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Lesson 2.2:
  Measuring Delinquency


In this Lesson

The portfolio is an MFI’s largest and most important asset, but it is held outside the institution, in the borrowers’ hands. There is a certain level of risk inherent in any portfolio because repayment, which happens in the future, is uncertain. The level of risk in the portfolio requires regular monitoring and analysis. Meaningful monitoring of risk requires an MFI to produce and use a portfolio report that provides detailed information on the portfolio size, disbursements, repayments, arrears, aging, principal write-offs and other elements necessary to ascertain the level of risk and track portfolio quality.

In Depth

Write-offs, accounting policy and portfolio quality

When a delinquent loan reaches a certain age in arrears, an MFI may write it off. This write-off and its timing depend on the accounting policy adopted by an MFI. Reporting portfolio quality in a meaningful way depends on two aspects: a sound write-off policy and its consistent application. Sound accounting policy will call for the institution to establish a loan loss reserve for the outstanding balance of delinquent loans according to the aging of the arrears. Appropriate policy must reflect the repayment intervals and duration of the loan. An accounting policy that underreports write-offs inflates the real size of the asset base. Conversely, an accounting policy that quickly removes delinquent loans from the books can unnecessarily deplete the real value of the portfolio, while simultaneously overstating portfolio quality. When reviewing the quality of the portfolio, the analyst must look at the level of write-offs for bad debt as well as the level of delinquency.

Repayment rates and importance of ratio disclosure

Some MFIs will report collection or repayment rates as indicators of portfolio quality. Such rates are based on cash flows for a given period; as such, they do not report cumulative arrears in the portfolio. In most cases, a consistent repayment rate of 98% is not equivalent to a 2% loan loss rate, and does not give an adequate indication of the level of risk in the portfolio. Repayment rates will only measure the cash flow of the period. They do not account for accumulated loss or increased future risk tied to those delinquent loans. Using historic repayment rates may be useful for cash flow predictions, but it is a dangerous and deceptive measure of portfolio quality. Like any ratio, you should always ask for the formulae involved to understand what is actually compared.

Aging of arrears report

The aging of arrears report breaks out the detail of an MFI’s delinquent loan portfolio and assigns different weights to each category of risk. The report uses aging categories to separate and then regroup the unpaid principal balance of loans by risk category according to how late an installment payment is. Aging is measured in the number of days late of the loan’s most delinquent payment. These categories range from the recently delinquent (<30 days) to those likely to default (>180 days).

In general, weights or reserve rates, which the institution’s financial management uses to determine the portion of the outstanding delinquent loan balance to keep in reserves, vary from 0% to 100%. The outstanding portfolio that is current, or on time, carries a 0% reserve rate. The reserve rate increases with the number of days of delinquency to a reserve rate of 100% when the amount of the portfolio is considered unlikely to be recovered. The sum of these weighted principal balances determines the amount of loan loss reserve that the institution should hold on its balance sheet. An MFI’s accounting policy determines the risk categories and reserve rates applied to each category. MFIs can track experience with repayments over time to generate a profile of the likelihood of default. This historical information can be used to calculate the reserve rate when an MFI is not subject to Central Bank regulations regarding reserves for loan losses. For example, if data analysis reveals that loans less than 30 days past due have a 10% likelihood of eventual default, the MFI would set the reserve rate at 10% for all unpaid principal balances on loans delinquent less than 30 days. While historical loan loss rates will inform these categories and rates for an MFI with a sufficient operating track record, start-up MFIs should adopt prudent industry norms appropriate to the structure and types of loan products that they will offer.

Restructured loans

Rather than write loans off, financial institutions sometimes decide to restructure loans that are in danger of default. Often times, this decision comes when a client has experienced an unavoidable crisis, such as a natural disaster or debilitating illness, which has prevented the normal repayment of the loan. In these cases, the client’s will and ability to repay are almost certain to begin again after a recovery period. MFIs should undertake loan restructuring only in rare circumstances, and then, only after serious consideration of how the crisis bears on the inherent risk of default. In these rare cases, a loan can be rescheduled.

MFIs should consider restructuring an exception, not the norm, in dealing with delinquent loans. If the institution’s management does decide to keep the loan on the books as a restructured loan, the principal should be reported separately from the healthy portfolio. Restructured loans should be reported in a separate account with all other restructured loan contracts. Moreover, in order to fully account for the increased risk of default in the restructured portfolio, the MFI should apply a steeper reserve rate.

