Types of Risks faced by Microfinance Institutions – Part 1Types of risks faced by Microfinance Institutions

There are number of risks that an MFI has to face these risks could be of delinquencies, frauds, staff turnover, interest rate changes, liquidity, regulatory etc.

But all these risks can broadly be classified into four major categories;

1. Credit risk

2. Operational risk

3. Market risk and

4. Strategic risk

Of the above four categories Credit risk and Market risk are directly of financial nature and hence are called Financial risks while Operational risk and Strategic risk are of non-financial character and result mainly from human errors, system failures, frauds, natural disasters or through regulatory environment, weak board, poor strategy, etc. However, it must be remembered that operational and strategic risk, as and when materialize will also translate into financial losses for the organisation.

Risks faced by Microfinance Institutions

Credit Risk

Credit risk is directly related to the portfolio of the organistion and is one of the most significant risks from an MFI perspective. Whenever an MFI lends to a client there is an inherent risk of money not coming back, i.e. the client turning into a defaulter, this risk is called the Credit risk. Credit risk is simply the possibility of the adverse condition in which the clients does not pay back the loan amount. Credit risk is the most common risk for the MFI. The risk is of greater significance for MFIs as it has to deal with large number of clients with limited literacy. Further, MFI provides unsecured loans, i.e. loans without any collateral. In case a client default the MFI does not have any asset to meet its loss, which makes the credit even riskier.

MFIs fund their portfolio through external borrowings, through their own capital and through client savings that the MFI has mobilized. By giving a loan, an MFI also attracts risk to these sources of funds. It is therefore said that an MFI deals in public funds, acquired through banks, clients savings or through donors who trust the MFI to carry out its activities effectively. If an MFI loses money it may not be in a position to meet its own financial obligations to its depositors or lenders thereby becoming a defaulter itself. This results in loss of confidence of the funders and the direct financial loss for the MFI as the organisation loses not only interest but also its principal amount.

We have discussed why risk is inherent to the financial activities that financial institutions undertake. MFIs can neither afford to be too conservative on their lending as it will restrict their growth nor can they be over enthusiastic which will result in losses. Hence, an MFI need to have effective risk management system to have reasonable growth without letting the risk cross the thresholds of acceptable limits.

Credit risk emanates from internal as well as external factors. GTZ, a German development agency with a strong financial sector department, in its Risk Management Framework has classified Credit risk into two broad categories.

a. Transaction risk: which is related to the individual borrower with which the MFI is transacting. A borrower may not be trustworthy and capable of repaying loan which will result in loss of loan. All loss of loan related to delinquency of individual clients which can be because client’s migration, willful defaulting, business failure etc is called transaction risk.

b. Portfolio risk: Portfolio risk is related to factors, which can result in loss in a particular class or segment of portfolio. For example an MFI may lose a portfolio with a particular community, locality or a particular trade due to some external reasons. These reasons could be political, communal, failure of an industry /trade, etc.

Indicators of Credit Risk

Although credit risk is inherent to all loan of the MFI, it materializes in the loans which start showing overdues. An amount is called ‘overdue’ if it is not received by the MFI on its scheduled time. Every loan that an MFI provides have fixed schedule for repayment. This is called Repayment schedule, which provides the schedule of payment and acts as the reference point for the MFIs to estimate their overdues.

At the time  of loan disbursement every client is given a repayment schedule, which shows the amount to be paid in each installment and the date of payment. If the amount is not received on or before the schedule date it is called overdue. If any loan has any amount overdue it is termed as a Delinquent loan or a case of delinquency.

MFIs try to have an objectives view of their credit risk and want to measure the extent of credit risk, which is the risk on their portfolio. There are various indicators, which help in measuring the credit risk profile of an MFI. Of these indicators portfolio at risk or commonly known as PAR is considered to be the most effective and is now very common indicator across MFIs. Apart from PAR, Repayment rate and Arrear rate are other ratios, which also provide information about the portfolio quality of an MFI.

PAR; Portfolio at risk or PAR tries to measure the amount of loan outstanding that the MFI stands to lose in case an overdue client does not pay a single installment from the day of calculation of PAR. PAR is the proportion of loan with overdue clients to the total loan outstanding of the organization.

PAR% = (Loan outstanding on overdue loans/Total loan outstanding of the MFI) x 100

PAR is further refined by MFIs to make it meaningful by including ageing in ilt. So MFIs often calculate PAR30, PAR 60, and PAR 90 etc. PAR30 means outstanding of all loans, which have overdues greater than 30 days as a proportion of total outstanding of the MFI, similarly PAR60 means outstanding of all loans, which have overdues greater than 60 days as a proportion of total outstanding of the MFI and so on and so forth.

One thing noticeable here is that overdue amount is not used anywhere in the formula. Overdues are simply taken as indicators to identify risky loans. Loan outstanding is used in the formula, as it is the maximum amount an MFI stands to lose if a client defaults. For example an MFI has five clients, each has taken 10,000 loan and have to repay on monthly basis and loan term is 10 months.

Therefore each month each one of them makes principal repayment of Rs 1,000. After five months of loan disbursement, it is necessary than 5 installments had to be paid which means each client should have paid back Rs 5,000 of principal amount. But say the actual repayment was as shown in the table below.

Clients DisbursedDuePrincipal paid

Principal overdue

Principal Outstanding

1 10,000 5,000 2,000 3,000 8,0002 10,000 5,000 3,000 2,000 7,0003 10,000 5,000 5,000 5,0004 10,000 5,000 4,000 1,000 6,0005 10,000 5,000 5,000 5,000Total 50,000 25,000 19,000 6,000 31,000

To calculate PAR, we have to take the following steps;

• Identify loans with overdues; in the given example loan 1,2 and 4 have overdues• Find outstanding on overdue loans and add; in example outstanding on overdue loans (1, 2 and 4) are 8,000 7,000 and 6,000. On adding them we get 21,000• Divide sum of outstanding of overdue loans by total outstanding

Arrear rate; Arrear rate is the principal overdue as a proportion of the total loan outstanding of the MFI.

Arrear rate = (Total overdue/Total loan outstanding) x 100.

In the given example it is Rs 6,000/Rs 31,000 = 19.35%

This ratio tells the proportion of loan portfolio the MFI is currently losing, i.e. the principal amount that should have been recovered out of the total portfolio but has not been recovered.

Repayments rate; Repayment rate on the other hand is the ratio of the amount received by the organization against the total amount due.

Repayment rate ;(( Total principal collection during a period – prepayments)/Total amount due for the period) x 100

Prepayments, if any have to be deducted from the collections, as this amount was not due for the period. Prepayment is the principal amount paid by clients before it was due.

As mentioned earlier, all these ratios, MFIs and financial institutions lay maximum emphasis on PAR and consider it as the best indicator for risk. This is because PAR is a forward looking ratio and provides an estimate of the total loss that an MFI is likely to make should the risky clients default. While arrear rate and repayment rate only provide information of current loss and indicate the past performance. Arrear rate and repayment s rate are not able to capture the future risk.

Causes of High Credit Risk and Managing them

Now that we know that MFIs have to undertake the credit risk, the question is why different MFIs have different degrees of credit risk indicated by their different values of PAR? Even in the same geographic location with similar client profiles, different MFIs have different values of PAR, reflecting different degree of credit risk they are exposed to.

This leads us to an important conclusion that the credit risk is a function of multiple variables of which client profile is only one. In fact risk emanates from reasons external to the organization such as client running away, any accident happening with the client migration, loss of business/crop etc and reasons internal to the organization such as MFIs policies, processes, systems and culture. Some of the major reasons for delinquencies observed in MFIs are discussed below.

