmission between the satellite offices and the Service Center. A number of underwriting functions previously performed by loan officers have been transferred to loan

198 The main purpose of this Service Center is to centralize and automate the

processing of ACCION New York’s loan applications for improved efficiency. This Service Center is also acting as the application processing center for other loan production offices of ACCION USA.

158

processors located in the Service Center, so that loan officers can spend more time making sales. Additionally, an underwriter has been hired whose primary responsibility includes the review of all loan underwriting and recommendations, a process that frees both loan officers and the senior loan officer for additional loan generation. Finally, a collections officer has been added to the staff, again freeing the loan officers of responsibility for credits delinquent greater than 10 days. The revised organizational structure, which reveals the significant market expansion of ACCION New York, supported by a centralized Service Center processing loan applications for all offices, appears in Figure 15.

Figure 15: ACCION New York Post-Reengineering

Organizational Chart

R egio n 1Lo an O ffice rs (2 )

R eg io n 2Lo an O fficers (1 )

R egio n 3Lo an O ffice r (1 )

R eg io n 4Lo an O fficer (3 )

R egio n 5Lo an O ffice r (2 )

U n d erw ri te r

C lerk

L oan P ro ces so rs (2 )

C o llec tio n s O ffice r

S ervice C en terM anager

S en io r L o anO fficer

M arke tin g an dO u treach

R ecep t io n ist

O ffice M anage r F u nd rais in g

C E O

SUMMARY OF RESULTSPHASE I While the initial results of Phase I have not led to a decrease in the cost to originate loans, the forms, automation and standardization implemented have positioned ACCION New York for enhanced lending capacity while strengthening the overall quality of the underwriting. The results of the first phase are set forth in Table 14.

159

Table 14: ACCION New York Phase I Reengineering Results BEFORE

REENGINEERING AFTER

REENGINEERING Loan Officer Responsibilities

Primarily loan underwriting and collections.

Primarily application generation with limited involvement in loan underwriting.

Number of Districts One. Five. Service Center located in primary office.

Number of Senior Loan Officers

None. One.

Number of Loan Officers Two. Nine.

Number of Underwriters None. One.

Number of Loan Processors

Performed by loan officers.

Two, supported by one clerk.

Number of Applications/Year

525. 1,530.

Loan Application Capacity per Year

550. 2,250.

Quality of Underwriting Moderate. High.

Application to Approval Ratio

75%. 80%.199

Average No. of Days—Completed Application to Disbursement

Eight Days. Eight Days.

Challenges Encountered As with any reengineering project, several challenges arose, most anticipated, some surprising. Those individuals identified as future loan officers struggled with letting go of full underwriting responsibility. They also struggled with the challenges inherent in spending a large portion of their workweek outside the base office. These challenges involved time management, logistics, preparedness when meetings with 199 Conversion rates of most conventional banks are 50% and below, so

ACCION New York was outperforming industry standards before the initiation of the reengineering effort.

160

prospective clients were suddenly cancelled, transmission of documents back to the Service Center and the personal challenges involved in making “sales” presentations to community groups and potential borrowers. Loan officers and loan processors alike struggled with the need to increase computer skills given the rapid automation of the lending process underway. None of these challenges was surprising. Instead, what was anticipated to be straightforward—the hiring of new loan officers—provided the surprise. Identifying the right combination of skills at affordable compensation levels necessary to achieve this new balance of sales initiative, relationship management and limited underwriting required greater effort than anticipated. So, too, the four-to-six-month average time frame required for loan officers to begin originating loans at anticipated levels was approximately two months longer than anticipated. As with many reengineering efforts, things may get worse before they improve. ACCION New York was no exception. During the height of implementing Phase I, loan originations declined to 25 per month (five per loan officer) as new loan officers were trained and existing loan officers grappled with changed responsibilities and processes. Despite this decline, ACCION New York’s board of directors maintained its focus on long-term objectives of greater impact. Within six months of the first significant change implementation, new loans climbed to 70 per loan officer per month and are anticipated to peak at between 80 and 100 per loan officer per month. The Importance of Leadership Throughout the process, the leadership demonstrated by ACCION New York’s CEO was the ingredient essential to the overall success of reengineering efforts. The CEO immersed herself in a level of detailed understanding of the processes unusual at the CEO level but necessary for decision-making. In addition, she made difficult decisions carefully but swiftly as the need arose (including staffing changes, changes in recommended mission, major changes in long-held policies, etc.) and communicated continually with the staff regarding the changes being made. As a result, although the ACCION New York staff exhibited the typical stress associated with major change, all of the staff200 members were able to transition into new roles and responsibilities after additional

200 Retaining 100% of staff after major changes in job responsibilities is unusual

in most reengineering efforts.

161

training, clarification of job responsibilities, and the firm establishment and monitoring of production expectations.

THE REENGINEERING PROCESS—PHASE II Phase I of the reengineering project was intended to improve the overall quality of underwriting, introduce greater standardization in that underwriting, and establish an organizational and procedural basis for expanded lending capacity. Phase II of the reengineering process is oriented toward the continued and significant reduction in the time spent underwriting various credits. To this end, Phase II is focusing heavily upon the concomitant development of a differentiated product base and underwriting and approval processes, and the implementation of credit-scoring methodologies. In developing this differentiated product base, ACCION New York is evaluating the composition of its loan portfolio to ensure that, on an overall basis, the net contributions/resource utilization of each product group results in an overall self-sufficiency of 100%. The objectives of Phase II include the introduction of a loan portfolio with three product types (including a new character-only loan product) and a three-tiered loan underwriting/documentation process (called no-doc, low-doc and high-doc) which together are anticipated to reduce the time spent in underwriting individual credits 35% to 80%, and the turnaround time between application and loan disbursement by 50%. ACCION New York’s underwriting processes for loan renewals will also be streamlined. The standardized underwriting processes implemented in Phase I result in the ability to score individual loans for credit-worthiness, a rating that will be reviewed in conjunction with payment history on prior ACCION New York loans to significantly reduce underwriting on renewals. Furthermore, the implementation of formal credit-scoring models is also under development.

162

BANCOSOL

THE PRE-REENGINEERING SCENARIO The year 1999 represented a turning point for BancoSol. The results of a late-1998 marketing study undertaken by BancoSol highlighted shifting customer needs, including demands for increased loan sizes and for individual, rather than solidarity, loans. BancoSol’s customer base was further threatened by increased competition from private consumer lenders that had recently entered the market and commercial banks. Intrigued by the strong profits earned by MFIs,201 commercial banks moved into the microfinance sector, offering a broad array of products, customer respect (making clients feel “important”) and lower pricing. This market entry had two important effects, creating a crisis, as described in Chapter One, for BancoSol: � Desertion: Competition increased customer choice and expectations

regarding service levels, generating a desertion of BancoSol’s customers. Many of BancoSol’s best customers left, drawn to the aura and attractive pricing of commercial banks and the more client-tailored product of competing MFIs such as Caja Los Andes whose individual loans were better suited to BancoSol’s more established customers.

� Over-Indebtedness: Many of the foreign financieras (finance

companies) seeking to steal market share and earn quick profits engaged in predatory pricing with loose underwriting standards.202 Clients, heady with the cash options and the fight by competing financial institutions, took on greater debt loads then they could ultimately manage, creating a system-wide increase in defaults. This crisis began after BancoSol initiated its reengineering process, but it helped build support for the need to change.

201 In 1997 and 1998, BancoSol was one of the most profitable banks in

Bolivia—commercial or microfinance—with an ROE of 3.84% and an ROA in excess of 20% at December 31, 1998.

202 The credit bureau (Centro de Riesgos) in Bolivia only allows banks to trade information on clients, so debt from MFIs often does not show up in credit checks.

163

In order to better meet customer needs, improve overall service levels and halt this customer loss, BancoSol embarked upon its initial reengineering project with an emphasis on the efficiency of the branch (lending) network. (“Headquarters” as defined at BancoSol was only peripherally involved in the reengineering analysis.) The main goals were to improve loan officer productivity, increase client retention, and reduce the cost to the client of the lending process (including time and number of requirements).

At the beginning of 1999, BancoSol was organized in a three-tier structure—the headquarters, five regional offices and 48 local branches, with staff complements of 64, 110 and 456, respectively. Of the total staff of 630, 267, or 42%, were loan officers. Each region operated with a high degree of autonomy and maintained its own set of policies, procedures and forms, with regional office managers reporting directly to the CEO. The regional office structures, with their full complement of staff, including a credit officer, a commercialization and marketing officer, and information technology, legal, finance and human resource staff, duplicated components of both the branch structure and the headquarters structure. Branches were managed by a branch manager and staffed by a marketing and commercialization officer to whom all loan officers reported and an operations officer to whom various administrative staff reported. Branch managers’ responsibilities included inputting data into the management information system (MIS) and significant data manipulation for reporting purposes. The high number of direct reports to the regional managers (averaging seven per regional office) and the high number of direct reports to the CEO (eleven) limited both the regional managers’ and CEO’s abilities to develop and supervise standardized loan evaluation and service processes. The MIS system was made more complex by the multiple regional formats employed for similar data and processes, and despite a fairly large number of finance staff distributed throughout the organizational tiers, little information existed regarding the cost to originate or maintain the loans disbursed. Policies and procedures within each region required that loan officers spend a considerable amount of their client interaction at the client’s place of business. In mid-1999, however, loan officers typically spent only 20% of their time in the “campo” visiting with clients and prospective borrowers with the remaining 80% of their time spent in the

164

branch office. Loan officers lacked individual lending authority. The lending authority at the branch level was also limited. Thus, each loan, no matter how small or how low in risk, went through a lengthy review process within the branch and then ultimately at the regional level. Loan renewals followed the same general process for first-time loans. Loan officers were responsible for all collection efforts, which increased in intensity toward month-end, often to the detriment of loan production. The origination process was unusually taxing on the borrower. Frequently, the step lending methodology implemented years ago to facilitate client financial literacy and underwriting practices resulted in loan amounts that were either inadequate or excessive for borrower needs. Worse, prospective clients visited a BancoSol branch four to five times prior to being approved for the loan. Each visit lasted an average of two to three hours, much of which was spent simply waiting to be served. Delinquencies at some branches peaked at 12% to 14% and although a certain component of this delinquency spike was a direct result of the microfinance credit crisis brought about by the overextension of microfinance, the spike was also the result of nonstandardized and inadequate collection procedures.

THE REENGINEERING PROCESS203 To initiate the reengineering process, a multi-disciplinary team was created, led by an outside consultant steeped in both microfinance and commercial business practices. Team members were drawn from across the organization and from within and outside the bank. Members included a management information specialist, the head of BancoSol’s organizational development department,204 a staff person from the national operations department, a loan officer new to the organization (with former banking experience) and a representative from ACCION International’s consulting support staff. All were trained in process reengineering by the team leader. The team undertook a staged reengineering process, beginning with a pilot analysis of one region in June 1999, followed closely by a detailed review of the operations of

203 Susana Barton of ACCION International led the technical team that

supported the reengineering efforts described herein. 204 This department, located within the headquarters staff, is responsible for the

overall review, analysis and development of processes.

165

another region in August 1999. The operations of the remaining four regions were reviewed between October 1999 and August 2000. A thorough review of processes, responsibility allocations and the degree of synergy between skill sets and job requirements was undertaken within each branch and its regions. As is common with most projects, the reengineering team identified multiple factors at work simultaneously that, individually and collectively, were reducing the efficiency of BancoSol’s regional and branch operations. The primary problems identified and solutions implemented at the branch level included reinstating existing policies regarding how much time loan officers spent in the field generating new loans. Rather than spending 80% of their time in the branch, loan officers were expected to spend 80% of their time in the campo. To effect this transition, other measures were required and implemented. � A three-tier loan approval process was established, empowering loan

officers and branch managers to make the majority of credit decisions.

� Perhaps most importantly, the cultural orientation of BancoSol regarding the customer was transformed. The onus historically placed on customers to visit BancoSol multiple times throughout the application process and to wait until loan officers were available to assist them was removed and replaced with a new and more competitive customer service. This orientation, along with the implementation of changes in processing and campo/office time allocation, required a reassessment of loan officer skill sets to ensure that loan officers on staff could embrace and implement the changes wrought by the reengineering process.

� The step lending process was, in many cases, replaced by a cash-flow approach to loan size determination and the borrower’s capacity to repay, creating a better match between client need and amount disbursed. This alignment, in turn, reduced overall risk levels.

� Greater emphasis was placed upon product development, especially the development and delivery of loans to individuals.

� Underwriting procedures and forms were standardized and streamlined. The extent of financial analysis and the breadth of the information required were narrowed to include only the most essential information. This change in underwriting required modifications in management information systems. Clients were encouraged to assume greater responsibility for the preparation of

166

their application, to the extent they were able. Important components of the underwriting process, such as borrower guarantees, were analyzed and evaluated for credit-worthiness for the first time.

� Responsibilities were shifted to increase reliance upon lower-cost staff and to free loan officers and branch managers to focus on customer procurement and customer service (e.g., administrative staff in the branch were given responsibility for data input and report generation).

� Loans were classified according to risk, collections officers installed and collection processes standardized. The highest-risk loans were transferred to collection officers.

� An activity-based costing system was implemented to capture and measure the cost of loan origination and maintenance.

Like all reengineering processes, however, inculcating these changesin particular, the cultural change in orientation toward the customerwas not always easy. To further cement the changes, the overall organizational structure was modified. In some instances, determinations were made that certain loan officers did not or could not fulfill the new objectives or execute the new policies and procedures. In other situations, senior and middle management were hired from the commercial banking sector to assist in the overall development and implementation of a more efficient, customer-oriented MFI. To facilitate the transition and ensure the establishment of new routines, key performance indicators were established down to the loan officer level and supported through the implementation of an incentive compensation plan that rewarded branches for attaining of branch production thresholds. To sustain the reengineering, BancoSol implemented a process team, trained by the reengineering team, to review and analyze processes and procedures on an ongoing basis. Thus, a process of continuous improvement was implemented.

SUMMARY OF RESULTS The results of this first phase of reengineering are noteworthy, even if somewhat modest, given that the process is only partially complete and the effort coincided with a huge competitive and macro-economic crisis in Bolivia. The national organizational structure was streamlined as depicted in Figures 16 and 17.

167

Figure 16: BancoSol Pre-Reengineering Organizational Chart

Figure 17: BancoSol Post-Reengineering Organizational Chart

The percentage of individual loans in the portfolio increased from approximately 2% to 35%. The number of days from application to loan disbursement dropped from a range of nine to 12, to a range of 2.5 to seven days, depending on the type of loan. The dollars of loans managed per loan officer rose 23%, to US$340,000, while the number of loans managed per loan officer remained constant from 1998 to 1999. The lending cost to the client was cut drastically, including a reduction in required office visits by one-third. As encouraging as these results are, however, this phase of reengineering represents only a first pass at strengthening the organization. As mentioned previously, BancoSol’s reengineering efforts left the

R egion 1 R e gion 2

R egion 3 R e gion 4

R egion 5

M arke ting/C om m e rc ia l L oans

O pera tions/F ina nc e

In te rna lA udit

L e ga l Inform a tionTec hnology

O rgan iza tiona lD eve lopm e nt

C E O

R egio n 1 R eg io n 2

R eg io n 3 R eg io n 4

R eg io n 5

M ark e tin g/Lo an O ffice r

O p era tio n s /F in an ce

Lega l In te rn a lA u d i t

In fo rm atio nTech n o lo gy

O rgan iza t io n a lD eve lo p m en t

C EO

168

administrative functions of the regional and national offices virtually untouched. Given that these functions constituted 29% of the total bank staff in December 1999, work is now underway to identify additional opportunities for streamlining. The restructuring of the national organizational structure was one of the first steps in initiating this next reengineering phase. Additionally, the branch structure employed at BancoSol includes 121 administrative staff of a total branch staff of 439 (in December 1999) responsible for finance, payment processing, MIS maintenance and building maintenance. The replication of this administrative staff at every location represents a significant expense for BancoSol, one that might benefit from greater consolidation and centralization, without a significant impairment in decision-making and customer service.205

MIBANCO

THE PRE-REENGINEERING SCENARIO In 1997, Mibanco’s senior management undertook a sweeping reengineering endeavor encompassing the breadth of its operations. Having recently transformed into a for-profit bank, Mibanco realized that it needed to be better able respond to the expectations of two important constituencies: 1) clients demanding agile customer service and 2) investors demanding sustainable operating ratios. Though Mibanco was very profitable, this profitability was diminished by a very high cost structure—annual operating costs were nearly 60% of its loan portfolio. Investors and management knew that the pricing levels that had allowed them to achieve such high levels of profitability would not be sustainable in the future due to impending competition in the form of commercial banks moving down-market and the entrance of foreign consumer lenders entering Peru.206

205 In early 2000, BancoSol hired a new CEO who has begun instituting

significant cost-cutting measures, including a consolidation of the regional branch structure and a reduction of duplicative functions at the local level.