Benchmarks in MFI portfolio quality

Like any ratio, portfolio quality as measured by portfolio at risk (PAR) can be compared across institutions when the calculations are standardized. This gives MFIs, their managers and board, a means of comparing their portfolio quality to that of institutions with similar methodologies, at similar stages of growth or in their same geographic zone. Groups formed with similar characteristics for the purpose of comparison are called peer groups. The MicroBanking Standards Project and its MicroBanking Bulletin ( list such ratios comparatively across institutions and within peer groups, providing potential benchmarking for MFIs.

Financial Terms and Formulae

Loan portfolio balance

The loan portfolio generates the lion’s share of an MFI’s operating income. As such, accurately calculating the current gross loan portfolio balance is essential for management, analysts and investors. The balance includes several operations undertaken since the last Balance Sheet was produced. The formula below summarizes the calculation of the current gross portfolio balance:

Previous Gross Portfolio Balance + Loan Disbursements –

Principal Repayments – Write-Offs = Current Gross Portfolio Balance

Three types of operations will affect an institution’s gross portfolio balance. As the MFI makes loans to its clients, the capital lent increases the size of the portfolio. If a loan of 2500 is made, with expected interest of 400 over the life of the loan, only the 2500 of principal would be added to the gross portfolio balance. As loan installments are paid on outstanding loans, principal repayments will be subtracted from the gross portfolio outstanding. In an installment payment of 100, if 95 is principal and 5 is interest, the gross portfolio outstanding will be reduced by 95. Finally, write-offs decrease the amount of the gross portfolio outstanding. Write-offs only include capital and do not recognize lost income (interest not collected). Hence, if a delinquent loan with an outstanding balance of 300 is written off, only these 300 will be subtracted from the gross portfolio outstanding.

In order to calculate the current Gross Portfolio Outstanding balance, you must have four pieces of information: the opening Gross Portfolio Outstanding balance, the amount of disbursements (principal), the amount of reimbursements (principal) and the amount of write-offs (principal).

Beginning period balance + sum of ending period balances
Number of periods plus 1

These periods represent equal and regular subintervals of the whole period. In calculating the AOP for a year, you could use quarters, months, weeks or even days as the periods within that year used for calculating the average. An overriding logic holds true here: the more frequent the period chosen, the more accurate the average calculated. Finally, notice that the denominator is the sum of the number of periods (i.e. 12 months, if months are selected as the subinterval) plus one. This last addition represents the fact that the beginning period balance must be added to the sum of the ending period balances. Hence, if you calculate monthly AOP using information from the gross portfolio balance at the end of four consecutive weeks, you must add the opening balance to the numerator and ‘one’ to the denominator, as in the following example:

You would calculate the average as follows:

10000 (opening balance) + 44300 (sum of ending balances)
4 (number of ending balances) + 1 (opening balance)

This yields an average of 10860. Notice that simply choosing to average the opening and closing balances for the period (10000 and 12000) would overestimate the average at 11000, given the sudden balance increase in the last week of the month.

Averages, in general, and AOP, in particular for an MFI, are important in calculating indicators or ratios that provide you a picture of activity over a given period.

Arrears Rate and Portfolio at Risk

Making loans carries an inherent risk. As recovery of principal and earning from interest rely on future activity, the lender must assess whether a borrower can repay— she will have the necessary future cashflow to do so— and will repay—she will have the incentive to do so.

This inherent risk means that MFIs and their management must closely watch borrowers’ repayment behaviour to assess the level of risk in their portfolio. The two formulae discussed below provide different approaches to assessing this risk.

The arrears rate is a measure of the amount of loan installments past due as a percentage of the gross portfolio outstanding. As such it is expressed as follows:

Total loan installments past due
Gross portfolio outstanding

As an indicator of portfolio risk, this formula only measures the borrowers’ current behaviour (that is, the actual amount of loan installments past due). The arrears rate does not take into account any measurement of future behaviour. Delinquency of current or past payments means that future installments should be considered riskier than normal. Because the arrears rate does not reflect the higher future risk of already delinquent loans, it underestimates their exceptional repayment risk. This exceptional risk is intuitive, but can also be historically measured by an institution: a borrower who has missed three (3) installments presents a greater risk to an MFI than does a borrower who has just missed his current installment payment.

