FEATURE ARTICLES

FEATURE ARTICLES
Designing Financial Incentives to Increase Loan Officer Productivity: Handle With Care!
Martin Holtmann Efficiency in micro and small business lending is arguably the strongest single driver of financial performance. This realization has increasingly been reflected in the microfinance literature. In February 2000, the MicroBanking Bulletin dedicated a whole issue to the topic of efficiency. More significantly, during the last decade, a number of lending institutions have made significant improvements in their operating efficiency. One aspect of efficiency is the productivity of staff members. This article takes a closer look at the contribution that one specific toolloan officer incentive schemescan make to improving productivity. It also makes some suggestions for the design and implementation of such schemes. As a reflection of the authors limited experience with group lending, all examples are from individual loan programs. However, most of the findings of this article should also be applicable to group lenders. credit operation, loan officers possess vastly more detailed and accurate information about the local environment and the clients than do central management and the owners. In the presence of such information asymmetries and high monitoring costs, managers are well advised to align the goals of the institution (which usually include a mix of outreach and profitability indicators) with those of the agents who actually make the vast majority of operational decisions. Again, well-designed incentives can be useful in achieving this goal.

Design and Typology of Incentive Schemes

As the basis for designing an incentive scheme, the loan officers duties must first be clearly defined, and they should be derived from the goals of the lending institution. This yields a range of targets that the loan officer is supposed to meet. Typical examples include: Number and volume of loans issued; Number and volume of outstanding loans; 2 Number of loans to first-time customers; Quality of the loan officers portfolio (in the form of the lowest feasible portfolio-at-risk rate).

Why Focus on Loan Officer Productivity?

In microfinance institutions (MFIs), loan officers are responsible for creating and safeguarding the quality of the assets (i.e. the size and arrears rate of the loan portfolio) as well as for generating the income (i.e. interest payments from clients) for the institution. In addition, since they are the point of contact with clients, the work of the loan officers has an enormous impact on an institutions outreach. In a nutshell, the loan officers are the agents that produce an MFIs output. On the input side of the equation, loan officers account for a significant share of staff costs, which in turn accounts for a significant portion (50 to 70 percent) of administrative expenses. Clearly, a production factor that accounts for most of the costs and generates almost all of the output and income should be given incentives to become as productive as possible! Financial incentives can enhance employee performance and productivity in microfinance just as in other industries. A second argument supporting the design and implementation of loan officer incentives is the highly decentralized structure of the decision-making and credit delivery process. In a typical microMICROBANKING BULLETIN, APRIL 2001

Most incentive schemes consist of some or all of these variables. The individual components must be weighted to ensure that the goals pursued by loan officers match the institutions goals as closely as possible. It is impossible to achieve a perfect match between the goals of loan officers and those of the institution. Also, outreach, credit volume and portfolio quality cannot be maximized simultaneously. When putting together an incentive package that gives due consideration to all three factors, achieving the optimal mix of the three variables inevitably involves certain trade-offs.

Since lending to existing customers involves less processing and analytical effort than lending to new customers, experienced loan officers with a large pool of customers tend to focus on their existing clients. This type of behavior is clearly contrary to the MFIs outreach objectives. 5

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While loan officers make the most important contribution to reaching the output goals, numerous factors, such as external economic shocks or devaluation, are outside their control. Furthermore, loan officers basic living expenses must be covered to ensure that they will be willing to take appropriate risks in the course of their work. Given these two points, loan officers should not only receive a performance-related bonus, but should also receive a fixed basic salary. Regarding the weighting between bonuses and salary, the general rule is that a bonus of less than 20 percent of total remuneration does not create significant stimulus to improve performance. Conversely, a bonus of more than 70 percent of the remuneration package will attract loan officers who are active risk seekers. In practice, the share of the performance-based bonus in overall compensation is best if it is between 30 and 50 percent. Financial incentive schemes vary in complexity. The simplest form is the piece rate system, in which the loan officer receives a set bonus per unit of output. Multiplying the figures for the indicators in question (e.g. number of loans issued to new customers) by the respective set amount yields the total bonus. To discourage delinquency, a penalty can be deducted based on arrears. Complex bonus systems allow management to set targets for loan officers in regard to specific variables. Such systems have the advantage of being oriented to the performance values of the institution as a whole, and therefore also allow fine-tuning.

Loan officer incentive schemes introduced in several downscaling programs in Eastern Europe typically gave a boost to loan officer productivity. The performance of loan officers of the Russian State Savings Bank is significantly better in branches that allowed the implementation of an incentive system than in branches that opted to maintain a fixed salary. In the Siberian city of Krasnoyarsk, for instance, introduction of incentives led to positive productivity differentials of more than 30 percent. In Kazakstan, incentives have been introduced in all the banks participating in the European Bank for Reconstruction and Developments small business program, and the effect on productivity has been quite strong. When a re-designed financial incentive system was introduced at FEFAD Bank in Albania in early 2000, loan officer productivity (measured in average number of loans disbursed per loan officer per month) increased by more than 100 percent within a period of five months, while the portfolio-at-risk ratio remained at the same low level as before.

