Handout 1 Risks faced by MFIs
The seven main areas of institutional-level risks facing MFIs are in the areas of: 1. Credit Risk 2. Liquidity risk 3. Market risk 4. Operational risk 5. Interest risk, 6. Foreign exchange risk, and 7. Environment Compliance & Regulatory risk 1. Credit Risk: refers to the risk of default or non-payment by clients on their loans. Additional factors that relate more to the microfinance sector are: Loans are often provided without collateral, or use non-traditional collateral, and so there may be a danger greater than for other financial institutions. This may require specific mitigation techniques such as larger loan provisioning or immediate followup on delinquency loans. Limited sector variation (e.g. loans are largely agricultural, perhaps even to only amongst clients with few crops), limited geographic spread (e.g. loans are provided in a few districts only), or specific targeting (e.g. to a specific minority) can increase the portfolio risk to the microfinance institution. These concentrations are often referred to as covariant risk. 2. Liquidity or Maturity Risk: refers primarily to the holding of appropriate cash balance levels and deposit mobilization, and is mainly a cash-flow planning, monitoring and management issue. The reasons for this risk arising includes: seasonality (given the cyclical nature of the local economy); the difficulty in obtaining contingent credit lines; poor cash-flow forecasting, and related management (such as with inadequate monitoring of cash flows and in ensuring matching terms); a lack of investment strategies or investment avenues during periods with surplus funds; and inadequate deposit mobilization (due mainly to difficulties getting savings and time deposit accounts), often due to weak marketing and product development. Skills development and training in relevant areas is seen as a key area of support need for microfinance institutions in this area. This risk area is also referred to as maturity risk simply as the ability to meet maturing obligations (Current Assets > Current Liabilities). 3. Market Risk: refers to the risk of loss owing to changes in market rates and prices on investments by the microfinance institution. This risk is limited to those institutions who invest in equities, fixed-interest instruments, or commodities. 4. Operational Risk: refers to failures in the operation of the microfinance institution, hence the name, and includes breakdown of information systems, poor governance, risk of loss due to inadequate or failed internal processes and systems, external events, and human error. Management risk largely the risk of depending on a few individuals, and fraud are also considered components of operational risk. 5. Interest Risk : Interest rate risk is the primary measure of market risk on an MFIs loan portfolio. It is the risk that an unfavourable change in interest rates might have on the MFIs earnings, based on gaps that exist in the matching of its interest rates on its loan portfolio assets and funding liabilities (e.g. when long-terms loans are funded by shortterm deposits). This is a particular problem when the microfinance institution is not able
to adjust interest rates on loans they have issued against the interest paid on fixed term deposits. There is a natural tendency for microfinance institution clients to want to commit to fixed deposits of as short a term as possible to have access to their funds, and to secure as long a term as possible over debt to lower repayment amounts. Interest risk is faced by most microfinance institutions that mobilize deposits. 6. Foreign Exchange Risk: Foreign exchange (FX) risk arises most often for microfinance institutions who borrow in a foreign currency to lend in local currency. FX risk then occurs when there is a currency mismatch in the MFIs assets and liabilities, that exposes it to FX rate fluctuations, that could cause either losses or gains. 7. Environmental risk: this covers a range of other risks facing microfinance institutions, including: New industry risk: this relates to the risks of trying out new and innovative financing techniques with clients new to credit and savings; Subsidy dependence risk: this is the dependence risk donor-funded microfinance institutions have on subsidies without which they not be sustainable; Transitioning risks: many microfinance institutions were established for social rather than financial purposes, and as these institutions transform into regulated and sustainable institutions a range of organisational culture, performance, management, and governance issues often arise; and Compliance & Regulatory risk: the risks associated with regulation