CHAPTER FOUR

Risk Management in Microfinance

4.1 Introduction

Risk is an integral part of financial intermediation. Hence, risk management must be at the heart
of finance. However, it is disturbing to note that systematic risk management is still not as
widespread as it should be in the microfinance industry. Except for a few flagship microfinance
institutions (MFIs), which constitute the core of the industry, most MFIs do not pay adequate
attention to systematic risk management.
The microfinance industry has grown rapidly during the last decade in breadth, depth, and scope
of outreach. The rapid growth seems to continue, given the massive unreached and underserved
market. The growth of the industry has changed the risk profile of MFIs. Yet many MFIs seem to
continue to seek growth without much attention to attendant risks. Surprisingly, many MFIs
appear to neglect even the basic credit risk management which helped MFIs achieve high growth
rates historically.
To help in this effort, we need to bring into the discussion—now dominated largely by issues
related to introducing sophisticated systems and technical tools of risk management – the
institutional cultural issues and issues related to cognitive biases in executive decision-making
behavior.
The breadth, depth, and scope of outreach of the microfinance industry have been growing
significantly. The erstwhile microenterprise-credit-only institutions are now providing a broader
range of credit products. Their loans are no longer confined to short term working capital loans
but now also include loans with relatively longer maturities, and those intended for other
purposes such as acquiring fixed assets. Some microfinance institutions (MFIs) even venture into
the financing of agricultural operations. Other MFIs have expanded their deposit services, thus
contributing to the expansion of the scope of outreach.
One of the significant changes in the microfinance industry has been the growth in commercial
and semi-commercial borrowings, including loans denominated in foreign currency to finance
operations. Although MFIs and the industry have suffered serious setbacks, the industry has been
relatively stable in most countries. However, it must be recognized that the changes in markets,
products and services, delivery models, and technology used in the industry have had, and
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continue to have, profound implications on the overall risk profile of the industry over time.
MFIs or others which provide microfinance services can no longer afford to focus only on credit
and liquidity risks and consider other types of risk on an ad hoc basis, often in a reactive manner.
Risks in microfinance must be managed systematically and the importance of risk management
will further increase as the industry matures further and microfinance markets become more
competitive.
Microfinance risk is defined broadly as “the potential for events or ongoing trends to cause
future losses or declines in future income of an MFI or deviate from the original social mission
of a MFI.” The deviation of the social mission is included in the definition because such
deviation can occur without necessarily causing losses or declines in future income and, in our
view; the risk of mission drift is one of the most significant risks in microfinance. This is not
considered part of the risk profile of conventional financial institutions because they do not have
a social mission.
4.2 A Taxonomy of Risks for Microfinance

The word risk comes from the Vulgar Latin ‘rescum’ which can be said to mean ‘risk’ or
‘danger’. In finance, this leads to the concept of compensation. The expression risk-return trade-
off implies that to bear the risk one needs to be compensated. Risk in fact the uncertainty related
to future events or future outcomes. This uncertainty does not mean that the event or the
outcomes must be negative.

Risk management , then, deals with the definition, the measurement and the control of risk
(expected and unexpected changes) in order to price the investment correctly and to reduce
losses determined by changes in future events or outcomes. The scarce attention dedicated to risk
management in microfinance can be explained mainly by the fact that the main goal of
microfinance lies in social and humanitarian objectives.

Identifying the risk, measuring them and controlling the exposure to these risk allows us to better
identify the key variables that affect performance and to implement the financial and operational
solutions in order to reduce the performance variability.

Risks associated with social mission, foreign exchange, competition, and system integrity have
surfaced and are assuming greater importance. The first step for a risk management model is to

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identify the risk categories that refer to microfinance. There are number of risks that a MFI has to
face these risks could be of delinquencies, frauds, staff turnover, interest rate changes, liquidity,
regulatory etc. But all these risks can broadly be classified into three major categories as
business risk, financial risk and process risk.

 Business risk: refers to the activity itself

 Financial risk: derive from the portfolio of assets and from the liabilities associated with
the project or stored in the institution’s balance sheet

 Process risk: includes all those risks determined by the process designed to implement the
activity.

Unlike Financial risk, the rest two are of non-financial character and result mainly from human
errors, system failures, frauds, natural disasters or through regulatory environment, weak board,
poor strategy, etc. However, it must be remembered that those risks, as and when materialize will
also translate into financial losses for the organization.