206 This onslaught of commercial competition was made possible in part by financial and trade liberalization policies introduced by President Fujimori in the early to mid-1990s.

169

Prior to this reengineering effort, front-office (sales) and back-office (processing) functions were not well differentiated, creating inefficiency in the loan delivery system. Loan officers performed all aspects of loan underwriting for loan applicants. (Collection efforts were managed from headquarters.) This process included attendance at daily credit committee meetings, even if the loan officer had no loans being presented. The credit committee was the only body authorized to approve loans. Upon approval, loan officers prepared all aspects of loan disbursal, including entry of the loan into the computer system. As a result, loan officers were able to effectively manage only 50 new and renewal applications on average per month. At the same time, branch managers were finding that the many routine tasks for which they were responsible, such as opening and closing the office, ordering supplies, managing the cashiers, etc., were making it difficult for them to dedicate sufficient time to managing their portfolio. Even more troubling was the fact that application and underwriting processes were different in every branch. Different branch managers and loan officers would apply distinct criteria in evaluating applications. In addition, branch managers suspected that many loan applications never even reached the branch, as loan officers conducted rapid appraisals of potential clients in the field and bringing in only those they felt were “high” quality. This process was not only inefficient—management estimated that for every loan ultimately approved, loan officers had to process four applications—it was inconsistent in the eyes of potential clients, as an application that was rejected in one branch might well be approved using the standards of another. If Mibanco was to improve its efficiency, a radical restructuring of processes was required.

THE REENGINEERING PROCESS207 Mibanco’s reengineering endeavors rested upon three cornerstones: � A shift in organizational structure and responsibilities to optimize the

use of higher paid staff. � A restructuring of core processes to improve efficiency. � An increased use of technology.

207 César Lopez of ACCION International led the technical team that the

supported the Mibanco reengineering effort.

170

Organizational and Responsibility Changes One of the most notable changes was the introduction of an operations manager (a “funcionario”) into the largest branches. This individual assumed most of the administrative responsibilities formerly performed by branch managers. As a result, branch managers now have much more time to focus on more important issues, such as planning for future growth, monitoring and controlling late repayments, chairing the credit committee, developing the skills of credit officers and maintaining the quality of the loan portfolio. To encourage staff to improve productivity, key performance indicators were established using target levels of performance. For example, after two years working for Mibanco, loan officers will be expected to maintain portfolios of approximately 400 loans. These performance objectives were reinforced by an incentive program for credit officers rooted in the twin objectives of portfolio growth and credit quality.208

Mibanco also created a more standardized process for managing staff hiring in growing branches by establishing benchmarks for appropriate staff levels at different stages in a branch’s growth. Using estimates of the number of clients required to break even (achieve 100% self-sufficiency at the branch level), Mibanco established three general stages of branch growth (small, typical, and large), with corresponding standards in terms of required staff. (See Table 15 for the detailed standards.) By establishing these standards, Mibanco has been able to significantly reduce unplanned and unsupported staff expansion.

Table 15: Mibanco’s Standardized Branch Staffing

Requirements SMALL TYPICAL LARGE Branch Size (# of Clients) < 2,000 2,000−3,000 > 3,000 Branch Manager -- 1 1 Loan Officers 3-4 5-6 7-8 Office Manager -- -- 1 Receptionist 1 1 1 Operations Support * 1 1 Cashier * * 1-2 * Service provided by receptionist or operations support person.

208 Loan officers are required to generate 150 loans before being eligible to

participate in Mibanco’s incentive plan.

171

Core Processes Revised Mibanco management turned a critical eye to every aspect of its lending operations. With standardization, simplification and delegation as its guiding principles, management implemented a radical overhaul of the lending process. Some of the changes with the greatest impact included: � Tiered Approval Authorities: Loan officers had to have one year’s

lending experience and a high-quality loan portfolio in order to be eligible for loan approval authority. Authority levels were based on the size of the loan and the depth of loan officer experience.

� Delegated Job Functions: Mibanco transferred the input of all loan-

related data and loan disbursement to the administrative staff of the branch—funcionarios—to consolidate back-office functions.

� Streamlined Underwriting: In addition to job delegation, Mibanco

further optimized employee time by segmenting loan applications by client risk. Clients were divided into Type “A” and “B” based on their economic situation, geographic area of operation, business type and repayment history (for repeat borrowers). This classification established a risk profile and profitability for each market segment that defined the type of loan analysis undertaken for each.209 Type B analysis, reserved for lower-risk clients with established repayment histories, streamlined financial analysis in the underwriting process, reducing the number of basic ratios calculated from nine to four. Mibanco also instituted an automatic approval process for low-risk loans (e.g., clients with a history of at least three loans with Mibanco, no delinquent payments during the last loan and a stable economic market). While a site visit was still required for loans meeting these criteria, the pages of paperwork required previously were all but eliminated.

The combined effect of these actions was the ability to reduce branch staffing by at least one loan officer. Granted, in some offices loan officer reductions were offset by the addition of an office manager or cashier. Nonetheless, even in those branches where a loan officer position was

209 This client risk classification was an important input in the credit-scoring

system Mibanco established.

172

exchanged for an office manager position or other administrative support position, the reduction in compensation and benefits was notable. Increased Use of Technology Mibanco sought efficiency improvements through increased computerization. All loan officers and branches were networked into the mainframe computer. All applications were fully automated, including basic client information, information collected in the loan application process, disbursals and repayments, branch expenditures, etc. Loan applications requiring review by others were transferred electronically. The new system offers increased flexibility to service multiple transactions and different currencies, and can handle a larger volume of loans and clients.210 Computerizing all elements of the loan process and tracking this information in a database enabled Mibanco to achieve much greater standardization in the credit evaluation process. Using the nonfinancial data tracked through this process, Mibanco developed a predictive decision-tree model to be used in evaluating new loan applications. In a more substantial effort, the historical financial information in the database has been incorporated and used to develop a credit-scoring model, which helps both to select new clients and identify top-performing clients within Mibanco’s existing customer base. Challenges Encountered The primary resistance to the changes implemented came from branch managers who resented the loss of power implicit in the application of centralized standards regarding branch staff levels and credit evaluation processes. They were skeptical, too, of the changes, since there was no track record for the recommendations being proposed. In some cases, because of this opposition, Mibanco rotated or let go of some branch managers. Nonetheless, those who remained have come to appreciate the changes, particularly because they move the mundane office management tasks to the funcionario and allow the branch manager to focus on the parts of the job that are both more interesting and affect compensation—the management and growth of the branch’s portfolio.

210 Campion and White, p. 105.

173

SUMMARY OF RESULTS The results achieved during this reengineering process were impressive as is illustrated in Table 16.

Table 16: Mibanco Reengineering Results BEFORE

REENGINEERING AFTER REENGINEERING

Branch Manager Responsibilities

All staffing decisions. Most loan approvals. Office management. Portfolio management.

Implementation and monitoring of office objectives and standards. Portfolio management. Training and development of branch staff.

Loan Officer (LO) Responsibilities

Primarily loan underwriting and collections.

Primarily application generation with limited involvement in loan underwriting.

Change in Financial Analysis Requirements

No standard requirements for financial analysis.

Four or nine ratios for basic or complex applications.

Initial Loan Appl. for Credit Committee (CC) Decision

Four Days. Two Days.

CC Decision to Disbursement

Three Days. One Day.

No. of Loans to External CC 100%. 30%. LO Time in CC Daily Two Hours. 15 Minutes. No. of LO/ Branch Six to seven. Five to six. No. of Appl./LO/Year 600. 1,200.

No. of Loans Managed/LO 200. 400 (objective).

Application Conversion Rate 30%.211 75%-80%. > 30 Days Delinquent 8%. 2%.

Note: Appl.--Application

211 The actual rate pre-reengineering is not known, as credit officers were

evaluating and rejecting many potential applications in the field. This number represents management’s best estimate of the pre-reengineering situation.

174

As evidenced in Table 16, the reengineering improved customer service through significant reductions in the delay between the receipt of the initial loan application and the ultimate disbursal of an approved loan (from more than seven days to less than three days). Mibanco also increased the acceptance rate of new loan applications (from 30% to 75%) without a concurrent increase in portfolio risk. In addition, the reengineering increased loan officer productivity by 100%in terms of applications per loan officer per year. While the reengineering process achievements at the branch level are impressive, they represent only the first step in improving Mibanco’s efficiency. As mentioned above, Mibanco’s reengineering efforts left the administrative functions of the regional and national offices virtually untouched. Given that these functions constitute a significant percentage of Mibanco’s total compensation expense and administrative expenses, there is still room for further improvement in efficiency and cost-reduction. These are the next challenges that face Mibanco as it continues to work to meet the ever-increasing demands of its clients and investors.

CONCLUSION

As highlighted in this chapter, business change and, in particular, reengineering, whether sweeping as in the case of ACCION New York or partial as in the case of BancoSol, can greatly enhance productivity, profitability and customer service when done well. These projects also demonstrate that reengineering need not be automatically equated with “down-sizing” (i.e., job loss) but, rather, “right-sizing”(job redefinition). Thus, rather than automatically meaning significant reductions in human resources, reengineering can result in the improved deployment of human resources (the improved matching of skill sets with operational needs) and can position the organization for significant growth built upon existing human resource bases.

CHAPTER FIVE

CONCLUSION

177

This monograph has combed through increasing levels of institutional analysis to offer a more in-depth understanding of efficiency. The exposition of the topic is consistent with the monograph’s overall recommendation, namely that efficiency analysis must begin at the managerial levels, as part of the overall strategy of the institution, and carry through each business unit, in order to identify all opportunities for cost reduction and improved revenue generation. Moving through the deepening layers of analysis, it is clear that efficiency maximization involves a combination of high-level scrutiny, innovative problem solving, vigilant attention to detail, and most importantly, a plan of action. In this way, efficiency maximization can be an unglamorous endeavor and continual hard work, requiring experimentation with a variety of alternative strategies, as is clear from the array of techniques and tools presented in this monograph. Yet efficiency maximization also involves creative and simple enhancements that, like an elegant mathematical model, can have profound benefits in improving an MFI’s performance. This chapter summarizes the most salient points of the monograph and provides a practical “first-steps” guide for those readers ready to embark on some of the more radical improvements suggested in Chapters Three and Four. Many of these recommendations on the reengineering of microfinance are drawn from ACCION’s experiences in both Latin America and the US, which have been challenging, though fruitful, for those MFI leaders bold enough to undertake the painstaking process of institutional change. The chapter also looks at the implications of the ideas advocated for MFI leadership and then concludes by acknowledging the breadth of the subject matter and identifying topics beyond the scope of this monograph that warrant further study.

178

TENETS NO LONGER TRIED AND TRUE

Like any industry, microfinance rests, in large part, upon widely held beliefs and premises. But as has been repeatedly raised in this monograph, many of these tenets appear questionable under the harsh light of efficiency analysis. Some of the more important tenets are set forth below so that they may be opened to the intense reevaluation they warrant.

CUSTOMER FOCUS The paternalism that once defined the practices of many players in the industry (donors and practitioners alike) is less appropriate for more developed microfinance markets. Once termed beneficiaries, clients have evolved into customers with demands and preferences that MFIs need to respect in order to succeed. Indeed, customer satisfaction has become a new benchmark of success, though this orientation does not imply that an MFI should try to be all things to all people. Rather, this customer orientation requires that MFIs begin segmenting their markets more carefully to define the specific niches they will target and adjust their products accordingly. Internally, this customer orientation must pervade the back-office as well as sales efforts, to ensure that there is alignment among all aspects of MFI operations. Externally, this client-driven orientation implies that product design—including pricing, underwriting and delivery channels—should be shaped by the realities of the marketplace and adjusted by the goals of the institution, including both mission and financial viability.

AVERAGE LOAN SIZE Average loan size is widely tracked in the field but is a poor indicator for both impact and efficiency. Average loan size keeps the focus on portfolio characteristics rather than on customer satisfaction, and is thus an unidimensional measure of impact. As such, average loan size is a poor measure of whether an MFI has maximized efficiency from a social point of view. Still, average loan size is used by some not only as

179

evidence of impact but as an excuse for low self-sufficiency. While a low average loan balance indeed can make self-sufficiency more challenging, it should not be the determining factor if an MFI is serious about maximizing efficiency. Indeed, a serious and thoughtful focus on efficiency avoids the false dichotomy between financial self-sufficiency and social impact. As a result, a few market leaders have creatively managed to keep average loan balances low while focusing on efficiency and even achieving break-even financial results.

DIFFERENTIATED PRICING AND PRODUCTS The differentiation—among market segments and competitors—that a customer focus requires has important implications for pricing. Different customer segments have distinct risk profiles and price sensitivities, both of which make the cost of credit as important as access. MFIs that understand these customer preferences and risk considerations and incorporate them into pricing and product policies will be able to establish an important competitive advantage. Even for those MFIs operating in less competitive environments, a more sophisticated understanding of pricing—including cross-subsidies, demand elasticities, risk-based pricing, etc.—will enable them to define a strategy and a product mix that optimizes both revenues and impact, thus maximizing efficiency.

NET CONTRIBUTION It is important to consider fully the definition of efficiency—maximizing output per unit input—in measuring and improving how effectively an MFI employs its scarce resources. Traditionally, efficiency has been equated with cost control, and while this discipline is important, it is only part of the story, and sometimes a misleading one. First, cutting costs indiscriminately—without, for example, considering the differential impact on revenue of eliminating certain resources—can actually reduce efficiency. For example, cutting back on basic market research will save costs in the short term, but may actually result in more inefficient operations if product design is poorly aligned with the target market. Secondly, holistic efficiency maximization involves looking at revenues as well as expenses, to determine whether more could be produced from the existing resource base. In other words, even if costs are held constant, an MFI can improve overall efficiency by generating more revenues

180

from existing capacity. For example, improving loan officer productivity, a common efficiency-enhancing strategy, increases revenues (loans generated) while holding costs (salary) constant. Net contribution analysis, discussed in Chapter Two, facilitates this holistic approach to efficiency analysis by examining revenues and (fully allocated) costs jointly, rather than independently. By looking at net profit generated by each resource—rather than just cost consumed—an MFI can determine how well each input is being leveraged. In this way, the bank efficiency ratio (which measures total expenses as a percentage of net interest income) moves beyond the traditional microfinance efficiency ratio (administrative expenses as a percentage of average portfolio), by analyzing costs as a function of profitability, rather than just scale. In this way, an MFI with a small loan portfolio that strategically compensates for its down-market focus via higher interest rates can achieve efficiency levels comparable to an MFI making larger loans. Net contribution analysis enables this type of strategic decision making at the heart of efficiency maximization.

