Portfolio at Risk & Portfolio Quality Item General introduc tion / Role in Simfi

Description Portfolio at Risk (PAR) is a standard international measure of portfolio quality that measures the portion of a portfolio which is deemed at risk because payments are overdue. So, PAR is the proportion of the loan portfolio that has an increased default risk.

Where?

In the Simfi simulation, the amount of loans outstanding can be found on the balance sheets under Gross loan portfolio outstanding. This is the sum of the various loan products which can be found under Short term loans individual, Short term loans groups, Long term loans individual and the Long term loans groups in the Detailed portfolio.

Definitions

Currently, the numerator cannot be derived from the balance sheet. Determining defaults A probabilistic process determines whether or not a loan defaults. Every month, the dice are cast and the simulation determines, per loan, whether a default occurs. Defaults are the defaults that have occurred in the period preceding the PAR analysis. Currently, the PD (probability of default) is divided by twelve to get a monthly PD. The simulation generates a random number, and If that random number is smaller than the threshold monthly PD, a default occurs. The time period considered, is either the duration of the loan, or a one year timeframe, in case the loan has a remaining duration of over twelve months. In case multiple defaults are registered for various months within the duration of the loan, the first occurrence is taken into consideration, and the other later defaults are ignored. The approach above takes two shortcuts: 1. The monthly PD is assumed to be 1/12 of the annual PD. This results in small errors. 2. The default events occurring throughout the remaining duration of the loan or the one year period are assumed to be independent. In reality, they are dependent in since a default can only happen if no default occurred in the previous months Both issues will be fixed by using the following calculation that is not based on the PD but on the chance that the loan survives, so: (1-PD). The monthly PD can be calculated through 1-(1-B3)^(1/12) and the monthly PD is made dependent on the PD of previous months. This is done by modelling the survival rate, which is the complement of the PD, and can be calculated as (1-PD). The PAR workflow Whenever a default occurs, the loans follow the flowchart depicted in figure 1.

Figure 1: Process flow in case of default

At this point in time, the complete remaining loan amount is classified as loans outstanding with a default. Although the amount of loans outstanding with a default in reality includes all of the loans on which an arrear occurred in the repayment of the principal amount as well as the interest payments, the Simfi simulation assumes that there are no interest arrears. So, defaulted loans are exempt from interest calculation and payment. Even if defaulted loans recover, the interest due for the period the loan was under water is ignored. Rescheduled loans The first branching is between rescheduling and the various PAR time categories. Rescheduling occurs in practice whenever special conditions apply, which urge the MFI to reconsider the loan agreement conditions. The MFI has the option to renegotiate the contract and reschedule the loan. These loans are visible under the heading Rescheduled (no current arrears).Personal circumstances such as illness and the passing away of a family member account for this category. The trainer can adjust the Percentage rescheduled loans in the set-up screens and under the menu Institutions. The rescheduled loans are included in the PAR. At the quarter, the amount under rescheduled loans is recalculated: 1. The rescheduled loan can recover (see below) 2. The rescheduled loan can be written off definitely 3. The rescheduled loan stays put in the PAR under rescheduled loans.

At the start of each quarter, an inflow of rescheduled loans occurs with the new batch of defaulted loans. Time bins The loans under PAR that are not renegotiated, will end up in a chain of PAR bins or time categories: 1. 2. 3. 4.

PAR 1-30 days PAR 31-60 days PAR 61-90 days PAR 91-180 days

5. PAR 181-365 days 6. PAR > 365 days.

Monthly PAR categories Default does not necessarily result in a complete non-payment of the loan, since loans can recover. Although, in the simulation, the calculations are run on a quarterly base, the model takes into consideration the roll-over of the defaulted loans on a per-month basis. This is necessary, since the granularity of the PAR categories is a month for the first three bins. This results in a complex calculation, as at the end of every month events such as recovery and write-off can occur. The loans that stay put move from one bin to the next as time progresses. For the first three categories at the end of the month, there are three options: 1. The loan recovers 2. The loan is written off 3. The loan moves to the next category.

Non-monthly PAR categories Once the troubled credit arrives in the fourth bin (PAR 91-180 days), there is a fourth option: the loan remains stationary within the PAR category. This is possible as the PAR bin covers more than one simulation period. The same goes for all following PAR categories. For the bins PAR 91-180 and PAR 181-365, the PAR calculation is done at the end of each quarter and there is no need to take the monthly roll-over into consideration, as was necessary for the lower PAR categories. At the end of each quarter, an evaluation takes place for the age of the various credits. Only those loans that have reached the full time limit of the time category they are in, are selected for either: 1. Recovery; 2. Write off, or 3. Moving to the next bin.

