UNIVERSITY OF DAR ES SALAAM

BUSINESS SCHOOL
DEPARTMENT OF FINANCE
 
 

FN212: MICROFINANCE
Topic Five Part I: MFIs RISKS

Godsaviour Christopher
(Bcom – Udsm, MA Economics – Udsm)

1
 Outline
• Introduction
• Types of risks and management strategies
• Pricing strategies and interest rate
determination
 Introduction
• A risk is the probability that an actual return/outcome
on an investment will be lower than the expected
return.
• MFIs are very vulnerable to risks because
– their smallness in size, which makes them to be highly
dependent on donor financing and external debt, which
might be uncertain or not provided according to MFIs
expectations,
– their levels of formality, i.e. the majority of them being
semi-formal or informal, and therefore, are not fully
protected by legal and regulatory framework;
 Introduction (cont’d)
– their target clients are low income households, informal
and small businesses, who keep no records, have low
educated and experience, lack collateral and are very
vulnerable to social and economic changes;
– the target location, i.e. less developed countries, where
the legal and regulatory frameworks to enforce contract
compliances are weak.
• Thus, MFIs , they cannot eliminate their exposure to
risks, but through an effective risk management
process, they can significantly reduce their
vulnerability.
 Categories of Risks
• Categorization based risks within MFI’s
control:
– External risks
– Internal risks
• Categorization based on courses:
– Operational risks
– Financial risks
– External risks
 Operational risks
• These are vulnerabilities confronting MFIs due
to poor, ineffective or inefficiencies in
management and execution of MFIs’ activities.
• They are within the MFI control.
• Subcategories:
– fraud risks,
– security risks,
– system integrity risks and
– human capital risks
 Fraud risks
• Occur when a MFI has:
– weak information management systems,
– no clearly defined policies and procedures,
– no authorization limit on lending,
– Clients are unaware of proper procedures and requirements
• As a results:
– Credit officers may lend money to a ghost client or to themselves
and their relatives,
– Credit officers may charge unofficial loan fees and penalties and take
them
– board members may approve the provision of loans to themselves or
their friends and relatives without following appropriate procedures.
 Security risks
• Causes
– Poor security system in low income countries
where the majority of MFIs operate, coupled with
– high poverty in areas where MFIs operate, and
thus, high temptation which may lead to thefts
 System integrity risks
• Occur when a MFI has a weak information
(operational and financial) management system.
– Lack of proper records and reports that are timely
provided
– Weak/No internal and external audits of operational
and financial systems to verify the integrity of financial
and operational activities,
• As a result the MFI is vulnerable to:
– Loan default, late payments, frauds, theft, inability to
respond to changes in the environment.
 Human capital risks
• Occur when a MFI
– uses low trained, inexperienced and unmotivated personnel,
– Lacks clearly defined tasks and responsibilities
– Lacks operational manuals to guide workers
• As a result
– High inefficiencies and ineffectiveness in the provision of
financial services to clients,
– Non follow-up of loan repayment
• and thus,
– increased operational and financial (bad-debts) costs
– poor quality of services.
Operational Risks control and management

• Control and management measures:

– preventive measures, which inhibit undesirable
outcomes from happening, and
– detective measures, which identify undesirable
outcomes when they do happen and take actions
accordingly.
 Preventive measures
• The presence and application of a good labor
policy to facilitate
– hiring of trustful and competent employees,
– motivate of employees,
– provision of on-job training,
– stipulation of clear tasks and responsibilities
 Preventive measures (cont’d)
• The presence of operational manuals that
specifies
– tasks,
– working procedures and segregation of duties to
prevent intentional wrong doing,
– requirements and responsibilities to enable
employees act accordingly
 Preventive measures (cont’d)
• The presence and application of a good
credit/loan/financial policy that requires
– the presence of credit committee,
– authorization limits for lending and
– use of MFIs resources at different levels to prevent
frauds;
– Client education on the nature of services offered
and their obligations;
 Preventive measures (cont’d)
• The presence of well functioning information
management system to facilitate
– record keeping and
– preparation and provision of reports on time
• Installing sufficient security measures (i.e.,
locks, guards, safes) to protect cash and other
assets.
 Detective measures
• Frequent bank reconciliation;
• Frequent operational auditing and staff performance
monitoring to ensure policies and procedures are followed;
• Undertaking internal and external audits of financial
reports;
• Visiting clients to ensure that their loan and saving account
balances and transaction dates correspond with the MFI’s
records; and
• Installing a customer complaints and responses
mechanism.
 Financial risks
• Financial risks include credit risks, liquidity
risks, interest rate risks and foreign exchange
risks.
• Credit and liquidity risks are internal.
• Interest rate risks are partially internal and
partially external.
• Foreign exchange risks are external
 Credit risks
• Credit risks occur when
– their borrowers fail to meet their loan obligations, i.e. timely
repayment of loans and interests.
• MFIs’ vulnerability to credit risks is high as
– their clients do not keep records, thus selection of good clients
becomes difficult
– Clients lack formal collateral and thus sale of pledged assists is
somewhat impossible,
– Clients are relatively low income earners, and therefore, they are
vulnerable to negative changes in the business environment.
– Target of clients in specific sector or location which makes
diversification of risks less applicable.
 Liquidity risks
• These occur when MFIs fail to meet their payments
obligations as they fall due.
• Causes – failure to match cash inflows and outflows
• Consequences:
– borrow expensive short-term funds, which is sometimes
unreliable,
– MFI’s reputation negatively affected
– Loose clients
– Increased delinquencies and defaults
 Interest rate risks
• Occur when a MFI’s funders’ interest rates rise before it
can adjust its lending interest rate. This happen when
– The environment which MFIs operate is characterized with
high inflation.
– MFIs have limited bargaining power
– Funders charge MFI variable interest rates while the MFI
charge clients fixed interest rate.
– In financial cooperatives in Tanzania, rates are agreed in the
general meetings which are sometimes once a year. After
getting the loan from Bank MFI cannot wait for the meeting.
• Thus, a decrease in interest rate spread, and thus loss.
 Foreign exchange risks
• Occur when a MFI finance its assets (loan portfolio)
with liabilities denominated in foreign currencies. The
assets are denominated in local currency which is
highly vulnerable to devaluation due to high inflation.
– i.e. a MFI gets a loan in foreign currency from a funder,
– converts it in local currency, then
– offers loans to its clients.
– The clients repay loans in local currency while
– the MFI repay its debt in foreign currency.
– When there is devaluation of the local currency, the MFI
will face foreign exchange currency risks.
 Foreign exchange risks (cont’d)
Scenario 1 - SAR Scenario 2 - SAR
USD (no devaluation) (Devaluation)
Amount lent to a MFI 100,000 600000 600000
Interest rate 0.20    
Exchange rate at due date   6 7
Amount due 120000 720000 840000
Principal 100,000 600000 700000
Interest 20000 120000 140000
Actual costs of funds 20,000 120,000 240,000
Interest revenue (rate 70%),   420000 420000
Operating costs (40% of
loans ) 40% 240000 240000
operating income   180000 180000
profit/loss   60,000 -60,000
 Financial risks management – credit
risks
• Credit risks control and monitoring involves
– the application of preventive control measures
before MFI issues a loan . This aims to reduce the
potential for delinquency or loss.
– monitoring/detective measures are taken after
issuing a loan. These aim to reduce actual losses.
• Important credit risks control measures are
related to product design, client screening,
credit committees, and delinquency
management.
 Credit risks control – product design
• Loan design features should try to meet the needs of
clients.
• Features are:
– Eligibility criteria: business experience, savings, membership
– loan size: small loan with the option of getting the next loans, etc.
– Loan term – short, medium or long,
– repayment schedules: weekly, monthly, lump sum after
harvesting
– collateral requirements: non-traditional collateral (i.e. personal
guarantees, household assets, forced savings) and collateral
substitutes (i.e., peer group lending methods,
– timing of provision
– Interest rate
credit risks control – client screening
This is performed to ensure that selected loan applicants are willing and
able to repay a loan.
Screening is based on five Cs:
• Character: An indication of the applicant’s willingness to repay and
ability to run the enterprise. Gather information from other people
like community leaders, relatives, neighbors, etc
• Capacity: Whether the cash flow of the business (or household) can
service loan repayments. MFI offers small loans and learn about the
client
• Capital: MFIs may collect information on the assets and liability of
applicants’ businesses and/or households.
• Collateral: assets the applicant pledges to secure loan. MFIs use peer
groups, compulsory savings, household assets and cosigners.
• Conditions: The analysis of a loan applicant by conducting SWOT
analysis of her business or household.
 Credit Risks Control–Credit
Committee
• Presence and application of credit committee
with at least two members
• The presence of a written policy on loan
approval authority
• For group loan, involvement of group
members in loan approval is necessary
 Credit Risks Control – Delinquency
Management
• Applied after the provision of loans
• Include the following measures:
• Institutional Culture: This involves the embracement of zero tolerance
of arrears and immediate follow up on all late payments
• Client Orientation: communicate a zero-tolerance institutional culture,
together with the services offered and procedures that will be followed
in case of arrears, to each new client before she receives a loan.
• Staff Incentives system: a system creating staff involvement in
discouraging delinquency.
• Delinquency Penalties: Penalize clients for late payment. E.g. penalties:
fees pegged to the number of days late and limiting access to repeat
loans based on repayment performance.
• 5) Enforcing Contracts: certain accommodations can be made for
borrowers who are willing but unable to repay. Apply severe penalties
to delinquent clients with uncooperative behavior.
• 6) Loan Rescheduling: for clients who are willing but unable to repay,
reschedule loans and maintain a small number of rescheduled loans.
 Credit Risks Monitoring
• Involve the monitoring of portfolio quality
ratios on, at least, a monthly basis
• Be aware of the number and value of
rescheduled loans
• Maintain an aging of delinquency report
 credit risks monitoring (cont’d)
Portfolio quality ratios:
• Portfolio at Risk: is used as the indicator for monitoring
portfolio quality.

