The formal financial institutions look at the market risk and individual risk to assess the risk of business loan. The market risk is captured through Market Potential Assessment. The individual risk is captured through income appraisal and credit appraisal.
Large Scale Problem
A rural household typically has multiple livelihoods (e.g. daily wage labor, agriculture, livestock, job employment etc). Cash moves from one livelihood to another. There is no way to track the cash movements and therefore, it becomes impossible for any last mile financier (SHG or JLG or bank) to estimate the income of a household.
Without the income of entrepreneur (and its immediate household), the repayment capability cannot be estimated. Institutional lenders (like PSBs, RRBs) have to resort to collateral based lending to avoid risk of default. The need for collateral, from lender perspective, arises because default rates in this segment are higher and are unviable for profitable lending; however, only a small portion of borrowers (entrepreneurs) default and majority of this group forms a genuine customer base. But unfortunately, today there is no mechanism to segregate good portfolio from the bad and hence the lenders, to avoid the risk, mandate some form of collateral. Most of the micro enterprise owners do not have the means/ assets to present a collateral and hence do not qualify for this finance. This systemic hindrance creates a gulf, stopping both micro-entrepreneurs and lenders from reaching their complete potential. It is a lose-lose situation. Entrepreneurs also do not possess substantial business history and credit history to avail unsecured loans from conventional channels and resort to high interest loans from money lenders.
Furthermore, in rural areas, there’s no model that can predict credit default of an individual borrower. In organized sector, credit rating agencies have created models that provide credit score for any individual, organization and security. The credit rating helps in facilitation of finance. In unorganized sector, few rating agencies have attempted to develop a credit rating model for JLG clients using past data. As of now, somewhat reliable data (and credit model) exists for urban/ semi-urban areas. No such credit model exists for rural portfolio. Such a credit model can facilitate parametric decision making (in rural areas) that will not only result in elimination of field level frauds, but also reduce dependence on senior-most officers, thereby impacting the bottom-line of last mile financiers.
How the problem can be addressed
To assess loan eligibility of a borrower, a lender needs to know borrower’s repayment capability, which in turn can be assessed from the income and expenses of the borrower (and immediate household). This can be met through income appraisal of rural household – different questions (in local dialect) to capture the income from numerous livelihoods – and translating it into the repayment capability of borrower by applying a Debt Service Coverage Ratio (as is a best practise in commercial banking).
The income appraisal contains proper checks and balances for validation of input. The benchmarks (with high confidence intervals) are used for validating the correctness of data input.
To assess default risk of a borrower, a lender needs to know the credit history of borrower – various loans taken, outstanding amounts, NPA history, deferred payments, credit defaults – to estimate ‘Value at Risk’. This can be met through credit appraisal of rural household – estimation of credit worthiness by probing the credit history of borrower. Through credit appraisal, a lender can segregate good borrowers from bad borrowers. Last mile financiers can make informed decisions about lending options and can enhance current reach significantly, while keeping the default rates low.
Appraisal product addresses the risk of wilful default or individual risk by assessing the entrepreneur systematically in key stages of wilful default. Appraisal is carried out assessing the following important factors
- Does the entrepreneur has willingness and integrity to repay? – Character
- Can the entrepreneur operate the business profitably at the desired level? – Capability
- Is the entrepreneur in a financially stable condition to repay the loan? – Capital
- Is the environment progressive for growth and repayment of loan? – Conditions
Based on the risk ratings from multiple modules, overall individual risk can be assessed and an optimal loan eligibility can be arrived at: at this eligibility threshold, loan can be given to the entrepreneur at an optimal risk. The loan eligibility calculator estimates the maximum loan which an enterprise should receive based on income and repayment capacity of a household. It then calculates the exact loan requirement based on purposes chosen.
Following this approach, last mile financier can effectively distinguish between good prospects and bad prospects and extend loans to customers with low risk ratings. This assists the lenders in enhancing their portfolio reach among small business owners, by negating the need for collateral.