4.3 The Business Risk

Business risk can be split into 2 categories: specific risk and generic risk.

 Specific risk; it arises from the products and services offered. From a risk management
perspective, business risk is mainly determinate by the impossibility to reach a higher level
of product standardization, a fact emphasized by the ethical goal of the microfinance,
which prioritizes the beneficiaries’ needs, rather than institutional strategies.

 Generic risk: it derives mostly from the location of the program. It bears no relation to
country risk (which is the component of credit risk) but refers to the development policy
implemented in the area o activity.

The risk comes from the possibility that the geographical context in which the program is based
is not supported, at an international or local level. By adequate financial, fiscal and regulatory
policies, or that it can be affected by a change in these policies that would hinder the
development of the program

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4.4 Financial Risk
Financial risk can be divided as Credit risk and Market risk.
I. Credit Risk
Credit risk is directly related to the portfolio of the organization and is one of the most
significant risks from a MFI perspective. Whenever a 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 does
not pay back the loan amount. Credit risk is the most common risk for the MFI. The risk is of
greater significance for MFIs as it has to deal with 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 can
neither afford to be too conservative on their lending because of restriction effect on their growth
nor can they be over enthusiastic which will result in losses. Hence, an MFI need to have
effective risk management system to have reasonable growth without letting the risk cross the
thresholds of acceptable limits.

Many scholars agree that the initial success of MFIs can be largely attributed to the management
of credit risks. These remarkably high loan recovery ratios triggered the initial wave of funds
from funding agencies and the subsequent inflow from a variety of social investors which they
could use to expand their operations. While many successful MFIs continue to contain credit
risks within desired levels, they face greater challenges than before as indicated by the increased
volatility of their Portfolio-At- Risk (PAR) ratios. The sources of these challenges include
increased competition in the market, addition of new credit products with longer-term structures,
shift to individual lending, increased scale of operations, and geographical expansion and efforts
to deepen the outreach.
Credit risk also has other dimensions. Initially, microfinance credit risk was assumed to have
been confined almost entirely to risk associated with the possible default by borrowers of MFIs.
This is reflected in the definition of credit risk as “the risk to earnings or capital due to
borrowers’ late and nonpayment of loan obligations.” However, a broader definition of credit
risk also includes the risk of default by other financial institutions, which have payment
obligations to MFIs. This is particularly true with MFIs that continue as NGOs. Such payment
obligations may arise because MFIs use those institutions as depository institutions, investment
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outlets, or for money transfers. Also, such risks may arise due to the agency services that MFIs
provide to other financial institutions.
Credit risks are more acute today than in the early stages for those MFIs which have accumulated
a significant amount of reserves, part of which in turn is kept in other financial institutions in the
form of deposits or investments.
Aside from generally recognized default risks by clients, another type of credit risk arises when
MFI clients deposit their savings in other financial institutions which are weak and not covered
by a credible deposit protection scheme. Clients may not have ready access to their funds and
thus lose a source of loan repayment for their MFI loan if the bank where they keep their
deposits runs into difficulties. In such cases, loan recovery rates may suddenly fall.

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 MFI provides have fixed schedule for repayment. This is called Repayment
schedule, which provides the schedule of payment and acts as the reference point for the MFIs to
estimate over dues. 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 schedule date it is called overdue. If any loan has any amount
overdue it is termed as a Delinquent loan or a case of delinquency.

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 very common indicator across MFIs. Apart from PAR, Arrear rate is another ratio,
which also provide information about the portfolio quality of an MFI.

A) Portfolio at risk (PAR):

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 loan with overdue clients to the total loan outstanding of the organization.

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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 ageing it. So MFIs often
calculate PAR30, PAR60, and PAR90 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 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 a MFI has five
clients, each has taken 10,000 loans and has to repay on monthly basis and loan term is 10
months.

Therefore each month each one of them makes principal repayment of Birr 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 Birr 5,000 of principal amount. But say the actual repayment was as

Principal Principal Principal

Clients Disbursed Due paid overdue Outstanding
1 10,000 5,000 2,000 3,000 8,000
2 10,000 5,000 3,000 2,000 7,000
3 10,000 5,000 5,000 5,000
4 10,000 5,000 4,000 1,000 6,000
5 10,000 5,000 5,000 5,000
Total 50,000 25,000 19,000 6,000 31,000

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 over dues

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  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

B) 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 Birr 6,000/Birr 31,000 = 19.35%

This ratio tells the proportion of loan portfolio 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.

