Credit Risk Management in Microfinance: The Conceptual Framework

This paper aims at tracing the developments in credit risk management in MFIs and exploring the different mechanisms used by these institutions to achieve a high repayment rate. It also discusses the use of forecasting methods for screening and selecting individual microfinance borrowers. The paper tries to show how MFIs can succeed in reaching the poorest of the poor in a more effective way than the formal financial sector by devising innovative strategies, such as group lending, dynamic incentive, collateral substitutes, regular repayment schedules, and the provision of nonfinancial services. It covers the following sections in detail:

• Theoretical explanation of why traditional banks find it difficult to lend to the poor;
• Mechanisms for credit risk management in microfinance including the use of dynamic incentives, collateral substitutes, enforcing regular repayment schedules, and providing nonfinancial services;
• Three main credit risk management approaches: the structural approach, the statistical approach, and the expert-judgment approach or subjective judgment approach;
• Use of credit scoring models as a credit risk management tool in MFIs.