INTENTIONALITY The strong recommendations included in this monograph—such as market-driven strategies, differential treatment of pricing and risk, maximization of revenues as well as reduction of costs, alignment of mission and methodology, etc.—should not be misinterpreted as advocating a specific path for all MFIs. On the contrary, the analytical framework presented in Chapter Three highlights the fact that the diversity of the microfinance industry requires a plethora of tools and techniques for efficiency enhancement. In fact, the diversity of the field—both in terms of regional market differences and distinct missions and goals of different players—has in some cases fostered the innovation that efficiency maximization requires. What this monograph does advocate strongly is intentionality by each MFI and strategic stakeholder in defining the organization’s unique path. In other words, each MFI should have a clearly defined vision, driven by its mission and executed through its strategy, that is well aligned to ensure the maximum leverage of scarce resources. MFIs should have clear goals that they monitor and measure on an ongoing basis to see if they are maximizing efficiency—output per unit input—based on their own benchmarks of success. If success for one MFI is improved health and education of its clients, it should track customers’ welfare and measure the differential impact of

181

distinct strategies to know where to focus resources. Similarly, if the goal for another MFI is to be 100% financially self-sufficient, it should track the net contribution of each product to see which ones are draining disproportional resources. This monograph does not state that an MFI should prioritize profitability over social goals. It does, however, insist that however success is defined, it should be pursued and tracked in every aspect of the MFI’s operations.

REDEFINING COMMERCIALIZATION This monograph has highlighted the increasing commercialization of microfinance as one of the primary drivers of efficiency. The move toward commercialization in microfinance is typically explained by the industry’s financial formalization that began with BancoSol’s transformation in 1992 from an NGO into a regulated bank and evolved with the recent entry of commercial banks into the sector. In other words, commercialization of microfinance is discussed in terms of the type of institutions that now operate in the market, as most of the recent works on the topic212 mention the market entry of primarily profit-driven institutions, such as banks and consumer lenders. It is indeed noteworthy and critically important for the long-term viability of the industry that commercial institutions have taken an interest in microfinance. However, the significance has less to do with the type of institution than it does with the culture. Most commercial entities, because they are accountable to exacting shareholders, are results-driven. This sense of accountability, in turn, makes it difficult to ignore efficiency. MFIs can employ this same kind of culture to tremendous effect, by being accountable to clients, donors, investors and regulators, defining success not only in terms of loan volume or portfolio size, but how well they are operating, in terms of efficiency and profitability, for example. Identifying accountability as the most important aspect of commercialization addresses the polarization within the field between those whose main motivation is serving the poorest and those who are primarily concerned with self-sufficiency. This new notion of commercialization will be what gives impetus to MFIs to improve efficiency and their financial performance, enabling the deepened outreach that is at the heart of most missions. 212 Works that discuss this issue include Rhyne and Christen; Downing; Vargas

and Bass; and Baydas, Graham and Valenzuela.

182

REENGINEERING: WHERE TO BEGIN

Once an MFI has defined its vision and identified inconsistencies in its strategy, product offerings or internal operations, it must undergo change in order to realign these different institutional components if it wants to maximize efficiency. Appendix C discusses this business redesign process in detail. What follows are some of the primary requirements for consideration by MFI leaders who elect to move forward in instituting such change initiatives.

DIAGNOSE THE PROBLEM The first step is to bring together key stakeholders (board members, senior management, investors, etc.) to define a clear vision and corresponding strategy for the organization. They then should identify what each perceives to be the major problems, challenges, as well as the opportunities in realizing that vision. Only after the perceptions and biases are laid on the table should the MFI undertake a more rigorous financial analysis to help diagnose some of the main culprits of inefficiency. This diagnosis should start with an analysis that first fully allocates the MFI's revenue and expenses to its products and services so that the net profitability (or loss) of each becomes evident. Then the stakeholders should undertake an honest, wide-eyed examination of the board and senior management to determine the extent to which the current leadership is entrenched in “business as usual” or a mission that is outdated or too narrow. If the existing leadership lacks specific skills, expertise or creativity, it might be necessary to bring in new blood to complement or replace them and to introduce fresh ideas that affect change.

SEEK OUTSIDE ASSISTANCE Examples of significant change that was successfully instituted by staff without the objectivity and expertise of outside help are almost nonexistent. The scale and scope of work contracted to outside help will vary depending on the resources an MFI is able or willing to dedicate to

183

such assistance.213 Those MFIs with more limited resources could consider bringing in a consultant to conduct a three- to five-day general diagnostic that reviews the organizational structure, the institutional culture, the internal processes, human resource capacity and technology utilization. The goal of this analysis would be to confirm or expand upon the initial analysis done by senior management and set a road map for further analysis. The results of this initial analysis can then serve as the basis for decisions about reengineering, including how much is needed, whether the organization has the internal leadership to undertake it, whether any or all of the resources needed are available, etc. The consultant can also help the decision-makers consider the extent and pace of change depending upon the seriousness of the issues. For example, if donors or other investors believe the mission is misguided and the board is too entrenched, more radical steps might have to be taken.

IDENTIFY BOLD DECISION-MAKERS The most challenging issue in the reengineering process is typically the cultural change that comes with the (often inevitable) decision to bring in new blood—whether at the most senior levels (CEO and board) or in executive and middle management. Effective change efforts require hard decisions about who to keep, who to bring in, who to redeploy or let go—a painful, disruptive process that is critical to creating a culture that will institutionalize efficiency. Many of the efficiency-improving techniques described in this monograph also demand individual accountability and increased responsibility, which can be an unwelcome change for people who are not accustomed to it. Thus, creating the team of decision-makers that can balance the existing organizational culture with the required change is the most important issue. As highlighted in Chapter Four, leaders who are able to make bold decisions for the good of the institution—rather than for personal aggrandizement or benefit—are key in instituting the changes needed to maximize efficiency.

213 ACCION began dedicating resources and building its competency in

reengineering to make the technical support it offered its affiliates more relevant to their needs for increased efficiency.

184

FOCUS ON RESULTS The decision-making team should be very explicit about its goals at the outset, specifying exactly what type of changes they hope to achieve with the reengineering effort and how these will be institutionalized. Focusing on results will clarify the steps that must be undertaken and can help depersonalize painful staffing decisions. Moreover, quantifying the goals will allow the MFI to establish both a baseline and target benchmarks to enable an ongoing comparison of projected versus actual change. Thus, any consultants who are brought in should clarify and quantify the added value they will bring and define the time frame of the process. As important, the consultant should include a detailed plan for the transfer of responsibilities and knowledge regarding efficiency and reengineering techniques to staff as they are ready to assume responsibility. This knowledge transfer should be thoroughly and exhaustively detailed so that staff can carry on the work and resist the temptation to revert to old habits and business as usual. Quantifying, measuring and tracking these goals will allow leadership to monitor the degree of progress achieved and quickly identify outstanding issues to be tackled.

INSTITUTIONAL IMPLICATIONS: LEADERSHIP

As is clear from the field examples drawn upon throughout the monograph, a number of MFIs have institutionalized the efficiency orientation discussed throughout the monograph. This efficiency orientation serves as the basis for not only the more innovative and radical practices (such as Palm Pilot applications or institution-wide reengineering efforts), but the more commonplace, day-to-day vigilance needed for reducing costs and maximizing revenue opportunities. These practices have had profound impact on the MFIs that adhere to them in terms of marked improvement in outreach, self-sufficiency and, in many cases, profitability. Establishing this vision at the outset and maintaining an efficiency orientation suggests the critical role leadership plays in maximizing efficiency. Strong leaders are needed to set the course for MFIs and navigate the difficult waters that changing markets will inevitably bring. Moreover, today’s microfinance leaders need to be bold and creative thinkers to successfully balance the multiple goals—social, financial, and

185

competitive—MFIs typically must manage to maximize efficiency. These leaders need to push through the stalemate regarding mission and self-sufficiency, understanding that with creativity and hard work, these goals need not be at odds. Strong leaders must not only define the mission, culture and strategy but also execute the changes required to realize this vision. The manner in which MFI leadership responds to the inevitable resistance to change (whether overt or covert) is among the most critical determinants of the success of any organizational redesign or business enhancement process.

AREAS FOR FURTHER STUDY

The scope of this monograph, albeit ambitious, is not comprehensive. Several topics were covered in only a cursory manner and deserve more complete treatment. For example, the conditions under which functional specialization makes most sense were only superficially covered. Additionally, the reengineering case studies included here had only partially completed their planned phases. Follow-up analysis is needed to understand the lasting impacts of radical redesign on microfinance performance. Finally, an in-depth consideration of financial tools to improve efficiencyranging from transfer pricing strategies employed by some sophisticated MFIs, such as BRI in Indonesia to reducing the overall cost of capital by deliberate financial managementare areas that merit more in-depth discussion. Additionally, there are areas of investigation that were truly beyond the scope of the monograph but certainly in need of further elaboration. Six of these topic areas—namely savings, marketing, technology, institutional structure, decentralization and staff specialization—are discussed in greater detail below.

SAVINGS The savings activities of microfinance institutions are of increasing interest to practitioners, investors, donors, and customers because of their critical importance strategically, socially and financially for microfinance. Asian MFIs, such as those in Bangladesh and Indonesia, have advanced much further than their Latin American and African counterparts in their offering of savings products and services. Savings

186

mobilization has not been a priority or a necessity in these latter two continents mainly because of the availability of alternative funding sources, both commercial (banks, private investors, etc.) and subsidized (donors, governments, etc). The development of savings products, however, not only provides stable funding sources upon which to finance future loan growth, but also meets client’s financial needs214 and, in so doing, fulfills the MFI’s social mission. Thus, both from a financial viability and a customer service point of view, savings mobilization can have important implications for an MFI’s efficiency and self-sufficiency. Whether the motivation is strategic, social or financial, incorporating efficiency techniques from the outset will be key to success. One of the main barriers to expanded savings mobilization is the cost of collecting deposits. The success of Asian MFIs in profitably capturing savings deposits suggests that there are efficiency gains that have yet to be exploited in MFIs that currently rely on other sources of funds. Moreover, MFIs that do offer savings have learned over time (especially with an increase in competition) that customers’ need for versatile products and streamlined delivery holds true for deposits as well as loans. Kenya Post Office Savings Bank (KPOSB), for example, piloted a new savings product (called “Bidi”) in response to extensive market research documenting clients’ unmet need for an agile deposit product that allowed for more flexible withdrawals. The design and piloting of this product followed the establishment of an institution-wide cost allocation system that enabled KPOSB to more accurately price its products to more closely approximate their respective net contribution. Microsave Africa, which assisted KPOSB in this costing and product design effort, is incorporating these efficiency considerations into their savings mobilization strategies. These techniques must be tested and applied more broadly, however, so that the challenges to efficiency in savings mobilization may be better understood and, more importantly, overcome.215

214 Rutherford, p. 104. 215 Microsave Africa, a project sponsored by the Department for International

Development of the UK and the United National Development Program, is expanding into southern and western Africa, and is also considering partnerships with other MFI networks in other regions of the world.

187

MARKETING MFIs are also increasingly integrating marketing—through explicit plans or dedicated departments—into their operations to improve customer service (through product development), to establish a brand identity and, ultimately, to increase sales. Part of these efforts involves a more careful segmentation of the market so that an MFI can identify distinct niches it wants to target and the products to penetrate these market niches successfully. Done well, marketing can improve the alignment among customer, product design and delivery, a significant efficiency enhancement. Yet the use of marketing is still in elementary stages for most of the industry, and thus it is opportune to utilize an efficiency frame as MFIs build in-house marketing capacity. Many MFIs have historically resisted big investments in marketing because they are a cost center with only weak ties to revenue generation. Indeed, some marketing efforts do result in unimpressive sales results, especially when they consist of promotional campaigns that are pulled together at the eleventh hour, poorly aligned with the total product (including the core client needs and preferences they are intended to serve), and not executed from a client perspective. Other marketing efforts, though better aligned with the MFI’s overall product strategy and mission, run into difficulty when the results of the campaign are not carefully tracked nor monitored. Some of the tools presented in this monograph can assist MFIs in becoming more discriminating in their marketing efforts so that strategic decisions can be made regarding which specific activities warrant additional (or lower) investment. For example, analyzing the net contribution of different promotional campaigns can allow an MFI to focus its resources on those particular marketing efforts that produce the strongest results. Correlating marketing expenditures and revenue generation would allow MFIs to weed effective marketing campaigns from weak ones. To date, little such analysis is done to determine how best to invest the limited marketing funds MFIs have at their disposal. Moreover, MFIs have conducted limited experiments with conventional marketing approaches, such as segmentation by psychographic characteristics, which have proven to be strong predictors of consumer behavior that are also correlated with customer satisfaction. Leading MFIs have begun to borrow some marketing techniques from conventional bank practices—such as cross-selling and market

188

share/penetration indicators. Research is needed to differentiate these types of conventional marketing practices from those that have limited applicability in microfinance.216 The success with which MFIs apply efficiency tools to their marketing efforts should be documented to disseminate best practices in this area.

TECHNOLOGY Chapter Three offered a number of technological applications and innovations that MFIs have begun to use to improve efficiency. Unfortunately, though, the power of this technology is far from being fully exploited in the industry. Credit scoring and Palm Pilots are being implemented in limited circumstances to enhance the efficiency of loan underwriting; however, there are additional technological applications that could result in significant gains in efficiency. For example, as described in Chapter Three, ACCION International has very recently begun designing credit-scoring systems that help an MFI analyze the conditions under which vigilant delinquency work-out pays off so that collection resources are targeted at those borrowers with the greatest likelihood of repayment. Other innovations include smart card technology, which a few MFIs have begun to employ, and informal credit bureaus that are created through collaborative industry efforts to share data. Perhaps, however, some of the greatest contributions technology can make to efficiency maximization have little to do with state-of-the-art innovations. Rather, additional research is needed on the enormous efficiency gains to be had from the regular automation of detailed processes that form an MFI’s normal, day-to-day operations. Many MFIs have begun to electronically link headquarters to branch networks for facilitated data transfer and up-to-date information tracking and analysis. Yet additional components of the lending process remain unautomated, including the download of credit reference materials and the automatic generation of forms (rather than reentry of key data into documents). Integrating systems is also a largely untapped source of increased efficiency through eliminating duplicate entries. The cost/benefit of

216 Microsave Africa, for example, has experimented with more participatory

research techniques that are more conducive to the cultural and demographic realities of the markets within which it is working.

189

software interfaces, their ease of purchase or development and the challenges of keeping such interfaces current all warrant further study.

INSTITUTIONAL STRUCTURE The entrance of private banks, with their myriad operational structures, into microfinance raises the issue of which institutional structure is most conducive to maximizing efficiency. Whether a wholly-owned subsidiary or a division of an established commercial bank, these units typically enjoy certain efficiency advantages over nonbank microfinance MFIs, including the ability to rely upon an existing infrastructure as necessary,217 more stable sources of low-cost financing and widespread experience in financial markets. Yet many bank divisions also have some disadvantages in relation to the specialized MFI, such as the bias of a traditional banking culture, a lack of expertise in this market segment and slow decision-making. This slow decision-making is generally a result of two contradictory factors: bank management’s need to exert control over microfinance operations because of their risk aversion when entering new markets, and a lack of attention, given that the microfinance portfolio represents an insignificant proportion of the bank’s total assets and interest income. Specialized MFIs, on the other hand, tend to be more knowledgeable about the peculiarities of microfinance. A large portion of general management’s time is focused on understanding the business of microfinance and the whole organization is oriented to the specific sector, but typically at a higher cost than the operation of a microfinance division of a big bank. If microfinance institutions can take advantage of being first entrants in the market to build their infrastructure and establish a solid position, they might preempt the late entry of traditional financial institutions or, at a minimum, compete effectively to maintain niche leadership. Further study is needed in assessing the impact of commercial banks in microfinance markets and the advantages of different institutional structures. Study is also necessary to identify those bank practices and conditions that can be replicated by MFIs in order to compete effectively with these recent market entrants.