Words of Caution
Design and implementation of loan officer bonus systems requires careful planning. One obvious challenge is to ensure that the incentives are properly aligned with the goals of the organization. Misalignments can be avoided by testing the system during the design phase, both through spreadsheet calculations and a limited field test 4 (e.g. in a branch office). The effectiveness of incentive systems depends on the cultural environment in which a microfinance institution operates. Timing is another critical issue. It is useful to phase in an incentive system gradually. During their training period, loan officers need to make mistakes in order to learn from them, thus they should not be penalized. Later on, as the whole organization moves up the learning curve (i.e. average loan officer productivity increases) the bonus system can be adjusted. The introduction of new products also requires changes to the bonus system. Implementation of a bonus system at the loan officer level usually generates the need for incentive systems at other layers of the organization (department heads, branch managers, etc.). The empirical observation that many systems have produced completely unwanted effects leads to the conclusion that it is better not to have an incentive system than to have one that is badly designed.
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Impact of Financial Incentive Systems: Some Empirical Evidence

There is ample empirical evidence that the introduction of loan officer incentive schemes can make positive contributions to loan officer efficiency. Some of the most efficient Latin American MFIs with very high loan officer productivity use financial incentive systems, including WWB Cali, Financiera Calpi, CMAC, Banco ADEMI, and Caja Los Andes. The BRI Unit Desa, a high productivity lender in Indonesia, uses a profit bonus system (based on unit performance) to motivate staff. In addition, 3 there is a semi-annual contest for cash prizes.

Based on MicroFinance Training Program, Boulder, Colorado, course notes by Richard M. Hook. Pure profit-sharing schemes at the loan officer level generally work well in small groups where potential free riders can be sanctioned. For larger groups, this self-regulating mechanism usually does not work and performance should be measured individually.

Spreadsheet calculations also help to calibrate the impact that the system will have on the cost of lending operations and to forecast the break-even point. MICROBANKING BULLETIN, APRIL 2001

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A bonus system for loan officers is only one part of a productivity-focused lending technology. Other, and probably more important elements are: standardization of products and procedures, decentralization, effective screening of clients to reduce dropout rates during analysis, and effective use of MIS. Furthermore, compiling and posting individual and branch rankings creates a healthy spirit of competitionwith the corresponding positive impact on productivity. What conclusions may be drawn? There is strong evidence that a well-designed monetary incentive system for lending staff does indeed boost productivity. But a bonus system is only part of an overall culture of high productivity. Every bonus system must be carefully designed and adapted to 5 the local situation. Do not e v e r copy someone elses system: rather, design your own! For a system to be successful, it: Needs to incorporate the basic goals embedded in the lending policies of the organization; Must be fair. Loan officers should feel that better performance is adequately rewarded and that on average the goals set by the system are achievable. This requires continual efforts by managers to communicate fairness as an overall objective of the system, so that the inevitable adjustments in the bonus formula are accepted by loan officers as routine and not interpreted as breaches of trust or as a lack of appreciation for their efforts; Should be transparent so that loan officers can adjust their actions according to a few simple 6 parameters.

The bonus is derived as: Bonus = L + P + A Where: L = Lending (number of loans disbursed to new and repeat clients) P = Portfolio (number of loans and balance outstanding) A = Arrears (number of loans and portfolio at 8 risk) The variables create a ratio of actual results to intended targets. Additionally, weights are applied to the variables, and for each part of the formula a bonus factor is given. The sum of the bonus factors is the amount the MFI is prepared to pay as a bonus. It is possible to convert the bonus into any currency. In this illustration, summarized in Figure 1, the bonus factor is denominated in US$. The overall variables are weighted (w1 through w7) according to the importance of the respective performance indicator to the MFI and can be defined for each loan officer individually, depending on what the institution expects the loan officer to achieve during a certain period (usually one month). Each component of the formula is explained below. Number of Loans Disbursed (L) L is the number of loans disbursed to new and repeat clients by the following formula: L = [(n / g) * w1 + (o / h) * w2] * w8 Where: n = The number of loans issued to new clients g = The loan officers target for loans issued to new clients o = The number of loans issued to repeat clients h = The loan officers target for loans issued to repeat clients w1, w2 = The weight given to the number of loans issued to new and repeat clients, respectively. w1 plus w2 must equal 1. If more importance is attributed to the number of loans issued to new clients, w1 should be given a weight greater than 0.5
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No incentive system is perfect. All bonus systems must be regularly reviewed and adapted to the changing business environment as well as to the maturing of the lending organization. Finally, any system that helps to improve the performance and loyalty of staff deserves to be implemented.

