White paper credit scoring

White Paper

No. 9

September 2008

Credit Scoring in Microfinance
Objective This white paper provides an overview of credit scoring for microfinance organizations. The Opportunity Network is at the very beginning stage of exploring credit scoring. Opportunity Finance in South Africa currently uses it, and FORUS Bank in Russia and Opportunity International Bank of Malawi have undertakenfeasibility studies to begin its implementation. This paper is based on their learning, as well as published best practice in the field. It conveys the benefits and risks of credit scoring and describes how it works. It also explores the basic stages of implementing credit scoring, and outlines the questions and guidelines that executives should consider prior to introducing it. The objective is toinclude the wider Opportunity Network in conversation and early learning about this promising tool. What is Credit Scoring? Credit scoring analyzes the characteristics and performance of past loans to predict the performance of future loans. The two most commonly used scorecards are application and behavior scorecards. Application scorecards predict the probability of firsttime loan applicantsdefaulting at a future point based on demographic, business, and financial data, loan characteristics, and (if available) credit bureau data. The scorecard isolates characteristics that are statistically predicative of default based on the organization’s recent experience, and uses those variables to predict the risk of new loan applicants. Behavior scorecards predict the probability of an existingaccount going bad at a future point in time based on repayment information. They are used to define risk-based loan terms that reward good clients with lower interest rates and larger loans. Scorecards have been used successfully with individual microfinance loan clients by a number of organizations. Opportunity is also exploring possible data capture for group loan

Opportunity Internationaloffers hope to women and men in poverty through microfinance — access to micro loans, savings, insurance and training.

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clients for use as they transition to individual loans. (See box on page 8). What are the Benefits? Credit scoring supports growth to reach more clients,helps manage default rates, lowers costs, enhances productivity, increases client retention and, when used wisely, can help us achieve our transformational objectives.

graph). This resulted in a $2 million increase in profit the year after implementing behavior scoring.1 Organizations may also use the predictive capacity of scorecards to experiment with credit policies that may slightly raisedefault, assuming the benefits, such as a substantial increase in the number of clients served, outweigh the costs.

Supporting Growth Microfinance organizations can use scorecards to protect their performance as they grow their programs. Scorecards create consistency in loan decisions which protects the quality of the portfolio during expansion efforts, including large scale branch roll-outs.Traditionally, loan officers have needed a substantial amount of time to develop the subjective experience Source: Credit Risk International. July 2003. necessary to make good Both pricing for the bad debt as well as the loan decisions. Scorecards make the criteria transformational impact would need to be taken explicit and reduce the role of subjectivity in the into consideration. loan decision. Forthe many Opportunity partners with strong operational performance Managers can see the effect that a scorecard will who are looking to grow, maintaining loan have on their default rate before they even roll it decision quality during growth will be the out. After the scorecard is developed managers leading benefit. can run a ―historical test‖ to understand how varying credit policies would have...