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Risk Management in Microfinance Institutions

Article  in  SSRN Electronic Journal · May 2008

DOI: 10.2139/ssrn.2885361

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

RISK MANAGEMENT IN MICROFINANCE INSTITUTIONS

OLUYOMBO, ONAFOWOKAN ONABANJO

and

OLABISI, JAIYEOLA

Department of Financial Studies

Redeemer’s University
Km. 46, Lagos – Ibadan Expressway
Redemption Camp Post Office
Ogun State, Nigeria.
E-mail: ooluyombo@yahoo.com

Abstract

Microfinance is fast becoming a household name globally due to its acceptance as a means of

reaching those that were not served by the conventional big banks. The survival of

microfinance institutions in any country depends majorly on the overall political and economic

environment of such a nation. However, the greatest challenge the microfinance institutions

will face globally in pursuance of its financial intermediary role is how best to manage its

credit and risk exposures in comparison with the rising competition, sophistication and

turbulent economic and social environment especially in developing nations. After examining

different concept of microfinance and risk management, this paper focus on those peculiar risks

associated with microfinance business and suggested how regulators and operators in the

sector can best guide against distress or imminent collapse while striking a balance between

profitability and unhealthy risk exposure.

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

JEL Classification: G21

INTRODUCTION

Business is all about risk taking. However, the level of risk from one industry to another varies

and it depends largely on the nature and services provided by the organization. Banking

business world wide is exposed to more risk than any other business concern as a result of their

trading in money market instruments. Though, some Microfinance Institutions (MFI) does not

take deposit, but operate through grants and donor fund. However, majority of them (MFI) are

deposit taking organization just like a conventional bank. Hence, as a result of accepting

deposit and giving of credit, the MFI are therefore exposed to risks that are inherent in their line

of business.

In order to prevent the occurrence of distress in financial sector as experienced by conventional

banks in some countries in the past, risk management in MFI need to be considered now.

According to Oluyombo and Ogundimu (2006), MFI are not bank, even though, some seems to

work like banks while others may be called Microfinance Bank (MFB), but their services and

products are peculiar and targeted to the low income earners. Hence, the need for overview of

microfinance before risk issue is examined.

CONCEPTUAL CLARIFICATION

There is need to examine some concepts like microfinance, features of microfinance, risk and

risk management in this paper.

Overview of Microfinance

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

According to Asian Development Bank (2000), microfinance is the provision of a broad range

of financial services such as deposits, loans, payment services, money transfers, and insurance

to poor and low-income households and their micro enterprises. Microfinance services are

provided by three types of sources: formal institutions, such as rural banks and cooperatives;

semiformal institutions, such as non-governmental organizations; and informal sources such as

money lenders and shopkeepers. Institutional microfinance is defined to include microfinance

services provided by both formal and semi-formal institutions. Microfinance institutions are

defined as institutions whose major business is the provision of microfinance services.

Otero and Rhyne (1994) defines microfinance as a revolution that involves the large scale

provision of small loans and deposit services to low-income people by secure, conveniently

located and competing commercial financial institutions thereby generating the process needed

to democratize capital. This definition means that the numbers of microfinance institutions

should be enough to meet the needs of low income earners in the nation through the provision

of loan facilities and to give room for healthy competition among them.

Robinson (2001) described microfinance as small-scale financial services-primarily credit and

savings-provided to people who farm or fish or herd; who operate small enterprises or micro

enterprises where goods are produced, recycled, repaired or sold; who provide services; who

work for wages or commissions; who gain income from renting out small amounts of land,

vehicles, draft animals, or machinery and tools; and to other individuals and groups at the local

levels of developing countries both rural and urban.

This definition is encompassing as it tries to state those who may benefit from microfinance

institutions and also inform that developing countries need microfinance institutions more than

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

developed countries and especially, that microfinance is meant for those operating small and

micro enterprises.

Microfinance has been described as an economic development approach intended to benefit

low-income women and men. Ledgerwood (2000). It means that the purpose of microfinance is

to reach the low income earners either in the urban or rural areas with financial services that

will enable them create wealth without any discrepancy as to the sex of such person.