A more meaningful measure of portfolio risk is the Portfolio at Risk (PAR) measure. This measures the total outstanding loan balance on delinquent loans as a percentage of gross portfolio outstanding:

Total outstanding loan balance on delinquent loans
Gross portfolio outstanding

Notice, in both cases, that portfolio risk is measured at a point in time, not over a given period. Rather than an average, risk measurement is directly linked to a given portfolio held by an MFI at a given moment.

Loan Loss Rate

The loan loss rate is a historical measure of loss from unrecoverable loans. It is calculated by using loan write-offs from a given period as follows:

Total amount written off (over a given period)
Average outstanding portfolio (for that same period)

Notice that the denominator is an average, rather than an amount at a point in time. The average is used because a portfolio evolves over a given period as the MFI disburses loans and receives reimbursements. Likewise, the amount written off is associated with the portfolio activity over this period, not with the balance at the end of the period. More simply, write-offs of loans at the end of December most likely represent risk of loans made sometime ago and are less indicative of the current level of risk in the portfolio, especially if the loans have been delinquent for a long time. For current risk levels, PAR calculations should be used.

If not given on the portfolio report, the amount of write-off must be calculated from the income statement and the balance sheet as follows:

Write-off = Loan Loss Provision Expense (for a period) + Loan Loss Reserve balance
(beginning of period) – Loan Loss Reserve balance (end of period)

As loan loss provision expense adds to the loan loss reserve for a period, if no loans have been written off, the loan loss reserve at the end of a period should be the sum of these two. However, if loans have been written off, the write-off will be equivalent to the difference between the sum of the provision expense and the beginning balance of the loan loss reserve and the ending balance in the reserve account.

Recommended Reading

CGAP. “Measuring Microcredit Delinquency: Ratios Can Be Harmful to Your Health,” Occasional Paper No. 3, June 1999.

Additional Reading

Stearns, Katherine. The Hidden Beast: Delinquency in Microenterprise Programs. Somerville, MA: ACCION International, 1991.

Yaron, Jacob. “The Assessment and Measurement of Loan Collections and Loan Recovery,” World Bank Agriculture and Natural Resources Department, 1994.

Practice Questions 2.2

  1. What are the potential costs of delinquency to a borrower? What are the potential benefits? What are the costs of on-time payment? What are the benefits? In your answer, consider more than just financial costs/benefits.

  2. The chart below shows the monthly loan balances for the end of each month over a period of a year. In calculating the loan loss rate for year, the MFI’s financial officer is torn between using a yearly average for the outstanding portfolio (first and last of year), and one weighted by month (the year’s opening balance, plus each of the month’s closing balances). She knows that the MFI just expanded its service by opening up 10 new branch offices in a push to reach new areas outside major cities. These branch offices started disbursing loans at the end of the year. The MFI wrote off 25000 in delinquent loans for the period. Calculate the average outstanding portfolio using each method. Calculate its loan loss rate using both types of average outstanding portfolio calculations. Which do you think is more accurate and why?

  1. Your local MFI has been thinking of changing its accounting policy on arrears aging and delinquent loan write-off. It offers one standard working capital loan with a 3-month duration and weekly repayment installments. The current accounting policy is tight and starts provisioning loans as soon as the first payment is missed. Loans in arrears continue to be provisioned gradually until they are 90-days past due, at which point they are entirely provisioned (100%). The table below shows the current loan provisioning for the MFI:

At year’s end, according to the MFI’s policy, it must write off all loans that are fully provisioned (100%). The 50 loans from the >90 days category are in this state, with an outstanding balance of 7000. They will be written off. What will the net outstanding portfolio be after this write-off? This MFI experienced rapid growth during the year, and its average outstanding portfolio was 250,000. What is its loan loss rate for the year?

The committee in charge of revising the MFI’s accounting policy with respect to arrears aging proposes changes to the provisioning of the portfolio. The following table represents the impact of such changes on the current portfolio:

What would the new arrears rate be for all loans past due? And the portfolio at risk (PAR) for these same loans? What about the reserve amount? What effect does this policy change have on these numbers? The write-off policy would not change (i.e. only fully provisioned loans would be written off), and under this new aging, the 30 loans in the >180 days category would be written off. What is the new net portfolio outstanding after this write-off? What would the new loan loss rate be for the MFI? What are the risks/advantages in adopting this new policy with respect to the MFI’s current methodology and products?