• Loan Loss Ratio: indicates the extent of unrecoverable loans

over the last period.

• Reserve Ratio: indicates adequacy of reserves in relation to

portfolio.
 credit risks monitoring (cont’d)
• Loan Rescheduling Ratio: indicates the extent of loans that
have been rescheduled in the last period.

• MFIs may further need to monitor their loan portfolio

composition and quality by clients’ attributes (e.g. region,
business sector, loan cycle number and loan size) to reduce
the institutions' vulnerability to external threats that may
affect a portion of clients
 Financial risks management – Interest risks
monitoring
Interest rate risks monitoring is through the following ratios:
• Net interest margin (spread): this indicates the income remaining to
the institution after the payment of interest to all liabilities, then
divided by the average total assets or the performing assets of the
institution.
• OR: take interest revenue minus financial expenses, then divided by
average assets. Financial expenses include interest expenses, inflation
adjustment, exchange rate depreciation expenses and subsidized costs
of funds adjustment.
• It is important to compare the above ratios with the operating
expense ratio which is calculated as total operating expenses divided
by average total assets to assess the ability of MFIs to meet operating
expenses.
Financial risks management – Currency risks
control measures

• Add the expected devaluation rate to the local

nominal interest rate in any loans offered
• Negotiate for loans to be offered in local
currency and payments to be made in local
currency.
• Include provision of currency devaluation in
income statement and balance sheet.
 Financial risks management – Liquidity risks
management
• needs to balance costs incurred due to liquidity shortfalls and lost
revenue arising from the maintenance of liquid assets.
• Apply cash flow management, which involves the timing of cash
flows to ensure that cash inflow is equal to or greater than cash
outflow, which is possible when the following are performed:
– Liquidity needs are planned on the basis of worst-case scenarios to limit
the potential for liquidity crises
– Policies are set for minimum and maximum cash levels
– Cash needs are forecast
– Cash budgets are continuously updated
– Surplus funds are invested or disbursed as loans
– Cash is available for savings withdrawals and loans
 Financial risks management – Liquidity risks
management (cont’d)
• Liquidity monitoring indicators are:
– Quick ratio = liquid assets divided by current
liabilities
– Liquidity ratio = cash plus expected cash inflows in
the period divided by anticipated cash outflows in
the period. Should be > /= 1.
– Idle funds ratio = cash plus near cash assets
divided by outstanding loan portfolio.
 External Risks
• Regulatory risks
– Usury laws – specify the maximum interest that can be charged
– Directed credit – political pressure on the provision of loan to
certain group of disadvantaged people
– Contract enforcement- where there is poor legal and regulatory
system to enforce contract
– Labor law – specify minimum salaries for each category of
employees
• Monitoring:
– Conduct regular compliance audit.
– Participation in industry association can influence policies and
regulations for the creation of favorable environment for MFIs.
 External Risks
Market risks
• Occur when the prices and markets for MFI’s products are negatively
affected by economic factors:
– New entrants in the MFIs industry, which increase competition for good clients,
– economic downtown which may reduce demand for MFI’s services,
– hyperinflation and other factors.
• Also occur when a MFI’s clients’ businesses and households economic
conditions are negatively affected by economic factors, which reduce
their ability to repay loans.
• Measures:
– offer short-term loans,
– lending in foreign currency and incorporating inflation in interest rate estimation,
thus passing the costs to their clients. Conduct regular compliance audit.
 External Risks
• Geographical risks
• Physical Environment Risk
Go to Part II