DESIGNING MICROFINANCE LOAN PRODUCTS

Prepared by Charles Waterfield MFI Solutions, LLC Lancaster, PA USA Email: Waterfield@microfin.com 10 January 2001

DESIGNING FINANCIAL PRODUCTS FOR THE MSE SECTOR

1. Introduction
The proper design of financial products and their respective delivery methodologies is fundamental to an institution's effective and sustainable delivery of financial services. A financial product is defined by the various conditions attached to it C loan size, term, interest rate, collateral requirements, usage restrictions, repayment terms.1 Delivery methodologies are the set of systems and procedures an institution develops in order to deliver its services to participants. Perhaps the most fundamental error in program design is to choose an inappropriate delivery methodology C inappropriate either for the target group the institution wishes to reach or for the financial products it wishes to provide. As this paper will argue, there is no one best methodology. Rather, there is a best methodology for the context of each institution. One of the goals of this paper is to assist institutions in the selection and adaptation of the best methodology for their context. This paper advocates that credit institutions need to incorporate financial products and delivery methodologies which are both appropriate and sustainable. They must be appropriate for the specific needs of the target group, and as will be demonstrated the MSE is not a homogeneous target group. Financial products also need to be sustainable from the institution's point of view in order for the target group to continue having access to these financial products in the long term. Micro and Small Enterprise financial products deviate radically from those employed by formal lending institutions, particularly those products directed at microenterprises. In order to be sustainable their delivery methodology must be significantly altered as well. To illustrate, commercial banks have established systems for disbursing loans in such a way as to minimize the risk of loan default, but these systems are oriented toward analysis of larger loans, typically a minimum of $10,000. To offset the costs incurred through disbursing a loan of this size, the bank earns interest income on this amount. An MSE credit institution with an average loan size of $100, however, would have to make 100 loans of $100 in order to lend an equivalent $10,000. Furthermore, if the MSE institution's loan term is 4 months, as is often the case, these 100 loans must be processed 3 times per year in order to keep the same amount of money loaned out and yield interest income equivalent to that earned by one $10,000 loan with a one-year loan term. 300 loans of $100 with 4 month terms = 1 loan of $10,000 with a one-year term In other words, for both systems to be sustainable at the same rate of interest, 2 the MSE institution must be 300 times as efficient in loan disbursement as the commercial bank. Clearly, an appropriate and sustainable credit methodology must deviate significantly from standard formal lending institution practice.
1 Although savings instruments are clearly financial products as well, this paper focuses only on credit services.

2 More accurately, the efficiency of the two approaches should be compared on the point of the operating cost per unit of loan portfolio, where operating costs also includes the costs associated with establishing a realistic bad debt reserve. This measure separates operating costs from financial costs (such as cost of funds) since the cost of funds is theoretically (1) the same for both institutions, and (2) beyond the control of institutions. This measure is called the "spread", because it is the percentage that, when added to the cost of funds, results in the breakeven interest rate for the institution. Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

This first section of this paper describes the popular financial products and methodologies that have evolved in Latin America, which are attempting to incorporate these lessons about efficiency. The next section describes the heterogeneous nature of the MSE target groups and how these differences result in needs for different financial products. The final section then outlines which delivery methodologies are most appropriate for each target group.

2. Evolution of the Current Methodologies

2.1.

LIMITATIONS OF PRE-EXISTING FINANCIAL SERVICES

Prior to the involvement of development agencies and donors in microenterprise support, the poor had to rely on the pre-existing financial services to try to meet their financial needs. These potential sources included informal sources such as Rotating Savings and Credit Associations C or ROSCAs (see explanation in Box 1) C and moneylenders and middlemen, and formal sources such as banks and cooperatives. All of these sources, however, suffer serious limitations in their ability to provide viable financial alternatives for the poor, which restrains the growth and development of the microenterprise sector. These limitations are summarized in Table 1 and detailed in the following paragraphs.
Informal Sources ROSCAs inflexible timing of loans limited and inflexible loan amounts risk of loss of investment Moneylenders/Middlemen extremely high interest rates often limited loan amounts obligation to sell to middleman at sub-market rates or buy expensive inputs Formal Sources Banks and Coops very limited access high transaction costs rigid collateral requirements