217 The cost advantages of a large bank are a function of its existing “installed”

capacity. If a microfinance portfolio can be added within the existing branch structure, with minimal adjustments to management information systems (MIS), then the cost advantages will be significant.

190

(DE)CENTRALIZATION Closely related to the issue of institutional structure is the degree to which MFIs benefit from centralized or decentralized operations. Internationally, the industry’s emphasis is on the decentralization of responsibilities and decision-making. This decentralization has had the positive impact of speeding client decisions and enhancing overall customer service in many MFIs. It has also, however, resulted in the maintenance of excessive administrative staff at many MFIs. This international trend is under intense scrutiny by ACCION USA as it tests a more highly centralized process predicated upon the consumer and residential lending models found in US banking. This “centralized” model disperses loan officers and some decision-making across the lending region; however, a high utilization of technology coupled with a highly specialized administrative staff allows for the centralization of staff and processes, and thus, an increase in overall productivity. Further study is needed to analyze these structures, their long-term impacts upon efficiency, and the conditions under which an MFI would apply one structure or another.

STAFF SPECIALIZATION The efficiency implications of staff specialization by function or by loan product is an area that would benefit from further research. Though traditional economic theory suggests that there are economies to specialization, practical experience in microfinance and conventional banking shows mixed results. There has been more unequivocal success with specialization by function, especially when simpler duties are delegated to lower level staff who focus exclusively on a defined set of rote tasks or when full loan authority is pushed down to the branch or field level. Additionally, some MFIs specialize staff by product type, particularly when the nature of the underwriting or client profile is unique. Examples include agricultural specialists hired for rural lending and university trained economists to handle the more sophisticated financial analysis required to underwrite individual (vs. solidarity) loans. Yet specialization can create silos within the institution (particularly when incentives are improperly aligned) that prevent the holistic analysis required to maximize efficiency. Unfortunately, this kind of tunnel vision

191

can also happen when loan officers are generalized for the purpose of cross-selling different products. For example, cross-selling at some commercial banks in the United States through generalized agents has failed because incentives encouraged emphasis on more lucrative products, such as real estate loans, over less lucrative products, such as checking accounts. Some MFIs, such as BancoSol, are experimenting with generalized loan officers as they introduce new products to encourage cross-selling and to improve productivity of existing loan officers. Other MFIs are training specialized loan officers by loan size, risk level and other differentiated product characteristics. Research needs to be done to determine the efficiency enhancements of each strategy. Some of the more sophisticated specialization techniques developed by commercial financial institutions in the United States should also be tested in the microfinance arena. Examples include data-mining techniques based on computer algorithms whereby institutions track specific indicators based on customer profiles and preferences to tailor product design and marketing efforts by specific segments.

RISK ANALYSIS A handful of MFIs have had years of experience maintaining strong portfolio quality and managing risk. Others have begun experimenting with new product development with distinct risk profiles, loosening their vigilance on zero-risk tolerance in order to improve customer service and efficiency. As a result, MFIs are realizing that the cost of vigilance in controlling risk—whether in delinquency or internal fraud—does not always produce optimal returns. Some research efforts have begun analyzing this cost-benefit trade-off, trying to identify how MFIs can safely assume more risk without contaminating their portfolio quality. An overwhelming majority of MFIs claim that they maintain less than a 2% delinquency rate. While holding aside the question of consistency in how portfolio quality ratios are calculated, the question still remains: Is this level the “right” amount of risk? Deepening understanding about how much risk an MFI can tolerate and, more importantly, the true cost of maintaining different risk levels, is an important area for further study.

192

These areas warrant serious attention to assist MFIs in their continued pursuit of efficiency maximization. This vigilance will be required of MFIs that confront the competition of profit-driven institutions and the general commercialization of their markets, as well as those interested in sustainably expanding and deepening their level of outreach to the poor. The success of these efficiency-improving strategies means increased outreach and financial formalization—and the stability, service quality, market penetration and impact they imply.

APPENDIX A

COMPONENT ROA ANALYSIS

195

This appendix, and in particular, Figure 19, provide an overview of the component ratios and results that contribute to an MFI’s return on assets (ROA) ratio, including the interrelationship between an MFI’s ROA and its return on equity (ROE). The sections that follow describe this process in detail.

OVERALL RETURN ANALYSIS

ROE BREAKDOWN ROA is derived from a related profitability ratio—namely return on equity (ROE). As illustrated in the first line of Figure 19, the ROE ratio—measured as net income divided by average equity—is comprised of two fundamental components: ROA and leverage. ROA demonstrates how well an institution generated income from its asset base, while leverage illustrates how the capital structure—the use of debt vs. equity to finance operations—impacted profitability. Because most MFIs still enjoy vast sources of “patient” capital (such as donors and socially motivated investors) and are therefore typically under-leveraged, the majority of the efficiency analysis in microfinance focuses on the ROA.218 As illustrated in Figure 19, by deconstructing ROA—defined as net income divided by average total assets—into its component parts, an MFI can identify which income sources and related cost components are driving profitability. The first section of the ROA analysis in Figure 19 describes the income or return each different type of asset (productive, financial, and nonproductive) produces. The second section of Figure 19

218 This monograph does not address the issue of how an MFI can manage its

financing options as way of reducing the cost of capital for efficiency maximization, an area for further study.

196

analyzes the component operating expenses. An analysis of financial expenses, commonly referred to the industry as “cost of capital,” and leverage are not included in this appendix, but are touched on briefly below.

FUNDING COSTS AND LEVERAGE A complete analysis of ROE would include an examination of capital structure, including where an MFI obtains its funds and the costs associated with these different sources. In traditional financial terms, “leverage” typically refers to the ratio of long term debt to equity in an institution’s capital structure. The breakdown is important to shareholders, who benefit from increased leverage to the extent the return on borrowed funds exceeds the interest costs and the value of their shares rises. However, increased leverage also introduces risk depending on whether the institution’s income stream is stable and sufficient to cover the ongoing required interest and principal payments. In the ROE breakdown depicted in the first section of Figure 19, leverage is defined slightly differently, as the ratio of average assets to equity. In traditional microfinance applications, like ACCION’s CAMEL, leverage is used more to analyze risk (capital adequacy) rather than return.219 Unlike conventional financial institutions, which have access to a variety of financial instruments in the private capital markets, the ability of MFIs to obtain additional funding quickly from different sources is more restricted. Moreover, financial costs are still a tiny percentage of an MFI’s overall cost structure because MFIs enjoy a variety of inexpensive sources to fund their lending and other activities including donor grants, loans (debt), savings220 deposits, and capital (equity). In calculating the

219 As explained in Chapter Two, CAMEL is a institutional diagnostic that

ACCION developed to assess the financial and managerial quality of MFIs, based on a similarly named tool used in US banking. CAMEL sets maximum leverage ratios to determine “prudent” capital adequacy, typically recommending that an MFI’s risk-weighted assets be no more than 5-8 times its equity base. Saltzman, Rock, and Salinger, p. 37.

220 It is important to note, however, that the lower cost of funds from savings can be partially offset by the additional administrative burden involved in mobilizing retail deposits. A review of data collected by MicroRate shows that savings mobilization typically adds, on average, two percentage points to the efficiency ratios (total costs as a percentage of average net portfolio) of MFIs that collect deposits, adversely affecting the efficiency ratio. Farrington, p. 20.

197

cost of funding for an MFI, it is often useful to adjust the cost associated with any subsidized sources of capital, such as donor funds. This calculation enables an MFI to see whether it can generate sufficient investment revenue to cover its cost of capital as if it were no longer subsidized. Yet because many MFI have continued access to these inexpensive sources of subsidized capital, there is currently not much reason to analyze how different capital structures might improve (financial) efficiency. Thus, the ROA efficiency analysis focuses on the different types of assets in which the MFI invests this capital and the corresponding return, as well as non-financial (or operating) expenses.

ROA: PRODUCTIVE, FINANCIAL, AND NONPRODUCTIVE ASSETS

The second section of Figure 19 highlights the portions of assets that are productive (i.e., portfolio and financial capital) vs. those that do not generate income (e.g., buildings and equipment), and identifies how efficiently the institution is using productive, income-generating assets. Typically, 90% of an MFI’s assets will be productively employed (usually 80% in net loan portfolio and 10% in other financial assets). Understanding this split between productive, financial, and nonproductive assets is important in that the lower the percentage of productive assets relative to total assets, the harder each asset must work to generate a return, as illustrated in Table 17. In this example, MFI Deep Pockets bought a great deal of land on speculation as a quick way to deploy its large cache of idle funds, rather than making many small loans over time. As a result, it must maintain a much higher return (90% vs. 50%) on its relatively fewer productive assets (17% of total vs. 30%) to match the ROA of its competitor, Small and Solid.

Table 17: Asset Composition Analysis SMALL & SOLID

MFI DEEP POCKETS

MFI 1. Net Income/Productive Assets 50% 90% 2. Productive Assets/Total Assets 30% 17% 3. Return on Assets (1 * 2) 15% 15%

The next step in the process of deconstructing an institution’s ROA involves understanding the return an institution is earning on the two parts of its income generating assets—its loan portfolio and its “idle”

198

capital—as well as the impact (negative or positive) the nonproductive assets have on income.

RETURN ON LOAN PORTFOLIO The largest percentage of an MFI’s income is generated by its productive assets-–its loan portfolio. The return on average net portfolio, defined as net income from lending operations divided by average net loans (total portfolio loans less loan loss allowance based on anticipated delinquency).221 Net income from lending operations is the effective net interest income earned on the portfolio, including interest income and other fees charged to borrowers less the cost of debt and capital to fund those loans, provisions, and related operating costs.

RETURN ON INVESTMENTS The income earned on an MFI’s idle funds is a function of the revenue earned from investing these funds and the cost of the debt and capital used to fund those assets. Investment returns are primarily driven by institutional policy. For example, an MFI might restrict its investment of financial assets to government bonds with investment grades of “B” or better in order to ensure the availability of the funds when needed, while still earning a reasonable return. While it is important to know that an MFI is earning a positive return on its investments, the size of an MFI’s investment pool will generally be small relative to total assets.222 Thus, the income that non-portfolio capital produces will be correspondingly small.

RETURN ON NONPRODUCTIVE ASSETS Just as an MFI calculates its return on its loan and investment portfolios, so too is it able to calculate the return on its nonproductive assets, assets that typically include the building and equipment and other miscellaneous assets maintained on an MFI’s general ledger. Typically,

221 Average net portfolio is used to isolate only those assets that are truly

productivegenerating incomewhich the delinquent portion is not. 222 The extent of unmet loan demand in most markets implies that few MFIs can

find returns on capital greater than their portfolio.

199

these assets generate little income; however, like all other assets, they require funding. Thus, the income component of the calculation in Figure 19 includes any ancillary income received by the MFI that is not directly attributable to the loan and investment portfolios (e.g., the gain on sale of a building), offset by the costs of debt and equity necessary to fund those assets. As a result of the low amount of other income typically attributable to these assets, this return is frequently negative. Thus, the financial objectives of any MFI should include the minimization of these assets, especially as a percentage of total assets, to the extent possible. The remaining sections examine key variables in the most commonly used measure of operating efficiency—operating costs as a percentage of average portfolio.

OPERATING EXPENSE ANALYSIS

Operating costs are the heart of efficiency maximization. Controlling operating costs relative to net portfolio has an important impact on an MFI’s ability to increase its profitability and ROA. For example, commercial banks that attempt to move down-market are often able to substantially under-price less efficient MFIs and still earn comparable margins through relatively lower operating costs. As depicted in Table 18, the less efficient MFI must charge a substantially higher rate of interest to earn a margin similar to that earned by a competing bank. In a competitive market where consumers can choose their preferred financial service provider, this price differentiation is ultimately not sustainable.

Table 18: Margin Breakdown AS % OF

PORTFOLIO: EFF. INT.

RATE FIN.

COSTS OPER. COSTS

PROVISION

MARGIN

Conventional Bank

75% 20% 10% 5% 40%

Transformed MFI

105% 20% 40% 5% 40%

Eff. Int.—Effective Interest; Fin.—Financial; Oper.—Operating Careful ROA analysis can reveal such differences in operating expenses and allow management to make preemptive adjustments to fend off competitive threats. The remainder of this analysis focuses on a couple of

200

the largest cost items facing an MFI, namely headquarters (vs. branch) expenses and personnel expense.

HEADQUARTERS VS. BRANCH EXPENSES The next analysis deconstructs the most commonly used efficiency measure in microfinance: operating costs as a percentage of average portfolio. Operating expense is broken down into two aggregate cost centers: headquarters vs. branch expenses excluding loan officer expense and personnel expense of loan officers. As depicted in Figure 18, ACCION’s CAMEL considers an MFI “top-heavy” if its headquarters expense is over 30% total operating costs. Whether or not the MFI needs to streamline its centralized administrative functions depends upon a number of factors, as discussed in Chapter Two, including the population density, wage rate and the level of available technology required to automate and centralize certain functions.

Figure 18: Example of Operating Cost Breakdown for an Efficient MFI

(2 % ) Costs

Loan Portfolio Total Costs

Financial Costs

(% o f Loan Portfolio)

(20%)

(2 % )

Field Personnel Expense

Branch Expenses(Non-Field Personnel)

Headquarters Expense

30%(6% o f L oan

Portfolio)

30% (6% o f L oan

Portfolio)

Example of Split of Operating Costs - Efficient Latin American MFI

Example of Total Costs to Loan Portfolio -Efficient Latin American MFI

Operating Costs

Note: The pie chart represents the break down of the operating costs, represented in the light gray bar graph, which are typically equal to one-fifth of the MFI loan portfolio.

40 %( 8 % of LoanP o rtfo lio )

201

CAMEL compares headquarters costs to administrative expenses at the branch level, neither of which, taken individually should be greater than the salary expense, including bonus and benefits, of the loan officers. In an efficiently operating MFI in Latin America, as depicted in Figure 18, remuneration of field personnel,223 including bonuses and benefits, is typically about 40% of total operating costs—or 8% (40% of 20%) of average loan portfolio. Often, salary expenses may be higher if a large proportion of the field staff compensation is incentive-based, driven, for example, by sales volume. It is important to note, however, that the analysis to this point tells very little about where within the MFI the inefficiency lies. Overall operating expenses may be high, but this bureaucracy may mask significant variation at the regional or branch level. To locate the source of the problem, an MFI would have to perform an expense breakdown similar to the one above on a region-by-region or branch-by-branch basis. If expenses of a particular branch or region are high, management can target their improvement efforts in these areas. Given that loan officer salary will usually be the largest single cost and the one that is directly tied to revenue generation for most MFIs, the remainder of the ROA analysis focuses on this particular ratio.

LOAN OFFICER EXPENSE The final step in the process of deconstructing the components of an MFI’s ROA examines the ratio of loan officer expense (including base salary, bonuses, and benefits) to average net loan portfolio. As indicated in Figure 19, this ratio is a function of loan officer salary and portfolio volume, which in turn is driven by average loan size and loan officer productivity. Loan officer salary is largely determined by local macroeconomic factors but can be tied more closely to income by increasing the proportion of performance-based pay to total compensation. Portfolio volume is a function of both the average loan size of the MFI and the productivity of loan officers, measured as clients managed per officer.

223 Field personnel include loan officers, promoters and other marketing officers,

branch managers, and, in some cases, collections officers.

202

This ratio illustrates some of the basic ways an MFI can improve its operating efficiency (operating cost as a percentage of net loan portfolio): � Reduce loan officer salary. � Increase average loan balance. � Improve loan officer productivity (or increase loan term, which

increases productivity because the reduced frequency of loan renewals allows for an increased caseload).