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 different degree 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 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.

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1. Poor MIS – MIS on loan outstanding, collection etc plays a critical role in generating reports
and making them available in minimum time to the right people. If an MFI does not have a
good MIS, it may not know how much to collect, it may not know it’s overdue or age-wise
overdue. A with weak reporting system on overdue will result in delayed input on overdue to
the top management and consequently result in delayed action by the top management.
Sometimes weak MIS also results in generation of inaccurate report. If the correct and timely
information is not generated and report the problem cannot be dealt with resulting in
delinquencies getting aggravated.
2. Poor screening of borrowers – Poor choice of clients results in delinquencies. If client with
bad reputation or history of defaults are selected then it can result in delinquencies
3. Weak appraisal – Poor or weak appraisal of loans is one of the major reasons for
delinquencies. Before giving any loan, client’s repaying capacity, status of business and cash
flows must be assessed. This helps in taking loan decision that whether a client should be a
given a loan and about appropriate volume of loan. Poor appraisal can lead to loans going to
unworthy clients or disbursement of higher amount loans. Loans given beyond repaying
capacity puts clients in stress situation as they do not have sufficient income to repay
installments resulting in delinquencies.
4. Unclear communication about product and methodology-Clear communication of
policies and procedures is very important. If the clients do not know the policies and
procedures it can result in confusion and delinquencies even if clients are capable of paying.
5. No immediate follow-up – MFI having strong overdue follow up system can control
overdue to a large extent. It also gives clear message to the clients that the MFI is serious on
repayments and thus prevents the future occurrences. MFIs which are weak in overdue
follow up give a signal that it is not serious in overdue collection resulting of other clients to
imitate. Also if the overdue are immediately followed up the chances of recovery are quite
high but if the case becomes old then the chances of recovery also goes down.
6. Mixing other social activities with micro-finance – Sometimes delinquencies may also
result if MFIs carry out grant based activities along with micro-finance with the same set of
clients and with same staff. Mixing activities of two different natures confuses the client
wherein one activity is being provided free while repayment is asked on micro-finance. This
confuses the clients who may think that loans to be given to them may also be grants for
them and they need not return it. Also enforcing repayments and discipline through a staff
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 who is involved with the community in other social activities also will be very difficult and
hence results in delinquencies.
7. Poor product – Delinquencies occur if the product is not suitably designed. If the
repayments do not match with the cash flow of the client then it may result in delinquencies.
Client cash flow means that when do the clients receive income and when they need to
spend. In agriculture economy, clients may need to spend during sowing season and hence
need money. While they may receive income during harvest. Other important point is if the
repayment period is too long or too short or frequency of payments and installments size are
not well thought off, it can all lead to delinquencies.
8. Natural disasters – Delinquencies can also happen as an aftermath of a natural disaster such
as flood, drought, earthquakes or epidemic.
9. Corruption – Corruption at field staff level such as taking bribe for loans or frauds can result
in delinquencies. A staff taking favor from clients cannot enforce discipline or strict
repayments. If the staff is committing fraud it will also show up as delinquency.
10. De-motivated employees – If the working conditions or incentive systems are not good, it
will result in staff de-motivation and ultimately delinquencies. Motivated staff can make a lot
of difference in enforcing policies in the field but of staff is de-motivated then they will not
put sufficient efforts to enforce polices with the clients resulting overdue.
Thus we see that delinquencies do not occur, exclusively on account of client related reasons.
Much of it can be attributed to internal systems and policies of the MFIs. It also means that if
internal reasons related to the organization are taken care of then delinquencies can be controlled
to a large extent. It is also important to understand why MFIs, investors and assessment agencies
give so much importance to delinquencies and portfolio quality. This is one of the most (if not
‘the’ most) critical parameter for investors and assessors to rate and MFI and taking lending
decisions. This is because portfolio is the most o important asset for the MFI and the only or the
main source of its income. Any problem with the portfolio can adversely affect the MFI in a
number of ways. In the next section we will see what different affects delinquency can have on
an MFI.

