But all these risks can broadly be classified into four major categories;
Types of risks faced by Microfinance Institutions – Read Part 2 here
Types of risks faced by Microfinance Institutions – Read Part 2 here
Credit Risk
Credit risk is directly related to the portfolio of the organization 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 do not pay back the loan amount. Credit risk is the most common risk for MFI. The risk is of greater significance for MFIs as it has to deal with a 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 organization 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 needs to have an 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 loans which will result in loss of loan. All loss of loan related to the delinquency of individual clients which can be because the client’s migration, willful defaulting, business failure, etc are called transaction risk. b. Portfolio risk: Portfolio risk is related to factors, which can result in a loss in a particular class or segment of the 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 overdue. An amount is called ‘overdue’ if it is not received by the MFI on its scheduled time. Every loan that an MFI provides has a fixed schedule for repayment. This is called the Repayment schedule, which provides the schedule of payment and acts as the reference point for the MFIs to estimate their overdue. 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 scheduled 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 a very common indicator across MFIs. Apart from PAR, the 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 loans 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 aging in it. So MFIs often calculate PAR30, PAR 60, and PAR 90, etc. PAR30 means outstanding of all loans, which have overdue greater than 30 days as a proportion of total outstanding of the MFI, similarly PAR60 means outstanding of all loans, which have overdue 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 the overdue amount is not used anywhere in the formula. Overdue 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 loans and have to repay on a 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 the principal amount. But say the actual repayment was as shown in the table below. To calculate PAR, we have to take the following steps; • Identify loans with overdue; in the given example loan 1,2 and 4 have overdue • 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 portfolios 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 the arrear rate and repayment rate only provide information on 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 the different degrees 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 the 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.
Impact of Delinquencies
Delinquencies adversely affect MFI in many ways. We will see how delinquencies can result in a multi-dimensional effect for an MFI.
MANAGING CREDIT RISK
Clarity of vision
We saw that delinquencies have widespread impacts and are harmful not just for the MFI but also for others. It is therefore important to manage credit risk. In order to 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. The 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 an impact on each other. It is, therefore, important to maintain clear segregations among programs of different natures. The social activities should be separate from micro-finance and the community should not be confused with the two programs.
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 cash flow of the target group. In general, it is good to have frequent repayments as it maintains contacts with clients. If the frequency is too low it results in loss of contact with the client and escalates the risk of delinquencies. The higher the frequency of repayments the better it is from risk perspective however the repayments have to match the cash flow 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 a 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 the Head Office level in a timely manner. If the 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 action to manage it. A strong MIS is characterized by a 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 the field should know how much to collect from a group, how much are the overdue/prepayments. The branch manager should have the information on disbursements and repayments, saving collections, a number of clients, overdue, aging, etc. Similarly, the Head Office should get details of all branches/units on disbursements, collections, and the 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 staff at various levels as well as an independent internal audit at a 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 the 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 the loan or the borrower may not be trustworthy or capable of paying, which will result in loss of loan. All loss of loans related to the 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 the right policies at various stages of loans. Transaction risk management starts with the first step of client selection. MFIs focus on selecting the 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 the trust of the community or have dubious past do get into the system. Once the clients have been identified, the next step is grouping formation. At the time of group formation, it is extremely necessary that 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 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 cashflows, the income of the household and repaying capacity of the household has to be seen. Often it is seen that MFI instead of focusing on the cash flow from the enterprise in which loan is being invested: focus on the cash flow of the entire family. The MFIs then access the household expenditures and based on that decide the final amount to be disbursed. Also, the 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 the 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 the expansion of existing business rather than investment in 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 a branch level committee or committee composition that can also change with the size of the loan. This means that for loans above a certain size credit committees 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 thought 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 the 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 a 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 the 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 the bank can also help in controlling risk related to frauds and misappropriation. Transaction risks can be managed effectively with strong internal systems such as overdue management systems, strong management information systems (MIS) as explained above. A 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 the availability of accurate information, an 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 staff can play a vital role in managing overdue as field staff is the first one to know whenever 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 the overdue situation in an appropriate manner. MFIs have policies of enforcing group pressure such as field staff may hold longer meetings to discuss overdue, can ask other members to pool in money. Field staff may call other colleagues, visit the client’s house, etc. Pressure can also be applied by not disbursing fresh loans 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 overdue –depends on an accurate assessment of the situation at hand. It is seen that MFI has developed appropriate e policies to handle overdue in different age classes differently. For example, overdue above 30 days have to be followed up by the 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 the 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 overdue. If the MFI does not react to overdue 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 a loss in a particular class or section of a 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 100% of the 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 a 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 to 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 stakeholder’s such as government agencies, local politicians. It is important to also inform about the MFI, its objectives, and its 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 is 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 a certain percent of the total portfolio Credit risk is definitely the most common risk for the MFIs but with the right policy framework, it can be kept under acceptable levels. But credit risk is not the only risk that MFIs face. The next category of risk that we will discuss in the next post is operational risk. Part 2 of this article can be viewed by clicking the link below: Microfinance Risks – Operational Risk – Part 2
