PROFESSIONAL CERTIFICATE IN MICROFINANCE AND

ENTREPRENEURSHIP

MICROFINANCE LENDING AND RISK

MANAGEMENT
Prepared by T Mutambanadzo (MR T)
 Objectives

• define credit risk; apply the cannons

of lending to evaluate a credit
application; Should be able to define
and explain the credit analysis
process
• explain the importance of
understanding a client’s business
when accessing a credit application.
 Objectives
• identify the ideal features of security as well as the
various types of security that can be used to secure a
loan including the advantages and disadvantages
• students should have an appreciation of what causes
a firm to borrow and the common sources of
repayment
 Objectives
• identify the causes and early warning signs of bad
loan; Understand the stages of recovering a problem
loan; understand the legal process to follow when
dealing with problem loan; Identify and apply
common remedies of nursing problem loans as well
as preventing them
• use the various techniques taught to perform credit
assessment of any given entity
• know the basic contents of a credit policy manual.
 Credit risk
• Credit risk arises from the potential that an
obligor is either unwilling to perform an
obligation or its ability to perform such
obligation is impaired, resulting in loss to the
bank.
• Credit risk is an informational problem ie. the
credit-giver does not know enough about the
quality of the credit-taker and how the obligor
will perform in the future.
• As a task, credit risk management involves
identifying the source of risk, selecting the
appropriate evaluation method or methods
and managing the process.
 Credit risk
• Credit risk management can be seen as a decision
problem.
• The assessment involves determining the benefit of
risk taking versus the potential loss.
• Decisions about extending credit are complex and
subject to change, but at the same time are critical
elements of risk control within most organisations.
• While it is easy to outline the credit analysis decision,
implementing an effective approach is more
complicated.
 Credit analysis
• Credit analysis is the process by which lenders determine if a
borrower has the ability to repay the loan on a timely basis.
• Getting all the facts is all that is needed.
• After that, it is a matter of analysis and judgment.
• Analytical skills can be acquired.
• Credit judgment is a matter of common sense and perception.
• Analysts must however be guided by basic credit principles and
the credit policies, procedures and standards of their organisation
 General Principles of lending
• Philosophy for lending “Art or Science”
• The lender lend money with the hope that at some future date it
will be repaid .
• The lender thus needs to look into the future and ask “will the
customer repay by the agreed date?.
• There will always be some risk that the customer /borrower will be
unable to repay and it is in assessing this risk that the lender needs
to demonstrate both skill and judgement.
• The lenders objective is to assess the extent of credit risk and to try
to reduce the amount or level of uncertainty that exist over the
prospect of repayment.
• While there are guidelines to follow there is no “magic formula” .
• The lender must gather together all the relevant information and
then apply his/her skills to making a judgement.
• Number crunching will never be enough and this is why many
experienced lenders describe lending as an “art” rather than a
science.
  
The professional Approach
• The professional lender who is confident in his or her ability will
always apply the following principles;
• Take time to reach a decision –detailed financial information takes
time to absorb. If possible , it is preferable to get the ‘paperwork’
before the interview , so that it can be assessed and any queries
identified.
• Do not be too proud to ask for a second opinion - some of the
smallest lending decisions can be the hardest.
• Get full information from the customer and do not make
unnecessary assumptions or ‘fill in’ missing detail.
• Do not take a customer’s statements at face value thus ask for
evidence that will provide independent corroboration.
• Distinguish between facts, estimates and opinions when performing
a judgement.
• Think again when the “gut reaction” suggest caution , even though
the factual assessment looks satisfactory.
 Methodical approach to appraisal

• There are basically four stages to any analysis

of a new lending proposition.
• Introduction of the customer
• The application by the customer
• Review of the application
• Monitoring and control
 Introduction
• Lenders do not have to do business with
people they do not feel comfortable with.
• Approaches for borrowing from customers
of other institutions merit special caution.
• Why is the approach being made at all?
• Has the proposal already been rejected by
the other bank?.
• If the potential customer ought to have a
financial track record , but does not have
one, a degree of suspicion is in order.
 The application.
• This can take many forms but should include
a plan for repaying the borrowing and an
assessment of the contingencies that might
reasonably arise and how the borrower would
intend to deal with them. It might be in
detailed written form or merely verbal.
• There are many instances when the lender
will have to draw out sufficient further
information to enable the risk in the
proposition to be fully assessed.
 Review of the application
• At this stage all the relevant information that is required needs to
be tested and other data sought if necessary. Either formally or
informally the lender applies what are generally known as the
cannons of good lending. It is sometimes difficult to remember all
the points to be covered during an interview and many lenders use
a mnemonic as a checklist.
• There are a number of mnemonics in common use but the most
prevalent are probably CCCPARTS ( Character, Capital, Capability,
Purpose, Amount, Repayment, Terms and Security),
• PARSER (Person, Amount, Repayment, Security, Expediency
(feasibility/usefulness) and Remuneration ),
• 5Cs ( Character, Capacity, Capital, Capability and Collateral)
• CAMPARI ( Character, Ability, Margin, Purpose, Amount,
Repayment and Insurance. CAMPARI is probably the most popular
of the mnemonics and is the one we shall describe in detail.
The Classic Five C’s of Credit
 Basic credit principles
• The most basic principles used to evaluate a borrower’s
creditworthiness are known as The Five C’s of credit.

• They are the absolute considerations of commercial

lending.
• The Five C’s of Credit have worked very well in the past.
 The Five C’s of Credit
• Character
• Capacity
• Conditions
• Capital
• Collateral
 Character
• Thou shalt make sure that the person or company you are lending to is
of honorable character.
• Character is the most important risk point to consider:
1. Money is borrowed and repaid by people.
2. MFI needs to know the people it is dealing with
• Character involves the borrower’s
1. Willingness to pay its obligations
2. Business character based on payment record
3. Management quality, honesty, integrity, reliability,
trustworthiness
• Unwillingness to pay cannot be mitigated by the other four Cs of
(Good) Credit.
 Capacity
Thou shalt make sure that the person or
company you are lending to has the capacity to
repay the loan.
•Capacity means ability to run the business successfully and generate cash
(liquidity) to repay obligations when due.
•To have liquidity, management must have products, markets, competitive
position in the market, and exercise cost control to generate profits.
•Capacity can be further assessed through the borrower’s payment history
and profitability track record.
•Capacity refers to management experience (know-how), training, and skills
to operate the business profitably
•Capacity equated to potential, capability, adequacy, sufficiency, strength
 Conditions
Thou shalt extend credit with the understanding that business and
economic conditions can and will change.
• Conditions refer to economic and environmental factors that might
adversely affect the borrower’s operational and financial performance,
and therefore its ability to repay the loan.
– Include “the economy”, the business climate, the legal and
regulatory environment, the national and world economic outlook,
the business cycle, technological changes, natural disasters, etc.
• Such conditions are typically beyond the borrower’s control
• Conditions also refer to the purpose of the loan:
– Equipment loan to finance plant expansion
– Working capital loan to finance seasonal build up of inventory
 Capital
Thou shalt make sure that the company you are lending to is
adequately capitalized.
• Capital refers to the borrower’s investment in the business and the
adequacy of funds the business needs to operate efficiently and
generate cash to repay the loan.
• Capital reflects the borrower’s faith in the business, products, future, …
• Capital broadly means borrower’s financial position.
• Synonyms of capital include: assets, means, resources, wealth, etc.
• Owners’ equity must exceed the amount of debt capital.
• Capital also refers to liquidity available to meet maturing obligations
and run the business successfully.
 Collateral
Thou shalt make sure that collateral does not drive lending decisions.

