Introduction

Risk is one of the enthralling challenges facing most financial institutions in recent times.
Many financial institutions have failed due to risks which were not managed efficiently. In
Mauritius, the Non-Bank Financial Institutions (NBFIs) industry complements the main
stream banking institutions to provide financial services to customers. The increasing
importance of the NBFIs industry coupled with global economic crisis in recent years has
made it necessary to ascertain the risk levels of these institutions as well as the impact of risk
on their performance.

According to Psillaki et al. (2010), as institutions in an industry increase their activities

become risky and Schumpeter (1911) attributes this to competition amongst these institutions
to perform better. Since NBFIs are already into activities that are risky, more competition
increases further the risk which they are exposed to. Bloom and Milkovich (1998) define risk
as the possibility of an adverse event occurring and its negative impact on firms. Gupta
(2004) also states that risk refers to the possibility of deviation from the standard path and
these deviations reduce the value of the firm and implies unhappy situations. Both definitions
point to the fact that there are two sides to risk but the downside is what institutions are
mostly concerned about.

To ensure that shareholder value is maximised, risk must be optimally managed by firms.
Over the years many economies have collapsed due to problems in the financial services
sector. In the early 2000s and the 2008 financial crises have all caused indelible blow to the
financial systems of many countries. These situations call for proper risk management
strategies that could help manage risk optimally. Extant literature suggests an overwhelming
impact of risk on the performance of financial institutions. Research however is inconclusive
on the relationship between financial institutions performance and their risk-taking
behaviours. Amidst the rising controversy surrounding the importance of risk management
practices of financial institutions, assessing the effect of the risk on the performance of NBFIs
makes a study as this a necessity. Odonkor et al. (2011) did a study on bank risk and
performance in Mauritius but since these institutions are different with respect to the business
they do and are also regulated differently from banks by the Bank of Mauritius, it is
important to ascertain the impact of risk on their performance. This has also been made
imperative due to apparent lack of studies in this area.

NBFI’s in Mauritius

The NBFI’s include a formal stock exchange, a score of insurance companies, several
pension funds, house finance and leasing companies, non-bank deposit taking entities, foreign
exchange dealers, money-changers and thousands of global business companies engaging in
global market financial business, ranging from acting as simple repositories of invested assets
to active managers of international funds and trust business. Microfinance was recently
started by the Development Bank as an explicit NBFI activity. However, a well designated
legal and regulatory framework for this activity is yet to be introduced.

Much of the more recent NBFI development in Mauritius has come about as a result of tax
and regulatory arbitrages. Corporate listing was induced by a tax incentive scheme whereby
the listed company and its shareholders were lightly taxed compared to other corporates.
Similarly, insurance, pensions and unit trusts have generally been marketed with reference to
relative tax benefits. The leveling up of tax rates over time has raised questions among some
stakeholders concerning the judiciousness of their past decision to form part of the NBFI
accountability framework, once those incentives ceased to constitute a distinct advantage.
The unfolding of the regulatory embrace of the Financial Services Commission on NBFI’s
has similarly started raising questions in parts of the NBFI sector as to whether they are not
being made more accountable than it is justified by their sheer business pursuits.

Seen from another angle, Mauritius is equipped with a modern Real Time Gross Settlement
(RTGS) system since 2000, which ensures that interbank transactions are cleared and settled
within seconds, with instantaneous finality. The Central Depository System of the Stock
Exchange is also based on an automated trading system, the full capacity of which remains to
be utilized as the market gains in depth and liquidity. Advancing technology support, backed
by a well defined system of bank rules and regulations, became the driving edge in favour of
the banking sector, compared to NBFI’s which have proved to be slower in terms of product
development or targeting of cross-border opportunities. The more this gap is efficiently
plugged, the sooner will the financial sector of Mauritius, including NBFI’s, equip itself to
better serve our regional economic hinterland. This Seminar would, I believe, enlighten us
on how to improve regional financial integration and, hence, best serve the underlying
economic interests.