Ndiaye (2005) opined that access to improved financial services – access to more and better

ways of turning savings into lump sums – helps poor people from sliding deeper into poverty

and helps them lay foundations for their ambitions to better themselves and their families.

Microfinance is about providing financial services to the poor who are traditionally not served

by the conventional financial institutions. Three features distinguish microfinance from other

formal financial products. These are: (i) the smallness of loans advanced and or savings

collected (ii) the absence of asset-based collateral, and (iii) simplicity of operations. Central

Bank of Nigeria (2005). This give a clue that the CBN is aware that there are people that are not

served by the conventional banks because the loan requires by them is very small compare to

the activities and loan portfolio of these banks.

Microfinance institution is now a growing phenomenon all over the world. It is emerging as a

rapidly growing financial services industry worldwide as a solution to the crippling effects of

the conventional banks interest on the poor and those operating micro and small scale

enterprises (MSSE).

Microfinance can therefore be define as an economic approach to take financial services to

those that are hitherto un-reached at a reasonable fee that is affordable and economic to the

users of such services, and also, using funds from the providers of financial services to generate

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

adequate returns for the users, thereby building up their enterprises and creating employment

opportunities which will reduce the poverty level in the economy. Microfinance is a holistic

approach that has been used in different countries to alleviate the plight of MSSE both in the

rural and urban areas in accessing fund as at when required which was not possible from the

conventional banks.

Features of Microfinance Institutions

The distinguishing features of sustainable finance as totally different from other banking

institutions as identified by ADB (2000), CBN (2005), CBN (2006) and Oluyombo (2007)

includes the following:

i. The smallness of loans advanced to their customers

ii. Savings from the customers are very small

iii. The absence of asset-based collateral

iv. Simplicity of operation

v. The extension of banking services beyond economic to social and cultural upliftment of

the people.

vi. Development of good inter-personal relationship between the bank and her customers

which lead to high degree of trust and openness on both parties.

vii. Their products and services are targeted towards MSSE in their locality.

Risk

Risk can be examined both internally (within the MFI operations) and externally (factors

beyond the control of the MFI). Van Horne (1983) defines risk as the possibility that the actual

return will deviate from that which was expected. It means that result realized from an

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

investment may differ from the actual plan. Hence, risks evolve because there is plan that is not

met due to unfavourable circumstances or conditions. Risk was also defined as the chance of a

loss, or the loss itself. Dunn, Kalaitzandonakes and Valdivia (1996).

According to Adewunmi (2005) to survive in today’s very competitive and turbulent economic

and social environments, business and financial institutions in particular must learn to live with

risks by intelligently and professionally managing them (risks). Risk is the probability that the

consequence of an event will be different from the original plan due to certain factors and that

the outcome may not be in the interest of the planner. It should be noted that there would be no

risk where there is no exposure and uncertainty. Where outcome of a decision can be predicted

with 100% level of accuracy without any exposure, then risk will be absent. However, in

today’s business world, the outcome of any plan and/or decision is based on many parameters

and economic factors such that MFI are exposed to outsider and there is no guarantee that all

loans and advances will be paid as at when due, hence risk is present in MFI.

RISKS IN MICROFINANCE BUSINESS

Like any other business organizations, those involved in microfinance business are also exposed

to some peculiar risk. Although, their (risks) names may seems to be the same with other sector

of the economy. However, these risks affected MFI in different ways.

Risk Factors of Microfinance Institutions

The following factors brought about a different risk for MFI compared to other conventional

banks.

i. MFI services and products are targeted to the poor and low income earners in the

society.

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

ii. Most clients of MFI do not have physical assets (house, land, automobile, plant and

machinery) and financial assets (share, bond, stock and debenture certificates) to

pledge as collateral for loans and advances collected.

iii. There is no supportive regulatory and supervisory policy framework on the part of

some government which lead to physical and economic challenges for MFI.

iv. Where regulatory framework exists, the peculiarity of MF business in most cases is

not taken into consideration. In such country, MFI and other banks are regulated

under the same policy.

v. The ownership structure of MFI is dominated by donors in many countries instead of

private investors as owners. (MFI are dominated by private ownership in Nigeria).

