By Gaurav Kumar, IFMR Capital
Microfinance institutions (MFIs) essentially act as financial intermediaries, bridging the gap between mainstream financial institutions and low-income households for a specific type of credit need that is short-term and unsecured. The concept of risk lies at the heart of any such financial intermediation.
Systematic risks that face the entire sector, such as rainfall failure, impact the livelihoods of a large numbers of clients simultaneously and cannot be eliminated, but can be mitigated by purchasing insurance at a portfolio level, or diversifying across regions. However, a significant systematic risk that has emerged in recent times and which has impacted MFIs severely is political risk.
As MFIs deal with low-income households, their operations are subject to scrutiny by State governments and local powers, in addition to formal regulators. Recent experiences of political interference bring out the vulnerability of MFIs to these risks: In 2006, 50 branches of two major MFIs were closed by authorities in Krishna district of Andhra Pradesh; in 2009, repayments almost came to a grinding halt in Karnataka’s Kolar district; and in 2010, the Andhra Pradesh Government introduced a law that reduced MFI repayments dramatically.
Clarity on regulatory framework, and jurisdiction of State governments vis-à-vis non-bank financial institutions is critical in mitigating political risk. At the institutional level, this can be managed by building a closer connect between the institution and customer groups so that there is resistance to local political interference that constrains the business activities of MFIs.
Idiosyncratic risks are internal to an entity and comprise primarily operations and credit risk. In microfinance, these two are deeply intertwined and are potentially among the primary reasons why MFIs fail.
In the Joint Liability Group (JLG) model, typically followed by MFIs to disburse credit, as “credit decisions” are taken by the group on the basis of its access to private information about each member, the quality and robustness of the group formation process becomes crucial in credit risk management. The mechanism of group cross-guarantee, if implemented as per the rules that govern group formation, will result in positive selection of members. It is important, however, that the under-writing process be undertaken by the group and not by the MFI.
Dilution of group formation and meeting norms are early warning signs of process deterioration that should trigger concerns about credit quality. Outstanding MFIs pay a great deal of attention to factors such as length of the group formation process, regularity of group meetings and attendance rates.
Microfinance is an operations-intensive model and weak processes affect internal control and manifest as fraud and other operational failures. Detailed mapping of the processes and sub-processes will help MFIs identify risks, as also the weak links that pose a greater threat of fraud. To detect fraud early and take action, MFIs should have a risk-scoring model, giving each branch a risk score. Taking a holistic view, the model should be based on diverse parameters. Branches with history of fraud should be penalised in the risk-scoring model and the frequency of audit linked to the risk score. This helps understand two key questions: Which branch has poor portfolio quality? Is the branch witnessing fraud?
As all MFI disbursements and collections are cash-based, the institutions face high risk due to movement of cash. This is exacerbated for institutions operating in remote geographies. If movement of cash is not tracked and checked against demand and collections, it can result in fraud.
Such fraud can be mitigated by MFIs setting cash retention limits for branches, with deviations approved and recorded. Reconciliation of cash through MIS in the branches’ bank accounts is important in scrutinising float and idle cash at each level. Risks such as burglary during cash movement can be mitigated through insurance for cash-in-transit; cash-in-safe and branch; and fidelity insurance.
Interest rate volatility
Interest rate volatility is among the key risks MFIs face today. Changes in interest rates at which they borrow impact spreads, especially in the short term. Most MFIs do not explicitly manage interest rate risk. Increase in cost of funds severely squeezes margins, impacting profitability and operational self-sufficiency.
With increased competition and pressure to cut interest rates, MFIs are also not in a position to pass on interest rate increases to clients. With proposed regulations on capping margins, interest rate risk will continue to be one of the key threats for MFIs.
Long-term borrowing, with hedging and diversification of funding sources, will enable MFIs to mitigate interest rate risk. Given that MFIs typically have positive duration of equity (liabilities are longer dated than assets), their asset-liability management strategies have also to take into account scenarios arising from interest rate movements that impact profitability.
As with any other financial institution, risk management is critical to the success of MFIs. The unique context of MFI operations that involve under-writing by client groups and dealing in large amounts of cash outside branch locations create specific risk management needs. MFI boards, lenders and investors should be cognisant of these features.
This article first appeared in The Hindu Business Line.