ROSCAS are limited primarily by their lack of flexibility. The rotating nature of the distribution system reduces the likelihood that a member will be able to receive her disbursement at the time when she can make the best use of the money. Her business may need cash immediately, or she may have an opportunity to buy something for her business at a special price, but she is forced to wait her turn in the credit rotation. The lack of flexibility is also apparent in the loan amounts. The members all receive exactly the same amount, regardless of their precise needs. Disbursement amounts are also limited in size by the mutual agreement of the group members. Thus, a member with more ability to absorb and productively use credit will be unable to do so. In some situations, the social and transactional costs of participating in a ROSCA C i.e., participating in regular meetings, or providing refreshments for group members C can be perceived as an additional cost of receiving credit. Finally, some people may be unwilling to assume the risk involved in participating in a ROSCA C another member may default before everyone has had a turn to receive credit, causing the group to disintegrate.

Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

Nearly every culture has developed an informal financial system (called ROSCAs) by which members form a self-selected group and agree to each contribute a regular, fixed amount every week or month. The members then take turns collecting the full contribution for that period until all members have had an opportunity to receive the pot. The order in which members receive the pot is sometimes determined by lottery, sometimes by mutual agreement of the group members, and sometimes by need or personal emergencies of the group members. For example, seven market women may choose to contribute $10 to their group fund every Monday morning, forming a pot of $70. Over the course of seven weeks, each woman receives one pot of $70 and also contributes $70 to the pot at the rate of $10 per week. The first people to receive the pot are, in essence receiving interest-free loans from the other members.* The last members to receive the pot are no better off financially than if they had simply saved up their own money themselves on a weekly basis. The advantages of joining a ROSCA are that it provides a discipline for savings that might not otherwise occur, and that it bonds the members together socially and in some cases allows them to respond to each other's emergency needs. The risk offsetting these advantages is that a group member may drop out after receiving an early pot, refusing to make the additional contributions necessary for others to receive their full pots. In the worst case, if the group disbands before a full cycle is completed, those members failing to receive their pots lose their entire savings contribution. Because of this risk factor, groups need to carefully select their membership. Their experience and success in doing so C evidenced by the prevalence and popularity of ROSCAs C is what the group lending methodologies attempt to incorporate into their programs.

Interestingly, however, members do not typically perceive what they are doing as "borrowing" and "lending;" rather they claim they are "saving" money.
*

The MONEYLENDER/MIDDLEMAN system has the obvious drawback of charging extremely high interest rates. Although providing for needed capital in times of personal emergencies, few longterm investment opportunities can support such a high cost of capital. Only investment activities with fast turnaround, such as retail, can benefit, and even then loan amounts have to be relatively small with very short loan terms. Otherwise, interest payments rapidly build up to unbearable levels. Middlemen often have a monopolistic hold over small producers, particularly in agriculture. Producers need inputs for their business, which middlemen provide. When producers lack the cash to pay for these inputs, middlemen are often happy to provide them in the form of a loan using the producer's output as the collateral for the loan. The middleman can either inflate the price of the inputs (the producer has nowhere else to turn for lack of cash), charge a specified C and high C interest rate, require the producer to sell his or her output to the middleman at suboptimal prices, or apply some combination of the above. In any case, the producer loses a great deal of potential income due to the lack of alternative credit sources. The formal sources, such as BANKS AND COOPERATIVES, tend to be accessible only to the largest businesses, typically those with $10,000 of assets or greater. Even for these businesses, transaction costs are very high, with financial institutions requiring exhaustive analysis and lengthy loan processing periods. Finally, these institutions, due to their risk-averse orientation as well as requirements imposed by banking regulators, have highly restrictive collateral requirements, normally limiting access to those borrowers owning their own home.

Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

2.2.