Major Risks in Microfinance Sector

Haven’t considered the risk factor of MFI, the question that follow is what are these risks?

Berenbach and Churchill (1997) and Ledgerwood (2000) identified four main areas of risks that

are peculiar to MFI as: Portfolio risk, Ownership and governance risk, Management risk and

New industry risk. Adewunmi (2005) recognized risks like: Credit risk, Operational risk,

Interest rate risk and Liquidity risk as those affecting financial institutions. However, this paper

is of the opinion that Liquidity risk, Credit risk, Foreign exchange risk, Ownership return risk

and Operational risk are those that affect MFI directly and they are discussed below.

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

Figure 1. Major Risks in Microfinance Sector

Liquidity Risk Credit Risk

Operational
Risk
Foreign
Exchange Ownership
Risk Return
Risk

Liquidity Risk

This is the risk associated with meeting regular and unplanned high withdrawals by large

depositors who are always few in numbers. Some MFI get funds from mandatory legal deposit

from banks and government at different levels. For such MFI, a change of government or

change in government policy may reduced available fund to MFI considerably, which posses

liquidity risk to them. In Nigerian for example, the CBN encourage each state government to

dedicate an amount of not less than 10% of their annual budget for on lending activities of

microfinance banks in favour of their residents.

Liquidity risk will also arise through donor fund which the donors might call back for some

period or suspend forever. In such case, the financial base of such MFI will be threatened.

Credit Risk

Olfield and Santomew (1997) opined that credit risk arises from non-performance by a debtor.

It may arise from either an inability or an unwillingness to perform in the pre-committed

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

contracted manner. This can affect the lender who underwrote the contract, other lenders to the

creditor, and the debtor's own shareholders. This is the risk associated with default in loan

repayment as at when due or the uncertainty of meeting financial obligations by client at the

right time. This risk is pronounced in MFI as a result of inadequate collateral for loan disbursed

if the borrower is unable to pay due to financial constraint and/or complete refusal to pay.

Credit risk is not limited to unrepaid loans and advances alone, but extend to those loan

applications that were turn down by MFI, because it may hinder their growth and cause

reduction in size, earnings and profitability.

Ownership Return Risk

It is apparent that MFI can not boast of profit like the conventional banks. Where the owners of

MFI are desirous of getting a sizeable return on their investment in a short time, which is

common in a private ownership led businesses; this may lead to unhealthy practice in the

operation and management of MFI so that appropriate return can be given to the owners.

Actually, this risk is in force from the inception of MFI except the owners see their investment

as part of their modest contribution in alleviating the plight of the poor at the short run before

dividends could be declared. However, this is not the case because average investors want

adequate return from the investment at shortest possible period, or else, the fund will be

invested in another line of business with less risk and better return.

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

Operational Risk

Adewunmi (2005) defined operational risk as the risk of loss resulting from inadequate or failed

internal processes, people and systems or from external events. However, the operational risk of

MFI essentially has to do with the employee who works in the organization.

In most nations, banks’ employee earns relatively more than many other sector of the economy.

If employee of MFI see them self as banker and form their mind set, it will create a disorder and

operational breakdown. It is expected that this will lead to agitation for better welfare package

and may tend towards unionism which hamper the operation of MFI since they will found it

difficult to pay similar remuneration like the conventional banks and other notable financial

institutions.

Foreign Exchange Risk

Most MFI, especially those in developing countries source for funds from international

organization/donor in foreign currency but lend such fund in their local currency. Despite

lending in local currency, the repayment to the agencies/donors will always be in foreign

currency. As a result of inconsistency in foreign exchange policy in most developing nations, at

the time the loan is due for repayment, the exchange rate would have gone up, which will made

it impossible for MFI to earn profit from the fund. Repayment may have to be met from another

source which may wipe out depositors funds if adequate care is not taken.