Impact of Delinquencies
Delinquencies adversely affect the MFI in many ways. We will see how delinquencies can result
in multi-dimensional affect for an MFI.
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1. Loss of portfolio for the MFI – the major impact of delinquency is the loss of portfolio. The
money given to a client by the MFI is lost if client defaults. MFI lends to clients and interests
along with principal. However, default by client can result in even principal getting lost.
2. Loss of interest income – if a client does not repay its loan then the MFI loses interest
income as well. Interest is the main source of income for an MFI and loss of it directly
impacts its profitability and sustainability.
3. Growth hampered -an MFI having overdue has to invest lot of its time and other resources
in recovering the overdue. This diverts the focus of the MFI from expansion and growth to
controlling the overdue thereby hampering its growth.
4. Cost escalation – in order to recover overdue MFI has to spend its staff time on recovering
overdue. An extra visit by staffs at various levels also adds to travel costs.
5. De-motivated staff – increase in overdue de-motivates the staff. Staffs of a branch having no
overdue are zealous as they expand the operations, get incentives and promotions. While
staffs associated with bad portfolio are mostly engaged in overdue recovery, growth is slow;
staff does not get incentives and instead may be criticized for poor performance resulting in
de-motivation.
6. Cash flow mismanagement – MFI disburses new loans or meets its liabilities such as
repayments of its owing to banks, through repayments that it receives from the field. If the
repayments are timely then the MFI will not be able to collect enough cash from the field and
hence will not be able to meet disbursement target or even pay back to its lenders. MFI plans
its disbursements assuming certain amount of collection from the field but there are defaults
then it disturbs these plans. This makes cash planning and fund management very difficult.
7. Loss credibility of the MFI – an MFI suffering from delinquency may lose reputation and
credibility with other peer MFIs, lenders and donors. Most of the investors put a lot of
weight-age on portfolio quality as it is the most important asset for the MFI and this is where
the investors ‘money will be utilized. Poor portfolio quality makes investors uninterested and
fund raising becomes difficult.
8. Loss due to competition – MFI struggling with delinquencies may lose out on completions
with other MFIs. While good MFIs may focus on growth, experiment with new products and
other service, the MFI struggling with overdue has to concentrate on recovering overdue. It
may also lose out on its staff and clients as the MFI is not performing well.

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The above list of potential losses shows the multiple impacts or chain reaction delinquencies can
spur. So we see that there is a lot to be lost if the credit risk is not proactively managed and
contained within the acceptable limits.

Apart from the MFI itself, delinquencies also impacts those associated with it and otters as well.
Some of the other impacts of delinquencies are;

1) Bad reputation to sector; Today micro –finance has gained lot of important and recognition
as it has proved that good recoveries are possible even from the poor clients. If delinquencies
become rampant across MFIs, the sector will lose its creditability and recognition. Investors,
government, researchers, etc. Will lose interest and the industry will die out.
2) Staff employability; Micro-finance has created a lot of jobs. It has created jobs for
moderately educated people. We see that now micro-finance is a specialized field. The good
staffs that have performed well get ready employability with other agencies across the sector.
They command higher salaries and an exciting career. However, staff associated with
delinquencies and poor portfolio loses out on such opportunities. If staff is dismissed from an
MFI because of delinquencies it may be difficult for him/her to find jobs at other places.
Hence delinquencies can be harmful for the staff at all levels too at the personal level.
3) Loss of reputations of an area; Delinquency in a particular area can result in loss of
reputations a locality or region. Many finance companies ‘blacklist’ certain villages, areas or
even districts because of delinquencies in those regions. So delinquencies of one MFI may
result in even other MFIs not venturing in those areas and thus denying those areas of
financial services.
MANAGING CREDIT RISK
Clarity of vision
We saw that delinquencies have wide spread impacts and are harmful not just for the MFI but
also for others. It is therefore important to manage credit risk. In order 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. Clear mission helps
the MFI defining its path and where it wants to go. Lack of clarity in mission can result in loss of
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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 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 frequently is too low it results in loss of contact with client and escalates the risk of
delinquencies.

The higher the frequency of repayments the better it is from risk perspective however the
repayments has 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 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 Head Office
level in a timely manner. If 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 actions to manage it.