This ratio clearly explains how any of these factors improves operating efficiency. For example, as illustrated in Table 19, if an MFI’s average loan balance is $400, its average loan officer salary is $12,000, and each serves 350 clients per year, one can calculate the change in efficiency if productivity improved to 380 clients per year:

Table 19: ROA Efficiency Drivers A. Monthly

Salary B. Average Loan

Balance C. Loan Officer

Productivity D. Efficiency

= A/(B*C) $12,000 $400 350 8.6% $12,000 $400 380 7.9%

CONCLUSION This type of detailed ROA analysis can help identify some obvious culprits of inefficiency. This kind of macro analysis is obviously a first step in a more nuanced understanding of the underlying causes of inefficiency. Chapters Two and Three help contextualize this tool, highlighting the distinct market and institutional factors that can impact the major ROA efficiency drivers, namely loan officer salary, average loan balance, and loan officer productivity.

Fig

ure

19:

RO

A A

naly

sis

OV

ER

AL

L A

NA

LY

SES

RO

E

= N

et I

ncom

e A

vera

ge E

quit

y =

N

et I

ncom

e

Ave

rage

Ass

ets

x A

vera

ge A

sset

s

Ave

rage

Equ

ity

=

RO

A ;

Lev

erag

e

RO

A

=

Net

Inc

ome

Ave

rage

Ass

ets

=

Net

Inc

ome

A

vera

ge P

rodu

ctiv

e A

sset

sa x

Ave

rage

Pro

duct

ive

Ass

ets

Ave

rage

Ass

ets

PR

OD

UC

TIV

E, F

INA

NC

IAL

AN

D N

ON

PR

OD

UC

TIV

E A

SSE

T C

OM

PO

NE

NT

S

Ret

urn

on L

oan

Por

tfol

io

R

etur

n on

Inv

estm

ents

Ret

urn

on N

onpr

oduc

tive

Ass

ets

RO

A

=

Loa

n In

com

e –

Pro

visi

ons

– O

pera

ting

C

osts

(I

nter

est C

osts

+ C

ost o

f C

apita

l)

Ave

rage

Loa

ns

+

Inve

stm

ent I

ncom

e –

O

pera

ting

Cos

ts

(Int

eres

t Cos

ts +

Cos

t of

Cap

ital)

A

vera

ge I

nves

tmen

ts

+

Oth

er I

ncom

e –

O

pera

ting

Cos

ts

(Int

eres

t Cos

ts +

Cos

t of

Cap

ital

) A

vera

ge N

onpr

oduc

tive

Ass

ets

OP

ER

AT

ING

EX

PE

NSE

AN

AL

YSI

S

Hea

d-qu

arte

r

vs.

Bra

nch

Exp

ense

T

otal

Ope

rati

ng C

osts

A

vera

ge N

et L

oan

Por

tfol

io

=

H

eadq

uart

er O

pera

ting

Cos

ts +

Bra

nch

Cos

ts (

w/o

per

sonn

el)

– L

oan

Off

icer

Exp

ense

A

vera

ge N

et L

oan

Por

tfol

io b

L

oan

Off

icer

Exp

ense

A

vera

ge N

et L

oan

Por

tfol

io

=

L

oan

Off

Exp

ense

/ No.

of

Loa

n O

ffic

ers

Ave

rage

Net

Por

tfol

io/N

o. o

f L

oan

Off

icer

s

A

vera

ge L

oan

Off

icer

Sal

ary

(i

nc. B

enef

its)

A

vera

ge N

et L

oan

Por

tfol

io/ N

o. o

f

Loa

n O

ffic

ers

=

A

vera

ge N

et L

oan

Por

tfol

io

No.

of

Cli

ents

x

No.

of

Cli

ents

N

o. o

f L

oan

Off

icer

s

Loa

n O

ffic

er

Exp

ense

A

vera

ge N

et L

oan

Por

tfol

io

No.

of

Loa

n O

ffic

ers

=

A

vera

ge L

oan

Bal

ance

Loa

n O

ffic

er P

rodu

ctiv

ity

Not

es:

a P

rodu

ctiv

e as

sets

incl

ude

the

Net

Loa

n P

ortf

olio

and

Inv

estm

ents

b N

et L

oan

Por

tfol

io =

Tot

al L

oan

Por

tfol

io –

Loa

n L

oss

All

owan

ces

APPENDIX B

PROCESS CHANGE APPROACHES

207

In this appendix,224 three business improvement strategies—continuous improvement, total quality management, and process reengineering—are highlighted and compared for their applicability to efficiency optimization. Together they form a continuum of business change as depicted in Figure 20.

Figure 20: The Process Change Continuum

CONTINUOUS IMPROVEMENTINCREMENTAL CHANGE

Continuous improvement (CI) is a way of operating with a management attitude that encourages and supports ongoing innovation of existing business processes to achieve incremental levels of efficiency (incremental improvement in business value).225 The implementation of

224 The authors are grateful for the research provided by Laura Frederick, CEO

of E-Change, in support of this appendix. 225 Continuous improvement theory has its roots in the quality improvement

strategies of the 1980s.

Continuous Improvement

Total Quality Management

Process Reengineering

Modest Degree of Change Radical

208

these incremental changes is consistent with the current strategic direction of the organization and generally leaves basic structures (infrastructures) intact. Continuous improvement can affect, but does not generally disrupt, the existing organizational balance among mission, strategy, culture, products, processes, procedures and human resources. Thus, CI is not necessarily rooted in alignment theory, although both rely upon cross-functional teams for analysis and implementation. Nor does continuous improvement necessarily result in radical change. In traditional CI practice, a process owner is assigned responsibility and authority over (re)designing the process, measuring the performance of the process and training the process team. CI focuses on the tasks that make up an overall process, seeking ways to improve these activities. These tasks are scrutinized to identify possible reductions in performance time and opportunities for improving the quality of the work. Efficiencies are frequently gained through streamlining, standardizing and eliminating tasks. Examples of CI in microfinance include: � Regular reviews of processes for preparation of loan documentation

to standardize the forms used for various loan products. � Creation of standardized templates for form generation. � Interface of computer systems that might already contain the

customer’s name and address to avoid duplication of entry when loan documents are printed for customer signature.

These examples of continuous improvement highlight the fact that change is localized in a narrowly defined task within one division. This feature is different from process reengineering, which typically reaches across divisions and tasks to look at processes more broadly. Quality is achieved through the manner and time in which a task is completed. This analysis is not intended as a onetime event but rather, an ongoing process that is a part of the organization’s culture and seeks to reduce error rates to zero. The pace of its implementation varies depending upon the breadth of the process being analyzed and the degree to which management empowers the process owner’s decision-making. The evolutionary nature of continuous improvement processes affords an organization the opportunity to change gradually, thereby potentially increasing its capacity to change and manage the resources necessary for the adjustment. While the approach permits a slow rate of change, it does not require it. Furthermore, the incremental implementation enables more

209

employees to participate in the development of modifications, raising overall organization commitment to changes implemented. The concomitant risk, however, is that the organization will lack the necessary momentum to create, implement and sustain the changes recommended. Perhaps most importantly, changes in individual processes or components may result in a narrower vision of the change required—due to the lack of a holistic approach—thus diminishing or even thwarting the anticipated benefits of the changes implemented.

Critical success factors include a high level of interest, attention and support by the management team, financial resources for training and support, clearly determined performance measures, effective teamwork, and analysis within the context of long-term strategic goals.

TOTAL QUALITY MANAGEMENTMODERATE CHANGE

Total quality management (TQM) is both a management philosophy and a method for achieving efficiency and quality through a system of continuous improvement and a focus on customer satisfaction. If pursued consistently over time, TQM is capable of achieving high multi-year improvement rates. Incremental improvement is gained by using statistical monitoring and participatory management. The difference between TQM and CI is that total quality management takes a more holistic approach to change than continuous improvement, though neither are as overarching as process reengineering. If successfully implemented, TQM practices build strong customer loyalty, encourage teamwork, create meaningful work for employees, promote an ethic of continuous improvement and enable an organization to respond in a timely manner to problems, needs and opportunities. As with continuous improvement, critical success factors for total quality management include a high level of interest, attention and support by the management team, financial resources for training and support, clearly determined performance measures, effective teamwork and analysis within the context of long-term strategic goals. In the case of BancoSol, its reengineering effort was followed by an initiative of total quality management to help institutionalize the changes sought under the more radical business process redesign.

210

PROCESS REENGINEERINGRADICAL CHANGE

Process reengineering (PR)226 is a method for radically redesigning an organization’s business processes to achieve dramatic improvements in critical measures of performance, such as profitability, quality, service and delivery speed. Process reengineering seeks to maximize “out-of-the-box” thinking in order to achieve significantly improved performance. It is about changing course, making discontinuous leaps and shifting to a different process level. PR often draws upon the development of best practices from unrelated industries for adaptation to the existing situation. It is a form of analysis that seeks to identify the ideal environment, situation, process or structure within an organization without the constraints of inherent prejudices, operating biases and limited expectations. This vision is then compared to the existing state of affairs. The steps required to move from the existing state of affairs to the envisioned ideal is the basis for radical reengineering. While the changes that result from continuous improvement and total quality management processes can be swiftly implemented,227 process reengineering is traditionally the fastest paced of the three approaches. Certainly, the radical redesign of processes, organizational structures and technology use can be segmented to allow for a stepped implementation. Nonetheless, it is the degree of change and the fact that process reengineering most frequently results in change on multiple fronts simultaneously that creates at least the perception of a swift implementation pace.

226 The term process reengineering has multiple connotations. At one end of the

spectrum, reengineering means any attempt to change how work is done—even small, incremental changes to processes. At the other end of the spectrum, reengineering is synonymous with organizational transformation—major simultaneous change in strategy, processes, culture, information systems and organizational infrastructure. In this appendix, reengineering will be discussed as a method for achieving the more radical transformation of an organization and its business practices.

227 With continuous improvement and total quality management strategies, middle management and staff are often knowledgeable about the changes in organizational structure, processes, technology and staffing that will lead to immediate improvements.

211

Process reengineering provides a holistic approach to organizational change and, frequently, a sense of urgency to motivate such change. This sense of urgency is one of the primary catalysts necessary to obtain staff approval and acceptance for the recommended changes. (Again, the degree of acceptance of recommended changes is highly dependent upon the strength of leadership of the organization.) Ironically, the greatest motivators for instigating process reengineering are also some of the factors that pose the greatest threat to reengineering initiatives.

PROCESS REENGINEERING PARADOXES228 � The biggest potential for PR is in large organizations, but the

environment of large firms is usually the least conducive to innovation.

� The largest payoff of PR comes with cross-functional scope, but an effort that crosses functional boundaries is most likely to be stymied by functional managers defending parochial interests.

� PR attempts to change many things at one time—work processes, skills, roles, organizational structures, corporate values and management systems—but simultaneous change often leads to organizational confusion and identity crises.

� Employee participation is intended to increase staff commitment, but may instead produce alienation as employees begin to understand the impact of change.

� PR tends to encourage projects with large scope, but large projects are most likely to be left undone because of some firms’ drive for short-term results.

� The owners of business processes are often asked to lead the redesign and implementation effort, but the prevailing compensation schemes, organizational structures, and budget controls can undermine the effort.

� PR assumes breaking the rules, but in bureaucratic settings rules need to be applied to the exercise of breaking the rules.

� Automation is viewed as the catalyst for new order, but can frequently be used to cement the old processes instead.

Perhaps the greatest challenges to the successful implementation of process reengineering include the strong employee resistance that is 228 Stoddard and Jarvenpaa, pp. 4-5. Adapted from Deloitte and Touche,

Tomhatsu International.

212

often a response to the degree of change envisioned and the lack of effective senior management leadership to ensure that change is implemented and sustained. The third challenge is the risk that only partial implementation will take place when holistic change is required to ensure success of the changes implemented (e.g., implementing an incentive-based compensation plan to support the implementation of quantifiable loan production goals). Thus, factors necessary to ensure the success of process reengineering include the perceived need for change, redesign objectives radical enough to overcome employee resistance and inertia, management leadership and support, and continuous communication regarding the process. Also essential is the ability to review existing processes in a cross-functional, detached manner, to redesign processes creatively, and to implement systems and procedures (reporting, compensatory, technological, etc.) to support the long-term objectives of the reengineering.

COMPARISON OF BUSINESS IMPROVEMENT APPROACHES

When faced with the need to change tasks, processes or infrastructures, it is essential to gauge the degree of change required. Evolutionary change—the underlying characteristic of continuous improvement practiceresults typically in change on a much smaller scale than the radical change often generated by process reengineering projects. Total quality management results fall between these two poles on the change spectrum. The following table shows some of the key characteristics that differentiate these three improvement methodologies.

Tab

le 2

0: B

usin

ess

Impr

ovem

ent

Com

pari

son

C

ON

TIN

UO

US

IMP

RO

VE

ME

NT

T

OT

AL

QU

AL

ITY

M

AN

AG

EM

EN

T

PR

OC

ESS

R

EE

NG

INE

ER

ING

D

egre

e of

Cha

nge

Evo

lutio

nary

. M

oder

ate.

R

evol

utio

nary

. D

egre

e of

Ris

k L

ow.

Low

to m

oder

ate.

H

igh.

L

eade

rshi

p In

tern

ally

dri

ven.

In

tern

ally

dri

ven

with

ext

erna

l ov

ersi

ght o

r le

ader

ship

. E

xter

nall

y dr

iven

.

Em

ploy

ee

Invo

lvem

ent

Invo

lves

em

ploy

ees

(use

cur

rent

m

anag

ers

and

empl

oyee

s).

Invo

lves

em

ploy

ees

resp

onsi

ble

for

new

wor

k m

odel

. L

imit

s em

ploy

ee in

volv

emen

t (b

ring

in n

ew m

anag

emen

t tea

m).

C

omm

unic

atio

n B

road

(b

road

ly c

omm

unic

ated

pla

ns).

B

road

(th

ose

dire

ctly

invo

lved

, as

wel

l as

the

entir

e or

gani

zatio

n w

ith

proc

ess

prog

ress

and

har

d re

sults

).

Bro

ad

(bro

adly

com

mun

icat

ed p

lans

).

Pri

mar

y M

otiv

atio

n

Self

-im

prov

emen

t. O

ppor

tuni

ty-

or c

risi

s-dr

iven

. C

risi

s (o

r fa

ilure

).

Per

form

ance

M

easu

rem

ents

F

lexi

ble.

N

ew w

ay o

f m

easu

ring

pro

cess

es,

alon

g w

ith f

irm

mile

ston

es.

Firm

mile

ston

es.

Rel

atio

nshi

p of

O

rgan

izat

iona

l St

ruct

ure

to E

mpl

oyee

s

Ada

pt to

em

ploy

ees

(hig

hly

adap

tive

to n

eeds

of

orga

niza

tion

).

Cro

ss-f

unct

iona

l tea

ms

with

pr

oces

s-fo

cuse

d or

gani

zatio

nal

stru

ctur

e.

Qua

lify

em

ploy

ees

(nee

d to

cha

nge

root

str

uctu

re o

f th

e or

gani

zatio

n).

Cul

ture

(T

rust

) A

dapt

to e

mpl

oyee

s.

Ada

pt a

nd q

uali

fy.

Qua

lify

em

ploy

ees.

In

form

atio

n

Tec

hnol

ogy

Pro

cess

fir

st, t

hen

tech

nolo

gy.

Bot

h pr

oces

s an

d te

chno

logy

are

se

para

te b

ases

for

cha

nge.

Si

mul

tane

ous

proc

ess

and

IT

reen

gine

erin

g.

Goa

ls

Enh

ance

d pr

ofita

bilit

y th

roug

h er

ror

redu

ctio

n.

Enh

ance

d pr

ofita

bilit

y th

roug

h in

crea

sed

reve

nue

gene

ratio

n an

d de

crea

sed

cost

s.

Enh

ance

d pr

ofita

bilit

y th

roug

h in

crea

sed

reve

nue

gene

ratio

n an

d de

crea

sed

cost

s.