RISK MANAGEMENT

Risk management (RM) is a term that is synonymous to different area of human endeavours.

Risk management was defined by Baffa (1990) as the planning and controlling of all the

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

conceivable elements of risks which are inherent in the daily operations of an organization in

order to ensure the organization’s continued existence as well as the realization of its set goals

and objectives’. Meyer (2000) opined that in managing risk, banks must decide which risks to

take, which to transfer and which to avoid. If banks have options as to their risk exposure, do

MFI have such options?

Risk Management Tools

Risk need to be managed in MFI to avoid mishaps, hardship and loss of financial and human

assets and to guarantee continuous supply of loanable fund to the end user as at when needed.

According to Olfield and Santomew (1997), it has been argued that risk is an essential

ingredient in the financial sector and that some of this risk will be borne by all but the most

transparent and passive institutions. In short, active risk management has a place in most

financial firms.

Risk management is an integral part of monitoring and evaluating both liquid and illiquid assets

and depositors liabilities of MFI to ensure the sustainability of the industry. It should be

understood from the outset that risk can not be managed in any MFI if the management did not

set a goal in that direction. Therefore, the first thing to be done is that there must be a written

goal and drive from the owners and managers as to the need to manage risk on daily basis

before they arise and/or as they become known.

Furthermore, the management should put in place a risk management policy and procedures

covering all areas of their microfinance business, including those areas they (MFI) intend to

venture into in the nearest future. The policy should be followed in managing risks as they are

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

identified in the industry or in their own location, but not necessarily until it affect the business

negatively.

Management should also be ready to review the RM policy and procedures at regular interval

especially when there is change in regulation, economic policy and other indicators that may

affect their business locally and internationally.

The need for investment strategies and guidelines can not be over emphasized, because this will

help considerably to manage credit risk. Not all investment opportunity presented to MFI

should be financed as a result of the volatile of the industry or trade that may be involved. In

this case, selected trading should be identified, especially those with low risk profile. However,

this depends on the deposit base of the MFI, location and her source of fund.

A motivated employee is the one that will defend the course of his or her employer. Risk can

never be managed without the employee, hence MFI management should be ready and willing

to properly remunerate and motivate the workforce. The motivation should not be limited to

financial reward alone, but it should include an open acknowledgement of the employee who

works very well in the reduction of the firms risk without compromising the business ethics.

From economic point of view, risk should be prioritized using a simple scale of preference in

handling them (risk). Although, all form of risk should be managed, but the impact of these

risks on MFI business differs considerably, hence these risks should be analysed and given their

appropriate scale.

For example, ownership return risk must be given higher priority, if not; all other risk can not

be managed if the owners agitate for more return on their investment. Prioritization of risk will

help the MFI management to know the level of resources that will be deployed to each risk and

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

the likely effect on their business. If this is done, the owners and management will not be

caught unaware when these risks are about to occur and/or increase.

Sound internal control system (ICS) is another tool for risk management which has proved to be

necessary and reliable in any financial institution. The ICS should be able to monitor, review

and evaluate all business processes on regular basis to be able to determine the effectiveness or

otherwise of the processes in tracking risk.

This process is very essential because risks are assumed out of the daily business operation as a

result of mistake, incompetence, fraud and lack of concentration by one or more personnel that

do not do one thing or the other during or after the business process. However, with sound ICS,

some or all of the processes left undone can be detected early enough so that corrective

measures can be taken on time before the risk is passed to the MFI.

CONCLUSION

Risk is a daily phenomenon in every area of life and business. The management of these risks is

therefore important to reduce to the barest minimum the untold hardship of not recognizing and

managing the risk.

MFI are therefore enjoyed to rise above board in their risk management strategies and

procedures to protect the industry and also to encourage the generous national and international

donors who are eager to see many people lifted above the poverty level.

If the owners and management of MFI are not proactive and fully committed in their risk

management, the future of many poor people around the world will be jeopardized.

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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance
Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.

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