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A strong MIS is characterized by 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 field should know
how much to collect from a group, how much are the overdue/prepayments. Branch Manager
should have the information on disbursements and repayments, saving collections, number of
clients, overdue, ageing etc. Similarly, Head Office should get details of all branches/units on
disbursements, collections and 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 staffs at various levels as well as an independent internal audit
at 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 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
loan or the borrower may not be trustworthy or capable of paying, which will result in loss of
loan. All loss of loan related to delinquency of individual clients because of client’s migration,
willful defaulting, business failure, etc. is called Transaction risk.

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As transaction risk is related to individual clients, it has to be controlled by having right policies
at various stages of loans. Transaction risk management starts from the first step of client
selection. MFIs focus on selecting 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 trust of the community or have dubious past do get into the system. Once the clients
have been identified, the next step is of grouping formation. At the time of group formation it is
extremely necessary that a 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 that the client understands.

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 be 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 loan application cash flows, income of 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 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 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
expansion of existing business rather than investment in a new business. Strong loan appraisal
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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 branch level committee or
committee composition can also change with the size of loan. This means that for loans above
certain size credit committee 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 though 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 cheque or even some assets. These guarantees and
securities also help in managing transaction risks. After disbursement of 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 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 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 bank can also help in controlling risk related to frauds and
misappropriation.

Transaction risks can be managed effectively with strong internal systems such overdue
management system, strong management information system (MIS) as explained above. 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 availability of accurate

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information 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 staffs can play a vital role in managing
overdue as field staff is the first one to know whenever a delinquency occurs. Field staffs 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 overdue situation in
an appropriate manner. MFIs have policies of enforcing group pressure such as field staff may
hold longer meeting to discuss overdue, can ask other members to pool in money. Field staff may
call other colleagues, to visit client house etc. Pressure can also be applied by not disbursing
fresh loan 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 accurate assessment of the situation at hand.

It is seen that MFI have developed appropriate e policies to handle overdue in different age class
differently. For example, overdue above 30 days have to be followed up by 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 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 loss in a particular class or section of
portfolio rather than an individual. For example an MFI may lose a portfolio with a particular

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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 the 100% of 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 uprisings 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 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 of 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 necessar y
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 stakeholders such
government agencies, local politicians. It is important to also inform about the MFI, its
objectives and 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 are considered risky or certain locations which are risky
because of reasons such as frequent occurrences of natural disaster or security issues, can be
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avoided by the MFI or even if it wants to work in such areas or with such business then exposure
can be restricted to certain percent of the total portfolio

Credit risk is definitely the most common risk for the MFIs but the with the right policy
framework, it can be kept under acceptable levels. But credit risk is not the only risk that MFIs
face.

4.4.2 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. These are Liquidity risk, Interest rate risk and Foreign exchange risk.

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 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 portfolio, fixed deposits or other securities. Liabilities on the
other hand are sources of fund; these are the obligations of 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 fixed
deposit certificate or a fixed asset means its ability to be turned into cash. A fixed deposit for 3
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years cannot be turned into cash before three years and hence is not a liquid asset but an
investment. An investment which is maturing in 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 maturing of its assets (that is when they can be turned into cash) with
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 problem 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 snow ball into a big crisis. If an MFI is not able to pay back savings of
depositors when they come for withdrawal because they don’t have enough cash then it can
immediately give wrong signal in the market. Rumors may spread that either MFI does not have
intention to pay back savings or is financially bankrupt. Spread of this news with other
depositors can result in panic situation that may also come for withdrawal and this could lead to
a situation called run on savings, where everyone wants to withdrawal 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 of not only of current lender but also other lenders,
which can make borrowings very difficult in the future. Credit rating of the MFI can also fall
down which can create further problems in its fund raising.

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.
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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 high
amount of cash it loses out on the interest it could have earned had that amount been invested in
portfolio. The loss does not end there; the MFIs generally have this cash either from the
borrowed funds or from the clients 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 much 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 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 increase or decrease in the cost of fund 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 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:

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 1. Increasing interest upward in an issue of controls and is not easy even though MFIs put a
clause that interest rate can be changed from time to time. Therefore, normally once an
interest is indicated in a loan it is not varied till the end of the agreed terms. In case of
investments the issuer may not.

2. Floating rate loans and investments are not popular in the country.

3. With simple MIS that MFIs generally have, revising interest rate means managing
different sets of data, which becomes source of confusion and is very cumbersome.