1. Poor MIS – MIS on loan outstanding, collection etc plays a critical role in generating reports and making them available in minimum time to the right people. If an MFI does not have a good MIS, it may not know how much to collect, it may not know its overdues or age-wise overdues. A with weak reporting system on overdue will result in delayed input on overdues to the top management and consequently result in delayed action by the top management. Sometimes weak MIS also results in generation of inaccurate report. If the correct and timely information is not generated and report the problem cannot be dealt with resulting in delinquencies getting aggravated.

2. Poor screening of borrowers – Poor choice of clients results in delinquencies. If client with bad reputation or history of defaults are selected then it can result in delinquencies

3. Weak appraisal – Poor or weak appraisal of loans is one of the major reasons for delinquencies. Before giving any loan, client’s repaying capacity, status of business and cash flows must be assessed. This helps in taking loan decision that whether a client should be a given a loan and about appropriate volume of loan. Poor appraisal can lead to loans going to unworthy clients or disbursement of higher amount loans. Loans given beyond repaying capacity puts clients in stress situation as they do not have sufficient income to repay installments resulting in delinquencies.

4. Unclear communication about product and methodology- Clear communication of policies and procedures is very important. If the clients do not know the policies and procedures it can result in confusion and delinquencies even if clients are capable of paying

5. No immediate follow-up – MFI having strong overdue follow up system can control overdues to a large extent. It also gives clear message to the clients that the MFI is serious on repayments and thus prevents the future occurrences. MFIs which are weak in overdue follow up give a signal that it is not serious in overdue collection resulting other clients to imitate. Also if the overdues are immediately followed up the chances of recovery are quite high but if the case becomes old then the chances of recovery also goes down.

6. Mixing other social activities with micro-finance – Sometimes delinquencies may also result if MFIs carry out grant based activities along with micro-finance with the same set of clients and with same staff. Mixing activities of two different nature confuses the client wherein one activity is being provided free while repayment is asked on micro-finance. This confuses the clients who may think that loans to be given to them may also be grants for them and they need not return it. Also enforcing repayments and discipline through a staff who is involved with the community in other social activities also will be very difficult and hence results in delinquencies.

7. Poor product – Delinquencies occur if the product is not suitably designed. If the repayments do not match with the cashflow of the client then it may result in delinquencies. Client cashflow means that when do the clients receive income and when they need to spend. In agriculture economy, clients may need to spend during sowing season and hence need money. While they may receive income during harvest. Other important point is if the repayment period is too long or too short or frequency of payments and installments size are not well thought off, it can all lead to delinquencies.

8. Natural disasters – Delinquencies can also happen as an aftermath of a natural dis aster such as flood, drought, earthquakes or epidemic.

9. Corruption – Corruption at field staff level such as taking bribe for loans or frauds can result in delinquencies. A staff taking favor from clients cannot enforce discipline or strict repayments. If the staff is committing fraud it will also show up as delinquency.

10. De-motivated employees – If the working conditions or incentive systems are not good, it will result in staff de-motivation and ultimately delinquencies. Motivated staff can make a lot of difference in enforcing policies in the field but of staff is de-motivated then they will not put sufficient efforts to enforce polices with the clients resulting overdues.

Thus we see that delinquencies do not occur, exclusively on account of client related reasons. Much of it can be attributed to internal systems and policies of the MFIs. It also means that if internal reasons related to the organization are taken care of then delinquencies can be controlled to a large extent. It is also important to understand why MFIs, investors and assessment agencies give so much importance to delinquencies and portfolio quality. This is one of the most (if not ‘the’ most) critical parameter for investors and assessors to rate and MFI and taking lending decisions. This is because portfolio is the most o important asset for the MFI and the only or the main source of its income. Any problem with the portfolio can adversely affect the MFI in a number of ways. In the next section we will see what different affects delinquency can have on an MFI.

Impact of Delinquencies

Delinquencies adversely affect the MFI in many ways. We will see how delinquencies can result in multi-dimensional affect for an MFI.

1. Loss of portfolio for the MFI – the major impact of delinquency is the loss of portfolio. The money given to a client by the MFI is lost if client defaults. MFI lends to clients and interests along with principal. However, default by client can result in even principal getting lost.

2. Loss of interest income – if a client does not repay its loan then the MFI loses interest income as well. Interest is the main source of income for an MFI and loss of it directly impacts its profitability and sustainability.

3. Growth hampered -an MFI having overdues has to invest lot of its time and other resources in recovering the overdues. This diverts the focus of the MFI from expansion and growth to controlling the overdues thereby hampering its growth.

4. Cost escalation – in order to recover overdues MFI has to spend its staff time on recovering overdues. Extra visits by staffs at various level also adds to travel costs.

5. De-motivated staff – increase in overdues de-motivates the staff. Staffs of a branch having no overdues are zealous as they expand the operations, get incentives and promotions. While staffs associated with bad portfolio are mostly engaged in overdue recovery, growth is slow; staff does not get incentives and instead may be criticized for poor performance resulting in de-motivation.

6. Cash flow mismanagement – MFI disburses new loans or meets its liabilities such as repayments of its owing to banks, through repayments that it receives from the field. If the repayments are timely then the MFI will not be able to collect enough cash from the field and hence will not be able to meet disbursement target or even pay back to its lenders. MFI plans its disbursements assuming certain amount of collection from the field but there are defaults then it disturbs these plans. This makes cash planning and fund management very difficult.

7. Loss credibility of the MFI – an MFI suffering from delinquency may lose reputation and credibility with other peer MFIs, lenders and donors. Most of the investors put a lot of weightage on portfolio quality as it is the most important asset for the MFI and this is where the investors ‘money will be utilized. Poor portfolio quality makes investors uninterested and fund raising becomes difficult.

8. Loss due to competition – MFI struggling with delinquencies may lose out on completions with other MFIs. While good MFIs may focus on growth, experiment with new products and other service, the MFI struggling with overdues has to concentrate on recovering overdues. It may also lose out on its staff and clients as the MFI is not performing well.

The above list of potential losses shows the multiple impacts or chain reaction delinquencies can spur. So we see that there is a lot to be lost if the credit risk is not proactively managed and contained within the acceptable limits.

Apart from the MFI itself, delinquencies also impacts those associated with it and otters as well. Some of the other impacts of delinquencies are;

1) Bad reputation to sector; Today micro –finance has gained lot of important and recognition as it has proved that good recoveries are possible even from the poor clients. If delinquencies become rampant across MFIs, the sector will lose its creditability and recognition. Investors, government, researchers, etc. Will lose interest and the industry will die out.

2) Staff employability; Micro-finance has created a lot of jobs. It has created jobs for moderately educated people. We see that now micro-finance is a specialized field. The good staff who have performed well get ready employability with other agencies across the sector. They command higher salaries and an exciting career. However, staff associated with delinquencies and poor portfolio loses out on such opportunities. If staff is dismissed from an MFI because of delinquencies it may be difficult for him/her to find jobs at other places. Hence delinquencies can be harmful for the staff at all levels too at the personal level.

3) Loss of reputations of an area; Delinquency in a particular area can result in loss of reputations a locality or region. Many finance companies ‘blacklist’ certain villages, areas or even districts because of delinquencies in those regions. So delinquencies of one MFI may result in even other MFIs not venturing in those areas and thus denying those areas of financial services.