• Collateral include receivables, inventory, property or other fixed assets

that can be pledged to a lender to secure a loan.
• Other forms of collateral are: standby letters of credit, personal
guarantees of sponsors, corporate guarantees (firm, parent or sister
company)
• Collateral is a secondary source of loan repayment and the last
protection against loan loss.
• Collateral should not be the primary consideration for lending.
• Collateral is never there when it is needed. Vanished or non existent.
• Must be periodically inspected and valued by qualified individuals
 PRIMARY LENDING ITEMS

• All lending institutions have different

Underwriting Guidelines set in place when
reviewing a borrower's financial history to
determine the likelihood of receiving on-time
payments. The primary items reviewed are:
– Income
– Debt
– Credit history
– Savings
The Five C’s of Bad Credit
 The Five C’s of Bad Credit

• Complacency
• Carelessness
• Communication
• Contingencies
• Competition
 Complacency
Thou shalt not be complacent.
• Complacency characterized by:
– Over-reliance on guarantors (issuers of support)
– Over-emphasis on past performance
– Over-reliance on large capitalization
– Failure to recognize changes in business cycles
 Carelessness
Thou shalt not be careless.
• Carelessness characterized by:
– Inadequate or deferred loan documentation
– Lack of protective covenants in the loan
documentation
– Non completion of conditions precedent
– Absence of current financial information
– Information not kept in the credit file
 Communication
Thou shalt not communicate poorly.
• A communication breakdown can destroy the Bank.
• Bank Officers should learn how to communicate clearly with
seniors, colleagues and with subordinates
• Concerns about credit quality objectives must be
communicated clearly
• Bank Officers should acquire IT skills to be able to
communicate using modern IT equipment.
• Communication with regulators and other external
stakeholders should be carefully managed.
 Contingencies
Thou shalt not ignore contingencies.
• Insufficient attention to downside risk
• Do not forget “What if” analysis
• Plan B
 Competition
Thou shalt not be swept by competition
• Competition based on lending

• Import finance, asset acquisition finance, project finance done with

reduced or no contribution from the customer
• Strong appetite for single bank lending in a situation that requires risk
sharing
• Fight for largest share of loan syndication
• Providing longer loan maturities
• Extending consumer loans in excess of Capacity
• Reducing commission, fees, interest rates
• Loosening terms and conditions (collateral, documentation,
domiciliation requirements, …)
Business Vs Social Approach to
MFI Development
 Defining Business approach
• Business is about implementing planned and
specific activities in order to make profits or
surplus. The latter facilitates the business or
the activities as a going concern.
• People do not go into business just for its own
sake, but because they want to use such
business to add value to their lives.
• A business approach therefore emphasizes
the need to fully cover costs
 A ‘social welfare approach’
• Social welfare on the other hand involves
provision of services free of charge or at
minimal cost.
• But if there is no surplus or profit to sustain
continuity of services then the risks of
discontinuity are high and real.
• A social welfare approach emphasizes the
immediate needs of the clients as opposed to
the profits of the organization.
 Microcredit Vs Traditional Lending
Traditional Lending Microcredits
Objective •Profit-maximisation •Social goals predominant
•Shareholder value •Stakeholder value

Target groups •”Bankable“ clients •Low-income population

•Resalable collaterals •Mostly informal self-employed
•High solvency •Low solvency
•Socially marginalized

Provider •Commercial Banks •Informal Provider

•Savings Banks •NGOs
•Cooperative Banks and Post Banks •Specialized Microfinance Institutions
•Cooperatives

Credit Characteristics •Individual liability •Small sums

•Unlimited amounts and duration •Short-term (6 month to 1 year)
(depending on individual needs and •Alternative collaterals
solvency) •Joint liability (group lending)
•Market-based interest rates •Regular meetings (group lending)
•Obligatory savings

Business Procedures •Highly standardised (e.g. credit •Close personal contact to clients
scorings) •Loan officer responsible for the
•Highly decentralized (each step by a whole process
special division: sales, disbursement,
repayment etc).
 Credit Policies and Procedures
• ELIGIBILITY
• LOAN SIZE
• TYPE OF LOAN
• PURPOSE OF LOAN
• TERMS & CONDITIONS OF LOANS
– Charges
– Loan Duration
– Mode of Disbursement
– Collateral
 Defining Micro-Finance Clients
• Microfinance clients are drawn from the minimalist
approach to small and micro-enterprises (SME)
development paradigm.
• This is where a range of products are developed with
the aim of developing small and micro business, with
the aim of increasing income and employment
opportunities among poor communities.
• One common denominator the micro-finance clients
have is that they have to all be "Economically Active"
individuals.
CLIENT SELECTION
 Clearly defined client group
• A clearly defined target market such as ‘non-
agricultural businesses with at least one year
experience that have lived and worked in the
community for at least 3 years’ would be an
example of a target market.
• As much as possible, avoid lending to start-up
businesses. The rate of failure among start-up
businesses is high. It is believed that 9 out of
10 new businesses fail.
 Clearly-defined geographic areas
assigned to credit officers
• It is generally much easier to assign
geographic zones to loan officers to improve
follow-up and the efficiency of your staff.
• Trying to cover too large geographic area with
too few staff generally leads to inefficiency
and difficulties with regard to proper
supervision.
 Client selection based on character assessment
and repayment capacity, not
collateral
• The individual’s reputation in the community and the cash
flow of the business are more important than traditional
collateral.
• Examining a potential client’s character and their
repayment capacity is crucial.
• Proper client selection should be based on thorough credit
investigation and background investigation and analysis of
the client’s debt capacity or cash flow.
• Over-reliance on collaterals, on the other hand, can lead to
improper client selection.
• Collaterals tend to create a false sense of security in the
lender.
LOAN POLICIES
• Start loans small and increase lending
(i.e. amount and term) based on
successful repayment and improvements
in the client’s cash flow.
– Increase the amount and term of the
loans gradually as the client becomes
known to the micro finance institution.
• Be conservative in analyzing the
client’s cash flow when determining
how much to lend.
– We generally recommend that, for first-time
borrowers, loan payments should not exceed 25-
35% of the client’s net income.
– This allows the MFI time to slowly get to know the
client’s “real debt” capacity and reduces the risk
for the MFI and the debt burden of the client.
• Look at potential risks to supply, production
and sales.
– It is also important to look at potential business
risks, such as any potential risk to supplies (fish
vending being dependent on good fishing - what
happens when the weather is bad and fish are
scarce?); production (who operates the business
when the client is sick or away?
– sales or customers (what happens when there is
more competition, a new store opening up across
the street, or closing of the public market?).
• Focus on providing short-term, working
capital commercial loans
– Successful microfinance institutions generally
avoid businesses with more risky ventures such as
agricultural production or fishing. They
concentrate their lending activity on businesses
that generate regular income flows.
– Initial loans are generally for working capital as
opposed to fixed assets.
– Loans for fixed asset are provided only after
lending to the same client for at least one year.
• Frequent and small amortization payments
– The more frequent the amortizations payments,
the smaller they will be, and the easier will it be
for clients to pay.
– The frequency of payments, however, should be
balanced against the costs of collecting these
payments.
– Daily payments, for example, would have a higher
cost than weekly payments.
• Sufficiently high interest rates to make a
good profit
– Because microfinance loans are small with
frequent installment payments, the transactions
costs are high compared with those of regular
commercial loans.
– The interest rate for microfinance loans,
therefore, should be higher.
– Micro enterprise clients are willing to pay higher
rates for a good service.
DISBURSEMENT AND MONITORING
• Loan Officers should be responsible for loans they have
recommended for approval.
• Loan Officers staff should be involved in the loan approval
process (through a branch-level credit committee made up
of loan officers and their supervisor, instead of the branch
manager alone)
• Loans officers should maintain continuous contact with
clients
• Delinquency alarm signals(These include immediate follow-
up the day a payment is missed or at least the following
morning. As well as follow-up visits by the supervisor and
manager when payments are missed by 3 days and 7 days
respectively.)
• Performance-based staff incentive scheme
– Successful MFIs also provide monetary incentives
to their staff based on their individual
performance.
– Performance is usually measured in terms of the
number of accounts supervised by the loan
officer, size of the loan officer’s loan portfolio, and
the quality of their respective loan portfolio,
which portfolio, and the quality of their respective
loan portfolio, which is normally measured by the
portfolio-at-risk ratio (PARR).
CLIENT INCENTIVES
• Successful microfinance institutions provide
Incentives to their good clients by providing
larger repeat loans (depending on their debt
capacity) and rebates on interest rates or fees.
– These are done to encourage on-time instalment
payments.
• On the other hand, late payments are also
penalized by imposing penalty charges for late
installment payments.
CULTURE OF ZERO TOLERANCE
AGAINST LOAN DELINQUENCY
• Loans with payments delayed by just 1 day is
considered delinquent
• The micro finance institution must be willing
to pursue delinquent clients, in some cases,
whatever the cost to establish and maintain
zero tolerance.
• The culture of zero tolerance should start with
the top management
Role of Loan Officer-
Introduction
• The credit officer (CO) plays a critical role
because of the multiple roles of this position.
• The CO is expected to be a combination of the
following;
– Trainer
– Facilitator
– Counselor
– Debt collector
– Credit officer
• The role of credit/loan officer cannot be
emphasized enough as he/she is the link
between the customers and the institutions.
• In other words the CO is the
marketing/relationship manager and it is
therefore important that the CO conceptualize
this so that he/she can actualize it.
• These cadres of staff are expected to know it
all and often times are expected to be the
“jack of all trades”.
• Whether these staff see themselves as
described above is a matter for discussion.
• It is therefore important that CO has the
prerequisite skills to perform his/her role
effectively.
• While the institutions are held responsible for
recruiting and developing qualified staff, the
individual staff should also take the initiative
to be knowledgeable and remain informed.
ROLE OF THE LOANS/CREDIT OFFICER
 Planning the Operations
• The credit officer takes part in planning
process through the following activities;
– Conducting field surveys, enumerate businesses
and develop understanding of operational area.
– Evaluating accessibility to support auxiliary and
other services such as Banks, Police stations,
Schools etc.
– Identify other development agencies/government
departments for future collaboration.
 Outreach & promotion
• Preparing promotion message
• Preparing promotional materials
• Calling and organizing meetings
• Responding to enquiries
• Working with existing clients
• Re-organizing fragile groups
• Maintaining good public relations & upholding
correct image of the organization
• Organizing seminars for group leaders
 Recruitment and intake of clients
• The CO recruits clients;
– Respond to enquiries and make
scheduled and unscheduled visits to
potential clients for verification
purposes
– Make assessment of clients and
client business and if satisfied
 Training
• The groups are trained on;
– How to conduct group meetings
– How to take minutes and maintain group records
– How to open and operate a Bank account
– How to formulate a group constitution
– How to access loan application
– Good borrowing principles
– Advantages of shorter repayment periods
– Group character assessment
– Leadership roles and duties of group officials
– Group meeting formats, members rights and obligations
– Purpose and interpretation of individual member records
– Security for loans
 Loan processing, disbursement &
loan collection
• The CO facilitates the process by;
– Appraising the applicants and their groups
– Ensuring that application documents are duly
completed.
– Facilitating the disbursement
– Follow up
– Ensuring loan payments are on schedule.
 Reporting
• Information is important to determine
whether the institution is on course or off
course, and so the CO must periodically
prepare progress reports for his/her use and
for management use as well.
 Other duties
• Duties as may be assigned by the manager
and may include acting on behalf of the
manager, presentations at conferences etc.
Loans Appraisal Guidelines
 Group assessment
• Verify past group records (Watch for backdated records
to avoid being cheated!)
• Verify whether the registration certificate is genuine.
• Attach list of initial and current members with the ID
Nos.
• Probe further to establish stability of the group.
• Observe whether the group rules and regulations
constitution are being adhered to.
 The Client
• Name and Date of Birth – verify from available identification papers
• Age: (Take caution on dangers of lending to very young and very old
clients though, not all such clients in this category are risky).
• Marital Status: Be careful about singles without dependants. Experience
has shown that married people are more stable and reliable. Where one
has many dependants, there is risk of diversion of funds, hence default.
• Nationality: Where there is suspicion there is need for verification from
independent sources.
• Residence: Investigate and verify
• Length of Residence: Length of stay in the residence will indicate stability
of the client; i.e. a person, who has stayed in an area for a longer period,
indicates stability.
 The Client
• Home district: For future reference in case a client absconds (chief,
Headman)
• Year started business: Number of years in business will give an indication
of experience of clients in business generally.
• No. of years in current business: Will give an indication of business
stability and experience of client. Investigate change of business and
diversification to avoid experiencing new business ideas.
• Ownership: Use the licenses to verify ownership of business or any other
available. The same information can be obtained from neighbouring
businesses and also impromptu visits.
• Loans from other institutions: Verify from other members or institutions
in that area.
Delinquency Management
• Delinquency is a deviation from the expected behaviour,
and in the case of credit it starts when the amount due is
not settled in full.
• It is a direct measure of risk exposure for the lender.
• All lenders would wish to keep delinquency at zero levels,
but this may not be possible all the time because of various
factors within the organizations and/or their environments.
• It is a major challenge facing many MFIs today.
• Delinquency is a process that starts long before it becomes
evident.
• Depending on how it is handled, delinquency can be
averted.
• If not well combated, delinquency leads to myriad
problems for the institution.
• Delinquency is normally calculated as a ratio
of outstanding loan balances or the total
number of borrowers with outstanding loans.