Man

agem

ent

In

volv

emen

t Su

ppor

tive

, com

mit

ted.

D

irec

tion

and

det

ail a

s w

ell a

s su

ppor

t and

com

mitm

ent.

Com

mun

icat

ion

and

supp

ort;

vi

sion

. P

ost-

Cha

nge

Tra

inin

g M

inim

al.

Med

ium

to h

igh.

H

igh.

214

DOES BUSINESS IMPROVEMENT EQUAL JOB LOSS? The mere mention of business improvement projects produces frightening images of significant job losses for both staff and management. Staff are frequently haunted by the specter of lost jobs, while management is often beset by images of termination interviews. Certainly, in recent history a number of organizations have reduced their labor forces by significant percentages. These companies, however, tend to be larger corporations, whose staff sizes are far beyond that of most MFIs. Business improvement in the microfinance industry can mean the reduction of a certain number of positions; however, in many situations business improvement processes can result in a redeployment of staff (based upon a better match of skill sets and operational requirements) rather than a strict reduction in staff. Furthermore, business improvement processes are often geared toward preparing an organization for the next stage of growth, which can often be accomplished from the existing staff base. This increase in revenue generation on a constantrather than increasing-costbasis, in turn, boosts organizational efficiency.

SELECTING AN APPROACH

Each approach has been used historically to render change across wide areas of an organization. Each approach has also, when successfully implemented, created significant improvements in both customer service and profitability/efficiency. Experience suggests that pragmatism in choosing the approach is key. Other primary determinants include the degree of external risk or internal inefficiencies driving the change efforts, followed closely by the degree of change that the organization can effectively manage and the strength of leadership available to manage that change. The funding and length of time available for change efforts are also important variables.

PRAGMATISM AND RESULTS ORIENTATION The 1980s saw the development of a plethora of change initiatives that arose in response to the decline in worldwide manufacturing

215

productivity. These practices—activity-based costing, asset-based management, cross-functional teams, employee empowerment, seven-step problem-solving, statistical process control, total quality control, reengineering—were embraced with gusto. Unfortunately, though, they have been largely unsuccessful for a variety of reasons.229 As Robert H. Schaffer and Harvey A. Thomson argue, these “activities-centered programs” too often falsely assume an “explicit connection between action and outcome”230 and are too frequently “concerned with time-consuming preparations than with measurable gains.”231 Two of the key determinants that increase probability of success are the degree to which these change initiatives are adapted to the given context and the degree to which they are results-driven rather than activity-centered. Schaffer and Thomson describe the differences between activity-centered programs and results-driven programs as follows:

Table 21: Comparison of Activity-Centered and Results-Driven Programs

ACTIVITY-CENTERED PROGRAMS

RESULTS-DRIVEN PROGRAMS

Improvement Effort Defined By

Long-term, global terms. Measurable short-term performance-improvement goals within context of long-term, sustaining goals.

Management Takes Action Because

They are “correct” and fit the program’s philosophy.

They lead directly toward some improved results.

Approach Patient, stoic. Impatient, anxious for

results. Project Team And Consultants

Indoctrinate staff into design and vocabulary of the program.

Help managers achieve results.

Required Investment

Significant and upfront, before results have been demonstrated.

Typically low initially. Support for required expenditures builds as results materialize.

229 Joseph A. Ness and Thomas G. Cucuzza argue that “…no more than 10% of

[companies] now use activity-based management in a significant number of their operations. The other 90% have given up, or their programs are stagnating and floundering.” p. 49.

230 p. 189. 231 p. 190.

216

This sensitivity to context—to the culture of the organization, the skills and orientation of the staff, the breadth and depth of resources available to develop and implement the changes—is the hallmark of pragmatism, an approach essential to successful change.232 Pragmatism is the indispensable principle that guides decision-making when the ideal process has been mapped, existing resources have been compared to the ideal and difficult decisions are required. It orients organizational focus on results and thus requires organizations to modify various management theories to fit the needs of the MFI. This pragmatism has been reflected in a number of microfinance reengineering efforts. For example, an MFI undergoing reengineering chose to implement quickly an Excel spreadsheet to track the burgeoning number of applications under review rather than go without during the six-month period in which the sophisticated tracking system was developed. It is also evident when an MFI chooses not to let go of an employee incapable of performing the new tasks required by a change in processes (e.g., computer entry) but rather, assesses where in the revised process this employee’s skills can bring value.

MAGNITUDE AND BREADTH OF CHANGE REQUIRED The greater the degree of change required, the more radical the approach typically required. Similarly, the greater the reach of the change required—within one organizational unit, across several units, or across the organization as a whole—the more radical the approach required. The magnitude and breadth of the change initiative required by an MFI greatly depends on the nature of the gapthe difference between the current state of the organization and the desired state. In the simplest sense, continuous improvement results in incremental change, while the innovation that is the hallmark of process reengineering typically results in radical change. If closing the gap requires a shift in the strategic direction of the organization, then a reengineering initiative is most likely needed. Conversely, if the gap, whether large or small, is defined along the same path as the current

232 Nitin Nohria and James D. Berkley suggest four components of

pragmatism—sensitivity to context, a willingness to make do, a focus on outcomes and an openness to uncertainty. p. 206.

217

strategic direction of the organization, then a continuous improvement change initiative is perhaps more appropriate. These differences in process approaches, and the differing organizational approaches in which they are applied, do not require an either/or dynamic. In fact, institutions may realize increased benefits by applying multiple approaches, as did BancoSol, which chose process reengineering as its primary and initial change approach but then implemented a total quality management process designed to institutionalize the changes wrought under reengineering.

IMPETUS FOR CHANGE The source of motivation for change is an important factor affecting the choice of change process. The impetus for change can be internal. An organization’s survival is the most urgent internal force. Change is also warranted when an MFI reaches a significant new level of loan or deposit level, yet continues to operate (inefficiently) with an organizational and procedural infrastructure developed for a smaller, less sophisticated organization. The resulting gap between needs, structure, processes and resources, highlighted in Figure 21, is a strong impetus for change.

Figure 21: Growth and Infrastructure Gap

Size and Complexity

Time

Growth Gap

Growth Gap

Growth Gap

MFI’s infrastructure needs generated by growth and expansion

Actual infrastructure developed and available

218

Other MFI change motivators include a change in senior leadership, the uncovering of fraud, the replacement of outdated computer systems or conversion to regulated status. External forces are also drivers. These include market forces in the form of increased competition, a significant loss of customers, donor, investor or regulatory demands, or a change from nonprofit to for-profit orientation. The microfinance customer also serves as an external force for change, demanding new products and services, different levels of customer service and new approaches to lending. When the need for change is urgent or when the perception of crisis (real or created) exists, process reengineering is often the best change initiative. If general improvements in customer service levels are the driving force, TQM or continuous improvement are the preferred change approaches. If radical improvements in customer satisfaction are required, process reengineering may be more appropriate.

ORGANIZATIONAL CAPACITY FOR CHANGE Human beings generally resist most types of change. They view change as disruptive, intrusive, demanding and, ultimately, risky. As a result, it should come as no surprise that “companies are full of ‘change survivors,’ people who have learned to live through change programs without actually changing.”233 So deep is this resistance that the majority of organizational change initiatives fail or are only marginally successful. The organization’s ultimate capacity for change is thus one of the most important success determinants. Executives seeking to implement change view it within the context of opportunity, or at a minimum, as a necessary evil. On the other hand, for many employees, change is perceived as disruptive and risky. Even more of an impediment to successful change management is the fact that most employees don’t believe in the vision motivating the change or that changes to existing processes will actually work. They take a “wait and see” or “say yes and do no” approach. In response to these challenges, many organizations implementing radical change push revised processes to some of the lowest staff levels within the organization. They include staff at all levels in cross-functional teams to develop the changes, and 233 Duck, p. 55.

219

they seek ways to “empower” their employees. And yet, successful change remains elusive for many of these organizations. Every organization has a core value system. MFIs are no exception. In fact, the value system of the MFI is perhaps its most important asset when considering significant organizational change. Change programs are most successful in organizations that effectively connect with their staff through clear and strongly held beliefs and feelings—through the value structure of the organization. Thus, two key bases upon which an MFI can change behavior are (1) the repeated connection of the change process to the value system of the organization and (2) a clear understanding on the part of employees of their revised roles, the part that these roles play in fulfilling the MFI’s vision and performance expectations. The MFI executive is the driving force behind the successful creation of these building blocks.

STRENGTH OF LEADERSHIP Effective leadership is essential to effective change management. Leadership, in contrast to management, is about coping with change. As John P. Kotter of Harvard University’s Business School writes, leadership is about setting a direction, about aligning people, and about motivating and inspiring.234 Charles M. Farkas and Suzy Wetlaufer expand upon this view, arguing that “the CEO who takes on the role of change agent takes on perhaps the most demanding and daunting . . . approach”235 given that change is almost always accompanied by controversy, discomfort and resistance. The executive leadership of an organization is crucial in managing this controversy, while making the difficult decisions, day in and day out, that are part of the change management process. Although change is frequently traumatic, most staff are capable of changing behavior and daily tasks, given time and persistence and a lack of alternatives, as required by the process. Unfortunately, however, there are typically a number of hardened change survivors who represent barriers to change. Additionally, there may be a number of individuals whose skill sets do not meet the criteria required by the new processes. Finally, change programs often result in simultaneous changes across

234 Kotter, p. 41. 235 p. 141.

220

divisions that frequently appear, at least to the middle managers, to benefit one manager over another. Though strength of leadership in making the difficult decisions is critical in these situations, senior management is often conflict-averse. Leadership confuses the need to “sell” the change underway with the need to make everyone happy about the change. This conflict avoidance is especially true when the microfinance organization as a whole or the senior management team is small enough to feel like “family.” Worse, they may lack the courage or the skills to make difficult choices, including major staffing changes. Baldly stated, the behavior and skills of both the management team and the staff are, in fact, rented. This view does not preclude compassion in the leaders’ relationships with staff. It does, however, establish expectations and requirements for employee performance. Strength of leadership is required to ensure that employees meet these standards and that staff behavior is in line with the new vision. Only when management demonstrates this strength of leadership does action match the vision. Leaders’ vision for a transformed MFI is the driving force of change. Thus, leadership is critical in communicating the vision of the organization, establishing its value structure (its culture) and emphasizing that vision, over and over again.

TIME AND RESOURCES AVAILABLE FOR CHANGE For a reengineering effort to succeed, it is not enough for senior management to be supportive and committed. Time and resources to implement the change are also required. The more urgent the situation (e.g., the impending loss of significant funding or regulatory sanctions), the less time typically available for change. The less time available, the greater the extent of external involvement required to lead and make the required changes. The resources needed to develop and implement change are often underestimated. In attempting to obtain buy-in from middle management and staff, MFI leadership will often create cross-functional teams to manage the change process. Difficulties arise, however, in separating these individuals from their daily workload (frequently heavy) enough to think creatively and to develop the systems and procedures required to implement the change. Most MFIs operate with lean staff and resources.

221

For these individuals, daily production will typically take precedence over the creation of a new vision and processes, no matter how strong the impetus from the MFI leadership. No matter which change approach the MFI decides to undertake, it is important that it be systematic and carefully undertaken. There is no one-size-fits-all approach to process change. Thus, the MFI should tailor is chosen strategy to the market and institutional realities it faces.

APPENDIX C

REENGINEERING BASICS

225

This appendix looks more closely at process reengineering, the most radical of the three business change approaches described in Appendix B and the approach that typically generates the greatest change. The depth and breadth of the reengineering effort depends on the extent of the problem and management’s willingness to undertake meaningfuland often times, painful—change. Regardless of the scope, there are basic steps to reengineering. Kotter identifies eight steps to any organizational transformation:236

� Establish a sense of urgency. � Form a powerful guiding coalition. � Create a vision. � Communicate the vision. � Define and measure success. � Create a successful analytical approach. � Empower others to act on the vision. � Plan for and create short-term wins. From a reengineering standpoint, two additional steps might be added to Kotter’s list: � Consolidate improvements and produce still more change. � Institutionalize new approaches.

236 “Leading Change,” p. 7.

226

UNDERTAKING ORGANIZATIONAL CHANGE

ESTABLISHING A SENSE OF URGENCY Identifying or, in some cases manufacturing, a sense of urgency is an effective tool for moving people out of complacency and the status quo, and beginning the often lengthy process of breaking down resistance to change. This sense of urgency in the MFI may be crisis-driven, in which case it may require communicating facts not widely disseminated previously, such as low self-sufficiency, low customer satisfaction, high loss rates, stagnant growth or the potential loss of donor funds. Alternatively, this sense of urgency may be opportunity-drivenby the concern that a lack of action and change will result in the MFI forgoing important and beneficial opportunities.237

FORMING A POWERFUL GUIDING COALITION Support at two levels is critical for change initiatives. The executive leadership of the MFI must be fully supportive of the initiatives. This support includes not only the chief executive officer but also the board of directors and, frequently, the MFI’s donor base. Support is defined in numerous ways—in maintaining morale when staff are let go, in the provision of resources necessary to sustain and implement the reengineering efforts, and in the ability to live with the interim upheaval (e.g., a temporary decline in loan production) that may result as longer-term goals are sought. Support must also develop among senior and, ultimately, middle management. The broader the guiding coalition in support of the reengineering efforts, the greater the chances of success of the initiative as a whole. Maintaining this support requires initial and ongoing communication regarding the need for and results to date of the reengineering efforts. At the senior- and middle-management levels,

237 Kotter argues that the sense of urgency necessary to spur real and lasting

change is high enough when “75% of a company’s management is honestly convinced that business-as-usual is totally unacceptable.” “Leading Change,” pp. 5-6.

227

maintaining this support requires involvement in decision-making and reengineering. When resistance at these management levels threatens support for the coalition and changed processes, management may need strong reminders that their job security rests in their acceptance and promotion of the vision of the organization and their ability to endorse and implement necessary changes.

CREATING A VISION As stated in Appendix B, employees often connect with an institution’s values. This connection is especially true within microfinance, where most employees join and stay, despite more lucrative opportunities elsewhere, based upon their commitment to the values and objectives of the organization and the vision of its leadership. If reengineering efforts are to be successful, they must be aligned with the vision of the organization. This vision must go beyond quantitative performance objectives. It must be rooted in the value system of the organization and lead to both quantitative and qualitative assessment. This vision serves as the basis for the evolution of the culture of the organization. Thus, to the extent that a new vision generates a change in values, in orientation, or in how the organization functions (the reengineering process), so too does it require an adjustment in culture to ensure the longevity of the changes implemented.

COMMUNICATING THE VISION In times of turbulence, the most critical lever for reducing anxiety about reengineering is communication. Unfortunately, most executives underestimate the gap between their employees and themselves—a gap in vision, in understanding, in knowledge and in skill sets. Senior management often believes that the staff of the organization understands the organization’s vision and that the level of communication with them is adequate, in terms of both frequency and content. The staff often understands the situation much differently. They frequently complain of a lack of information and are often unclear about the vision and how it impacts daily decision-making and processes. If human behavior tends to resist change, it just as equally works to fill information gaps. To ensure that the vision is clear, that staff understand the impetus for change, its importance and how individual employees connect to and

228

contribute to that vision, MFI leadership must communicate constantly—not once, not at the beginning of the project, but continually. Management must also communicate the specifics of the process being employed, the expected performance targets, the “rules” of the new culture being developed and what is expected from each employee. A single meeting (usually group) with employees at the onset of a reengineering project is woefully inadequate. For example, from the beginning of ACP’s discussions about transforming into Mibanco, management met frequently with staff to review potential changes and to evaluate implications. Communication via newsletters, while helpful, must be augmented by other forms of communication. Everyday discussions and decisions regarding business challenges, employee performance evaluations and financial performance reviews need to be recast within the context of the new vision. Does a certain decision regarding resource utilization support or detract from attaining that vision? Does employee performance meet the needs of the new vision? What do financial indicators tell management about the gap between the vision and the present reality? This communication is strengthened when it involves two-way communication—aimed not only at airing staff anxiety and concerns but also allowing staff to convey their understanding of the vision to senior management. Despite senior management’s best efforts at communication, staff hear and interpret the vision differently than leaders do. Providing middle management and staff with regular opportunities to “echo” the new vision allows senior management to hear how their message is being interpreted and to make the necessary modifications in message delivery. Finally, as Kotter says, “[c]ommunication comes in both words and deeds, and the latter are often the most powerful form. Nothing undermines change more than behavior by important individuals that is inconsistent with their words.”238 For example, if a reengineering effort is targeted at improving efficiency, leadership sends a mixed message by maintaining large offices and heavy secretarial support in the midst of trimming costs throughout the organization.

