Investors looking to put their money into microfinance face the daunting task of determining which institutions are most suitable for their investment objectives. Unlike traditional investments, there are few benchmarks and little commentary on the best-performing microfinance institutions (MFIs). A lack of transparency on the risk, financial and social performance, and management of MFIs presents a significant barrier for investors.
In this blog we will look at Portfolio at Risk and how it can contribute towards defining the overall quality of the portfolio.
Portfolio at Risk (PAR)
This ratio is the most widely accepted measure of portfolio quality. It shows the portion of the portfolio that is “contaminated” by arrears (the amount of late or missing payments) and therefore at risk of not being repaid. The longer a client goes without making loan payments, the less likely it is that the loan will be repaid. MFIs with strong lending methodologies follow-up with clients immediately after a loan payment is late.
PAR is a useful measure, but it does not tell the whole story of portfolio quality. Like all performance measurements. PAR can be manipulated. The most common way an MFI could do this is to write-off delinquent loans. To account for this practice, it is critical to consider any MFI’s PAR in conjunction with the Write-Off Ratio. The combination of PAR30 and the Write-Off Ratio results in the Total Risk Ratio.
An opinion about the trustworthiness of the information system is another factor of analysis of the PAR and portfolio quality. Many cases are observed, where portfolio figures do not match the financial statements. In cases of glaring inconsistency, the PAR figures need to be treated with caution.
In the traditional banking sector, the most comparable indicator to PAR is non-performing loan ratio (NPL). Banks calculate this by dividing the total balance on all non-performing loans (not just arrears) excluding interest (the “carrying value” of the loan) by the gross loan portfolio. Non-performing loans occur when payments on the interest expense and/or the principal are past due for 90 days or more and the sum of these two amounts is taken as the balance of the non-performing loan.
In the next blog we will look at Write Off Ratio and how it impacts the overall portfolio of a MFI.