Amount past due/Amount outstanding*100

• Although this measure is the one most commonly used
among microfinance programmes, it understates the risk to
the portfolio because it only counts the payments as they
become past due, not the entire amount outstanding
(balance) of the loan actually at risk.
• For example, suppose a borrower with a six-month loan of
$300, with monthly repayments, misses the first four
monthly payments, totalling
• $200 in principal. According to formula a), only $200 would
be in arrears, or at risk. What about the remaining $100 of
the loan thathas not yet come due?
• Should it be treated as part of a healthy portfolio? Is it not
really at risk as well?
• In addition, if the portfolio is growing rapidly, a delinquency
problem will be hidden because the denominator reflects the
entire balance of new loans immediately, whereas the numerator
reflects only the amount of payments as they gradually become
past due.
• A similar effect occurs if loan terms are long, making the
payments relatively small. Each payment past due has a small
effect on the rate of delinquency, even though the amount of risk
to the portfolio might be increasing.
• If the $300 loan described above were a 12-month loan with
monthly payments of $25, then after four months with no
payments, only $100 would be in arrears, with the $200
outstanding balance considered as part of the healthy portfolio.
• The portfolio at risk formula, which is used by
banks and other formal financial institutions,
corrects for many of the weaknesses
described above.
– % delinquent = outstanding loans with payments
past due/amount outstanding
• This formula measures the percentage of the
portfolio at risk or contaminated by late
payment.
• Whereas the amount past due formula
measures the amounts that are actually past
due, the portfolio at risk formula considers
that the entire outstanding balance of a loan
that has any payment past due is at risk.
• As soon as the first $25 or $50 payment of
the $300 loan described above becomes past
due, this arrears formula regards the entire
outstanding balance of $300 as delinquent, or
at risk.
• An important issue in calculating delinquency
rates is defining “past due”:
– is it one day after the due date of a payment, 30
days after this due date
– or one day past the final due date of the loan?
• One rule of thumb is to consider loans past
due when a payment completes one entire
cycle without being made or, in most cases,
when two payments are past due.
• Thus, loans with weekly payments are
considered past due seven days after a missed
payment, and loans with monthly payments
are past due after 30 days.
Effects of delinquency
 • Reduces net cash flow
• Lowers profitability through lost
revenues
• Raises cost of lending
• Reduces customer’s or client value