INTRODUCTION OF MSE FINANCIAL SERVICES

Recognizing the limitations of existing financial services, private development organizations started initiating credit institutions for SEAs in Latin America during the early 1970's. These early MSE institutions were basically adaptations of existing bank practices, relaxing collateral requirements and developing more appropriate systems for analyzing loans and character. Over time, institutions gradually recognized that every activity and aspect of the loan process had to been streamlined to the fullest extent possible. Growing experience indicated which steps could be minimized while still ensuring the quality of the loan portfolio. Theoretically, all administrative aspects of credit systems are oriented toward the goal of minimizing the risk of loan default. Ensuring high loan repayment is the primary reason for requiring credit history checks, loan feasibility analysis, and strong collateral requirements. There is usually a direct tradeoff between less administration and greater risk of default. Banks have learned how to optimize their systems for their target group, that is, they do not apply systems which guarantee no default. Rather, they have systems by which an additional dollar spent in loan processing would result in at least one additional dollar collected that would have otherwise defaulted. By treating loan default as an expense, in other words, they are minimizing their expenses. Since SEAs represent an entirely different target group than the traditional bank clientele, the systems needed to be radically adapted. With experience, institutions learned how procedures could be creatively designed to decrease administration while actually enhancing the quality of the loan analysis. The following section describes this learning process.

2.3.

LESSONS LEARNED FROM EXISTING FINANCIAL SERVICES

The best micro-credit approaches that emerged starting in the 1970's learned valuable lessons from the positive elements of the pre-existing financial systems. A growing literature on ROSCAS concluded that peer review provided an excellent and efficient means of selecting trustworthy participants. That is, friends, neighbors, relatives, and long-time business associates are a better C or at least a more efficient C means of providing a character reference than the traditional banking procedures. Second, ROSCAs showed that the poor could often be persuaded to repay their loans through peer pressure. Peers put more pressure and a different kind of pressure on borrowers than institution staff are willing and able to do. In addition, borrowers felt more obligated to repay when their companions were the ones to lose out rather than a faceless institution with unimaginably large resources. ROSCAs also showed that the poor have the abilities and willingness to manage their own informal financial institution. Finally, ROSCAs demonstrated the very important fact that the poor, although truly poor, do have modest resources available which they can mobilize in the form of savings that can be used to benefit others in their group. Next, MONEYLENDERS/MIDDLEMEN were initially treated only with the wrath of the development field due to the crushingly high interest rates charged to the poor who had nowhere else to turn. Gradually, more research was done on why and how moneylenders continued to operate. Valuable lessons extrapolated from their experience include, first, the fact that the poor can indeed repay loans when they feel a willingness and a necessity to do so. Second, microeconomic analysis of SEAs showed that extremely high rates of return on assets enable the poor to pay higher interest rates than formal sector businesses and still have a profit left over.
Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