4. MFIs generally have printed cards, formats for its loans; it involves cost to change these
formations to a new interest policy

5. Staff training is also an issue; staffs are used to working with a certain policy and generally
get completely accustomed to it. A new loan system requires the staff to learn new
installment size etc. which against is time consuming and difficult.

6. It is also difficult to retrain the clients on new polices, new installment systems particularly
when the clients may be used to a particular kind of repayments schedules.

Even if an MFI could change its own interest rate, it will not be possible to do that for the
running loans. This is also known as the reprising risk. If an MFI has a taken a loan on which the
bank has put a clause that it can reprise (change the interest rate) the loan every six months and
the MFI has invested these borrowed funds in one-year fixed rate loans to its clients, the MFI
cannot change the interest rate before one year, although bank can changes its rate in every six
months, which can result in losses.

MFIs have to be very cautions while they sign loan agreements with banks or other financial
institutions. It is important to read such clause, be aware of them and their implications.
Generally, it is better to have funds, which have long reprising terms or are of fixed rates even if
they come at a slightly higher rate, as this will not expose the MFI to risk of interest rate
fluctuation. Specialized financial institutions take calculated risks reading the market situation

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and expecting the market trend and try to take advantage of it. If the long-term fixed interest rate
investments are funded through short-term floating rate funds, then if the interest rates in the
market fall it results in profit for the organization. For example if an organization gives a loan for
18% for two year and the rate is fixed for two year. The organization has given this loan from
funds, which it has borrowed at 12% floating rate, which will be reprised every 3 months. If the
overall interest rates in the market fall then the cost of funds for the MFI will fall down from
12% while its own interest rate will remain fixed at 18% thereby increasing the organization’s
profit.

Interest rate risk for financial institutions with a large portfolio will be subject to greater
complications. In the case of such institutions, a change in interest rate not only affect immediate
profitability but can also change the value of the underlying assets and liabilities because of the
change in the present value of the future cash flows. However, for MFIs interest rate risk is
mainly related to the immediate pressures on the margin and adapting to new market conditions.

It is important that while raising funds such clause on reprising are carefully considered and
compared between sources of funds. A s MFIs are not specialized in handling such kind of
market risks it is often better to go for fixed interest borrowing even if they cone at a slightly
higher rate. If there is a certainly about borrowings even if they come at a slightly higher rate. If
there is a certainty about borrowing rates MFIs can have strategic such as higher scale of
operations, cutting operational expenses or setting its own interest rates to factor in higher cost of
funds. But if the rates are fluctuating then it can be difficult for the MFIs to manage it.

c. Foreign exchange risk:

Foreign exchange risk arises due to fluctuation in exchange rate of 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 Indian micro-
finance perspective as Indian MFIs are generally not dependent on foreign sources of funds.

4.5 Process Risk

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Process is designed sequence of actions to be taken by different components of a system so that
the system can work effectively. In simple terms it means the systematic actions to be taken as
part of regular activities for accomplishing various functions. Lack of clearly defined process
within an organization can result in confusion, conflicting g actions, duplicity of work resulting
in loss of time and other resources. If an organization does not have clearly defined processes,
different staff may take different actions to same situation resulting in conflicts and sometimes
serious consequences.

Lack of internal processes or inadequacy of the process also weakens the internal control as there
are no set parameters against which an action of a staff can be judged. This are weak internal
systems such procedures for loan disbursement, collection, reporting cash handling etc. Can lure
staff and clients to take advantage of the weakness and result in frauds and misappropriation.
Lack of standard policies complicates work, as there could be variances in record keeping and
reporting making consolidation difficult and to get as there could be variances in record keeping
and reporting making consolidation difficult and to get information on time. This impacts
decision-making and ultimately results in overall management failure. Strong internal
management systems such as cash planning, cash handling, disbursement procedures, internal
checks – monitoring and audits help in managing process related risks.

Process risks can be distinguished into two main categories operational risks and other residual
risks. Internal event can be associated with the production process, to people and behavior to
system and their running. External determinants refers to all events (mainly legal risks) that
cannot be directly associated with the process or the institution.

There are two main ways of managing process risks: the implementation of internal auditing
procedures and the transfer of the risks to an external entity. The first option faces the difficulty
of structuring procedures for control that don’t meet with the flexibility needed by microfinance
practitioners. The second solution can be pursued only if and when financial markets offer
products specifically tailored for microfinance process risks.