Given the damaging effects of delinquency MFIs should focus their

effort in preventing it as its treatment is more difficult.
Prevention Of Loan Delinquency
• Provision of total quality services
• Careful screening
• Detailed orientation of loan officers and
clients
• High disincentives for defaulting
• Proper implementation of policy & procedures
• Accurate and timely information
In cases of serious defaults try the
following
• Check levels of compliance with policies & procedures
• Review credit system
• Design incentives and tolerance levels for MFI expectation
• Separate bad and performing portfolio for easier tracking and
decision-making
• Set deadlines
• Reshuffle and/or retrench loan officers
• Discontinue bad clients as they complete loans
• Review information system
Signs of Delinquency
• Lateness or absenteeism
• Irregular Loan Repayments
• Poor Group Leadership
• Conflicts in the Group
• Refusal to Participate in Other Group Activities
• Late Disbursement of Loans
• Poor Record Keeping
Causes of Delinquency
• Experience has shown that there are
three major causes of delinquency:
– i) Institution-related causes
– ii) Client-related causes
– iii) Externally driven causes
• While there are three major causes of delinquency,
the MFIs themselves are mostly to blame for the
delinquency that they have to deal with.
• Most cases of delinquency are caused by institutional
failure to operate professionally and their reluctance
to develop policies and procedures that define their
business operations and that are geared to client
needs.
• As a result, institutions cause more than 80% of the
delinquency, which they deal with, while about 15%
of delinquency emanates with clients.
• Only about 5% of delinquency is caused by
exogenous factors.
Institution-Related Causes of Delinquency
 Lack of clear policies and
procedures
• Some of the upcoming and even established
MFIs do not have a clear vision and mission,
and therefore have no clear focus on their
objectives and the activities needed to
achieve them.
• Consequently they have no clear policies and
procedures to guide them in their objectives,
creating room for default to creep in.
• Outreach and promotion is the beginning of the marketing
process for the institution and it is critical that potential
clients understand the institution’s products and services,
their benefits and the relationship with the institution.
• For example, clients should understand that the funds they
access from MFIs are loans not grants, and should be paid
back according to a schedule.
• Client failure to uphold their obligation to the institution
will lead to penalties both for the individual and the other
members of the group.
If this information is not communicated clearly, there is
ample opportunity for clients to misinterpret the
information relayed to them, which in turn could lead to
delinquency.
Outreach and promotion
• This problem may be further compounded by inadequate group
preparation.
• Once an institution has in-taken groups, they usually take them
through training, which is supposed to focus on the institution’s
policies and procedures vis-à-vis the financial services that
clients can access, and the obligations and responsibilities of
the client.
• Many institutions’ operations staff view this training as a one-
shot deal to be carried out when groups are in-taken, but
subsequent to that, no continuous client training is really
required.
• Training must be seen as a continuous process, which reiterates
the key aspects of the institution’s services and keeps clients
abreast with any new developments that may be relevant to
the business relationship between the institution and its clients.

Inadequate group preparation

• Many MFIs leave the responsibility of business and
loan appraisal to their clients.
• These clients do not have the requisite skills to carry
out proper appraisals and in many cases will
recommend loan amounts that the individual’s
business is not able to absorb.
• MFIs should take on the responsibility of carrying out
appraisals.
• The cost of dealing with bad loans falls squarely on
the institution and MFIs should invest in training
their staff to carry out appraisals, because many
operations staff also do not have the requisite skills
to carry out business appraisals.
Failure to assist with business and loan appraisal
• There is a great deal of institutional pressure for
operations staff to reach more and more clients and
a lot of emphasis is placed on numbers.
• In striving to reach these quantitative targets, little
attention is paid to the quality of those numbers.
• Microfinance operations need to balance numbers
with quality, and where targets have been set at
unrealistic levels, staff should point this out giving
justification for their stance.
• This will introduce a more professional way of
operating in the industry.

Quantity Vs Quality Loan Book Growth

• As institutions strive to become sustainable,
many institutions have stretched the
sustainability concepts beyond the normal
expectations and as a result, have
marginalized the staff development process.
• This has resulted in recruitment and
maintenance of inefficient staff hence
increases in delinquency.

Lack of staff development

• In many cases, management information
systems is the most important tool for
managing operations and so the lack of it or
inefficient systems in others has led to
inaccurate and/or late information leading to
wrong decisions.
• As a result, opportunities for default have
been created.

Lack of or inefficient systems

• Lack of sharing of information among credit
providers has created loopholes for clients to
cheat and obtain multiple loans, which later
become burdensome in payback.
• This means clients will be forced to make
choices to pay to other institutions while they
default in others based on perceived threats
or benefits
Lack of sharing of information among credit
providers
• Rapid expansion is a serious cause for default,
experience has shown that it leads to poor
marketing, inadequate preparation of clients
and minimal time for follow-up hence
increase in arrears and defaults

Rapid expansion
• Even though it is clear that external factors
such as political and economic instability and
cultural inhibitions can cause serious defaults,
it is important to remember management is
about that which is within the institution’s
control and ability.

External Factors
Interest Rates Setting/Loan
Pricing
 LOAN PRICING TECHNIQUES
• There are basically two ways a bank charge for
loans;
– Interest
– Fees
• Pricing is an important aspect of product design,
and therefore a balance should be found
between what clients can afford, and what the
MFI needs to earn in order to cover its full costs.
• It has been widely proclaimed that MFI clients
are not price sensitive, but a counter argument
to this is that the reason for their insensitivity is
because of limited options to credit access.
• So there is need to ensure that clients are not
made to pay for inefficiencies just because they
will not complain.
• As MFI clients continue to be empowered,
they are certainly going to be concerned
about the prices they have to pay for services,
and hence it is important that MFIs start to
strategize in advance.
• Good pricing must be based on actual cost
structures, and it is therefore important to
identify the different type of costs, and these
would normally include;
– Financing costs
– Operating costs
– Loan loss provision
– Cost of capital