It is estimated that over one third of Mauritius’ total financial assets are managed by NBFI’s.
The bulk of financial assets are consequently held by the banking sector. This situation is in
sharp contrast to what obtains in the developed financial markets where the banks’ share has
been dwindling as active NBFI’s have taken over the business of diversifying the financial
market. As stated, adoption of new technology and improvement of product quality have
been moving faster in the banking sector than in the non-bank sector. So that a better balance
is achieved in the relative weights of the bank and non-bank financial segments of the
economy, more product development and use of technology would do justice to the NBFI
sector. For the economy as a whole, a better balancing of the two segments of the financial
market is expected to send the appropriate price signals and speed up macroeconomic
adjustment. This development should usher the economy into a new phase of balanced
growth and take greater care of market volatility.

1. The importance of adequate capitalization, good risk management, competence, skills,

proximity to one’s market, competition and good governance in determining the
success of NBFI’s in the search for a wider market and the sharing of experience
regarding the financing needs of what may be called an essentially local environment.
Mauritius can look forward to play its role in this broader context once our NBFI’s
venture out into this bigger enterprise calling for regional alliances.

2. A vital role which NBFI’s play in an economy is to act as a buffer, especially in

moments of economic distress. The ongoing skilful manoevring of monetary policy
in the US, coupled with a correct balancing of potential policy slippages by constant
movements of prices on the bond and equity markets, has probably spared the US and,
 with it, the World economy, the pains of a pronounced economic downturn. The duty
to foster NBFI development extends therefore beyond the immediate objective of
creating jobs in specific sectors of the economy which are not readily served by the
more formal segments of the financial sector. As the developed markets’ experience
in the current economic cycle demonstrates, an efficient NBFI sector also acts as a
systemic risk mitigator and contributes to the overall goal of financial stability in the
domestic economy and in the region.

Risks

Firm risk is illustrated by portfolio theory (Donaldson, 1999), as a new model of

performance-driven organisational change in which risk plays central role. As Donaldson
states further, to understand whether an organisation is likely to make adaptive changes or
not, and whether it is likely to grow or not, we need to understand its degree of risk. The
stock market downturns in 2000 and 2001 have created the awareness that it is not only the
level of firm financial performance that counts but also the underlying risk of the financial or
any other industry (Orlitzky and Benjamin, 2001). From a managerial, practical perspective,
today’s managers will not only be concerned with possible predictors and consequences of
financial performance levels but also of their variability (i.e. firm risk). Executives’ ability to
manage firm risk can make the difference between future bankruptcy and organisational
health. Over the long run the market and events in the environment are going to penalise
behaviour that increases firm risk. Both principals and agents are likely to be concerned about
the degree of risk incurred by their firm (Bloom and Milkovich, 1998). With regard to the
impact of risk-taking incentives on the performance of financial institutions, a review of
literature indicates that there is a dearth of literature in relation to NBFIs. The environment
are going to penalise behaviour that increases firm risk. Both principals and agents are likely
to be concerned about the degree of risk incurred by their firm (Bloom and Milkovich, 1998).

Firm risk may not only increase because of increasing probability of civil legal proceedings,
minimal legal proceedings or both, but it may also increase because of the increasing
likelihood of regulatory intervention by the government if firms do not proactively engage in
socially responsible actions (Odonkor et al., 2011). According to Bettis and Thomas (1990),
low risk may allow for better planning because low firm risk makes projections of a firm’s
future cash flows more certain. Due to that Odonkor et al. (2011) postulate that managers in
low risk firms face less uncertainty with respect to future opportunities and opportunity cost
concerning performance. Smithson and Simkins (2005) found that lower risk levels increase
firm value. Financial institutions including NBFIs should institute measures that would
reduce their risk exposure significantly. Carey and Stulz (2005) suggest that many financial
institutions have substantial franchise value that could be lost if they are viewed as being too
risky. Merton (1993) emphasised that risk management is uniquely important for financial
institutions because in contrast to firms in other industries, their liabilities are a source of
wealth for their shareholders. They further give an instance where a financial institution that
writes long dated derivatives would usually be shut out of the market if the credit rating of
the vehicles it uses to write such derivatives fell below an A rating. Because its franchise
value depends on its risk, a financial institution has an optimal level of risk that maximises its
value for shareholders and this assertion is corroborated by Odonkor et al. (2011). Risk
maximisation is never optimal because there cannot be franchise value without taking risks,
so the firm always faces costs and benefits when its risk level increases (Carey and Stulz,
2005).