238 “Leading Change,” p. 13.

229

DEFINING AND MEASURING REENGINEERING SUCCESS Many reengineering efforts, while extensive in scope and in changes recommended, often fall short in terms of actual improvements realized. One of the challenges of reengineering is defining what constitutes success, whether in qualitative and quantitative terms or at the macro and micro levels. At the macro level, MFIs may define success as an increase in self-sufficiency or in assets managed per employee. At the micro level, an MFI’s success may mean a reduction in the number of hours required (and thus the cost) to originate a loan and reductions in branch staffing while maintaining or increasing loan production. Quality measurements may include reductions in error rates associated with particular functions, increases in customer service or increases in customer satisfaction. Whether macro or micro, qualitative or quantitative, or some combination, it is important that an MFI define success in real terms for two reasons. This definition provides clarity to the vision motivating the reengineering efforts. It provides management and staff with understandable objectives and clear benchmarks. It also gives the reengineering team a touchstone against which to compare every change or, as consultants say, to measure the “value added” of the reengineering changes. In essence, defining success at the onset and then measuring it throughout the process roots the project in the pragmatism vital to successful reengineering efforts. Setting aggressive yet attainable goals, whether for loan production, the number of loans processed in a service center, the number of loans managed per loan officer, the accuracy of data input into computers or the number of loans maintained per information specialist, establishes clear objectives for staff. Linking attainment of goals to performance evaluations and compensation levels, bonuses or annual raises reinforces the importance of attaining the goals.

CREATING A SUCCESSFUL ANALYTICAL APPROACH A two-pronged approach that couples a “clean-slate” methodology with the holistic analytical framework set forth in Chapter Three is optimal in reengineering efforts.

230

The “Clean-Slate” Approach The “clean-slate” or “blank-paper” approach allows team members to rid themselves, if only momentarily, of the organizational realities that encumber existing processes and preclude “out-of-the-box” creativity. This approach seeks to create the ideal process, organizational structure, labor pool and technology infrastructure. Frequently, this approach draws upon the methodologies and processes employed in other industries for best practices. Thus, insurance companies have drawn heavily upon mortgage originators, experts in the efficient processing of loan originations, to improve the processing of insurance applications. Banks have drawn upon the consumer marketing skills of the fast-food industry to expand customer reach and product penetration. Similarly, ACCION New York has drawn upon bank experience in streamlining its loan origination processes.

Figure 22: The Clean-Slate Approach

2 3 1

Drawing on best practices outside the organization, either from peers or other institutional models, allows the MFI to define its ideal. Once identified (Step 1 in Figure 22), the ideal is compared with existing processes, infrastructure and resources (Step 2 in Figure 22). The MFI then must make three important sets of decisions (Step 3 in Figure 22). The first set of decisions addresses the extent to which existing resources can be modified, expanded and retooled to meet the needs of the “ideal” scenario. Employees whose skills do not presently meet the required proficiencies in the new environment are assessed for their capacity to acquire those capabilities and training is provided. Technological systems are reviewed for the ability to expand their functionality. The second set of decisions addresses the need for replacing existing

Present Steps Required to Reach Ideal Ideal

231

organizational structures, processes and technology with new systems. The third set of decisions focuses on the timing of these changes. Ideals are never attained completely for a variety of reasons, including resource constraints, some degree of employee resistance and human shortcoming. Nonetheless, each major decision required of this reengineering process must seek a balance between pragmatism and the attainment of the ideal vision. Looking realistically at the ideals created requires ongoing communication with both the reengineering team and MFI staff. Envisioning the ideal can be heady work, generating excitement about possibilities and long-overdue fixes. Tempering the ideals developed with pragmatism can be discouraging to team members. Worse, a decision to seek only partial change may reflect negatively on executive management’s leadership abilities. To minimize the risk of disappointment, senior management should communicate regarding the ongoing process of establishing an ideal and then evaluating it realistically. Holistic (Process) Approach As discussed in Chapter Three, the organizational structure, processes, and resource mix and decisions for best attaining the ideal must not be envisioned in isolation. Rather, changes in processes must be considered in light of concomitant changes in human resources, technological systems and organizational structures. A holistic, or systems, framework requires analysis of processes (and correlating organizational structures) as the customer sees them—as continuous across divisions and across the life cycle of a loan—not as separate functions that begin and end within individual business units. This approach requires a cross-functional analysis, looking at both front- and back-office processes simultaneously as discussed in Chapter Three. Thus, when ASA intentionally chose to boost market share through increased competition with Grameen Bank, it placed high-quality customer service at the center of its expansion efforts. This orientation required a reengineering of all aspects of its organization—from the way it marketed to clients to the type of products and services it provided to the manner in which it collected payments. Thus, ASA looked at its products and processes as the client does—without division between the loan officers and the individuals responsible for processing loan payments but, rather, as one unified group.

232

EMPOWERING OTHERS TO ACT ON THE VISION Empowering others to act upon senior management’s vision of an energized and dynamic MFI is central to the fulfillment of that vision. Thus, the formation of the team that will initially lead these efforts is as essential an ingredient to that success as management’s support of the team’s efforts and recommendations. Creating the Team Reengineering teams are tricky entities. Much hope, almost too much hope, is placed upon the team as the determinant of success for the entire reengineering project. Creating a team requires the appropriate complement of internal and external expertise,239 the creativity and understanding of existing processes and systems, and an appropriate balance between idealism and pragmatism. While the size of the reengineering team may vary widely, the team composition should include a mix of knowledgeable front-office employees, technical experts and middle managers (ultimately responsible for implementing the change). In addition, the team should have the support and sponsorship of a senior management member (often labeled the “process owner” in reengineering literature.) For ACCION New York, the reengineering team was led by an outside consultant, sponsored by the chief executive officer of ACCION New York, the president of ACCION USA and the chief financial officer of ACCION International. The team also included ACCION New York’s Senior Lending Officer and two technical experts, one in processes and one in technological systems. This team, critical to the long-term success of the reengineering efforts, must include or link closely with those actually implementing change. As ACCION New York discovered quickly, envisioning new processes and organizational structures and identifying new job requirements and skill sets was invigorating. Bringing the recommended changes to fruition was a different story, fraught with unforeseen challenges, inevitable staff

239 Organizations populated by staff developed largely within the organization

(in comparison with organizations with a component of staff with experience and expertise developed in other organizations), or staff isolated from their colleagues in other like-organizations, tend to face greater challenges thinking “outside-of-the-box” due to their narrowed frame of reference.

233

tension and resistance to change, and temporary resource constraints that required short-term problem-solving until permanent solutions (e.g., technological systems) could be installed. The level of success achieved by ACCION New York in reengineering its loan origination process is directly attributable to the staff on-site who understood the vision and the recommendations and who worked day-by-day, minute-by-minute, to eliminate barriers to successful implementation. Challenges to Team Success The success rates of reengineering teams vary. A frequent impediment to their success is the team members’ inability to let go of or transfer their daily responsibilities so that they may focus exclusively on reengineering efforts. No matter how important the reengineering project is considered or how highly placed the impetus for the project within the MFI, the tendency of employees will be to place the day-to-day processing of loan applications, payment processing or collection calls above all else. Thus, reengineering efforts typically take a second seat to other activities or are performed in the margins of an employee’s day—after hours, on the weekends—stretching already full lives. Other impediments frequently encountered include the: � Simple lack of internal resources, whether in terms of numbers,

creativity or external expertise. � Inability of a cross-functional team to rise above the politics that

underpin, tacitly or explicitly, the operations of the MFI. � Lack of leadership support for the reengineering team’s

recommendations. � Internal lack of an individual with the requisite skills (including

project management, communication and analytical skills) to serve as team leader.

Use of Consultants Whether used to lead the process, or merely called upon for their expertise, outside consultants may add significant value to an MFI’s reengineering project. These consultants can bring expertise not only in microfinance best practices and project management but can also bring a level of creativity and “out-of-the-box” thinking that may initially be difficult for MFI management and staff. Finally, outside consultants can bring much needed assistance to already overloaded team members.

234

Hiring consultants may be an expensive proposition, especially in light of traditional MFI compensation levels. MFI senior management may have a jaundiced view of consultants based upon prior experiences. To avoid negative experiences and maximize resources, executive leadership should take care to identify consultants with proven track records in the practical (vs. theoretical) implementation of change. The consultant should take an organization’s culture seriously, weighing carefully its impact upon the structure of the project, the reengineering objectives, the process change recommendations and his/her ability to obtain the trust of a significant number of the staff and management. Clear guidelines should be established regarding the ultimate decision-making residing with the executive leadership who must, at the end of the day, own the reengineering efforts. Performance measures for the consultant should be established (usually in phases) and monitored. Finally, communication lines should be clear. Executive leadership must retain responsibility for the overall quality and quantity of communication with staff and management. Establishing guidelines regarding the degree of direct communication to be provided by the consultant(s) to staff and management may help to avoid problems as the project progresses.

PLANNING FOR AND CREATING SHORT-TERM WINS Reengineering efforts are typically long-term in nature and thus, often developed and implemented in phases. Given the challenges involved in implementing lasting change, it is often easy for a reengineering effort to lose momentum after the successful completion of a key phase of the project. A lull in momentum is often necessary and positive, allowing staff an opportunity to own (vs. simply become familiar with) the new structures, processes and resources implemented and allowing time for celebration of the benefits reaped. Such lulls, however, can be misleading. Staff and management may be so overwhelmed by or so pleased with the reengineering process to date that they believe enough change has taken place, when, in fact, more is either necessary or beneficial. Maintaining the longer-term vision of the project and pacing implementation appropriately, both in terms of the breadth, severity and rapidity of change is the task of executive leadership in order to optimize the results of reengineering. Pacing? also allows for the short-term wins

235

and celebrations so essential to the maintenance of long-term project support and to the development of belief in the reengineered vision. These interim milestones should be tied to (but distinguished from) the long-term objectives to reinforce the overall vision of the reengineering effort.

CONSOLIDATING IMPROVEMENTS These short-term wins, over the longer term, can also serve as the basis for even more dramatic changes. As Kotter suggests, all too often, victory in the reengineering effort is declared in conjunction with the celebration of short-term wins.240 This preemptory declaration often creates misunderstanding among staff and middle management, who imagine the reengineering efforts to be complete and future change to be minimal. To avoid this needless risk, senior management must make of these short-term wins what they are—an opportunity to highlight the success of the reengineering efforts to date and, perhaps, more importantly, an opportunity to ensure that changes continue to be integrated into the organization’s daily operations.

INSTITUTIONALIZING NEW APPROACHES As the new vision of the MFI takes hold and as more and more staff realize the benefits of reengineered processes, internal momentum builds. The culture begins to transform and with this transformation, staff and management enthusiasm for and ability to develop new ideas and experiment with new processes increases. To maintain this momentum and cultural shift, leaders must remove obstacles blocking the transformation. Obstacles that minimize or thwart the effectiveness of the reengineering efforts include: � Continued emphasis on divisions rather than processes. � Compensation or employee evaluation systems that establish

conflicting choices. � Management unable or unwilling to make difficult decisions. � Employees so resistant to change as to be obstructionist.

240 “Leading Change,” pp. 16-18.

236

Dedicated change survivors often employ the “ostrich syndrome”—the technique of putting their heads down until the latest change passes and they can revert to former modes of operation. These change survivors include not only staff but also senior and middle management reluctant to loosen their divisional grip in favor of a more holistic approach to customers, efficiency and profitability. To counter this tendency, the MFI must institutionalize changes, making them so much part of the operational base that they cannot be avoided and must be employed. The alignment theory presented in Chapter Three emphasizes the importance of concrete performance objectives, transparent and readily accessible reporting systems, and incentive-based compensation plans tied to the attainment of these objectives. Some employees may try to circumvent new lines of reporting responsibility. Repeated reminders to individuals who either purposefully or innocently circumvent the new structures are required in order to institutionalize the reporting lines. Ensuring that staff are trained to use new systems is also essential to guaranteeing that they will use the technology on a routine basis. As each new phase of change is institutionalized, it becomes the basis for the next level of change and perhaps, more importantly, it fosters an increasing capacity for change among staff and middle management.

BIBLIOGRAPHY

239

Allen, Paul H. Reengineering the Bank: A Blueprint for Survival and Success. Chicago: Irwin Professional Publishing, 1994.

Ayala Consulting, supervised by William Gheen. Estudio de Caso:

Programa Global de Credito a la Microempresa (GMC): Ecuador. Prestamos 851-SF-EC y ATN/SF-3602. Washington, DC: Inter-American Development Bank, December 1998.


Programa Global de Credito a la Microempresa (GMC): El Salvador. Prestamos 915-SF-ES y 780/OC-ES. Washington, DC: Inter-American Development Bank, December 1998.


Programa Global de Credito a la Microempresa (GMC): Paraguay. Prestamos 707/OC-PR; ATN/SF-4108-PR y ATN/SD-4107-PR (Fondo Suizo). Washington, DC: Inter-American Development Bank, December 1998.

BancoSol. Internal market research, La Paz, Bolivia. 1998-99. Barton, Susana. ACCION International. Interview by Julie Gerschick.

Somerville, MA, 17 September 2000. Baydas, Mayada M., Douglas H. Graham and Liza Valenzuela.

Commercial Banks in Microfinance: New Actors in the Microfinance World. Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc., August 1997.

Benjamin, McDonald and Joanna Ledgerwood. Democratizing Credit.

Dominican Republic: The Association for the Development of Microenterprises (ADEMI), January 1998.

Brand, Monica. “More Bang for the Buck: Improving Efficiency.” The

MicroBanking Bulletin. Issue no. 4: 13-17. Washington, DC: Calmeadow, February 2000.

------. New Product Development for Microfinance: Design, Testing, and

Launch. Microenterprise Best Practices Project. Washington, DC: United States Agency for International Development, 1999.

240

------. New Product Development for Microfinance: Evaluation and Preparation. Microenterprise Best Practices Project. Washington, DC: United States Agency for International Development, 1998.

------. New Product Development Case Studies: BancoSolidario de

Ecuador and Caja Municipal de Arequipa. Microenterprise Best Practices Project. Washington, DC: United States Agency for International Development, 1999.

Brown, Warren and Craig Churchill. Providing Insurance to Low-Income

Households: Part II–Initial Lessons From Microinsurance Experiments for the Poor. Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc., 2000.

Bruett, Till. FINCA International. Interview by Monica Brand.

Washington, DC, 24 September 2000. Buchenau, Juan. Frontier Finance. Interview by Monica Brand.

Washington, DC, 19 October 1999. Burnett, Jill. Individual Micro-Lending Research Project Case Study:

Financiera Calpiá, S.A. Toronto: Calmeadow, 1996. ------. Individual Micro-Lending Research Project Case Study: Caja

Municipal de Perú. Toronto: Calmeadow, 1996. Burrus, William and Katherine Stearns. Building a Model: ACCION’s

Approach to Microenterprise in the United States. Washington, DC: ACCION International, 1996.

Calvin, Barbara. Individual Micro-Lending Research Project Case

Study: Alexandria Business Association’s Small & Micro Enterprise Project. Toronto: Calmeadow, 1995.