Key drivers of costs in a financial

institution
• Financing costs are incurred when an MFI
uses borrowed funds to finance its loan
capital.
• Operating costs include salaries, rent, utilities,
transportation etc.
• Loan loss costs are made up of bad debt
provisions.
• Cost of capital is made up of loss of money
value caused by inflation
• Pricing can be used as a strategy to gain a
competitive edge over other competitors
especially now because of the increasing
competition from new and upcoming MFIs.
• Pricing in an MFI sense is about setting
interest rates and determining other fees.
• Effective interest rate (R) setting is based on
five elements that are expressed as a
percentage of average outstanding loan
portfolio.
• These elements are administrative expenses
(AE), cost of funds (CF), loan losses (LL),
capitalization rate (K), and investment income
(II), such that;
• R = (AE + CF + LL + K) / 1 - LL
• Administration expenditure includes all recurring
expenditure.
• Cost of funds includes the actual charge on borrowed funds,
and if the MFI is operating on grant the “supposed” charge on
the grant should always be estimated in order to accurately
determine sustainability performance.
• Cost of funds may be calculated by totaling all financial assets
and multiplying it by the inflation rate.
• Capitalization rate represents the net profit that the MFI
would like to achieve.
• This rate varies from one MFI to another, but to support long-
term growth, a capitalization rate of 5 to 15 percent of the
average loan portfolio is suggested
• Investment income comes from such financial assets as term
deposits, and/or other investments etc.
 Loan pricing methods
• Pricing based on cost
• Advantages
– The price is directly ties to the cost of doing
business ensuring continued viability of the bank
• Disadvantages
– It’s completely internal and therefore not
sensitive to market prices
 Loan pricing methods
• Pricing based on competition
• Advantages
– It’s simple since the bank may choose to price the loan exactly as the
competition has priced it or choose to undercut the competition by
pricing the loan slightly below competition.
– It involves the least amount of data collection. All the financial
institution does is to shop around for competitor’s price.
• Disadvantages
– Its completely external and therefore ignore the cost of doing
business.
– Can be misleading of the competition’s internal cost are different from
that of the financial institution and if this happens the financial
viability of an institution may be threatened
General Principles of Security
Attributes of good security
• Easy to value
• Easy to take
• Easy to protect
• Easy to realise
• Stable in value
 Direct and indirect security
• Direct security is security deposited by the
borrower and indirect security also known as
third party security is security deposited by
someone other than the borrower.
 Types of Securities
• Mortgages
• Stocks and shares
• Life policy
• Guarantees
• NGCB
• NSCB
• Cession of book debts
• Pledges
 THANK YOU
ASANTE SANA
CREDIT LENDING MODELS
• Microfinance institutions are the oldest financial
institutions in the world, but with time they have
adapted to the changes, and have started using
various credit lending models.
• Microfinance services are provided with different
methods, a total of 14 models are in existence.
• They include associations, bank guarantees,
community banking, cooperatives, credit unions,
Grameen, group, individual, intermediaries, NGOs,
peer pressure, ROSCAs, small business, and village
banking models.
• In reality, the models are loosely related with
each other, and most good and sustainable
microfinance institutions have features of two
or more models in their activities.
• The Microfinance lending models vary in their
legal forms, in the channels and methods of
delivery, in their governance structure, in their
approach to sustainability and also in their
approach to microfinance where their funds
are sourced from, and how the money is
governed.
Distinguishing different lending
methodologies
 Group Approach
• A group consists of two or more individuals.
• Groups consist of individuals who have
something in common; they come from the
same community, they worship in the same
church, they are the same age group or they
simply work in the same market.
• And so this is the first lesson in group
formation; defining the common bond.
 Group Approach
• The second lesson is understanding the reasons for
continued existence of such groups.
• Even though the MFI staff may facilitate this process, it is
best when the members of the group themselves can
articulate why they think existence of their group will
promote their purpose.
• It is only in this way that the MFIs help develop long
lasting groups.
• The reason we often see high group fragility rates is
because these issues were not clearly defined, and
furthermore members played a secondary role in that
process.
 Group Approach
• Where groups do not exist at all then MFIs can
use different ways to demonstrate to the
communities the advantages of pooling
together.
• The MFI must help the communities define
some common bonds upon which new groups
may be formed, and then go ahead to
facilitate the group formation process.
• Group method primarily involves a group of
individuals, which becomes the basic unit of
operation for the MFIs.
• As MFIs have to provide collateral free loans, group
methodologies help in creating social collateral (peer
pressure) that can effectively substitute physical
collateral.
• Group becomes a basic unit with which MFIs deal.
• The group approach delegates the entire financial
process to the group rather than to the financial
institutions.
• The amount of loan depends upon the total
accumulated amount of saving of the group.
• The group itself selects its members before acquiring
a loan.
• Loans are granted to selected member(s) of the
group first and then to the rest of the members.
• Most MFIs require a percentage of the loan that is
supposed to be saved in advance, which points out
the ability to make regular payments and serve as
collateral.
• Group members themselves decide about the
criteria of dividing the loan among the group
members.
• With this loan the whole group may jointly start a micro-
enterprise or the members may start their individual
businesses.
• An individual may also use his loan for consumptive purpose
or meeting other priority needs.
• Group members are jointly accountable for the repayment of
each other’s loans and usually meet weekly to collect
repayments.
• To ensure repayment, peer pressure and joint liability works
very well.
• The entire group will be disqualified and will not be eligible
for further loans, even if one member of the group becomes a
defaulter.
• The creditworthiness of the borrower is therefore
determined by the members rather than by the MFI.
• These type of group based credit delivery methods help to
empower the group members because they remain
involved in various group activities.
• They visit the bank, market and hold group meetings which
help them to increase self-confidence.
• The Group Model's basic philosophy lies in the fact that
shortcomings and weaknesses at the individual level are
overcome by the collective responsibility and security
afforded by the formation of a group of such individuals.
• The collective coming together of individual members is
used for a number of purposes: educating and awareness
building, collective bargaining power, peer pressure etc.
Group formation process
 Receiving individual applications
• The applications could be either verbal or
written, but aspiring members must express
the willingness to join and give reasons why
they want to join.
 Assessment of individuals
• This must be based on their character and
behaviour, whether they are people who can
easily interact with others and whether they
can be relied upon to keep established rules
and norms.
• Both group members and the MFI staff can do
this vetting. Informal interaction with members
of the communities will facilitate this process.
 Registration of members
• All those who qualify must then register by
completing the appropriate documents and
paying fees where necessary.
• Registration is a sign of commitment on the
part of the member and organization on the
part of the MFI.
 Constitution
• Once the common bond is defined and agreed
upon, the group operating rules must be
established through brainstorming session
with all members.
• Rules are usually in a constitution form
 Constitution
• Consist among other things;
• The name of the group
• Objectives
• list of members
• Eligibility criteria
• Registration procedure
• Resignation
• Expulsion
• Disciplinary procedures
• Election procedures
 Group leadership a strong
determinant of group success
• Below are a few characteristics of good group
leaders;
• Involve all the group members
• Be firm but fair
• Understand their roles within the groups i.e.
• Chairperson, Secretary, Treasurer
• Be committed to the group’s course
• Be honest and have integrity
• Be open to criticism
• Be compassionate
 A highly cohesive group will be
evidenced by
• High participation
• Small action committees
• Many social welfare activities
• Participative dialogue
• Open communication
 Leadership and Group Mgt
• Class discussion
 ADVANTAGES OF GROUP
METHODOLOGY
• The self-selection process of forming a group
doubles as a screening device due to the fact
that individuals are more likely to select credit
worthy peers that can repay the loan.
– This process allows an MFI to overcome inherent
information asymmetries by taking advantage of
social ties and peer pressure.
• The groups take part in peer monitoring,
which means that the social connections
facilitate the monitoring process.
• MFIs actually deliver the financial service at
the client’s location which could be a village in
rural areas or a colony/slum in urban area.
Having a group, helps the MFIs in getting all
clients at one spot rather than visiting each
individual’s house
• Group methodology is also important because
in case of larger loan defaults a financial
institution can take recourse or legal action
but in small loans legal recourse is not an
economically sound option, as the cost of
recovery through that method can be higher
than the amount to be recovered itself
• Finally, both group monitoring and group
meetings for distributing loans and collecting
repayments offer a structure that decreases
costs while sustaining high repayment rates
PITFALLS OF GROUP METHODOLOGY
• The group formation guides to lower
transaction costs for the MFIs, but on the
other hand, hostility among group members
can lead to “voluntary dropouts”, this process
leads to social costs.
• Due to group liability, “bad clients can ‘free
ride’ off of good clients causing default rates to
rise”. , there might be social costs leading to
tensions within the group and tensions outside
the group.
• It could be argued that problem of adverse
selection remains, since bad risk borrowers
will be more attracted to group loans than
good risk candidates, since more risk will
ultimately fall to those good risk candidates.
• Since lending demands may change over time,
tension can grow in the group, as those
demanding smaller loans will not want to act
as collateral on a peer’s larger loan.
• This heterogeneity of borrowers is restrictive
as it prevents those individuals doing well
from doing even better, therefore stagnating