The loans that have not reached the time limit of the bin remain untouched. The loans in the last bin (PAR > 365 days), are evaluated on a quarterly basis with the following options: 1. Recovery; 2. Write off, or 3. Staying put.

Overview Bins

Recovery rate

Write-off rate

Staying put

Time limit

After 1 month PAR 1-30

Monthly

Monthly

No option

One month

PAR 31-60

Monthly

Monthly

No option

One month

PAR 61-90

Monthly

Monthly

No option

One month

PAR 91-180

Quarterly

Quarterly

Option

One quarter

PAR 181-365

Biannually

Biannually

Option

Two quarters

PAR >365

Quarterly

Quarterly

Option

No limit

PAR Rescheduled

Quarterly

Quarterly

Option

No limit

Figure 2: Wrapping up PAR categories

Dynamic maximum rates for PD and Recovery The simulation contains a formula to cap the maximum PD and recovery percentages in such a way that the sum of the two never exceeds 100%. So, regardless of the maximum values the trainer has entered, the simulation might overrule these input values. The check is done dynamically which means that the maximum changes every period. How to interpret PAR? PAR is not only a gauge for the overall portfolio quality, but also provides an indicator of the size of the default amount in the case things go wrong. PAR 30 means the portion of the portfolio whose payments are more than 30 days past due. PAR 30 above 5 or 10% is a sign of trouble in microfinance. Of course, these percentages might be different for each MFI and geographical area. There is caveat with the interpretation of PAR. A sudden up or downswing of the loan intake can have a high impact on the PAR. The reason is that the numerator of the PAR ratio stays constant, while, in the case of an aggressive loan expansion policy, the denominator will increase as loans are given out. Just looking at the PAR would suggest a rapid improvement of credit quality, which is not the case. The other way round: putting on the brakes in the lending process will lead to an increase in the PAR percentage. Can participants influence the PAR? Participants can hardly influence the PAR in the decision making process. The PD, recovery, and write-off percentages are set by the trainer and are part of the economic scenario. The only choice participants have is between Group loans and Individual loans which might have different PD characteristics. The simulation has made Group loans optional for the trainee and Individual loans mandatory. Another tool at the disposal of the participant is the Write-off policy, Write-off PAR + 365 days overdue. Trainees might for instance decide for a 100% write-off of loans in this category. This will lead to an improvement of the PAR. The losses, however, will be channelled through the Loan loss reserves and eventually the profit. Formula

PAR can be calculated in the following way: Amount of loans outstanding with a repayment overdue / Amount of loans outstanding

Although this calculation is straightforward, the actual calculation in Simfi is complex. Portfolio Quality

Loan loss reserve ratio is the ratio between the total loan loss reserve and the average gross loan portfolio:

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This ratio indicates if the loan loss reserve is sufficient with respect to the total loan portfolio outstanding. The ratio should be of the same order of magnitude as the loan loss ratio which will be explained later on.

Loan loss reserves: Financial statement > Balance sheet Gross loan portfolio: Financial statement > Balance sheet

The risk coverage ratio is the ratio between the total loan loss reserve and portfolio at risk including PAR 30 and PAR Rescheduled:

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This ratio indicates if the loan loss reserve is sufficient with respect to the portfolio at risk. The ratio should be of the same order of magnitude as the portfolio at risk write-off index which will be explained later on.

Loan loss reserves: Financial statement > Balance sheet PAR 30: Ratio>Portfolio quality PAR Rescheduled: Ratio>Portfolio quality Gross loan portfolio: Financial statement > Balance sheet

The provision expense ratio (annualised) is the ratio between the loan loss provision expenses and the average gross loan portfolio:

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Loan loss provision expenses: Financial statement > Profit and loss (P&L) Gross loan portfolio: Financial statement > Balance sheet

The loan loss ratio (annualised) is the ratio between the total amount which is written off from all PAR categories and the average gross loan portfolio:

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This ratio is an indicator to see whether the loan loss reserve ratio is sufficient.

Total amount written off: Market information>Main parameters> Loans (not available for trainees) Gross loan portfolio: Financial statement > Balance sheet

The portfolio at risk write-off index (annualised) is the ratio between the total amount which is written off from all PAR categories and the total portfolio at risk (all categories):

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The ratio can be considered as the degree of riskiness of the total portfolio at risk and can be used as an indicator to see whether the risk coverage ratio is sufficient.

Total amount written off: Market information>Main parameters> Loans (not available for trainees) PAR Rescheduled: Ratio>Portfolio quality Gross loan portfolio: Financial statement > Balance sheet

08 PAR & Portfolio Quality

This document explains the terms 'PAR & Portfolio Quality' in SimFi