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Managing Credit Risk in Rural Financial Institutions in Latin America

Managing Credit Risk in Rural Financial Institutions in Latin America. Mark Wenner Rural Finance Research Conference March 19, 2007 Rome, Italy. Outline. Types of Risks Financial Institutions Face Significance of Credit Risk Ways of Evaluating Creditworthiness

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Managing Credit Risk in Rural Financial Institutions in Latin America

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  1. Managing Credit Risk in Rural Financial Institutions in Latin America Mark Wenner Rural Finance Research Conference March 19, 2007 Rome, Italy

  2. Outline • Types of Risks Financial Institutions Face • Significance of Credit Risk • Ways of Evaluating Creditworthiness • Common Portfolio Credit Risk Management Techniques • Results from Survey of 42 Latin American RFIs • Highlights of Four Case Studies • Conclusions and Recommendations

  3. Credit Liquidity Interest Rate Foreign Exchange Technological Operational Product Innovation Reputational Regulatory Types of RF Institutional Risks

  4. Two Most Important Risks • Credit • Interest Rate Focus is on credit risk because majority of rural finance institutions are non-deposit taking. Many smaller institutions are dependent on concessional funds. Note: a liquidity crisis is the culmination of other risks and is the immediate cause of insolvency and failure.

  5. Forms of Evaluating Creditworthiness • Repayment Capacity Analysis • Human Based Expert Systems • Mathematical Models • Credit Scoring (discriminant analysis & logit/probit) • Programming • Hybrids (computation, estimation, and plus simulation) • Asset-backed Analysis

  6. Geographic Diversification Sectoral Diversification Crop Diversification Loan Size Limits Minimal Enterprise Size Limits Over collateralization Joint Liability Contracts Graduated Lending Exclusion Lists Linking Savings to Credit Approval Guarantee Funds Donor Trust Funds Credit Insurance Portfolio Securitization Common Portfolio Credit Risk Management Techniques

  7. Survey Methodology • Methodology: Web-based survey instrument with was sent to 226 financial institutions in Latin America. The survey asked about perceived risks in rural lending and in particular agricultural lending; techniques used to manage credit risk; and basic information on the institution (size, age, loan products, interest rates charged, guarantees required, profitability, delinquency, staff profile, etc.) • 42 institutions responded.

  8. Ranking of Perceived Risks Political Interference 74% Climatic Risks 71% Price Risk 59% Lack of guarantees 56% Regulatory and Legal 36% Weak Contract Enforcement 36% Operational risk, lack of information (tied) 33% High cost of funds 31% Credit Evaluation Techniques Used Majority use human-based expert system One used credit scoring Guarantees were not seen as vital due to scarcity and high cost of enforcement. Survey Results

  9. Index of Credit Technology constructed consisting of reported use Financial and Character-based Information Requirements Decentralized decision-making Monitoring Guarantees Sharp differences between regulated and non-regulated 50% of regulated entities require a sales contract versus 11% of non-regulated (requirements) 39% of regulated entities required that client be part of a value chain Better performing entities monitored more, gathered less but more pertinent information. Regulated entities had more requirements as per law. Survey Results

  10. Survey Results Cont. • Keys Policies Used to Reduce Credit Risks • Staff Incentives (60% used, bonuses amount to approx. 50% of base salary) • Loan size limits (94%) • Additional Requirements about a Threshold (91%) • Loan Provisioning (88%) • Client Repayment Incentives (84%) • Use of Credit Bureaus (81%)

  11. Survey Results Cont. • Institutions that had a higher share of agricultural lending had higher PAR>30 • There seems to be minimum scale required to obtain strong financial results.

  12. Diversification Effect

  13. Table 9: Scale Effects – Ranked by Total Portfolio Size Share of Agricultural Credit (%) Agricultural Delinquency – PAR>30 days (%) Total Portfolio Delinquency - PAR>30 days (%) ROA (%) ROE (%) Quartile 1 Mean 0.53 4.11 10.60 1.72 0.08 Median 0.61 2.50 3.50 5.0 7.75 Quartile 4 Mean 0.25 4.56 5.87 2.57 14.65 Median 0.25 0.25 5.00 2.00 7.00 Total Portfolio - Correlation Coefficient -0.308* -0.009 -0.152 0.0238 0.295* Source: IDB Survey to Rural Financial Institutions – 2006. Note: Due to it significant different size, data from BancoCooperativo SICREDI was not included in this calculation. (*) Significant of at least 10 % level ( cut-off corresponds to is 0.296). Scale Effect * Significant difference of at least 10 % level.

  14. Case Studies • Banrural SA-Guatemala • Fundación para el Desarrollo Empresarial y Agrícola (FUNDEA) • Caja Municipal de Ahorro y Crédito (CMAC) Sullana-Perú • Entidad de Desarrollo para la Pequeña y Micro Empresa (EDPYME) Confianza

  15. General Indicators Source: Trivelli and Tarazona, 2007

  16. Agricultural Indicators

  17. Specialized staff Staff incentives Information gathered on character, managerial ability, reputation for repayment, and financial viability Cash flow and sensitivity analysis Client repayment incentives Preference for households with diversified income streams Regular monitoring Diversification Geographic Sectoral Commodity Portfolio exposure limit for agriculture (20-45%) Limits financing for or refusing to finance basic grains. Excessive provisioning (121% -260%) Key Elements in Credit Technology and Risk Management Technology Risk Management

  18. Conclusions and Recommendations • Leading institutions are using information-intensive appraisal systems and rely on well-prepared and motivated staff. Real guarantees are not important. • Repayment incentives are commonplace. RFIs seek to build long term relationships. • Diversification, portfolio limits, and provisioning are principal means of managing agricultural credit risk • Transfer instruments (guarantee funds, insurance, securitization etc.) not widely used or available.

  19. Continued • Some minimal economies of scale seem to be necessary in absence of more modern risk transfer instruments. Implications • Smaller institutions with rural vocation have to grow rapidly, emphasizing non-farm lending. • Mergers of small rural institutions should be encouraged. • Donors and policymakers should target larger institutions to provide rural financial services. Will be difficult entice urban institutions due to high perceived risks, lack of robust risk mgmt. instruments, lack of appropriately trained staff, and and more attractive risk-return profile of the consumer lending market.

  20. Continued • Agricultural microfinance has expanded the frontier but is limited. • Longer term options needed and desired. • Interest rates are very high probably surpassing average rates for more agricultural activities. • Specialized and more commercially–oriented small and medium sized agricultural producers seem to be disadvantaged due to lender preference for diversified households. However, they could benefit if the lender adopts a value chain approach. • Need to introduce more project-centered, yet economical, types of loan appraisal appropriate for larger sized agricultural loans. • Urgently need to introduce more robust and modern risk management instruments combined with delivery systems that lower operational costs.

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