Third, moneylenders and middlemen showed how they could approve loans based on a personal knowledge of the borrowers rather than a sophisticated feasibility analysis of the investment. Fourth, they demonstrated that informal collateral requirements are adequate for working in the informal sector. Finally, moneylenders/middlemen understood the importance of rapid response to credit needs. When emergencies strike or when crops need to be planted, borrowers need timely, non-bureaucratic access to credit. Although BANKS AND COOPERATIVES have been generally unsuccessful with lending to the poor, their experience provides several valuable lessons which literature in the field has usually failed to acknowledge. First, they show the value to the borrower of having access to various lines of credit in order to meet the wide variety of needs of borrowers. Second, banks have shown that the provision of medium- to long-term credit requires the ability of the institution to charge a "moderate" interest rate, perhaps higher than the formal sector commercial rate but significantly lower than the moneylender rate. Many institutions have been set up which charge higher-thanmarket interest rates, but as a result they are only able to supply a market for short-term loans. Third, they demonstrated the key indicators to be used if in fact a financial analysis is to be performed, e.g., inventory turnover rate and debt-equity ratio work better than the more elaborate cashflow projections expected of more formal business. Next, they have established a precedent by which disinterested parties can be expected to cosign for a loan, providing both a character reference for the borrower and a means of peer pressure on borrowers, as well as an alternative for loan recuperation if all else fails. Also, banks and coops have shown how (and when) the legal system can be used as a means for recuperating a loan. Development finance institutions have also learned from banks the value of and means to financially manage their operations. They have learned the importance of achieving a high degree of cost-recovery, the value of operating with a "business-like" rather than a "project-oriented" approach, and the necessity of monitoring loan activity through well-functioning accounting systems. Finally, formal financial institutions have shown the importance of external regulation of the institution to safeguard the savings deposits of its clients. A summary of these lessons learned from the ROSCAs, moneylenders, and banks and coops is presented in Table 2.
ROSCAs client selection through peer review repayment pressure through peers ability of participants to selfmanage their own program savings mobilization potential of the poor Moneylenders/Middlemen recognition that the poor can and will repay loans with interest awareness that high returns on assets allow payment of high interest rates client selection based on personal knowledge of borrowers loaning with informal collateral requirements need for rapid response to credit needs Banks / Coops designing credit lines to meet wide variety of needs of borrowers long-term credit requires low interest rates recognition of important aspects of business viability analysis usefulness of personal guarantors to pressure repayment how to use legal means of loan recuperation

Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

 value of a business-like approach importance of achieving cost-recovery loan accounting principles importance of external regulation to safeguard participant savings

2.4.

EVOLUTION OF MICROFINANCE METHODOLOGIES

SORRY THIS GRAPHIC IS MISSING ILL FIX IT LATER. ITS THE SAME AS IN THE METHODOLOGIES DOCUMENT The three current MSE methodologies dominant in Latin America C Individual Lending, Solidarity Group Lending, and Village Banks C did not appear simultaneously, nor did the adaptation of the lessons-learned described above occur immediately. Rather, a gradual evolution took place. Figure 1 illustrates this evolution, providing valuable insights into the rationale behind the various methodologies currently practiced. The first significant MSE credit institutions appeared in the early 1970's and used individual methodologies which, as mentioned previously, were primarily adaptations of bank and cooperative methodologies. In the diagram, these institutions are referred to as first generation institutions. With experience, these institutions improved with respect to operational efficiencies, repayment rates, and their willingness to charge higher interest rates. Many of these lessons came from studying the experiences of the moneylenders and resulted in the second generation of individual credit methodologies which appeared in the 1980's. Individual lending institutions were heavily concentrated in urban areas to exploit both the high density of businesses and the greater credit needs of the urban population, as both elements are essential to running an efficient and sustainable institution employing an individual credit methodology. Meanwhile, the Grameen Bank started in Bangladesh in 1976 as the first institution to use a solidarity group approach. Drawing on the ROSCA experience, the Grameen methodology used an initial savings period followed by sequentially-disbursed credit among a small group of selfselected borrowers. Group members were involved in decision making and loan approval.
Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

Grameen incorporated strong social elements into its approach, the most well-known being the requirement that participants adhere to the "Sixteen Principles" which attempt to change such social behaviors as usage of latrines and participation in the dowry system. The Grameen experience soon received worldwide attention. In Latin America, loan institutions that were using individual methodologies with mixed success looked for ways in which the Grameen experience could be incorporated into their existing methodology. The result was the Latin American Solidarity Group approach that appeared in the early 1980's.3 This approach used a small peer group strategy similar to that used by Grameen, but opted to retain loan approval and administration in the already-existing systems used previously with the individual methodology rather than incorporate the community-based aspects of the Grameen methodology. For example, each business owned by the group members was still visited and analyzed individually by staff of the institution. In its Latin American version, solidarity group lending was much more focused on provision of business support services (primarily credit and training) than the more sociallyoriented Grameen approach. The final step in the evolution to date occurred with the appearance of Village Banking in the mid-1980's.4 Advocates of this approach felt that Grameen C and all other approaches as well C did not go far enough in developing the abilities of the group to manage their own affairs. Although drawing on Grameen experiences, Village Banking broke ranks over the issue of "graduation." Grameen participants were never graduated from receiving services, whereas in Village Banking a highly structured three-year process was envisioned in which groups would be graduated into independence from other lending institutions. Drawing on the ROSCA experience, savings mobilization played a much more central role in Village Banking than in previous methodologies. In general, the Village Bank approach was philosophically focused on the creation of a mini-bank owned and operated by and for the poor. Current trends include some significant experimentation with the basic methodologies while staying within the bounds of the key elements of those methodologies. For example, some Latin American Solidarity Group methodologies are experimenting with an automatic loan process whereby all borrowers receive the same loan amount and term during their first few loan cycles until loan sizes grow to a point where individual loan analysis can be justified. Another trend is a growing interest in hybrid approaches, which combine key elements of basic methodologies. For example, borrowers within a Village Bank can be subdivided into multiple Solidarity Groups. Each member of the group is responsible for repayment of the loan to the village bank, but all bank members are still responsible for repayment of the loan to the NGO.