as opposed to encouraging growth.
COMMUNITY BANKING MODEL
• Community Banking model essentially treats
the whole community as one unit, and
establishes semi-formal or formal institutions
through which microfinance is dispensed.
• Such institutions are usually formed by
extensive help from NGOs and other
organizations, who also train the community
members in various financial activities of the
community bank, closely related to the village
banking model
• These institutions may have savings
components and other income-generating
projects included in their structure.
• They typically consist of 25 to 50 low-income
individuals who are seeking to improve their
lives through self-employment activities.
 Rotating Savings and Credit
Associations
• These are the most prevalent type of informal finance source around the world.
• People form a RoSCA by inviting individuals they trust to join.
• The group decides how often and where they will meet, how much will be
collected at the meetings (the group is self-managed).
• Each time the RoSCA meets, every member contributes a small set amount of
money.
• Then the group decides who will receive the total amount collected, usually one
member.
• When every group member has received funds from the group one time, the cycle
is complete.
• The group dissolves and may freshly reorganize.
• As an example, seven market women choose to contribute $1 to their RoSCA fund
every Monday morning, forming a pot of $7, which one woman receives at the
end of the week.
• Over the course of seven weeks each woman receives one pot of $7 and also
contributes $7 to the pot at the rate of $1 per week.
 Village banking
• It is similar in many ways to the group system,
but it is more rural focused.
• It is based on the concepts of the traditional
rotating savings and credit associations.
• The contact with the client happens at a
longer interval than a normal group system.
 CO-OPERATIVE MODEL
• Cooperatives are very much like 'associations
and Community Banks' except that their
ownership structure does not include the
poor.
• A co-operative is an autonomous association
of persons belonging to the same local or
professional community united voluntarily to
meet their common economic, social, and
cultural needs and aspirations through a
jointly-owned and democratically-controlled
enterprise.
 THE GRAMEEN MODEL
• Grameen model is based on the concept of joint liability.
• It is the brainchild of Prof Muhammad Yunus, founder of
Grameen Bank in Bangladesh.
• Grameen model is the most accepted and prevalent
micro-finance delivery model in the world today.
• Many MFIs have accepted the model as it has high focus
on standardization and discipline.
• It has been highly successful in its banking service to the
poor as well as in its poverty alleviation programmes .
THE OBJECTIVES OF THE GRAMEEN
BANK MODEL
• To extend banking facilities to poor men and women
• Eliminate the exploitation of the poor by moneylenders
• Create opportunities for self-employment for the vast
multitude of unemployed in rural area
• Bring the disadvantaged, mostly women from the poorest
households, within the fold of an organizational format
which they could understand and manage by themselves
• Reverse the age-old vicious circle of ‘low income, low saving
and low investment’ into a virtuous circle of ‘low income,
injection of credit, investment, more income, more savings,
more investment, more income’
 FEATURES
• Grameen credit’ according to Muhammad Yunus, is
based on the premise that the poor have skills which
remain unutilised or under-utilised.
• ‘Grameen credit’ promotes credit as a human right
and is targeted at the poor, particularly poor women.
• The most distinctive feature is that it is not based on
any collateral, or legally enforceable contracts, but on
trust.
• It provides service at the doorstep of the poor based
on the principle that the bank should go to the
people.
 FEATURES
• Another unique feature of ‘Grameen credit’ is that it gives
high priority to building social capital through the formation
of groups and centers, develops leadership qualities and
undertakes a process of discussion among borrowers.
• It lays special emphasis on protection of the environment
and children's education, and provides scholarships and
student loans for higher education.
• For the formation of human capital it attempts to increase
people’s access to technology, like mobile phones and solar
power.
WORKING OF GRAMEEN MODEL
 Operating Unit
• A bank unit is set up with a Field Manager and a number of bank
workers, covering an area of about 15 to 22 villages.
• The manager and workers start by visiting villages to familiarise
themselves with the local milieu in which they will be operating and
identify prospective clientele, as well as explain the purpose,
functions, and mode of operation of the bank to the local population.
• Grameen model, as mentioned, is a joint liability group model.
• Here five-member groups are formed and eight such groups form a
Center.
• Hence, in a full-capacity Center there are 40 members (8 x 5).
• However, over the years people have experimented with Centers of
different sizes and now there are variations of 5-8 groups within a
Center.
• Center is the operational unit for the MFI, which means that MFI
deals with a Center as a whole.
8
 Eligibility for Loan
• In the first stage, out of Group of five
prospective borrowers; only two of them are
eligible for, and receive, a loan.
• The group is observed for a month to see if
the members are conforming to rules of the
bank.
• Only if the first two borrowers repay the
principal plus interest over a period of fifty
weeks, other members of the group become
eligible themselves for a loan
 Group Meetings
• Meetings also take place only at the Central level and
individual groups do not meet. Group meetings take
place only in front of the Field staff of the MFI.
• The model suggests weekly meeting for frequent
interaction with the clients to reduce credit risk.
• These groups of five meet together weekly, with seven
other groups, so that bank staff meets with forty clients
at a time.
• The meetings are conducted for carrying out the
financial transactions only.
• The meetings are conducted systematically in a short-
time and other social issues are not discussed.
 Terms and Conditions of Loan:
• Flat interest is charged again for making the system
standardized.
• In flat rate system installment size of repayment remains small
for all weeks and hence is convenient and easier to explain.
• Also, it is easy to break the loan installment into the principal
and interest component.
• The group leader collects the loan repayments and savings
prior to the meeting and hands it over to the Centre leader
who gives it to the field worker during the meeting.
• This collected amount is deposited in the branch on the same
day.
• No new loan is issued from this collected amount.
• It discourages all possible leakages in monetary transactions .
 Joint Liability
• The Group and Center are Joint liability Groups, which means that
all members are jointly responsible (‘liable’) for the repayment.
• MFI recovers full money from Center, if any member has
defaulted: the group members have to pool in money to repay to
the MFI.
• If Group members are unable to do it, Center as whole has to
contribute and share the responsibility.
• According to the rules, if one member ever defaults, all in the
group are denied subsequent loans. Because of these restrictions,
there is substantial group pressure to keep individual records
clear.
• In this sense, collective responsibility of Group/Peer pressure
replaces the collateral
 Grameen Model
• If all five repay their loans promptly, each is
guaranteed access to credit for the rest of the
life - or as long as she elects to remain a
customer.
• The most significant aspect of the Grameen
Bank Model has been its high loan recovery
rate (98%and above).
 INTERMEDIARY MODEL
• Intermediary model of credit lending position is a 'go-between'
organization between the lenders and borrowers.
• The intermediary plays a critical role of generating credit awareness and
education among the borrowers (including, in some cases, starting savings
programmes.
• These activities are geared towards raising the 'credit worthiness' of the
borrowers to a level sufficient enough to make them attractive to the
lenders.
• The links developed by the intermediaries could cover funding,
programme links, training and education, and research. Such activities can
take place at various levels from international and national to regional,
local and individual level.
• Intermediaries could be individual lenders, NGOs, microenterprise/
microcredit programmes, and commercial banks (for government
financed programmes).
 INTERMEDIARY MODEL
• For recommendations, agents receive
incentives in monetary as well as
nonmonetary basis.
• The agents receive commissions based on
loan repayments.
• Second, there is a system of deposits and
bonuses aimed at ensuring that the agent
recommends good borrowers.
 INDIVIDUAL BANKING MODEL
• In Individual lending method, MFIs provide loans
to an individual based on his/her own personal
creditworthiness.
• Individual lending is more prevalent with clients
who generally need bigger size loans and have the
capacity to produce guarantee and generate
enough comfort to the MFI.
• MFIs generally base their decision on personal
knowledge of the client, his/her reputation
among peers and society, client’s income sources
and business position.
 INDIVIDUAL BANKING MODEL
• MFIs also ask for individual guarantors or take post-dated
cheques from clients.
• Individual guarantors come from friends or relatives well known
to the borrower and who are ready to take liability of repaying
the loan, should the borrower fail to do so.
• If the loan is significantly larger, then MFIs may also take some
collateral security.
• In this model, the financial institutions have to make frequent
and close contact with individual clients to provide credit
products customised to the specific needs of the individual.
• It is most successful for larger, urban-based, production-
oriented businesses. It is expensive and also limiting in outreach.
 ASSOCIATION
• An association is formed by the poor in the target community to offer
microfinance services (micro savings, microcredit, micro-insurance, etc.)
to themselves.
• Associations or groups can be composed of youth, or women; they can
form around political/religious/cultural issues; can create support
structures for microenterprises and other work-based issues.
• It gathers capital and intermediates between banks, MFIs and its
members. Example: Self Help Groups.
• In some countries, an 'association' can be a legal body that has certain
advantages such as collection of fees, insurance, tax breaks and other
protective measures.
 Credit unions (CUs)
• Rely totally on the savings and fees paid by their members to build
a loan fund.
• Community-based CUs often consist of 30 to 100 members.
• field agent assists in the formation of the group and provides
technical assistance.
• CUs set their own terms and conditions for loans to be made to
individual members.
• The amount of a member’s loan is often determined by the amount
the individual has saved.
• CUs may use members’ savings to secure a loan or may require
some form of collateral to guarantee loans.
• The collateral might be a small household asset, a bicycle, or a goat.
 Methods of monitoring