Kithinji (2010) assessed the effect of credit risk management on the profitability of
commercial banks in Sub-Saharan countries including Mauritius. The findings reveal that the
bulk of the profits of commercial banks is not influenced by the amount of credit and
nonperforming loans; therefore, suggesting that other variables other than credit and
nonperforming loans impact on profits. Felix and Claudine (2008) investigated the
relationship between bank performance and credit risk management. It could be inferred from
their findings that Return on Equity (ROE) and Return on Assets (ROA) both measuring
profitability were inversely related to the ratio of non-performing loan to the total loan of
financial institutions thereby leading to a decline in profitability.

Implications for Mauritius

Recent bank failures in Mauritius have demonstrated the importance of effective liquidity risk
management to maintaining institutional viability. Many non-bank financial institutions
(NBFIs or “nonbanks”) do not have the same liquidity risk drivers as banks – such as the
potential for a severe deposit runoff. However, nonbanks face their own inherent liquidity
risks and have a high degree of interconnectedness with banks.

NBFIs comprise a wide array of financial service providers such as private credit funds,
consumer financing companies, leveraged loan funds, money market funds, and “fintechs” (to
name a few). These firms provide services traditionally performed by banks such as
provisioning of credit and financial intermediation. While the specific types of NBFIs differ
greatly from one another, some NBFIs will see recent bank turmoil as an opportunity for
asset growth. Asset growth requires funding, and bank funding to NBFIs may become
constrained (or at least more costly) in a sustained environment of high interest rates and
economic uncertainty. More expensive funding may be uneconomical and firms may even be
unable to access once reliable funding sources. Such an abrupt loss of funding could create
liquidity gaps and, at a minimum, disrupt business activity, or worse - lead to shortfalls
wherein a firm cannot meet its cash obligations.

Policy makers have long-debated whether NBFIs need more stringent regulation similar to
the regulation applied to banks, and that debate will probably become more pronounced if
financial conditions worsen. However, even in the absence of prescriptive requirements,
NBFIs should recognize that effective liquidity risk management is a strategic capability that
facilitates stability, longevity, and growth. NBFIs should analyze the liquidity risk
management practices commonly used by the banking industry and adopt a streamlined
version that is tailored for the unique liquidity risk exposures of their business (see figure 1).
Most NBFIs in Mauritius have some form of liquidity risk management practices in place
today, although the level of maturity of these practices varies. NBFIs should consider the six-
point framework described below to test the comprehensiveness of their current practices and
identify opportunities to strengthen capabilities for identifying, measuring, monitoring and
controlling liquidity risk.

Risk identification is the process of identifying and understanding the distinct risks facing the
firm. This process is important because firms that are not aware of the scope and nature of
their risks may allow less visible issues to grow unchecked. Incorporating an exhaustive list
of liquidity risk drivers is an important first step in establishing processes for risk
measurement, monitoring and mitigation. A large confluence of seemingly “small” liquidity
risk drivers can lead to a material liquidity risk.
 Conclusion

Strong liquidity risk management is a differentiator in stressed conditions to protect financial

resources, and may even enable firms to be opportunistic as their competitors become overly
defensive. While it is possible that prescriptive regulation is forthcoming for NBFIs,
particularly if the current conditions evolve into a larger crisis, that should not be the driving
factor in establishing a stronger liquidity risk management framework. In Mauritius for
investing in better liquidity risk management capabilities is equal parts protecting the
financial viability of the firm and enabling opportunity.

Creating an inventory of liquidity risk drivers and performing basic scenario modeling
doesn't require a substantial investment and it can be a useful step in explaining the
importance of liquidity risk management. Investments to secure additional liquidity sources
and establish risk measurement systems can then be weighed against the financial impact of
liquidity stress.
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