3 ACCION is generally credited with introducing the solidarity group methodology into Latin America. Since its introduction, the approach has been adopted and adapted by a large number of NGOs and programs throughout the region. 4 The Village Banking methodology was developed by FINCA in Latin America. Since its introduction, the approach has been widely replicated, primarily in rural areas and often by agencies which formerly focussed on other activities but wishing to get involved in microenterprise assistance. Among these agencies are Save the Children, World Relief, World Vision, CARE, Catholic Relief Services, and Freedom from Hunger. Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

3. Target Group Characteristics

Due to increased experience assisting microenterprises as well as increased efforts to work with needier people, the microenterprise community has developed a more sophisticated awareness of the heterogeneous nature of their respective target groups, their specific characteristics, and their need for different financial products. One useful conceptual device that has been adopted by a number of microenterprise agenices is the IGA/SE Continuum, where IGA signifies "Income Generating Activities" and SE signifies "Small Enterprises".5 For the purposes of this paper, the continuum has been modified by adding an intermediate category, microenterprises (ME).

3.1.

THE IGA/ME/SE CONTINUUM

The device is a means to view economic activities as taking place along a continuum, with IGAs on at end and SEs at the other. Income generation implies part-time, often seasonal economic activities undertaken to supplement semi-subsistence lifestyles. Generally, several family members are simultaneously engaged in a wide array of such activities, as the household attempts to diversify its meager income sources. Small enterprises, at the other extreme of the continuum, are usually the entrepreneurs' primary source of income and they reinvest the profits of the enterprise to further its growth. The key distinction is in the actions, expectations, and aspirations of those who undertake economic activities. At the IGA end of the continuum, the entrepreneur needs to take as much money as possible out of the activity. At the SE end, the owner can reinvest in the expansion of the enterprise; profit becomes the fuel for growth. There is obviously a great distance between these two extremes. Conceptually, the broad grey area between IGAs and SEs is better visualized with the addition of the center column, microenterprise. See Table 3 for a listing of characteristics of IGAs, MEs, and SEs.

IGA

ME

SE

No Reinvestment
1. 2. 3. 4. 5. Little or no fixed assets Little or no investment in worksite No labor other than owner Traditional technology Mixed with household economy 1. 2. 3. 4. 5.

Some Reinvestment
Usually moderate fixed assets Usually little investment in worksite Family labor, apprentices, paid labor Out-dated technology 1. 2. 3. 4.

High Reinvestment
Extensive investment in fixed assets Extensive investment in worksite Paid labor Modern technology Separate from household economy

Mixed with household 5. economy, but shifting toward separation

5 The IGA/SE Continuum was first developed by CARE. For further information on the continuum refer to CARE Small Economic Activity Development (SEAD) Asia Workshop: The Facilitator's Manual (1989). Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

6. 7. 8. 9.

Part-time and seasonal employment Low or no skill level Ease of access Local markets

6. 7. 8. 9.