MANAGING CREDIT RISK

Clarity of vision

We saw that delinquencies have wide spread impacts and are harmful not just for the MFI but also for others. It is therefore important to manage credit risk. In order keep credit risk under acceptable limits an MFI must have clarity on its business. From visions and missions statement to the fine policies for the day-to-day operations, everything they should be clearly said/written and documented to avoid any confusion. A clear mission statement gives the right direction to the organization and it does not mix up too many things creating confusion. Clear mission helps the MFI defining its path and where it wants to go. Lack of clarity in mission can result in loss of focus. Such an MFI may get involved in diverse activities, without knowledge of what it wants to achieve.

Segregation of Business functions

MFIs should also be aware that different interventions on the field would have impact on each other. It is therefore, important to maintain clear segregations among programmes of different natures. The social activities should be separate from micro-finance and the community should not be confused with the two programmes.

Product Designing

Appropriate product designing can also curb credit risk to a significant extent. A poorly designed product puts stress on the client who may not be able to repay the amount. The products have to be designed suitable to the local livelihood context and general household cashflow of the target group. In general it is good to have frequent repayments as it maintains contacts with clients. If the frequently is too low it results in loss of contact with client and escalates the risk of delinquencies.

The higher the frequency of repayments the better it is from risk perspective however the repayments has to match the cashflow of the client group. One may not go for a daily repayment if people do not earn on daily basis or do not have surplus cash on daily basis. But repayments not exceeding monthly are generally recommended. This means that at least one installment must be collected each month, a frequency of less than this can enhance risk.

MIS

The importance of a good MIS cannot be overemphasized. MIS collects data and transforms it into the information which can ensure decision making. MIS should be able to generate overdue information almost on a daily basis. This information should also be reported up to Head Office level in a timely manner. If information takes too long to reach the right people, it loses its importance. A strong MIS is very important from the perspective of controlling risk as unless someone knows about delinquency, one cannot take actions to manage it.

A strong MIS is characterized by regular and focused record keeping and reporting system. Many people often confuse that a good MIS always means an elaborate software and computer driven system. A strong MIS may not necessarily mean big software. Many MFIs in India have grown to fairly large size with manual MIS and their manual MIS were very strong.

A good MIS means a systematic and simple record keeping system, which can generate timely and accurate reports needed for decision making and making the information available to the right people at the right time. A simple and systematic record-keeping system could also be manual. It should be able to generate important reports such as on disbursements, collections, demand/due, overdue, prepayments and loan cycles. Any field staff going to field should know how much to collect from a group, how much are the overdues/prepayments. Branch Manager should have the information on disbursements and repayments, saving collections, number of clients, overdues, ageing etc. Similarly, Head Office should get details of all branches/units on disbursements, collections and number of borrowers without much time lag. If the information is not available in time then effective decision-making is not possible and thereby increasing risk.

Internal Control System

Delinquencies also occur on account of policies not being followed or misappropriations. Therefore, a strong internal control system is very important for any financial institution. MFIs deal in a lot of cash and hence without proper monitoring anyone in the system can try to take advantage. Regular monitoring by staffs at various levels as well as an independent internal audit at regular frequency can significantly control risk.

We had earlier divided credit risk into two categories, transaction risk and portfolio risk. We will now discuss on management of these two categories of credit risk.

Managing Transaction risk

Transaction risk is related to the individual borrower with which the MFI is transacting. A borrower may be trustworthy, holds good intentions to repay and may be capable of repaying loan or the borrower may not be trustworthy or capable of paying, which will result in loss of loan. All loss of loan related to delinquency of individual clients because of client’s migration, willful defaulting, business failure, etc. is called Transaction risk.

As transaction risk is related to individual clients, it has to be controlled by having right policies at various stages of loans. Transaction risk management starts from the first step of client selection. MFIs focus on selecting right clients who match their criteria. NFIs develop clear policies and procedures for client identification and selection. The staff at MFI has to be very clear on the process of client selection and group information. It has to be seen that clients who do not enjoy trust of the community or have dubious past do get into the system. Once the clients have been identified, the next step is of grouping formation. At the time of group formation it is extremely necessary that a proper training covering all aspects of the MFI and its products, procedures and other policy are clearly told to the clients. After the training it is also necessary to ensure that clients have understood all procedures and there is no confusion. If the policies of the organization are not clear it can lead to delinquencies in the future. MFIs have procedures of training the clients and then conducting a test to verify the client’s understanding.

Once the group has qualified the test the next step is of taking loan application and loan appraisal. It is the responsibility of the field staff to see that all information is filled according to the policies in the application form. These policies could be such as loan amount as per the cycle, loan purpose should be verify the group member should agree to the loan amount, past repayment history should be good, client’s family income expenditure should be verified or any other policy that the MFI has. Apart from the loan application all other documentation has to be in order this may include taking client id, address and promissory notes.

Once the application has been prepared it has to be appraised by a senior person. All loans have to be appraised according to the merit of the enterprise in which it is being invested. While appraising a loan application casflows, income of household and repaying capacity of the household has to be seen. Often it is seen that MFI instead of focusing on the cashflow from the enterprise in which loan is being invested: focus on the casflow of the entire family. The MFIs then access the household expenditures and based on that decide the final amount to be disbursed. Also past repayment history of the client is taken into consideration while taking loan decisions. Other parameters used in loan appraisal are feedback from peers, experience in business, permanent address of client and other loans if any from other sources. MFIs also take extra precautions while funding a new business; MFIs are more comfortable in lending in expansion of existing business rather than investment in a new business. Strong loan appraisal often controls the transaction risk to a large extent. After the appraisal, the case may be presented to a Credit Officer and Area Manager. Or sometimes it could be just branch level committee or committee composition can also change with the size of loan. This means that for loans above

certain size credit committee could be at regional level rather than branch level or even head office level for very high loans. There is no fixed rule about the credit committee composition by the main idea is that every loan that is disbursed should be a very though out decision taking all potential risk aspects into consideration.

For larger size loans particularly in individual loans, MFI may resort to taking some security such as personal guarantees, taking post-dated cheques or even some assets. These guarantees and securities also help in managing transaction risks.

After disbursement of loan many MFIs also carry out loan utilization checks to see if the loan has been utilized for the purpose the loan has been given.

Once the loan has been approved the disbursement has to take place strictly in accordance with the organization policies. MFIs have policies of disbursement through cheque or cash, disbursement to take place only at branch or lonely at group meetings, signatures of clients to be taken at the time of disbursement, issuing of passbook and issue of repayment schedule at the time of disbursement. Again a clear disbursement procedure can help in controlling frauds or corruption at the time of disbursement and can control transaction risk.

After disbursement there have to be clear policies on collection and deposition of money. There are lots of delinquencies on account of unclear or weak collecting and money handling policies. A clear policy such as where collection should take place, how money has to be transferred and depositing money in bank can also help in controlling risk related to frauds and misappropriation.

Transaction risks can be managed effectively with strong internal systems such overdue management system, strong management information system (MIS) as explained above. Strong overdue management system starts with having a good MIS. Once the information is made available the information is analyzed and decisions are taken. With availability of accurate information organization can manage its delinquencies effectively by framing clear policies on overdue management.

Overdue management means what actions have to be taken by different levels in overdue situations. It is important to acknowledge here that field staffs can play a vital role in managing overdues as field staff is the first one to know whenever a delinquency occurs. Field staff who are well trained can manage the overdue situation well thereby cutting the transaction risk.