• Class discussion
RISK MANAGEMENT
 Introduction to Risk Management
• Risk is an integral part of financial services.
• When financial institutions issue loans, there is a risk of borrower
default.
• When banks collect deposits and on-lend them to other clients
(i.e. conduct financial intermediation), they put clients’ savings a
risk.
• Any institution that conducts cash transactions or makes
investments risks the loss of those funds.
• Development finance institutions should neither avoid risk (thus
limiting their scope and impact) nor ignore risk (at their folly).
• Like all financial institutions, microfinance institutions (MFIs) face
risks that they must manage efficiently and effectively to be
successful.
 Introduction to Risk Management
• If the MFI does not manage its risks well, it will
likely fail to meet its social and financial
objectives.
• When poorly managed risks begin to result in
financial losses, donors, investors, lenders,
borrowers and savers tend to lose confidence
in the organization and funds begin to dry up.
• When funds dry up, an MFI is not able to meet
its social objective of providing services to the
poor and quickly goes out of business
 Benefits of effective risk
management
• Early warning system for potential problems.
• More efficient resource allocation (capital and
cash).
• Better information on potential
consequences, both positive and negative.
 The Concept: A Risk Management
Framework
• Risk is the possibility of an adverse event
occurring and its potential for negative
implications to the MFI.
• Risk management is the process of managing the
probability or the severity of the adverse event to
an acceptable range or within limits set by the
MFI.
• Risk management is the process of managing the
probability or the severity of the adverse event to
an acceptable range or within limits set by the
MFI
 The Concept: A Risk Management
Framework
• A risk management system is a method of
systematically identifying, assessing, and
managing the various risks faced by an MFI.
• A risk management framework is a guide for
MFI managers to design an integrated and
comprehensive risk management system that
helps them focus on the most important risks
in an effective and efficient manner
 Risk management key
components
• 1. Identifying, assessing, and prioritizing risks
• 2. Developing strategies and policies to
measure risks
• 3. Designing policies and procedures to
mitigate risks
• 4. Implementing and assigning responsibilities
• 5. Testing effectiveness and evaluating results
• 6. Revising policies and procedures as
necessary
 Why is Risk Management
Important to MFIs?
• As MFIs play an increasingly important role in local
financial economies and compete for customers and
resources, the rewards of good performance and
costs of poor performance are rising.
• Those MFIs that manage risk effectively – creating
the systematic approach that applies across product
lines and activities and considers the aggregate
impact or probability of risks – are less likely to be
surprised by unexpected losses (down-side risk) and
more likely to build market credibility and capitalize
on new opportunities (up-side risk).
 Why is Risk Management
Important to MFIs?
• The core of risk management is making
educated decisions about how much risk to
tolerate, how to mitigate those that cannot be
tolerated, and how to manage the real risks
that are part of the business.
 Why is Risk Management
Important to MFIs?
• Many MFIs have grown rapidly, serving more customers
and larger geographic areas, and offering a wider range of
financial services and products.
• Their internal risk management systems are often a step or
two behind the scale and scope of their activities.
• Second, to fuel their lending growth, MFIs increasingly rely
on market-driven sources of funds, whether from outside
investors or from local deposits and member savings.
• Preserving access to those funding sources will require
maintaining good financial performance and avoiding
unexpected losses
 Why is Risk Management
Important to MFIs?
• In summary, MFIs need to design risk management
tools and approaches that respond to their specific
clients, lending methodologies, operating
environments, and financial and social performance
objectives.
 Major Risks to Microfinance
Institutions
• Many risks are common to all financial
institutions.
• From banks to unregulated MFIs, these include
credit risk, liquidity risk, market or pricing risk,
operational risk, compliance and legal risk, and
strategic risk.
• Most risks can be grouped into three general
categories: financial risks, operational risks and
strategic risks,
Major Risk Categories
 Financial Risks
• The business of a financial institution is to
manage financial risks, which include credit
risks, liquidity risks, interest rate risks, foreign
exchange risks and investment portfolio risks.
• Nature of funding determines the nature of
risks that an MFI faces.
 Credit risk
• Credit risk is the risk to earnings or capital due
to borrowers’ late and non-payment of loan
obligations.
• Credit risk includes both transaction risk and
portfolio risk.
 Transaction risk
• Transaction risk refers to the risk within
individual loans.
• MFIs mitigate transaction risk through
borrower screening techniques, underwriting
criteria, and quality procedures for loan
disbursement, monitoring, and collection
 Portfolio risk
• Portfolio risk refers to the risk inherent in the composition
of the overall loan portfolio.
• Policies on diversification (avoiding concentration in a
particular sector or area), maximum loan size, types of
loans, and loan structures lessen portfolio risk.
• Management must continuously review the entire portfolio
to assess the nature of the portfolio’s delinquency, looking
for geographic trends and concentrations by sector,
product and branch.
• By monitoring the overall delinquency in the portfolio,
management can assure that the MFI has adequate
reserves to cover potential loan losses
 Effective approaches to managing
credit risk in MFIs
• MFIs have developed very effective lending methodologies
that reduce the credit risk associated with lending to
microenterprises, including group lending, cross
guarantees, stepped lending, and peer monitoring.
• Other key issues that affect MFIs’ credit risk include
portfolio diversification, issuing larger individual loans, and
limiting exposure to certain sectors (e.g. agricultural or
seasonal loans).
 Effective approaches to managing
credit risk in MFIs
• Well-designed borrower screening, careful
loan structuring, close monitoring, clear
collection procedures, and active oversight by
senior management.
• Delinquency is understood and addressed
promptly to avoid its rapid spread and
potential for significant loss.
 Effective approaches to managing
credit risk in MFIs
• Good portfolio reporting that accurately
reflects the status and monthly trends in
delinquency, including a portfolio-at-risk aging
schedule and separate reports by loan
product.
 Effective approaches to managing
credit risk in MFIs
• A routine process for comparing
concentrations of credit risk with the
adequacy of loan loss reserves and detecting
patterns (e.g., by loan product, by branch,
etc.).
 Effective approaches to managing
credit risk in MFIs
• The importance of a “credit culture” in
minimizing problems and increasing
operational efficiencies cannot be overstated.
• MFI senior managers need to set up systems
that compel and offer incentives to loan
officers to prevent, disclose, and respond to
problem loans quickly, so as to limit potential
credit-related losses
Liquidity risk
• Liquidity risk is the possibility of negative effects on the
interests of owners, customers and other stakeholders of
the financial institution resulting from the inability to meet
current cash obligations in a timely and cost-efficient
manner.
• Liquidity risk usually arises from management’s inability to
adequately anticipate and plan for changes in funding
sources and cash needs.
• Efficient liquidity management requires maintaining
sufficient cash reserves on hand (to meet client
withdrawals, disburse loans and fund unexpected cash
shortages) while also investing as many funds as possible to
maximize earnings (putting cash to work in loans or market
investments)
• Liquidity management is not a one-time activity in
which the MFI determines the optimal level of cash it
should hold.
• Liquidity management is an ongoing effort to strike
a balance between having too much cash and too
little cash.
• If the MFI holds too much cash, it may not be able to
make sufficient returns to cover the costs of its
operations, resulting in the need to increase interest
rates above competitive levels.
• If the MFI holds too little cash, it could face a crisis of
confidence and lose clients who no longer trust the
institution to have funds available when needed
Principles of liquidity management
• Maintaining detailed estimates of projected cash
inflows and outflows for the next few weeks or
months so that net cash requirements can be
identified.
• Using branch procedures to limit unexpected
increases in cash needs.
• Maintaining investment accounts that can be easily
liquidated into cash, or lines of credit with local banks
to meet unexpected needs.
• Anticipating the potential cash requirements of new
product introductions orseasonal variations in
deposits or withdrawals.
 Market risk
Market risk includes interest rate risk,
foreign currency risk, and investment
portfolio
risk.
 Interest rate risk
• Is the risk of financial loss from changes in
market interest rates.
• In MFIs, the greatest interest rate risk occurs
when the cost of funds goes up faster than the
institution can or is willing to adjust its lending
rates.
 Managing interest
rate risk
• To reduce the mismatch between short-term
variable rate liabilities (e.g. savings deposits)
and long-term fixed rate loans, managers may
refinance some of the short-term borrowings
with long-term fixed rate borrowings.
 Foreign exchange risk
• Foreign exchange risk is the potential for loss
of earnings or capital resulting from
fluctuations in currency values.
• Microfinance institutions most often
experience foreign exchange risk when they
borrow or mobilize savings in one currency
and lend in another.
 To reduce foreign exchange risk
• An MFI should avoid funding the loan portfolio
with foreign currency unless it can match its
foreign liabilities with foreign assets of
equivalent duration and maturity.
 Investment portfolio risk
• Investment portfolio risk refers to longer-term
investment decisions.
• The investment portfolio represents the source
of funds for reserves, for operating expenses,
for future loans or for other productive
investments.
• The investment portfolio must balance credit
risks (for investments), income goals and timing
to meet medium to long term liquidity needs.
 Investment portfolio
management techniques
• To reduce investment portfolio risk, treasury
managers stagger investment maturities to
ensure that the MFI has the long-term funds