An Illustrative Incentive Scheme

This section describes how an incentive scheme might work. In this example, loan officers can earn 7 a monthly bonus up to a maximum of US$400.
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Among the many technical issues to be decided are: phasing in bonuses, their total value, and frequency of bonus pay. For an overview of some of these considerations see Christen, Robert P. (1997). Banking Services for the Poor: Managing for Financial Success. Washington DC: ACCION, pp. 182-189. Transparency can be a problem when implementing bonus systems in downscaling environments in which department heads and branch managers would prefer to provide bonuses based on their own subjective assessments of loan officers performance.

In theory, a loan officer could earn a bonus higher than US$400 by overshooting the targets. Nevertheless, these are set so that it is hard to surpass them, and readjusted as average performance improves. In the following paragraphs, the term arrears denotes portfolio-at-risk starting from the first day of irregular payment. 7

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Figure 1: An Illustrative Incentive System

Vari able g n h o b d a c #la $la Comments (L) Target number of disbursed loans to new customers (L) Actual number of disbursed loans to new customers (L) Target number of disbursed loans to repeat customers (L) Actual number of disbursed loans to repeat customers (P) Target number of outstanding loans (P) Loan officers actual number of outstanding loans (P) Target outstanding portfolio (US$) (P) Loan officers actual outstanding portfolio (US$) (A) Actual number of loans in arrears (A) Actual volume of loan officers loans in arrears (US$) Value 10 6 10 4 120 80 600,000 450,000 3 25,000 Factor w1 w2 w3 w4 w5 w6 w7 w8 w9 w10 Description Weight factor for L number (new) Weight factor for L number (rep.) Weight factor for Pvolume Weight factor for Pnumber Weight factor for A #la Weight factor for A $la Weight factor arrears Bonus level factor L ($) Bonus level factor P ($) Bonus level factor A ($) Value 0.7 0.3 0.3 0.7 0.5 0.5 5 100 100 200 <1 <1 <1 <1 <1 <1

w8 = The bonus level factor for L In this sample calculation, the total monthly bonus is US$400, which is divided up as follows: w8 = 100, w9 = 100 and w10 = 200. However, if for a certain period greater importance is attached to, say, new loan output rather than to low arrears, then w8 should represent a larger portion of the bonus than w9 or w10. In this example, the loan officer issued 6 loans to new clients, while the target was 10, and issued 4 loans to repeat clients, while the target was 10. As a result, the bonus amount for L is US$54. L = [(n / g) * w1 + (o / h) * w2] * w8 L = [(6/10) * 0.7 + (4/10) * 0.3] * $100 = $54 Portfolio Outstanding (P) P stands for portfolio and measures the extent to which a loan officer has met targets for the volume and number of loans outstanding. P = [(c / a) * w3 + (d / b) * w4] * w9 The individual variables are: c = Loan officers total outstanding portfolio a = Loan officers target for outstanding portfolio d = The actual number of outstanding loans b = The loan officers target for the number of outstanding loans w3, w4 = The weights represent the importance given to the volume and number of loans out8

standing, respectively. w3 plus w4 must equal 1. If more importance is attributed to the number of loans than their size, then w4 should be given a weight greater than 0.5 w9 = The bonus level factor for P This formula assesses the extent to which the loan officer has achieved the established targets for portfolio outstanding. In the sample calculation, the loan officer had an outstanding portfolio of US$450,000, or 75 percent of the US$600,000 target. In this example, more significance was given to the number of loans issued than their value, since w4 was set at 0.7. It was probably felt that the loan officer needed to increase the number of loans (for instance to increase outreach or diversification), and hence greater weight was attached to this target. The target was 120 loans outstanding, whereas the loan officer achieved 80, or 67 percent of the target. In our example the bonus for component P is calculated as follows: P = [(c / a) * w3 + (d / b) * w4] * w9 P = [($450,000/$600,000)*0.3 + (80/120) * 0.7] * $100 = $69.17 Arrears (A) A or arrears is determined by the following formula: A = (w7 [(#la / d) * w5 + ($la / c) * w6]* 100) (w7 * w10)
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This formula calculates the degree (by volume and number) to which a loan officers portfolio is delinquent, and how much the bonus is reduced as a consequence. The components of this formula are: w7 = The weight factor for arrears. This can be any number greater than or equal to 1. The lower the weight factor, the greater the negative effect on the loan officers potential bonus. The use of this weight factor and the fact that the arrears component is not deducted from the total bonus allows the institution to fine-tune the impact of arrears targets by changing the factors every month. Thus, a loan officer may get a substantial bonus for bringing down the arrears rate. #la = The total number of loans in arrears in the loan officers portfolio d = Total number of outstanding loans in the loan officers portfolio (same variable used in component P) $la = The total balance of outstanding loans in arrears c = Loan officers total outstanding portfolio (same variable used in component P) w5, w6 = The weight given to the number and volume of loans in arrears, respectively. w5 plus w6 must equal 1. If more importance is attributed to the number of loans in arrears, w5 should be given a weight greater than 0.5. w10 = The bonus level factor for the arrears portion of the formula. In our example the arrears bonus level accounts for half of the total bonus, i.e. US$200 out of US$400. The loan officer had 3 arrears cases representing a total of US$25,000 at the end of the month. The bonus for part A is calculated as follows: A = (w7 - (#la / d * w5 + $la / c * w6 * 100)) / w7 * w10 A = (5 ((3 / 80 * 0.5) + ($25,000 / $450,000 * 0.5) * 100)) / 5 * 200 = $88.14 Looking at this result and remembering the large portion of the maximum total bonus (50 percent) that the loan officer could have earned on arrears, it appears that the loan officer failed to make significant progress on this objective during the past month. Totals Now that all three components of the formula have been calculated, combine them according to the formula: Bonus = L + P + A. Thus, the resulting bonus is: $54 + $69.17 + $88.14 = $211.31
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The formula outlined above is only one variant of the multitude of bonus systems employed by MFIs. Attentive readers will have realized that the example and its target values do not originate from a high-productivity setting, such as urban Latin America or Indonesia. Indeed, this fictitious case is typical for Southeastern Europe and the Middle East, which are characterized by low productivity, high loan officer salaries, and high average loan sizes. But with a little imagination it is very easy to adapt the formula to other contexts.