4.5.1 Operational Risk

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Operational risk relates to the risks emanating from failure of internal systems, processes,
technology and humans or from external factors such as natural disasters, fires, etc. Basel
Committee on Banking Supervision defines operational risk as “the risk of direct or indirect loss
resulting from inadequate or failed internal processes, people and systems or from external
events”. Earlier, any risk, which was not categorized, as credit risk or market risk was considered
to be operational. However this was a vague definition of operational risk. As per the new
definition strategic risk is not considered under Operational risk.

Operational risk has gained a lot of importance over the years with increased used of technology
and also recognition of importance of human resource in the success or failure of enterprises.
Another facet of operational risk is that it cuts across all departments, as human resource and
technology are central to all departments. Technological interventions are now something very
perceptible in all walks of our life including in banking and finance.

Today financial markets and banking has changed dramatically with lot of reliance on
technologies such as ATM, e-banking, tele-banking, credit cards, etc. Secondly, over the years
industries across world have recognized the importance of human resource. Human Resource
departments within enterprises have gained a lot of importance. Companies now believe in
investing g in employees, their capacity building, employee retention, benefits and perks.
Salaries and other benefits in India have risen dramatically in the last one decade. This clearly
shows that human resource is getting the due recognition and importance that it commands.

To this larger change, micro-finance industry is no exception. Micro-finance has seen its own
share of technological advancement. From use of computers for simple desk jobs to the use of
advance software, introduction of swipe cards and biometric MFIs have witnessed changes in the
IT usage. Strong internal processes, systems, good human resource and preparedness against
external events are needed for managing the operational risk.

Operational risk is enhance by increased dependence on technology, low human and business
ethics, competition, weak internal systems, in particular weak internal controls.

The Operational risks that an MFI faces can broadly be seen from different angles as follows.

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 a) Human risks; Errors, frauds, collections, animosity.
b) System and technology risks; failure software, computers, power failures.
c) Relationship risk; client dissatisfaction, dropouts, loss to competitions, poor products.
d) Asset loss and operational failure due to external events; loss of property and other assets
or loss of work due to natural disaster, fires, robberies, thefts, riots etc.

Human Risks
As we discussed earlier human resource plays a key role in success or failures of enterprises. An
organization with good human resource can meet most challenges effectively whereas weak
human resource enhances the operational risks. Human resource is a complex subject. The issue
of keeping employees motivated and to encourage them to be honest and uphold integrity and
values is something very subjective and does not have any unique solution. MFIs have to deal
with large number of small loan clients and this requires them to keep more number of
employees with diverse skill sets at various levels.

These employees are expected to mange cash as well as records, which could be manual, or on
computers. Managing these operations of the field with set of staff who have limited education
qualification is a challenge of enhances operational risk. MFIs mostly transact in cash, which
increases the probability of frauds, misappropriation either by employees or even by clients.

Frauds consist of intentional embezzlements and misappropriations careered out by the staff or
client of an MFI. Frauds may vary in degree and the extent of financial damage caused to the
MFI. But irrespective of the size of fraud, it brings disrepute to the MFI and threaten the
credibility of the organization. Frauds can be caused by simple embezzlement of the
organizations money to more complex thefts and misappropriations in nature, which can go on
unnoticed for a long period of time. Some of the most common frauds in MFIs are field staff
taking bribes for loans, creating fake clients, misreporting information, fudging data and forgery.
Most often it has been seen that frauds occurs a result of weak monitoring and audit systems.
Staff or clients tend to take advantage of the gap between the senior officials and the field and
hence manipulate the situation to their personal advantage.

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Similarly, an employee may commit loss to the organization by lack of knowledge, capacity or
by error. Human errors can occur anytime at any place. There could be errors in record-keeping,
data entry, accounting, MIS, etc. Generally, the field staffs of MFI are people with limited
education qualification or computer sills making them prone to such errors. Regular training of
staff and careful monitoring are therefore very important in micro-finance institutions. Lack of
training or monitoring escalates the operational risk due to errors, which are although
unintentional but can nevertheless but can nevertheless bring loss to the organization.

Humans can also be destructive sometimes. Employees against whom an action has been taken
by the MFI may turn hostile and start working against the organization. They may spread rumors
in the community, instigate people, may create problems in the working of the organization in
field, may deliberately misreport data, etc.