Clear policies on overdue management will help the field staff in reacting to overdue situation in an appropriate manner. MFIs have policies of enforcing group pressure such as field staff may hold longer meeting to discuss overdue, can ask other members to pool in money. Field staff may call other colleagues, to visit client house etc. Pressure can also be applied by not disbursing fresh loan to a defaulting group or not increasing the loan size in the next cycle. It is important to act sensitive and knowledgeable here – pressure to recover the loan can cause risks itself, e.g. devastating the community or driving the creditor to desperate actions which will not help anybody. The right way to manage collection – i.e. manage the credit risk signaled by overdues –depends on accurate assessment of the situation at hand.

It is seen that MFI have developed appropriate e policies to handle overdues in different age class differently. For example, overdues above 30 days have to be followed up by Branch Manager along with the concerned field staff. Overdue above 60 days will be followed up by Area Manager, etc.

Immediate response by the MFI to overdue situation and regular follow up is extremely important in cutting down credit risks as it gives strong signal to the clients that the MFI is very serious on overdues. If the MFI does not react to overdues then this may spread the overdue problems to other clients/groups who will start taking advantage of the weak credit culture of the organization.

Managing Portfolio Risk

Portfolio risk is related to factors, which can result in loss in a particular class or section of portfolio rather than an individual. For example an MFI may lose a portfolio with a particular community or a particular trade due to some external reasons. These reasons could be political, communal, failure of an industry/trade etc. Portfolio risks are low probability and high impact kind of risks, it is necessary for the MFIs to manage this risk as they can impact a large portfolio.

For managing portfolio risk it is very important that MFI diversifies its portfolio. Funding/assessing agencies consider a concentrated portfolio as a big risk. The portfolio may be concentrated geographically or in a particular trade or with a particular group of people. Whenever the portfolio is concentrated over any parameter, it increases the risk. Failure or adversity with the particular parameter on which the portfolio is concentrated can seriously impact the MFI. If the portfolio of the organization is diversified geographically, or usage of loan it reduces the risk. For example if the 100% of portfolio of the organization is in agriculture in one or two blocks of a district then in case of drought or crop failure for any other reasons will impact 100% of MFIs. Similarly, if an MFI has a major proportion of its portfolio in a particular city then in any adverse situation such as bandh or riots will impact a major proportion of the MFIs portfolio. Therefore it is important that MFIs keep their portfolio diversified so that impact on a particular parameter will impact only limited proportion of the MFIs total portfolio.

It is necessary that MFI has transparent policies on interest rates, fees, penalties and all other procedures. Clients should not feel that there are hidden charges or any other policy of exploit them. It is seen that if full transparency with clients is maintained it can reduce the risk of client dissatisfaction and sudden adverse reactions. It is important to maintain transparency from the ethical point of view as well. MFIs deal with vulnerable sections of the society; it is necessary for the MFIs to carry out business ethically. In order to control risk from any external entities such as administration, it is important to maintain relations with the other stakeholders such government agencies, local politicians. It is important to also inform about the MFI, its objectives and working methodology. Working in isolation may sometimes spread inaccurate information in the society or other stakeholders may not understand about the activities of the MFI, which can go negative for the organization.

MFIs in order to control risk may adopt the strategy of avoiding or restricting the exposure. Some category of business, which are considered risky or certain locations which are risky

because of reasons such as frequent occurrences of natural disaster or security issues, can be avoided by the MFI or even if it wants to work in such areas or with such business then exposure can be restricted to certain percent of the total portfolio

Credit risk is definitely the most common risk for the MFIs but the with the right policy framework, it can be kept under acceptable levels. But credit risk is not the only risk that MFIs face.

Microfinance Risks – Operational Risk – Part 2In our previous post we had covered the types of risks faced by a micro finance which can be read at Microfinance Risks – Part 1

Given below is Part 2 of this series.

Operational Risk

Operational risk relates to the risks emanating from failure of internal systems, processes, technology and humans or from external factors such as natural disasters, fires, etc. Basel Committee on Banking Supervision defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”. Earlier, any risk, which was not categorized, as credit risk or market risk was considered to be operational. However this was a vague definition of operational risk. As per the new definition strategic risk is not considered under Operational risk.

Operational risk has gained a lot of importance over the years with increased used of technology and also recognition of importance of human resource in the success or failure of enterprises. Another facet of operational risk is that it cuts across all departments, as human resource and technology are central to all departments. Technological interventions are now something very perceptible in all walks of our life including in banking and finance.

Today financial markets and banking has changed dramatically with lot of reliance on technologies such as ATM, e-banking, tele-banking, credit cards, etc. Secondly, over the years industries across world have recognized the importance of human resource. Human Resource departments within enterprises have gained a lot of importance. Companies now believe in investing g in employees, their capacity building, employee retention, benefits and perks. Salaries and other benefits in India have risen dramatically in the last one decade. This clearly shows that human resource is getting the due recognition and importance that it commands.

To this larger change, micro-finance industry is no exception. Micro-finance has seen its own share of technological advancement. From use of computers for simple desk jobs to the use of advance software, introduction of swipe cards and biometric MFIs have witnessed changes in the

IT usage. Strong internal processes, systems, good human resource and preparedness against external events are needed for managing the operational risk.

Operational risk is enhance by increased dependence on technology, low human and business ethics, competition, weak internal systems, in particular weak internal controls.

The Operational risks that an MFI faces can broadly be categorized into five categories.

a) Human risks ; Errors, frauds, collections, animosity.b) Process risks ; lack of clear procedures on operations suchg as disbursements, repayments, day to day matters, accounting, data recording and reporting, cash handling, auditing.c) System and technology risks ; failure software, computers, power failures.d) Relationship risk ; client dissatisfaction, dropouts, loss to competitions, poor products.e) Asset loss and operational failure due to external events; loss of property and other assets or loss of work due to natural disaster, fires, robberies, thefts, riots etc.

Human Risks

As we discussed earlier human resource plays a key role in success or failures of enterprises. An organization with good human resource can meet most challenges effectively whereas weak human resource enhances the operational risks. Human resource is a complex subject. The issue of keeping employees motivated and to encourage them to be honest and uphold integrity and values is something very subjective and does not have any unique solution. MFIs have to deal with large number of small loan clients and this requires them to keep more number of employees with diverse skill sets at various levels.

These employees are expected to mange cash as well as records, which could be manual, or on computers. Managing these operations of the field with set of staff who have limited education qualification is a challenge of enhances operational risk. MFIs mostly transact in cash, which increases the probability of frauds, misappropriation either by employees or even by clients.

Frauds consist of intentional embezzlements and misappropriations careered out by the staff or client of an MFI. Frauds may vary in degree and the extent of financial damage caused to the MFI. But irrespective of the size of fraud, it brings disrepute to the MFI and threaten the credibility of the organization. Frauds can be caused by simple embezzlement of the organizations money to more complex thefts and misappropriations in nature, which can go on unnoticed for a long period of time. Some of the most common frauds in MFIs are field staff taking bribes for loans, creating fake clients, misreporting information, fudging data and forgery. Most often it has been seen that frauds occurs a result of weak monitoring and audit systems. Staff or clients tend to take advantage of the gap between the senior officials and the field and hence manipulate the situation to their personal advantage.

Similarly, an employee may commit loss to the organization by lack of knowledge, capacity or by error. Human errors can occur anytime at any place. There could be errors in record-keeping, data entry, accounting, MIS, etc. Generally, the field staff of MFI are people with limited education qualification or computer sills making them prone to such errors. Regular training of

staff and careful monitoring are therefore very important in micro-finance institutions. Lack of training or monitoring escalates the operational risk due to errors, which are although unintentional but can nevertheless but can nevertheless bring loss to the organization.

Humans can also be destructive sometimes. Employees against whom an action has been taken by the MFI may turn hostile and start working against the organization. They may spread rumors in the community, instigate people, may create problems in the working of the organization in field, may deliberately misreport data, etc.

Process Risk

Process is designed sequence of actions to be taken by different components of a system so that the system can work effectively. In simple terns it means the systematic actions to be taken as part of regular activities for accomplishing various functions. Lack of clearly defined process within an organization can result in confusion, conflicting g actions, duplicity of work resulting in loss of time and other resources. If an organization does not have clearly defined processes, different staff may take different actions to same situation resulting in conflicts and sometimes serious consequences.

Lack of internal processes or inadequacy of the process also weakens the internal control as there are no set parameters against which an action of a staff can be judged. Weak internal systems such procedures for loan disbursement, collection, reporting cash handling etc. Can lure staff and clients to take advantage of the weakness and result in frauds and misappropriation. Lack of standard policies complicates work, as there could be variances in record keeping and reporting making consolidation difficult and to get as there could be variances in record keeping and reporting making consolidation difficult and to get information on time. This impacts decision-making and ultimately results in overall management failure.

Strong internal management systems such as cash planning, cash handling, disbursement procedures, internal checks – monitoring and audits help in managing process related operational risks.

System and Technology Risk

As MFI becomes more and more dependent on technology such as computers, software, hand-help devices, etc. it also enhances their technology related operational risk. Hard disk crash, virus attacks, software or hardware failures, password misuse can impact MFIs to different degrees based on their extent of dependence on technology. MFIs working in rural areas often have to face other such risks as long power cuts which can again disrupt normal operations if proper alternative arrangements such as generators or invertors are available.

To manage this it is important to have proper software backup policies in the organization. It is necessary to invest in updated software and anti-virus, protecting computers from misuses, restricting accesses and limiting authorization of data access to different levels of staff. Daily back ups and storing back-ups at different locations can help in managing such risks. While designing software it is necessary to have strong security features, which can prevent data

tempering. A good and efficient process of troubleshooting can help in addressing software or hardware related problems, which can prevent MFIs from losing valuable data or data theft.

Relationship Risks

Clients are very valuable for MFIs. With competition more and more clients have options of choosing one MFI over another. Loss of clients or high drop out is a big cost to the MFIs. MFIs invest a lot of time and money in identifying clients, training them and nurturing them. Therefore loss of clients results in resource loss, which has been invested on these clients and hence is a big risk. MFIs are increasingly realizing the importance client relation. It is important to be sensitive to client requirements clients can drop out on account of poor products, unfavorable policies and procedures, poor staff behavior or a strong competitor.

As the sector becomes more competitive importance of strong client relation and meeting client requirement will only gain more significance. Managing good client relations can help the MFIs is not only managing this risk but turning it into an opportunity to maximize profits by not losing to competition and building client loyalty and instead attract clients from the competitors.

Basis for effective relationship management is collecting, regularly information about the clients’ satisfaction. This appears to be costly and has not been done by most MFIs so far. However, as MFI-staff interact much more regularly with their clients than other financial institutions do, this offers vast opportunities to “drop” question on satisfaction which are simple and not burdensome.

The greatest opportunity to learn about client satisfactions and to forge a strong relationship is through complaints, though. Most companies do miss the chance of complaint handling. So do MFIs. But complaints are a great opportunity, because it means that a client comes fully self-motivated and willing to convey his feeling s and perceptions of the MFI’s services. It is a kind of information that field staff and managers alike otherwise rarely get hand s on. Therefore, well managed MFIs encourage clients to voice their grievances and provide channels for addressing them.

Asset Loss and Operation Failure Due to External Events

There are various external factors, which are direct threat to an MFI. Such threats may include fire, natural disasters such as floods, draughts, earthquake, tsunami, epidemic etc. There could be other human related external threats as well such as robbery, thefts and rots. Such events although low in probability can cause high damage to the property of the MFI as well as can hamper normal operations for an extended period if time. Such risks can be managed through a variety of strategies. Natural disasters have the capacity to cause very high impact. Natural disasters not only adversely impact the infrastructure such as roads, telecommunications, which will ultimately hamper the MFIs working. Even if a natural disaster has not affected the infrastructure of an MFI directly it may completely destroy client business, which will ultimately result in loss for the MFI.

Riots, wars, communal problems can quite significantly impact the operations of an MFI as such situations may bring an MFI to a complete halt. Riots and other such situation are directly related to the issue of personal security of the staff as well as of the clients and hence are serious risks.

An MFI must keep its portfolio diversified to limit its loss on account of such external factors. If cases of robberies or thefts are common then it is better to transfer risk through insurance, cash carrying by staff can be limited and there can be polices on cash limits at branch. Again insurance for cash in branch or cash in transit can be taken by working out the cash benefit. Insurance involves payments of premium hence it is necessary to evaluate probability of such incident, potential loss possible against the premium the MFI has to pay.

Microfinance Risks Management

If potential losses or chances are high then it is better to take insurance. For dealing with fire or riot situation MFIs may have standard operating procedures, which could be stepwise set of rules to be followed under such emergency situation. This will help the staff to react in a more coherent manner and can control loss due to frivolous action taken by any staff under emergency. Personal safety and security of staff and client has to be given priority. Keeping backups at alternative places can help in preventing data loss and small fire extinguishers, fire proof vaults and help in controlling losses. Policies on storage and custody of important documents such as checkbook, client documents, cash etc., can again control losses.

Microfinance Risks – Market Risk – Part 3In our previous posts on risks faced by microfinance institutions we covered

Microfinance Risks – Credit Risk – Part 1

and

Microfinance Risks – Operational Risk – Part 2

Risks for MFIs do not end with just credit and operational risk, the third category of risk which we will now discuss in this post is the market risk faced by Microfinance Companies .

Market Risk in Microfinance

Market Risk

Market risks are risks of financial nature, which occur due to fluctuations in the financial market or due to mismatch in assets and liabilities of an organization. As the MFIs become bigger in size and complex in terms of their asset and liability composition market risks become more pertinent. The assets and liabilities composition of MFIs, expose them to various kinds of market volatilities. As a result changes in market conditions, through external to MFIs, impact them either favorably or unfavorably and are therefore risks. For MFIs there are three most important market risks.

a. Liquidity riskb. Interest rate risk andc. Foreign exchange risk: Foreign exchange risk arises due to fluctuation in exchange rate of currency in which the MFI has borrowed funds, against local currency: they can be mitigated (“hedged”) by accessing financial products offered by banks. Foreign exchange risk is not relevant from Indian micro-finance perspective as Indian MFIs are generally not dependent on foreign sources of funds.

a. Liquidity Risk

The financial position at any point in time of any organization is reflected by its Balance Sheet, which shows the position of Assets and Liabilities. Assets are the resources owned by the organization through which it generates its revenues. These are application of funds and reflect where all the funds available with the MFI are deployed. Funds could be lying in the form of cash, fixed assets or be invested in portfolio, fixed deposits or other securities. Liabilities on the other hand are sources of fund; these are the obligations of organization, which need to be fulfilled according to the contract. Borrowings, savings raised, other payables are all examples of liabilities as they are the obligations on the organization.