Full-time employment Moderate-to-high skill level Ease of access Local and regional markets

6. 7. 8. 9.

Full-time employment Higher skill level Limited access Regional, national, and export markets

10. Multiple activities 11. Low levels of literacy 12. Little or no written records 13. Informal economy 14. Makes rational choices

10. One activity 11. Literate 12. Few written records 13. Informal economy 14. Makes rational choices

10. One activity 11. Literate 12. Extensive records and systems 13. Informal economy 14. Makes rational choices

A careful analysis of the characteristics shows that the addition of this third column is more than a matter of semantics. There are clear distinctions between microenterprises and IGAs, primarily at the point where the activity becomes a full-time activity providing the primary source of income for the family. Likewise, microenterprises are distinct from small enterprises, but with perhaps a more vaguely drawn line separating the two categories. A common distinction is the transition from an informal activity to a formally registered activity. In general quantitative measures, IGAs have no employees and have assets of less than $500, MEs have up to 10 employees and $10,000 in assets, and SEs have up to 50 employees and $100,000 of assets. The continuum is similar to the three approaches to microenterprise assistance identified by James Boomgard in the 1989 USAID Stocktaking Report. Boomgard claims that these three stages C formation, expansion, and transformation C each have different target groups and different development goals. Formation programs attempt to integrate highly disadvantaged groups or individuals into the microenterprise sector. Expansion programs assist microentrepreneurs to expand their operations. Transformation programs seek to graduate enterprises from the microenterprise to the formal sector.

IGA/ME/SE Distinctions
Income Generating Activities (IGAs) Profit -----> Consumption Household Microenterprises (MEs) Profit -----> Reinvestment Consumption & Small Enterprises (SEs) Profit -----> Reinvestment

Employees: 0 Assets: less than $500

Employees: 0 - 10 Assets: less than $10,000

Employees: 11-50 Assets: less than $100,000

Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

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Strategy: Diversification

Strategy: Specialization

Strategy: Specialization

Impact: Economic security; Impact: Increased income; job Impact: Job creation; trade increased income creation issues Examples: $ Seasonal small scale grain trading $ Weekly market vegetable vendor $ Small-scale hog raising $ Village retail boutique $ Tailoring $ Blacksmith $ Furniture making $ Garment assembly$ Construction

3.2.

TARGET GROUPS AND FINANCIAL PRODUCTS

Thus, there are clear differences between IGAs, MEs, and SEs, and these differences result in needs for different financial products. Table 4 summarizes the main characteristics of these financial products. With IGAs, the need is for small, short-term, working capital loans, for which borrowers are able and willing to pay very high interest rates. Capital turnover and high returns to capital within IGAs make it sensible to borrow money at high interest rates; if $10 can be turned into $20 in one month's time, the borrower is content to pay 10% interest C or $1 C and have $9 left over as profit. MEs need more flexible financial products. MEs often require working capital loans, yet many MEs, particularly in the production and service sectors, also have needs for fixed asset investment loans. Such investments require access to larger loan amounts for longer periods of time, and as a consequence, borrowers can only afford interest rates significantly lower than those affordable by IGAs yet higher than the commercial bank rate. Finally, SEs have very different credit needs, essentially matching the credit conditions of the commercial banking sector C loan sizes and terms specifically matched to the investment and repayment capacity of the business, for which the borrower is able to offer solid collateral, but can only afford commercial interest rates.
Characteristic Use of loan IGA Working Cap ME Working Cap Fixed Assets 4 months - 2 years $200 - $3000 Low 15% - 30% SE Working Cap Fixed Assets Infrastructure 6 months - 5 years $3000 - $50,000 High 5% - 15%

Loan term Loan size Collateral Real Effective Interest Rates*

1 week - 6 months $10 - $300 None 30% - 240%

Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

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Effective interest rates are those rates which combine all financial costs of the loan C interest payments, commissions and fees, and collateral deposits. They show what an equivalent interest rate calculated on a declining balance would be. Real effective interest rates then are corrected for local inflation, showing the cost of the loan in real terms rather than nominal terms..
*

