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Handout 1 Risks faced by MFIs

The seven main areas of institutional-level risks facing MFIs are in the areas of:1. Credit Risk

2. Liquidity risk3. Market risk4. Operational risk5. Interest risk,6. Foreign exchange risk, and7. Environment Compliance & Regulatory risk

1. Credit Risk: refers to the risk of default or non-payment by clients on their loans.Additional factors that relate more to the microfinance sector are:

Loans are often provided without collateral, or use non-traditional collateral, and sothere may be a danger greater than for other financial institutions. This may requirespecific mitigation techniques such as larger loan provisioning or immediate follow-

up on delinquency loans. Limited sector variation (e.g. loans are largely agricultural, perhaps even to only

amongst clients with few crops), limited geographic spread (e.g. loans are providedin a few districts only), or specific targeting (e.g. to a specific minority) can increasethe portfolio risk to the microfinance institution. These concentrations are oftenreferred to as covariant risk.

2. Liquid ity or Maturi ty Risk: refers primarily to the holding of appropriate cash balancelevels and deposit mobilization, and is mainly a cash-flow planning, monitoring andmanagement issue. The reasons for this risk arising includes:-

seasonality (given the cyclical nature of the local economy); the difficulty in obtainingcontingent credit lines;

poor cash-flow forecasting, and related management (such as with inadequatemonitoring of cash flows and in ensuring matching terms);

a lack of investment strategies or investment avenues during periods with surplusfunds; and

inadequate deposit mobilization (due mainly to difficulties getting savings and timedeposit accounts), often due to weak marketing and product development.

Skills development and training in relevant areas is seen as a key area of support needfor microfinance institutions in this area.

This risk area is also referred to as maturity risk simply as the ability to meetmaturing obligations (Current Assets > Current Liabilities).

3. Market Risk: refers to the risk of loss owing to changes in market rates and prices oninvestments by the microfinance institution. This risk is limited to those institutions whoinvest in equities, fixed-interest instruments, or commodities.

4. Operational Risk: refers to failures in the operation of the microfinance institution,hence the name, and includes breakdown of information systems, poor governance, riskof loss due to inadequate or failed internal processes and systems, external events, andhuman error. Management risk largely the risk of depending on a few individuals, andfraud are also considered components of operational risk.

5. Interest Risk : Interest rate risk is the primary measure of market risk on an MFIs loanportfolio. It is the risk that an unfavourable change in interest rates might have on the

MFIs earnings, based on gaps that exist in the matching of its interest rates on its loanportfolio assets and funding liabilities (e.g. when long-terms loans are funded by short-term deposits). This is a particular problem when the microfinance institution is not able

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to adjust interest rates on loans they have issued against the interest paid on fixed termdeposits. There is a natural tendency for microfinance institution clients to want tocommit to fixed deposits of as short a term as possible to have access to their funds,and to secure as long a term as possible over debt to lower repayment amounts. Interestrisk is faced by most microfinance institutions that mobilize deposits.

6. Foreign Exchange Risk: Foreign exchange (FX) risk arises most often for microfinance

institutions who borrow in a foreign currency to lend in local currency. FX risk thenoccurs when there is a currency mismatch in the MFIs assets and liabilities, thatexposes it to FX rate fluctuations, that could cause either losses or gains.

7. Environmental risk: this covers a range of other risks facing microfinance institutions,including:

New industry risk: this relates to the risks of trying out new and innovative financingtechniques with clients new to credit and savings;

Subsidy dependence risk: this is the dependence risk donor-funded microfinanceinstitutions have on subsidies without which they not be sustainable;

Transitioning risks: many microfinance institutions were established for social rather

than financial purposes, and as these institutions transform into regulated andsustainable institutions a range of organisational culture, performance, management,and governance issues often arise; and

Compliance & Regulatory risk: the risks associated with regulation