An organization meets its committed payments or fulfills its obligations through the assets it has. In order to use the assets to meet obligations they should be available to the organization in liquid form that is cash. From the example of assets such as cash, fixed deposits, loan portfolio or other receivables and fixed assets we see that not all assets can be used, immediately to fulfill obligations. It is well known that to repay a loan from a bank an organization cannot send fixed deposit certificate or a fixed asset means its ability to be turned into cash. A fixed deposit for 3 years cannot be turned into cash before three years and hence is not a liquid asset but an investment. An investment which is maturing in next one month is liquid as it will be turned into cash in one month’s time. Asset liability management is therefore, a process through which an organization has to match maturing of its assets (that is when they can be turned into cash) with maturing of its liabilities (that when they are falling due for poor payments). If an organization does not have sufficient assets maturing to fulfill its liabilities falling due then there is a risk that the organization may not be able to honor its committed obligation and this risk is called Liquidity Risk.

Assets, maturing within one year period are termed as Current Assets, while liabilities which are falling due within one year period are called Current Liabilities. Liquidity management is therefore, basically managing current assets and currents liabilities. If an organization’s current liabilities are more than current assets than such an organization has an immediate liquidity risk.

Liquidity risk in financial institutions is considered to be one of the most sensitive issues and a risk of high priority. As liquidity problem can result in a financial institution failing to honor its obligations it can result in loss of reputation, loss of credibility among lenders and depositors and has the potential to snow ball into a big crisis. If an MFI is not able to pay back savings of depositors when they come for withdrawal because they don’t have enough cash then it can immediately give wrong signal in the market. Rumors may spread that either MFI does not have intention to pay back savings or is financially bankrupt. Spread of this news with other depositors can result in panic situation who may also come for withdrawal and this could lead to a situation called run on savings, where everyone wants to withdrawal their savings compounding the entire problem. Similarly, defaulting on repayments to be made by the MFI to its lenders can result in loss of confidence of not only of current lender but also other lenders, which can make borrowings very difficult in the future. Credit rating of the MFI can also fall down which can create further problems in its fund raising.

As we now understand the downside of the lack of liquidity: should we suggest that MFIs remain highly liquid (that is having sufficient cash) at all the times to meet any contingency The answer to the question is No. One must understand that liquidity comes at a cost and if the assets are held in cash the MFI may not be able to earn any fee or interest. Idle assets should be avoided. An organization maintaining high liquidity will be losing on the returns from the asset it could have invested the money in. For an MFI it is generally the loan portfolio. If an MFI keeps high amount of cash it loses out on the interest it could have earned had that amount been invested in portfolio. The loss does not end there; the MFIs generally have this cash either from the borrowed funds or from the clients deposits and both sources of funds have cost attached to them. MFI has to pay interest on its borrowing as well as deposits irrespective of the fact that they are deployed in loans or not .Any cash laying idle means that MFI is losing on income from that cash while it has to pay charges on it in the form of interest. Hence idle cash results in losses. It is the responsibility of MFI to deploy its cash as efficiently as possible so that it (Cash) does not sit idle. So we see that while high liquidity brings the profitability and sustainability of an MFI down; insufficient liquidity results in the risk of defaulting on obligations. All financial institutions including MFIs have to juggle their assets and liabilities to strike the right balance. This balancing, to strike the right mix of not having too much idle funds while at the same time having enough funds to meet all obligations, is called liquidity management or asset liability management (ALM). The MFIs need efficient cash planning and management systems within the organization to make required funds available to all branches for their operations. Any excess fund lying anywhere in the system has to be timely transferred to a place where it is required.

b. Interest Rate Risk

Interest rate risk arises due to the fluctuations in the interest rates at which the MFI has borrowed from financial institutions. Such as banks can change their interest rates (at which they lend to MFIs) based on their own change in internal policies/strategies or due to changes in marco-economic conditions. Changes in rate may mean increase or decrease in the cost of fund for the MFI which directly affects its margins. If the bank interest rates drop it may result in extra income for the MFI while exactly opposite may happen if the interest rates go up. It is this uncertainly, which brings in the element of risk for the MFI and is called interest rate risk.

One may argue that an MFI may also revise its own interest rate to match the bank interest rates to manage the risk. However, in practical terms revising interest rates frequently is not possible for the MFIs because of various operational reasons such as:

1. Increasing interest upward in an issue of controls and is not easy even though MFIs put a clause that interest rate can be changed from time to time. Therefore, normally once an interest is indicated in a loan it is not varied till the end of the agreed terms. In case of investments the issuer may not.

2. Floating rate loans and investments are not popular in the country.

3. With simple MIS that MFIs generally have, revising interest rate means managing different sets of data, which becomes source of confusion and is very cumbersome.

4. MFIs generally have printed cards, formats for its loans, it involves cost to change these formation to a new interest policy

5. Staff training is also an issue; staffs are used to working with a certain policy and generally get completely accustomed to it. A new loan system requires the staff to learn new installment size etc. which against is time consuming and difficult.

6. It is also difficult to retrain the clients on new polices, new installment systems particularly when the clients may be used to a particular kind of repayments schedules.

Even if an MFI could change its own interest rate, it will not be possible to do that for the running loans. This is also knows as the reprising risk. If an MFI has a taken a loan on which the bank has put a clause that it can reprise (change the interest rate) the loan every six months and the MFI has invested these borrowed funds in one-year fixed rate loans to its clients, the MFI cannot change the interest rate before one year, although bank can changes its rate in every six months, which can result in losses.

MFIs have to be very cautions while they sign loan agreements with banks or other financial institutions. It is important to read such clause, be aware of them and their implications. Generally, it is better to have funds, which have long reprising terms or are of fixed rates even if they come at a slightly higher rate, as this will not expose the MFI to risk of interest rate fluctuation. Specialized financial institutions take calculated risks reading the market situation and expecting the market trend and try to take advantage of it. If the long-term fixed interest rate investments are funded through short-term floating rate funds, then if the interest rates in the market fall it results in profit for the organization. For example if an organization gives a loan for 18% for two year and the rate is fixed for two year. The organisation has given this loan from funds, which it has borrowed at 12% floating rate, which will be reprised every 3 months. If the overall interest rates in the market fall then the cost of funds for the MFI will fall down from 12% while its own interest rate will remain fixed at 18% thereby increasing the organization’s profit.

Interest rate risk for financial institutions with a large portfolio will be subject to greater complications. In the case of such institutions, a change in interest rate not only affect immediate profitability but can also change the value of the underlying assets and liabilities because of the change in the present value of the future cash flows. However, for MFIs interest rate risk is mainly related to the immediate pressures on the margin and adapting to new market conditions.

It is important that while raising funds such clause on reprising are carefully considered and compared between sources of funds. A s MFIs are not specialized in handling such kind of market risks it is often better to go for fixed interest borrowing even if they cone at a slightly higher rate. If there is a certainly about borrowings even if they come at a slightly higher rate. If there is a certainty about borrowing rates MFIs can have strategic such as higher scale of operations, cutting operational expenses or setting its own interest rates to factor in higher cost of funds. But if the rates are fluctuating then it can be difficult fro the MFIs to manage it.

We discussed three types of marker risks: liquidity risk, interest rates risk and foreign exchange risk. One can now appreciate the varied kind of risks that MFis are exposed to and which are all of very different nature be it credit risk, operational risk or market risk. This again underscores the need for strong risk management system with in MFIs.

Microfinance Risks – Strategic Risk-Part 4So far we have discussed about the various risks in the Microfinance Sector that affect an MFI. They are

Credit Risk ,  Operational Risk & Market Risk .

However, we are still not done with all the risk categories and in this last  section we shall disucuss about another important risk called Strategic risk.