needed for growth and expansion.
• Policies establishing parameters for acceptable
investments within the investment portfolio.
These policies set limits on the range of
permitted investments as well as on the
degree of acceptable concentration for each
type of investment
Operational Risks
Operational risk arises from human or
computer error within daily product
delivery
and services.
 Operational Risk
• This risk includes the potential that
inadequate technology and information
systems, operational problems, insufficient
human resources, or breaches of integrity (i.e.
fraud) will result in unexpected losses.
• This risk is a function of internal controls,
information systems, employee integrity, and
operating processes.
Strategic Risks
 Strategic Risks
• Strategic risks include internal risks like those
from adverse business decisions or improper
implementation of those decisions, poor
leadership, or ineffective governance and
oversight, as well as external risks, such as
changes in the business or competitive
environment.
 Strategic Risks
• We shall focus on three critical strategic risks:
• Governance Risk, Business Environment Risk,
and Regulatory and Legal Compliance Risk.
 Governance risk
• Is the risk of having an inadequate structure or
body to make effective decisions.
• The social mission of MFIs attracts many high
profile bankers and business people to serve on
their boards.
• Unfortunately, these directors are often
reluctant to apply the same commercial tools
that led to their success when dealing with
MFIs.
 Governance risk
• To protect against the risks associated with
poor governance structure, MFIs should ensure
that their boards comprise the right mix of
individuals who collectively represent the
technical and personal skills and backgrounds
needed by the institution.
• Microfinance institutions are particularly
vulnerable to governance risks resulting from
their institutional structure and ownership.
 Effective governance
• Effective governance requires clear lines of
authority for the board and management.
• The board should have a clear understanding of
its mandate, including its duties of care, loyalty
and obedience.
• To govern and provide good oversight of the
institution, board members must have the right
information and review it frequently and on a
timely basis.
 Reputation Risk
• Reputation risk refers to the risk to earnings
or capital arising from negative public opinion,
which may affect an MFI’s ability to sell
products and services or its access to capital
or cash funds.
• Reputations are much easier to lose than to
rebuild,and should be valued as an intangible
asset for any organization.
External business environment risk
• Business environment risk refers to the
inherent risks of the MFI’s business activity and
the external business environment.
• To minimize business risk, the microfinance
institution must react to changes in the
external business environment to take
advantage of opportunities, to respond to
competition, and to maintain a good public
reputation.
External business environment risk
• MFIs can reduce their vulnerability to external
risks by systematically analysing their
preparedness for potential events.
 Regulatory and legal compliance
risk
• Compliance risk arises out of violations of or non-
conformance with laws, rules, regulations,
prescribed practices, or ethical standards, which
vary from country to country.
• The costs of non conformance to norms, rules,
regulations or laws range from fines and lawsuits
to the voiding of contracts, loss of reputation or
business opportunities, or shut-down by the
regulatory authorities.
Strategy to manage regulatory risk
• Establishing a good working relationship with
the regulatory authorities.
• Regardless of its formal regulatory status, an
MFI should encourage open communication
with regulators to ensure their full
understanding of the MFI and provide an
opportunity to defuse any potential problems
Additional Challenges for MFIs
 Rapid growth and expansion
• Rapid growth places several strains on an MFI’s operations.
• For many MFIs, growth has strained their capacity to
groom new managers from within the ranks, forcing rapid
promotions to fill management positions (e.g. new branch
managers) with less experience.
• The risk of having operations run poorly by inexperienced
managers can be exacerbated by weak human resource
planning or insufficient investment in training.
• When employee backgrounds do not match their
responsibilities, operational risk increases in the
organization
 Managing risk associated with rapid growth
• Careful attention to staff recruitment and
training.
• Control growth to allow time to develop
internal systems and prepare staff for changes
resulting from the expansion.
• Carefully monitor loan growth and portfolio
quality.
• Good communication from senior managers to
reinforce the MFI’s culture and commitment to
quality service and integrity
 Succession planning
• As a young industry, many MFIs are just
beginning to experience the first management
transition from founder to successor.
 New product development
• Is the potential loss that can result from a
product that fails or causes unintended harm
to the MFI.
Effective Risk Management
• (1) Identify the risks facing the institution and assess
their severity (either frequency or potential negative
consequences)
• (2) Measure the risks appropriately and evaluate the
acceptable limits for that risk;
• (3) Monitor the risks on a routine basis, ensuring that
the right people receive accurate and relevant
information; and
• (4) Manage the risks through close oversight and
evaluation of performance.
Key Components
Identify, assess, and prioritize risks
• The first step in risk assessment is to identify
risks.
• To identify risks, the MFI reviews its activities,
function by function, and asks several questions.
• For example, the MFI examines the credit and
lending operations, and reviews funding
sources,loan transactions and portfolio
management processes.
Identify, assess, and prioritize risks
• The second step involved in risk assessment is
to determine the probability of risks occurring
and their potential severity. To assess the
probability and severity of risks, a risk
management chart or matrix
Develop strategies to measure risk
• After the board and management define
priorities, they can develop strategies that the
organization’s management of those risks.
• The board typically develops policies and sets
the outer parameters for the business activities
of an organization.
• Within those broad policies, management then
develops guidelines and procedures for day-to-
day operations
 Design operational policies and
procedures to mitigate risk
• MFI lives with certain risks and designs a
lending methodology and system of controls
and monitoring tools to ensure that a) risk
does not exceed acceptable levels, and b)
there is sufficient capital or liquidity to absorb
the loss if it occurs
 Controls might include
• Policies and procedures at the branch level to minimize the
frequency and scale of the risk (e.g. dual signatures required
on loans or disbursements of savings).
• Technology to reduce human error, speed data analysis and
processing.
• Management information systems that provide accurate,
timely and relevant data so managers can track outputs and
detect minor changes easily.
• Separate lines of information flow and reconciliation of
portfolio management information and cash accounting in the
field to identify discrepancies quickly
 Implement into operations and
assign responsibility
• The next step is for management to integrate the
policies, procedures and controls into operations and
assign managers to oversee them.
• In the implementation process, management should
seek input from operational staff on the
appropriateness of the selected policies, procedures
and controls.
• Operational staff can offer insight into the potential
implications of the controls in their specific areas of
operation.
 Test effectiveness and evaluate
results
• Management must regularly check the
operating results to ensure that risk
management strategies are indeed minimizing
the risks as desired.
• Good management reporting is essential to
understanding whether these controls are
effective, i.e. yielding the intended results.
 Revise policies and procedures as
necessary
• Based on the summary reporting and internal audit
findings, the board reviews risk policies for necessary
adjustments.
• To be most effective, the internal audit should report
directly to the MFI’s board of directors.
• While only significant internal audit findings are
reported to the board, the directors should ensure
that necessary revisions are quickly made to the
systems, policies and procedures, as well as the
operational workflow to minimize the potential for
loss
 Guidelines for Implementing Risk
Management
• 1. Lead the risk management process from the top
• 2. Incorporate risk management into process and systems
design
• 3. Keep it simple and easy to understand
• 4. Involve all levels of staff
• 5. Align risk management goals with the goals of individuals
• 6. Address the most important risks first
• 7. Assign responsibilities and set monitoring schedule
• 8. Design informative management reporting to board
• 9. Develop effective mechanisms to evaluate internal controls
Key Roles and Responsibilities
 Board of Directors
• The board and management develop the
system and set the tone.
• Guide the institution in fulfilling its corporate
mission,
• Protect the institution’s assets over time
 Senior Management: The Risk
Management Officer
• The managing director or chief executive officer
(CEO) is responsible for the MFI’s overall risk
management system, and therefore usually acts as
the “risk management officer.”
• The risk management officer is responsible for
developing and maintaining the risk management
matrix ,which identifies the major risks, assesses
their reasonable probability and severity, and assigns
responsibility to a specific individual.
 Specific Risk Managers
• Risk management should be an explicit part of
their line functions (e.g., program, financial,
legal, etc.). For example, branch managers are
often responsible for managing the credit,
operational and fraud risks associated with
the branch’s loan portfolio.
 Specific Risk Managers
• The MFI should be clear in assigning
responsibilities to risk managers.
• The MFI should not assume that managers
understand their role in managing risks simply
because they fall under their areas of
supervision, but should clearly state the
expectations and limitations of their risk
management responsibilities.
 Obstacles to Risk Management
• The primary reason has been a lack of a
framework and understanding of the need to
do so.
• Successful microfinance institutions often
become over-confident of their future based on
their past successes.
• Lack of effective risk management is for the MFI
to have an active and effective board of
directors.
• MFIs lack institutional commitment.
 THE END

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