4. Matching Methodologies, Target Groups, and Financial Products

The final step is now to determine the appropriateness of each delivery methodology for different financial products and target groups. As practiced in Latin America, the three methodologies display the characteristics summarized in Table 5. Village Banking provides loans of between $50 and $300, with terms of 4 to 6 months. Thus, these loans are useful only for working capital, agricultural inputs, and some animal husbandry. Because of the ability to form groups of 30-60 members, this methodology works efficiently in areas of low-to-medium population density. Financial services can be integrated with other training services delivered through group meetings in a reasonably efficient manner.
Characteristic Loan Term Loan Size Integrated services Pop. Density Scale of activity Village Bank Lending 4 - 6 months $50 - $300 Medium Medium-to-low IGA Solidarity Group Lending 2 - 6 months $80 - $500 Poor High-to-medium IGA/ME Individual Lending 6 months and longer $300 and above Good High density ME/SE

Solidarity Group lending typically provides loans of between $80 and $500, with terms of 2 to 6 months. Thus, these loans are also useful only for working capital, agricultural inputs, and some animal husbandry.6 Because groups are smaller than in Village Banking, usually 4-7 members, this methodology works efficiently in areas of medium-to-high population density. Financial services are usually not integrated with other services. Finally, Individual lending methodologies can provide loans of $300 and above, with terms of 6 months and longer. It is the only methodology capable of providing loans for fixed asset purchases and investments in infrastructure. Working with individuals requires a high population density to result in efficient service delivery. Large loan amounts, however, provide sufficient program income to enable this methodology to be used effectively in integrated service delivery. Comparison of the loan conditions of the three methodololgies with the credit Methodology needs of across the IGA/ME/SE Individual Businesses continuum clearly show that each
Solidarity Groups Village Banks
6 Although the $500 upper limit on loans is sufficient for purchasing fixed assets, the maximum loan term, 6 months, is not sufficient to make payments. Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

IGA

ME

SE

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methodology is well-suited to reach only a specific range of the continuum. This correlation is expressed in Figure 3. One final factor to consider in the match between financial products and delivery methodology is the potential for the combination to result in sustainable financial services. When properly implemented and managed, all three methodologies have the potential to be sustainable. A complete analysis is beyond the scope of this paper. Table 6, however, does show basic calculations for the most important variable in projecting financial sustainability C loan agent portfolio. The amount of portfolio managed by a loan agent must generate sufficient revenue to cover the agent's costs and overhead costs of the institution. In many Latin America countries, this would require that an agent working in a well-run, efficient program to manage a minimum of $40,000.7 When agents carry sufficient caseloads of clients (as shown in Line 3) and average loan amounts are equal to those typically found in Latin American programs, agent portfolios are in excess of $40,000 for all minimalist approaches and for integrated individual lending.8 A key factor enabling Village Banking to attain sustainability is the fact that banks hold the entire loan amount for the entire loan term rather than making regular fixed repayments over the life of the loan. This fact doubles the agent portfolio and thus doubles the income generated by that agent. 9

Minimalist Indiv 1 Borrowers per group/bank 2 Groups/banks per agent 3 Number of borrowers per agent 4 Average loan size 5 Adjustment factor 6 Average agent portfolio 150 x $800 x 0.5 x SG 5 100 x VB 40 9 100 x $800 x 0.5 Indiv