Strategic Risks

Strategic risks are risks related to weak governance, weak leadership, poor strategic decisions as well as risks due to regulatory and administrative reasons. These are high impact risks and can adversely affect the organization for a long-term.

Providing governance is the job of the Board of Directors. It is a process through which Board ensures that the organization achieves its mission. Board directs and guides the management on various strategic issues, designs policies and reviews various reports to see that the organization is on the right way to achieving its vision and mission. However, if the Board of Directors were to take wrong decisions, design poor strategies or fail to review performance or take corrective measures in time, the organization runs. Board has to ensure that regulation s of the land are followed otherwise the organization may go out of the regulatory framework prescribed by the government and jeopardize the existence of the institution.

For providing good governance it is very important that the individual Directors of the Board are themselves well qualified and experienced and have clarity about the mission of the organization. The Directors themselves have to be convinced with the mission. The Directors have to work as

a cohesive unit, if there are conflicts among the Directors then the Board will not be able to provide right direction to the MFI.

As the MFI s evolve into structured organization, Strategic risk gains more and more importance. Since MFIs have to deal in issues of varied nature it is advisable that MFIs have Directors who also have diverse skills. There could be a mix of people with social, finance, banking and law background. An important aspect of micro-finance business is that although MFIs strive to become sustainable profit maximization is generally not the objective. The Board and the top management of the MFIs have to strike a balance between social objectives and commercial viability of an MFI. Therefore, it is necessary that the Board have people who can appreciate this kind of mission. If the Board cannot appreciate this kind of mission then there is a high probability that the MFI can from its mission.

Another very important aspect of strategic risk is regulatory risk. Regulatory risk refers to risk on non-compliance of the legal requirement as prescribed by the regulations. Micro-finance in India have mostly evolved from the not-for-profit societies or Trusts, which are not strictly regulated as compared to finance companies. As the MFIs grow in Societies and Trust may not be a suitable legal from the carrying out Micro-finance. MFIs are aware of this is why we now see many MFIs transforming from one legal entity into another for the sheer reasons of controlling the regulatory risk by adopting the suitable legal form. MFIs have option to co-operative, not-for-profit Company or non-banking finance company. It is a strategic choice for the MFI to adopt a correct legal form, which is most silted to its vision and mission and enables it to do what it is meant for.

Here again Board has an important role to play in deciding the suitable legal form for the MFI and to oversee smooth transformation. When the micro-finance started many MFIs were accepting public deposits even though it was not allowed. However, the increasing awareness and the realization of the risk it accompanied had most of the MFIs refund client savings. Regulatory risks are very serious in nature as they can bring the MFI in conflict with the law of the land. It is the responsibility of the top management to comply with all the legal requirements to avoid attracting such risk. It is also good to maintain cordial relations with the authorities by updating them on the MFIs activities.

Another form of strategic risk that has become important in recent times is of Political or administrative interference. As the MFIs are generally dealing with the poor their performance is subject to the scrutiny of politicians, administrators and the civil society. Various stakeholders have different interest in the clientele that MFIs serve. It could be a vote bank for some, while some stakeholders may genuinely be concerned about the protection of basic rights of the vulnerable sections. Issues of interest rate, recovery process, penalties, staff behavior with clients are all very sensitive matters and can easily become big socio-political issues.

Any behavioral lapse or any poor policy on part of MFI can bring disrepute to the institution. There could be violent protest, which can result in loss of portfolio, fixed assets and can even be dangerous from the perspective of staff security. There have been cases in India where MFI staffs have been threatened and offices vandalized over issues of interest rates and MFI staff coercion for repayments. These are risks, which have to be dealt immediately by the top

management and the Board. It is also necessary to always be aware of this kind of strategic risk, which can fast spurn out of control.

Strategic risk can also emanate from very rapid growth and expansion. This is quite a pertinent risk in the current scenario with most of the MFIs growing very rapidly. Rapid expansion means going to new areas, recruiting new staff and operating through them, making fast disbursements and also arranging for funds. Fast growth increases the volatility in the system and is therefore risky. Going to new areas or running operations through new staff has its own risk. It is also necessary that all the systems such MIS, internal controls also keep pace with the growth. If the systems do nit keep pace with the rapid expansion it can result in losses.

Also it requires high coordination at the top management particularly between the Operation Manager and the finance Manager. This issue was discussed while discussing liquidity risk. Coordination is also required among other department such as HR, which is responsible for recruitment, training and promotion of staff. With expansion staff has to be fast recruited, trained and promoted. It is important therefore that growth is planned and coordinated. MFI has to ensure that all the systems and funding plans are in place to support rapid growth.

Managing Strategic Risks

In order to manage strategic risk it is necessary for the MFIs to have a clear vision and mission. Many MFIs still do not consider vision and mission statement as important and many consider it just a mere formality. However, it is absolutely necessary for an MFI to clearly define what it wants to achieve. A clear vision can guide the organization and often help it in taking many strategic decisions.

Once an MFI has clarity of it own mission then it has to choose a right kind of Board members who agree with the mission of the organization. The Board should be a mix of people having variety of skills and strengths. They should be able provide strategic guidance when the organization needs to make critical decisions. Board should also be proactive in assessing risk and set the acceptable levels of risk.

Transparency is an important issue, which can help, in managing political and administrative risks to a large extent. MFIs should maintain transparency on its interest rates and other polices. It should also regularly report its information through Annual reports and at other forums. Board device strategies to keep various stakeholders informed about the activities of the organization and direct the management to implement fair policies. MFIs should try and involve and interact with various stakeholders such government authorities, local political lenders and media persons on the organization’s philosophy, its activities and other policies.

Business ethics is another important factor that cannot be comprised with. With micro-finance sector having gained a lot of recognition and is exposed to the larger audience. This makes it indispensable to define ethical behavior and code of conduct while dealing with clients. Any deviation from this should be seriously dealt with. It has to be considered that sometimes strict policies on repayment and staff benefit linked to repayments can also boomerang. While designing such policies it is necessary to be aware of its pros and cons and limitations.

The effect of organization’s policies as well as impact of regular operations has to be monitored Mechanisms within the organization are needed which can provide direct feedback to the management and the Board on the field realities, client satisfaction levels and small issues which can emerge as big strategic threats. There should be immediate response from the top to address sensitive issues of socio-political, regulatory, administrative or communal nature.

With growth in the size of MFIs as well as of the sector the complications also increase making governance increasingly complex. In a big size institutions the stake of all involved parties such equity investors, lenders, regulators also increase and hence Board has to assume greater responsibilities in providing good governance, which only can keep strategic risk under control.

Risk Management Framework

We have discussed the various risks that MFIS are exposed to. We had discussed earlier that risk management is a continuous process of identifying risk and addressing them to keep them under acceptable limits. Also risk managements framework has to be pro-active and forward looking rather than just reactionary. MFIs need to constantly identify the risks and measure them and then design suitable policy intervention to address those risks.

GTZ has come out with an effective risk management framework. According to it a good risk management framework in an organization should have the following features.

• MFI should have processes in its regular operations to identify measure and monitor different types of risks that an MFI is exposed to.• Should have continuous feedback loop between identification, measure and risk and processes to manage them. In simple terms, there should be processes to identify risk and the repot on this should be provided to departments managing them. Based on this feedback management will improve the process to manage risk.• Management should consider different risk scenarios and be prepared with some solution if the risk comes true.• Should encourage cost-effective decision-making and more efficient use of resources• Create an internal culture of “self-supervision” that can identify and manage risks long before they are visible to outside stakeholders or regulators.