Calvo, Ricardo. ACCION International. Interview by Monica Brand and

Julie Gerschick. March 2000. Campion, Anita. Improving Internal Control: A Practical Guide for

Microfinance Institutions. Washington, DC: MicroFinance Network with GTZ, 2000.

241

Campion, Anita and Victoria White. Institutional Metamorphosis:

Transformation of Microfinance NGOs into Regulated Financial Institutions. Washington, DC: The MicroFinance Network, 1999.

Caskey, John P. Beyond Cash-and-Carry: Financial Savings, Financial

Services, and Low-Income Households in Two Communities. Written at Swarthmore College for the Consumer Federation of America and the Ford Foundation. Swarthmore, Pa.: December 1997.

------. Lower Income Americans, Higher Cost Financial Services.

Madison, Wis.: University of Wisconsin-Madison, 1997. Castello, Carlos. “ACCION CAMEL: Lessons Learned and Challenges.”

CAMEL Seminar, ACCION International, Washington, DC, March 1998.

Castello, Carlos, Katherine Stearns and Robert Peck Christen. Exposing

Interest Rates: Their True Significance for Microentrepreneurs and Credit Programs. ACCION Discussion Paper no. 6. Washington, DC: ACCION International, July 1991.

Choudhury, Shafiqual Haque. “Achieving Microfinance Market

Penetration.” In Moving Microfinance Forward: Ownership, Competition, and Control of Microfinance Institutions, edited by Craig F. Churchill. Washington, DC: The MicroFinance Network, 1998.

Christen, Robert Peck. Banking Services for the Poor: Managing for

Financial Success. Washington, DC: ACCION International, 1997.

------. “Bulletin Highlights.” The MicroBanking Bulletin. Issue no. 4: 41-

46. Washington, DC: Calmeadow, February 2000. ------. “Keys to Financial Sustainability.” In Strategic Issues in

Microfinance, edited by Kimeyyi, Mwangi S., Robert C. Wieland and J. D. Von Pishcke. Aldershot, England: Ashgate Publishing, 1998.

242

------. What Microenterprise Credit Programs Can Learn From the Moneylenders. Washington, DC: ACCION International, 1989

Christen, Robert P., Elisabeth Rhyne, Robert C. Vogel and Cressida

McKean. “Maximizing the Outreach of Microenterprise Finance: The Emerging Lessons of Successful Programs,” in USAID Program and Operations Assessment Report no. 10. Washington, DC: United States Agency for International Development, August 1995.

Churchill, Craig F. Client-Focused Lending: The Art of Individual

Lending. Toronto: Calmeadow, 1999. ------. Managing Growth: The Organizational Architecture of

Microfinance Institutions. Microenterprise Best Practices Project. Washington, DC: United States Agency for International Development, May 1997.

Churchill, Craig F. and Kerri Moloney. Individual Micro-Lending

Research Project Case Study: Bank Rakyat Indonesia. Toronto: Calmeadow, 1998.

Collins, James C. and Jerry I. Porras. “Building Your Company’s

Vision.” In Harvard Business Review on Change. Boston, MA: Harvard Business School Publishing, 1998.

Downing, Jeanne with Katrena Henderson and Shannon Johnson.

Proceedings: The Commercialization of Microfinance Conference, Nairobi, Kenya: United States Agency for International Development, 11-14 May 1998.

Drake, Deborah and Maria Otero. Alchemists for the Poor: NGOs as

Financial Institutions. ACCION Monograph no. 6. Somerville, MA: ACCION International, October 1992.

Drucker, Peter F. “The Information Executives Truly Need.” In Harvard

Business Review on Measuring Corporate Performance. Boston, MA: Harvard Business School Publishing, 1998.

243

Duck, Jeanie Daniel. “Managing Change: The Art of Balancing.” In Harvard Business Review on Change. Boston, MA: Harvard Business School Publishing, 1998.

Eccles, Robert G. “The Performance Measurement Manifesto.” In

Harvard Business Review on Measuring Corporate Performance. Boston, MA: Harvard Business School Publishing, 1998.

El Shami, Nabil. “ABA’s Staff Incentive Scheme.” In Moving

Microfinance Forward: Ownership, Competition, and Control of Microfinance Institutions, edited by Craig F. Churchill. Washington, DC: MicroFinance Network, 1998.

El Shami, Nabil (ABA/Egypt), Md. Shafiqual Choudhury

(ASA/Bangladesh) and Carlos Danel (Compartamos/Mexico). “Innovations that Increase Administrative Efficiency,” Panel Presentation at the MicroFinance Network 7th Annual ConferenceMicrofinance in the New Millennium: Commercialization, Customer Satisfaction, and Efficiency, Dhaka, Bangladesh, 31 October – 4 November 1999.

Farrington, Todd. “Efficiency in Microfinance Institutions.” The


Gheen, William, Diego Jaramillo and Nathalie Pazmino. “Measuring

Unit Loan Costs.” The MicroBanking Bulletin. Issue no. 3: 3-7. Washington, DC: Calmeadow, July 1999.

Gheen, William and Glenn Westley. “Q&A: Measuring Unit Loan

Costs.” The MicroBanking Bulletin. Issue no. 4: 25-27. Washington, DC: Calmeadow, February 2000.

Gonzalez-Vega, Claudio. Microfinance: Broader Achievements and New

Challenges: Economics and Sociology Occasional Paper no. 2518. Rural Finance Program, Department of Agricultural, Environmental and Development Economics. Columbus, OH: The Ohio State University, October 1998.

244

Gonzalez-Vega, Claudio, et al. BancoSolidario S.A.: The Challenge of Growth for Microfinance Organizations. Rural Finance Program, Department of Agricultural, Environmental and Development Economics. Columbus, OH: The Ohio State University, May 1996.

Goss, Tracy, Richard Pascale and Anthony Athos. “The Reinvention

Roller Coaster: Risking the Present for a Powerful Future.” In Harvard Business Review on Change. Boston, MA: Harvard Business School Publishing, 1998.

Harbison, Anne in consultation with Robert Kegan. “Best Practices in

Professional Education: A Working Paper Proposal for Programs in Professional Education.” Cambridge, MA: Harvard Graduate School of Education, Fall 1999.

Heifetz, Ronald A. and Donald L. Laurie. “The Work of Leadership.” In

Harvard Business Review on Leadership. Boston, MA: Harvard Business School Publishing, 1998.

Holtmann, M and R. Mommartz. Analyzing the Efficiency of Credit

Granting NGOs: A Technical Guide. Frankfurt: Interdisziplinäre Projekt Consult GmbH, 1993.

Horngren, Charles T., Foster, George and Srikant M. Datar. Cost

Accounting: A Managerial Emphasis. Eighth ed. Englewood Cliffs, NJ: Prentice-Hall, 1994.

Jansson, Tor. “The Microfinance Industry: Does it Measure Up?”

Microenterprise Development Review. Vol. 2. no 1: 2-3. Washington DC: InterAmerican Development Bank, August 1999.

Kotter, John P. “Leading Change: Why Transformation Efforts Fail.” In

Harvard Business Review on Change. Boston, MA: Harvard Business School Publishing, 1998.

------. “What Leaders Really Do.” In Harvard Business Review on

Leadership. Boston, MA: Harvard Business School Publishing, 1998.

245

Krutzfeld, Herman. “Marketing Strategies in a Competitive Microfinance Environment.” In Moving Microfinance Forward: Ownership, Competition, and Control of Microfinance Institutions, edited by Craig F. Churchill. Washington, DC: MicroFinance Network, 1998.

Ledgerwood, Joanna. Microfinance Handbook: An Institutional and

Financial Perspective. Washington, DC: The World Bank, 1999. Ledgerwood, Joanna and Jill Burnett. Individual Lending Research

Project Case Study: ADEMI, The Dominican Republic. Toronto: Calmeadow, 1995.

Lepp, Anja. “Financial Products for MSEsthe Municipal Savings and

Loan Banks of Peru.” Small Enterprise Development 7, no. 2 (1996): 15-24.

Lok, Christina E. Women’s World Banking Global Directory of Banking

Innovations in Microfinance: Latin America. New York, N.Y.: Women’s World Banking, November 1999.

López, César. ACCION International. Interview by Julie Gerschick.

March 2000. Mabberley, Julie. The Price Waterhouse Guide to Activity-Based Costing

for Financial Institutions. Chicago, IL: Irwin Professional Publishing, 1996.

McDonald, Jennifer. “Compartamos, Mexico: Bulletin Case Study.” The

MicroBanking Bulletin. Issue no. 3: 13-17. Washington, DC: Calmeadow, July 1999.

------. “Credit Unions: Efficient and Profitable Financial Intermediaries.”

The MicroBanking Bulletin. Issue no. 4: 8-12. Washington, DC: Calmeadow, February 2000.

------. “PADME, Benin: Bulletin Case Studies.” The MicroBanking

Bulletin. Issue no. 4: 29-32. Washington, DC: Calmeadow, February 2000.

246

Meyer, Christopher. “How the Right Measures Help Teams Excel.” In Harvard Business Review on Measuring Corporate Performance. Boston, MA: Harvard Business School Publishing, 1998.

The MicroBanking Bulletin. Issue no. 3. Washington, DC: Calmeadow,

July 1999. The MicroBanking Bulletin. Issue no. 4. Washington, DC: Calmeadow,

February 2000. MicroRate. Fact Sheet, Women’s World Banking: Cali/Colombia.

Washington, DC: Private Sector Initiatives Corporation, December 1998, updated March 1999.

Mokhtar, Ahmed and Florette Makram. Alexandria Business

Association. Phone Interview by Sahra Halpern. June 1999. Morduch, Jonathan. “The Microfinance Schism.” World Development

28, no. 4: 617-629. Washington DC: Elsevier Science Ltd. April 2000.

Muhit, AKM Aminar. Association for Social Advancement. Phone

interview by Sahra Halpern. June 1999. Nagarajan, Geetha. “Fundusz Mikro, Poland: Bulletin Case Studies.” The


Navajas, Sergio and Claudio Gonzalez-Vega. An Innovative Approach to

Rural Lending: Financiera Calpía in El Salvador. Rural Finance Program, Department of Agricultural, Environmental and Development Economics. Columbus, Ohio: The Ohio State University, June 1999.

Navajas, Sergio, Jonathan Conning and Claudio Gonzalez-Vega. Lending

Technologies, Competition, and Consolidation in the Market for Microfinance in Bolivia. Rural Finance Program, Department of Agricultural, Environmental and Development Economics. Columbus, Ohio: The Ohio State University, October 1998, rev. August 1999.

247

Ness, Joseph A. and Thomas G. Cucuzza. “Tapping the Full Potential of

ABC.” In Harvard Business Review on Measuring Corporate Performance. Boston, MA: Harvard Business School Publishing, 1998.

Nohria, Nitin and James D. Berkley. “Whatever Happened to the Take-

Charge Manager?” In Harvard Business Review on Leadership. Boston, MA: Harvard Business School Publishing, 1998.

Oberdorf, Charles, Interviewer/Editor. Microfinance: Conversations

With the Experts. Toronto: The Microenterprise Policy Institute, 1999.

Otero, Maria. Breaking Through: The Expansion of Microenterprise

Programs as a Challenge for Non-Profit Institutions. ACCION Monograph no. 4. Washington, DC: ACCION International, October 1989.

------. “Effective Governance and Performance Benchmarking.” The

MicroBanking Bulletin. Issue no. 3: pp. 11-12. Washington, DC: Calmeadow, July 1999.

------. A Question of Impact: Solidarity Group Programs and Their

Approach to Microenterprise. ACCION Monograph no. 2. Tegucigalpa, Honduras: PACT and ACCION International, October 1987.

------. The Solidarity Group Concept: Its Characteristics and

Significance for Urban Informal Sector Activities. ACCION Monograph no. 1. Washington, DC: PACT and ACCION International, January 1986.

Otero, Maria and Elisabeth Rhyne, eds. The New World of

Microenterprise Finance: Building Healthy Financial Institutions for the Poor. West Hartford, Conn.: Kumarian Press, 1994.

Player, Steve and David Keys, eds. Activity-Based Management: Arthur

Andersen’s Lessons from the ABM Battlefield. New York, N.Y.: MasterMedia Limited, 1995.

248

Rhyne, Elizabeth. “Competition and Regulation: A Critical Interface.” Presentation at Third Annual Seminar on New Development Finance, Frankfurt, Germany, 27 September 1999.

Rhyne, Elisabeth and Robert Peck Christen. Microfinance Enters the

Marketplace. Washington, DC: United States Agency for International Development, 1999.

Rhyne, Elisabeth and Linda S. Rotblatt. What Makes Them Tick?

Exploring the Anatomy of Major Microenterprise Finance Organizations. ACCION Monograph Series no. 9. Washington, DC: ACCION International, September 1994.

Richardson, David C. “Unorthodox Microfinance: The Seven Doctrines

of Success.” The MicroBanking Bulletin. Issue no. 4: 3-7. Washington, DC: Calmeadow, February 2000.

Rutherford, Stuart. ASA: The Biography of an NGO. Bangladesh:

Association for Social Advancement, 1995. Rutherford, Stuart, ed. The Poor and Their Money. Oxford: Oxford

University Press, 2000. Saltzman, Sonia, Rachel Rock and Darcy Salinger. Performance and

Standards in Microfinance: ACCION’s Experience With the CAMEL Instrument. ACCION Discussion Paper no. 7. Somerville, MA: ACCION International, 1998.

Saltzman, Sonia and Darcy Salinger. The ACCION CAMEL Technical

Note. Microenterprise Best Practices Project. Washington, DC: United States Agency for International Development. September 1998.

Schaffer, Robert H. and Harvey A. Thomson. “Successful Change

Programs Begin With Results.” In Harvard Business Review on Change. Boston, MA: Harvard Business School Publishing, 1998.

Schmidt, Reinhard and Claus-Peter Zeitinger. The Efficiency of Credit

Granting NGOs in Latin America. Frankfurt: Interdisziplinäre Projekt Consult GmbH, 1994.

249

Stearns, Katherine. The Hidden Beast: Delinquency in Microenterprise

Credit Programs. ACCION Discussion Paper no. 5. Washington, DC: ACCION International, 1991.

Stoddard and Jarvenpaa. “Business Process Reengineering: IT Enabled

Radical Change.” Cambridge, MA: Harvard Business School Publishing, 2 June 1993.

Teal, Thomas. “The Human Side of Management.” In Harvard Business

Review on Leadership. Boston, MA: Harvard Business School Publishing, 1998.

Vargas, Cecilia and Jacqueline Bass, Informe de la Conferencia:

Instituciones Bancarias Propcionando Servicios en Microfinanzas, Santiago de Chile: United States Agency for International Development, April 1998.

Waterfield, Chuck. “Paperless Loan Processing Technology.” The

MicroBanking Bulletin. Issue no. 3: 17. Washington, DC: Calmeadow, July 1999.

Wenner, Mark and Rodolfo Quiros. Financiera Trisan: An Agricultural

Credit Card Innovator. Washington DC: InterAmerican Development Bank, June 2000.

Winaro, Jarot Eko. “Small-Scale KUPEDES: Product Development at

the BRI Units.” In Moving Microfinance Forward: Ownership, Competition, and Control of Microfinance Institutions, edited by Craig F. Churchill. Washington, DC: The MicroFinance Network, 1998.

Woodrow Wilson School of Public and International Affairs, Students

Under the Supervision of Jonathan Morduch. “Maximizing Efficiency in Microfinance: A Report to ACCION International and the MicroFinance Network.” Princeton, N.J.: Princeton University, 15 January 2000.

Wright, Graham. Microfinance SystemsDesigning Quality Financial

Services for the Poor. London: Zed Books, 2000.

maximizing efficiency in microfinance: the path to ......to help microfinance institutions (mfis)...

Documents