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 risk
b. Interest rate risk and c. Foreign exchange risk:
Foreign exchange risk arises due to fluctuation in the exchange rate of the 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 the 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 the 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 a portfolio, fixed deposits, or other securities. Liabilities, on the other hand, are sources of the fund; these are the obligations of the 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 a 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 that is maturing in the 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 the maturing of its assets (that is when they can be turned into cash) with the 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 problems 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 snowball into a big crisis. If an MFI is not able to pay back the savings of depositors when they come for withdrawal because they don’t have enough cash then it can immediately give the wrong signals in the market. Rumors may spread that either MFI does not have the intention to pay back savings or is financially bankrupt. The spread of this news with other depositors can result in a panic situation who may also come for withdrawal and this could lead to a situation called to run on savings, where everyone wants to withdraw 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 not only of the current lender but also other lenders, which can make borrowings very difficult in the future. The credit rating of the MFI can also fall down which can create further problems in its fundraising. 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 a high amount of cash it loses out on the interest it could have earned had that amount been invested in the portfolio. The loss does not end there; the MFIs generally have this cash either from the borrowed funds or from the client’s 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 many 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 the 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 macro-economic conditions. Changes in rate may mean an increase or decrease in the cost of funds 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 the 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:
