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 produc-
tivity. 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.
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-mak-
ing and credit delivery process. In a typical micro-
MICROBANKING BULLETIN, APRIL 2001
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 incen-
tives 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).
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 simultan-
eously. When putting together an incentive pack-
age that gives due consideration to all three factors,
achieving the optimal mix of the three variables
inevitably involves certain trade-offs.
2
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
FEATURE ARTICLES
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 per-
formance-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. Con-
versely, 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 cus-
tomers) 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 vari-
ables. Such systems have the advantage of being
oriented to the performance values of the institution
as a whole, and therefore also allow fine-tuning.
Impact of Financial Incentive Systems:
Some Empirical Evidence
There is ample empirical evidence that the intro-
duction 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.
3
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.
6 MICROBANKING BULLETIN, APRIL 2001
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.
4
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.

A bonus system for loan officers is only one part of
a productivity-focused lending technology. Other,
and probably more important elements are: stan-
dardization of products and procedures, decentral-
ization, 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 bonus. It is possible to convert the bonus into any
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 over-
all 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.
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
a monthly bonus up to a maximum of US$400.
7 loans issued to new and repeat clients,
5
Among the many technical issues to be decided are: phasing in
bonuses, their total value, and frequency of bonus pay. For an
overview of some of these considerations see Christen, Robert
P. (1997). Banking Services for the Poor: Managing for Financial
Success. Washington DC: ACCION, pp. 182-189.
6
Transparency can be a problem when implementing bonus
systems in downscaling environments in which department
heads and branch managers would prefer to provide bonuses
based on their own subjective assessments of loan officers
performance.
MICROBANKING BULLETIN, APRIL 2001
FEATURE ARTICLES
The bonus is derived as:
Bonus = L + P + A
Where:
L = Lending (number of loans disbursed to new
and repeat clients)
P = Portfolio (number of loans and balance
outstanding)
A = Arrears (number of loans and portfolio at
8
risk)
The variables create a ratio of actual results to
intended targets. Additionally, weights are applied
to the variables, and for each part of the formula a
bonus factor is given. The sum of the bonus factors
is the amount the MFI is prepared to pay as a
currency. In this illustration, summarized in Figure
1, the bonus factor is denominated in US$.
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
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
7
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.
8
In the following paragraphs, the term arrears denotes
portfolio-at-risk starting from the first day of irregular payment.
7
FEATURE ARTICLES

Figure 1: An Illustrative Incentive System

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

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 out-
standing, respectively. w3 plus w4 must equal
1. If more importance is attributed to the num-
ber 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)

8 MICROBANKING BULLETIN, APRIL 2001


This formula calculates the degree (by volume and
number) to which a loan officers portfolio is delin-
quent, 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 fac-
tors 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
MICROBANKING BULLETIN, APRIL 2001
FEATURE ARTICLES
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 out-
standing as opposed to the volumes). Thirdly, the
system is not overly complex and can be under-
stood 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 com-
plexity of tasks. It is possible to incorporate a
higher degree of complexity in the formula by add-
ing 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
9
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.
10
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
FEATURE ARTICLES
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 re-
ceive further training, opportunities for advance-
ment, social status, the sense of a common
mission, and last but not least, the feeling of
contributing to local or national economic and social
10
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 stim-
ulus. 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 candi-
dates 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.
MICROBANKING BULLETIN, APRIL 2001