Evaluation
The example above has a couple of shortcomings and some important strengths. Beginning with the advantages, the model contains many of the basic variables that make up the target functions of microlending organizations. Secondly, the formula is flexible in that the parameters can be adjusted to reflect different environments as well as different organizational values (e.g. the outreach objective can be strengthened by assigning a higher weight factor to the number of loans disbursed and outstanding as opposed to the volumes). Thirdly, the system is not overly complex and can be understood both by a keenly analytical loan officer and reader of this Bulletin. The computation of individual bonuses is simple enough and does not require more than a spreadsheet. Fourthly, the bonus formula is linear rather than staged. Staged bonus systems often produce unwanted 9 incentives. One of the models strengths is also a weakness: Microlenders have to act in a complex environment, and this simple formula may not reflect this complexity of tasks. It is possible to incorporate a higher degree of complexity in the formula by adding more variables, but this comes at the cost of making the system less transparent. Loan officers will find it harder to keep track of the trade-offs and goal conflicts contained in the formula and to adjust 10 their actions accordingly. The balancing of trade-offs is particularly relevant in the treatment of delinquency. The age of arrears has a strong bearing on the chances of recovery, which suggests that shorter-term arrears should be
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Loan officers will typically adjust their performance in these circumstances so that they remain close to a particular stage or limit, e.g. a cap on the permitted arrears level. Linear systems, in contrast, provide a reward or penalty for any change in the output or quality variables.

Remember that this concern was one of the reasons for introducing an incentive system in the first place. An effective bonus system will induce loan officers to act in the interests of the organization without additional supervision. If the system becomes too complex, this cannot be achieved. 9

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subject to a higher penalty. However, it is also counterproductive to penalize short-term arrears (say, from 1 to 7 days) too heavily since it would make loan officers overly risk-averse and have a negative impact on productivity. This train of thought could be factored into the model by assigning different weights to different age categories. Furthermore, if delinquency is a serious concern for an institution with a large portfolio, the formula could be improved by changing the purely additive calculation contained in the example above into a multiplicative link between outstanding portfolio and arrears level, thereby making it much more sensitive to portfolio quality. At a more general level, some readers may take exception to this articles focus on financial incentives. Indeed, there are many other and potentially more powerful factors that influence an individuals job performance. Opportunities to receive further training, opportunities for advancement, social status, the sense of a common mission, and last but not least, the feeling of contributing to local or national economic and social

development are important components of loan officers job satisfaction and performance. Nevertheless, loan officers are normally rational in the economic sense, and few would deny that financial incentives do provide an important stimulus. It is important to inform potential loan officer candidates during the selection phase if a performance-based incentive system is in place or is to be introduced. This will help to screen candidates by ensuring that they are willing to align their compensation expectations with the MFIs goals, and to be compensated on the basis of their contribution to those goals; it will also help to sort out risk-averse individuals. Despite the general limitations of monetary incentive systems, they have proven their value in practice.
Martin Holtmann is a Managing Director of IPC. He is based in Moscow, working with several commercial banks in the EBRD Russia Small Business Fund project. The author would like to thank Andreas Francke, Bryan Nielsen, and Ralf Niepel, all from IPC, for many useful inputs and suggestions.

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MICROBANKING BULLETIN, APRIL 2001