System and Technology Risk

As MFI becomes more and more dependent on technology such as computers, software, hand-
help devices, etc. it also enhances their technology related operational risk. Hard disk crash, virus
attacks, software or hardware failures, password misuse can impact MFIs to different degrees
based on their extent of dependence on technology. MFIs working in rural areas often have to
face other such risks as long power cuts which can again disrupt normal operations if proper
alternative arrangements such as generators or investors are available.

To manage this it is important to have proper software backup policies in the organization. It is
necessary to invest in updated software and anti-virus, protecting computers from misuses,
restricting accesses and limiting authorization of data access to different levels of staff. Daily
backups and storing back-ups at different locations can help in managing such risks. While
designing software it is necessary to have strong security features, which can prevent data
tempering. A good and efficient process of troubleshooting can help in addressing software or
hardware related problems, which can prevent MFIs from losing valuable data or data theft.

Relationship Risks
Clients are very valuable for MFIs. With competition more and more clients have options of
choosing one MFI over another. Loss of clients or high drop out is a big cost to the MFIs. MFIs

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invest a lot of time and money in identifying clients, training them and nurturing them. Therefore
loss of clients results in resource loss, which has been invested on these clients and hence is a big
risk. MFIs are increasingly realizing the importance client relation. It is important to be sensitive
to client requirements clients can drop out on account of poor products, unfavorable policies and
procedures, poor staff behavior or a strong competitor.

As the sector becomes more competitive importance of strong client relation and meeting client
requirement will only gain more significance. Managing good client relations can help the MFIs
is not only managing this risk but turning it into an opportunity to maximize profits by not losing
to competition and building client loyalty and instead attract clients from the competitors.

Basis for effective relationship management is collecting, regularly information about the clients’
satisfaction. This appears to be costly and has not been done by most MFIs so far. However, as
MFI-staff interact much more regularly with their clients than other financial institutions do, this
offers vast opportunities to “drop” question on satisfaction which are simple and not
burdensome. The greatest opportunity to learn about client satisfactions and to forge a strong
relationship is through complaints, though. Most companies do miss the chance of complaint
handling. So do MFIs. But complaints are a great opportunity, because it means that a client
comes fully self-motivated and willing to convey his feeling s and perceptions of the MFI’s
services. It is a kind of information that field staff and managers alike otherwise rarely get hand s
on. Therefore, well managed MFIs encourage clients to voice their grievances and provide
channels for addressing them.

Asset Loss and Operation Failure Due to External Events

There are various external factors, which are direct threat to an MFI. Such threats may include
fire, natural disasters such as floods, draughts, earthquake, tsunami, epidemic etc. There could be
other human related external threats as well such as robbery, thefts and rots. Such events
although low in probability can cause high damage to the property of the MFI as well as can
hamper normal operations for an extended period of time. Such risks can be managed through a
variety of strategies. Natural disasters have the capacity to cause very high impact. Natural
disasters not only adversely impact the infrastructure such as roads, telecommunications, which

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will ultimately hamper the MFIs working. Even if a natural disaster has not affected the
infrastructure of an MFI directly it may completely destroy client business, which will ultimately
result in loss for the MFI. Riots, wars, communal problems can quite significantly impact the
operations of an MFI as such situations may bring an MFI to a complete halt. Riots and other
such situation are directly related to the issue of personal security of the staff as well as of the
clients and hence are serious risks.

An MFI must keep its portfolio diversified to limit its loss on account of such external factors. If
cases of robberies or thefts are common then it is better to transfer risk through insurance, cash
carrying by staff can be limited and there can be polices on cash limits at branch. Again
insurance for cash in branch or cash in transit can be taken by working out the cash benefit.
Insurance involves payments of premium hence it is necessary to evaluate probability of such
incident, potential loss possible against the premium the MFI has to pay.

Microfinance Risks Management

If potential losses or chances are high then it is better to take insurance. For dealing with fire
or riot situation MFIs may have standard operating procedures, which could be stepwise set
of rules to be followed under such emergency situation. This will help the staff to react in a
more coherent manner and can control loss due to frivolous action taken by any staff under
emergency. Personal safety and security of staff and client has to be given priority. Keeping
backups at alternative places can help in preventing data loss and small fire extinguishers,
fire proof vaults and help in controlling losses. Policies on storage and custody of important
documents such as checkbook, client documents, cash etc., can again control losses.

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