Integrated SG 5 x 60 x VB 40 6

= 500 x $200 x 0.5

= 360 x $150 x 1.0

= 300 x $200 x 0.5

= 240 x $150 x 1.0

$60,000 $50,000 $54,000 $40,000 $30,000

$36,000

7 See Designing for Financial Viability of Microenterprise Programs , Charles Waterfield, May 1992, MEDA, for a complete treatment of the importance of loan agent portfolio to sustainability. Note that there are many variables other than loan agent portfolio influencing financial viability, not least of which is the interest rate to be charged on that portfolio. The $40,000 figure proposed here is based on observations in a large number of programs throughout Latin America as a realistically attainable portfolio that can enable a well-run program to achieve viability while charging appropriate rates of interest. 8 Minimalist approaches are those that focus only on financial services. Integrated approaches add other services, typically management and/or technical training. 9 The adjustment factor in Line 5 is used to calculate the average loan balance held by the average client. For programs which require regular payments throughout the loan term C which individual and solidarity group approaches commonly do C the average balance is half the average loan amount. With Village Banking, the payment usually is a lump sum at the end of the term. Thus the average balance held by the average client is the full loan amount. Designing Microfinance Loan Products Charles Waterfield, 10 January 2001

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5. Conclusions
In summary, the MSE field has made significant advances in recent years, both in terms of its understanding of the target group C or more precisely the target groups C with which it works as well as in the sophistication of its delivery methodologies. These methodologies have advanced due to the careful consideration given to the limitations and lessons-learned from both informal and fomal credit sources as well as to the observation and study of other programs and other methodologies. The thorough understanding of the specific characteristics and needs of the various target groups assisted by MSE institutions has enabled program designers and donors to develop appropriate financial products for each target group. In addition, an understanding of the strenths and limitations of the basic methodologies currently in use in the region allows the selection of the methodology most likely to result in the sustainable delivery of these financial services. Donors can play a key role in advancing the efforts of MSE institutions to assist the poor by encouraging them to adopt more appropriate and sustainable financial products and delivery methodologies.

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Bibliography
Berenbach, Shari and Diego Guzmn. November 1992. The Solidarity Group Experience Worldwide. ACCION. Monograph Series No. 7. Boomgard, James. 1989. AID Microenterprise Stock-Taking: Synthesis Report. USAID. Bouman, F.J.A. 1984. Informal Savings and Credit Arrangements in Developing Countries: Observations from Sri Lanka. Discussion Paper No. 4 (Revised), Colloquium on Rural Finance. Sponsored by the Economic Development Institute of the World Bank. CARE. 1989. Small Economic Activity Development (SEAD) Asia Workshop: The Facilitator's Manual. Castello, Carlos, Katherine Stearns, and Robert Peck Christen. July 1991. Exposing Interest Rates: Their True Significance for Microentrepreneurs and Credit Programs. ACCION. Discussion Papers Series, Document No. 6. Christen, Robert Peck. 1989. What Microenterprise Credit Programs Can Learn from the Moneylenders. ACCION Discussion Papers Series. Document No. 4. CRS. The Community Banking Promotion Manual. CRS/Thailand Small Enterprise Development Program. Drake, Deborah and Mara Otero. October 1992. Alchemists for the Poor: NGOs as Financial Institutions. ACCION. Monograph Series No. 6. Duval, Ann. 1993. WWB Best Practice Manual on Building Strong Credit and Savings Operations. Women's World Banking. Hatch, John K. March 1988. Suggestions for Implementing the New Microenterprise Act: Presenting a Generic Model for Village Banking Programs. FINCA. Hatch, John K. and Marguerite Sakir Hatch. 1989. Village Bank Manual for Community Leaders and Promotors. FINCA. Holt, Sharon. December 1991. Village Banking: A Cross-Country Study of a Community-Based Lending Methodology. GEMINI Working Paper No. 25. March, Katherine and R. Taqqu. 1990. Women's Informal Associations and the Organizational Capacity for Development. Working Paper No. 6. Rutgers University, New Brunswick. Mommartz, R. and M. Holtmann. April 1993. Analyzing the Efficiency of Credit-Granting NGOs: A Technical Guide. Interdisziplinre Projekt Consult (IPC), (Draft Version). Olivares, Mirtha. 1989. ACCION International/AITEC: A Methodology for Working with the Informal Sector. ACCION.

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Otero, Mara. 1986. The Solidarity Group Concept: Its Characteristics and Significance for Urban Informal Sector Activities. ACCION. Waterfield, Charles. May 1992. Designing for Financial Viability of Microenterprise Programs. MEDA/GEMINI.

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