For effective management of risk ‘Risk Management Feedback Loop’, which is a six-step cycle, can be followed. The six steps of the cycle are:

1. Identifying, assessing, and prioritizing risks2. Developing strategies and policies to measure risks.3. Designing policies and procedures to mitigate risks.4. Implementing and assigning responsibilities5. Testing effectives and evaluating results6. Revising policies and procedures as necessary

This feedback loop is a management tool and can be followed are various levels. E.g. a Branch Manager can follow the loop for his/her branch while a CEO can follow it at the organization

level. The exercise can be done from time to time to take to take stock of the risk scenario and be prepared accordingly. The type of risks identified and their severity will changes from time to time, hence it is necessary to constantly carry out this risk analysis.

This section draws from GTS’s Risk Management Framework for MFIs, July 2000.

Identifying, assessing, and prioritizing risks:

The first step in risk management cycle is to identify different risks. In above sections we had discussed the genepageral categories of risks that MFIs face. However, here specific risks pertinent to the MFI have to be identified. E.g. liquidity, legal compliance, competition, portfolio quality, reputation etc can be identified as the risks for an MFI. Once the risks have been identified it necessary to assess the possibility of the adverse event occurring. Based on this information the MFI has to prioritize the risks. This can be done using a risk management matrix. The MFI can lay down all risks in the form of a risk management matrix, which can help it in prioritizing the risks.

In the risk management matrix MFI lists down all the risks it is exposed to. In the second column of the table above, it tries to assess whether that threat is low, moderate or high for it. In the third column it is assessed that how are the existing risk management system within the organization to counter that threat; whether they are weak, acceptable or strong. The fourth column makes the final assessment on the risk exposure of the organization based on the aggregate of the previous two columns.

If the quantity of risk is high and quality of risk management is weak then the aggregate risk is high. The management needs to take as action as it is exposed to that particular risk and does not have sufficient systems to counter it. The fifth column shows the trend of risk as compared to last time when similar exercise was done. E.g. the first risk Credit Policy and underwriting shows aggregate risk profile as ‘moderate’ and direction as stable. This means that while last time such an exercise was done, the aggregate risk on this parameter was ‘moderate’. Since, it was ‘moderate’ last time and now, the direction is ‘stable’. This means that it is not going up or down. Similarly, in Portfolio monitoring and collection risk profile is ‘high’ and direction is ‘stable’. This is not good as despite being recognized high last time it still remains ‘high’ which is not good.

Effort should be made so that the trend is ‘decreasing’ for high risks and stable for low risks. The direction gives the information that whether the steps taken to counter that risk have yielded sufficient results or not. If the risk profile has been stable at high level or it has been increasing then it is warning for the management to react fast or modify its risk management approach for that particular risk. However if it has been coming down then it is a signal that risk management for that particular risk is in the right direction.

Developing strategies and policies to measure risks: Once the risks have been identified and prioritized the MFI has to design suitable policies to measure these risks. The top management and the board generally set policies for the measurement of risk and the acceptable limits of risk. It is a strategic decision to decide the levels of risk that the organization is willing to take. An

organization may take aggressive stand and go for rapid growth in the beginning and way be willing to take the associated risk while another organization may like to have gradual growth keeping the risk profile low. The Board plays a crucial role in designing such strategic and deciding what kind of risks have to be avoided, controlled, accepted or transferred. Cost-benefit evaluations, business targets, capacity to absorb risk and external environment are some of the factors that are taken into consideration while taking decision on risk strategy.

Designing policies and procedures to mitigate risks: Once the policies for risk measurement and acceptable thresholds of risks have been set, the MFIs then have to design policies and systems to mitigate risks. All policies and procedures of each department are documented in the form of manuals. Operation Manual is one of the most important manuals, which documents all the policies and procures for the operation department and plays a vital role in controlling credit and operation risk. All policies related to disbursement, collection, cash handling, cash deposition, cash limits, process of recording, reporting, reconciliation of records, signatories, limits and authorities are to be clearly defined in the Operation Manual.

Similarly, clear policies on human resource regarding recruitment, training, incentive/disincentive systems, disciplinary action, promotions, employee benefits and code of conduct has to defined. Another important manual is on Internal Audit, it is necessary that clear policies on internal audit are developed. It should lay down the policies on frequency of audit, forms and formats for audit, scope of audit, methodology to be followed, samples to be taken and reporting system. Such clearly laid out policies and processes are critical for risk management. Lack of polities results in lack of standards to be followed and in dilution of control.

Implementing and assigning responsibilities: Once the policies have been framed it is very important that they are implemented by assigning specific roles and responsibilities to each staff. Without setting responsibility it is not possible to hold anyone accountable for the lack of implementation or for any deviation. It is also important that policy deviations be taken as a serious issue within the organization. If there are deviations those responsible for implementing such as Branch Manager, Area Manager, Operation Manager, Internal Auditor etc. have to be held accountable.

There should be clear procedures for handling cases of policy deviations. These could be in the form of asking for written explanation, marking in the personal staff file impacting promotion, adversely influencing the incentives, supers ions or even dismissals based on the severity of deviation from the policy. It is also important that any modifications or changes in policies are clearly communicated across the staff and the manuals are regularly updated and copies of manual are made available to staff at all levels.

Testing effectiveness and evaluating results: Once the policies have been implemented the top management has to evaluate the results. It should receive regular information from the field and should evaluate how effective the policies have been in mitigating the risks and whether the policies have been able contain the risks within the acceptable limits or not. MIS and reporting system plays a crucial role in this. Effective MIS can generate timely and accurate repots, which has to reach in appropriate form to different levels. Field information should reach the branch on

daily basis. This could be in form of details of groups, new clients formed, dropouts, overdues, etc.

While Area office should get the consolidated branch information. An Area office may have several branches under it, so all the repots of various branches should get added at the area level and to form an area level report. The same information should be further consolidated Area wise to be sent to Head Office. Head Office should also receive this information in reasonable time, which could be weekly. Although with intervention of technology, particularly MFIs working in urban areas can consolidated all information and Head Office can receive it on daily basis. However, even in remote areas, information should reach Head Office can evaluate results and see the effectiveness of its policies. Performance should be reported to the Board, which can then take further actions based on the results. The Board must receive concise reports, which can enable it to understand the overall performance through critical indicators. Report to Board must include.

(i) Details of disbursements, repayments, saving collection – product wise breakups(ii) New clients formed, drop outs, net growth in borrowers and savers – product wise breakups(iii) Variance analysis: comparison of targets and achievements and variances(iv) Portfolio quality PAR with ageing, repayment rates(v) Profitability: Operation Self-sufficiency, Return on asset(vi) Trend of ratios: PAR, OSS, Return on portfolio, capital adequacy, staff/branch efficiency(vii) Funding situation – funds required and current position (debt/equity)(viii) Financial statements: Balance sheet and income statements

This is the most critical information that must be reported to the Board. In addition to operation reports, Internal Audit report, which is presented directly to the Board, provide valuable feedback on the overall risk environment of the organisation. It enables cross-verification of the operation reports and results being presented to the Board, as Internal Audit is an independent check.

Revising policies and procedures as necessary: If on evaluation of results it is found that the policies and processes have not been effective in managing the risks then they have to be revised and redesigned and then re-implemented. It has to be evaluated whether the policy implementation has brought the risk down to the acceptable levels and has it been working as expected. If the results are not as per expectation then the policies have to be revised and fine-tuned and re-implemented.

The risk management loop is a good tool that can help in proactively managing the risk and keeping them under the limits that the MFI considers acceptable.