Evaluating Nonprice Terms to Ration Microfinance Loans Based on Expected Loan Loss Function

Abstract

Microfinance institutions (MFIs) play a unique role in the financial sector, using an alternative financial intermediation system (business model) to provide banking services to the marginalized. This is particularly important in areas where collateral-based conventional banking could be more effective. Thus, access to financial services, particularly microfinance loans, is crucial for developing small and medium-sized enterprises (SMEs), especially in rural areas where traditional banking services may be inaccessible. The objectives of this study are to investigate the extent to which factors other than interest rates impact microfinance loan allocation, evaluate the acceptable level of expected loan loss (ELL) that banks can tolerate without compromising financial stability, and explore how banks strategically allocate assets to risky loans under uncertain market conditions. The results from the ELL function indicated that varying risk profiles significantly influenced sensitivity to changes in loan size. This, in turn, affected the institution’s risk sensitivity and tolerance levels at each branch or with each loan product, thereby aiding in the appropriate loan allocation. The recommendations based on the studies include using nonprice terms, loan evaluations, and strengthening branch-level decision-making by empowering branch managers with the necessary tools and training to make decisions that reflect the local context and specific loan products.