UNITED NATIONS CAPITAL DEVELOPMENT FUND    Microfinance

Issue 17 / October 2005

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By Rebecca Goldfine, Editor, Women's World Banking

If you think every financial institution has a clear strategy for managing financial risk, think again. Many microfinance institutions (MFIs) lack formal policies governing how they monitor and handle financial risk. This shortcoming has led some to falter, either damaging their reputations or, more fatally, triggering liquidity crises that have jeopardized operations.

But if the stick of possible ruin has failed to push some managers into taking swift action, the carrot of greater access to private capital - and access to it at lower cost - may do the trick.

Private investors like to see more than just a few safeguards in place against financial risk, as well as a few managers who seem well informed on the subject. Financial factors must be tracked regularly, relating both to the MFI's operations and to its external environment. Comprehensive policies need to be set; safeguards must be monitored routinely to ensure they are still sufficient; and plans of action must be made in advance and triggered automatically when risks in one area or another rise above preset tolerance levels. And the establishment of these precautions and procedures on paper will matter little unless an MFI assigns clear roles and responsibilities to specific managers and institutional bodies, ensuring accountability for prudent risk management.

"Implementing stronger risk management systems can help MFIs access more capital from existing private investors and new investors, including the capital markets," according to Louise Schneider-Moretto, an ex-banker and now Manager of the Financial Products and Services group at Women's World Banking (WWB). In the past, one reason investors avoided microfinance was their assumption that low-income borrowers were a high-risk proposition. Another reason was the sense that developing and emerging markets might pose greater risks than most MFIs could handle reliably. Meanwhile, "MFIs often have viewed financial risk management merely as a defensive measure against negative consequences," Schneider-Moretto says. "But with the private sector's mounting interest in microfinance, and MFIs' increased need for private capital, the establishment of strong, comprehensive risk management policies is emerging as a way to instill confidence in investors, regulators and rating agencies."

Greater confidence translates into greater access to capital, and at lower cost. This is especially true when one considers the more recent success of MFIs in tapping their local capital markets through bond issues. A prime example of this was the February 2005 issue of $US30 million worth of bonds, in Colombian pesos, by the WWB affiliate, Fundación WWB Colombia in Cali (FWWB). This was the first time ever that an unregulated, non-profit MFI had issued unsecured bonds. In most countries, access to capital markets requires a rating by traditional rating agencies like Fitch or Standard & Poors. These raters often take an in-depth look at the MFI's risk management systems and liquidity, and how these compare with local regulations for financial institutions. Increasingly, MFIs are motivated to improve their risk management systems not only to shield profits, but more proactively to improve profits and gain access to a diversified base of commercial funding sources.

Until recently, MFIs wanting to build good risk management policies found scarce guidance specific to their needs in the microfinance context. Now the member institutions of WWB are sharing their experience with a new Tool for Developing a Financial Risk Management Policy.[1] "WWB has developed an important document that provides the boards and management of microfinance institutions with an invaluable tool," says Bob Annibale, formerly Citigroup's Senior Treasury Risk Officer, and now the Global Director of its Microfinance Group.

Authored by WWB's Schneider-Moretto, the tool draws from the collective expertise of WWB's member institutions, including two of its commercial bank members, Citigroup and ShoreBank, and many of its leading MFIs.[2] The WWB mission of sharing experience and best practices, not only within its network but also with the industry at large, has led to training workshops in financial risk management and plans for the creation of an e-learning course on the subject.

For MFIs that are already private, regulated financial institutions, there is frequently a major need to improve or expand whatever financial risk management policy they have in place. What some MFIs need is guidance on anticipating and mitigating risks, on how to design appropriate policies and how best to assign staff responsibility for monitoring risk and taking action. WWB's risk-management tool steers MFIs through procedures such as tracking and reporting risks, making appropriate financial calculations and negotiating bank loans. The tool includes a template to help guide MFIs in designing their own financial risk policies. It also offers operable spreadsheets that can be tailored to MFIs' individual needs.

At least four components of a good financial risk management policy are recommended: institutional structures to manage risk; balance-sheet policies to measure and control risks in individual accounts; asset-liability management, which involves a consolidated view of both assets and liability, thus monitoring the relationship between these two accounts; and finally, liquidity and cash management, including sensitivity testing, liquidity ratio monitoring and calculation of cash projections.

Both for-profit and non-profit MFIs would do well to approach risk from a broad perspective, performing 360-degree risk assessments of all aspects of risk, including insurance policies, physical operations and other facets that might be overlooked in a typical risk assessment. In such comprehensive evaluations, called "enterprise risk assessments," financial institutions manage three principal risk areas: credit risk (client default on loans), operational risk (human error, fraud or failed internal systems), and market risk, which refers to losses incurred by market volatility. WWB's new risk-management tool focuses primarily on the market risk angle, which encompasses liquidity, interest rate and foreign exchange risks.

In developing a risk-management strategy applicable to all MFIs, WWB visited the finance team of ShoreBank in Chicago, a bank focused on financing small businesses and community projects. WWB experts also worked closely with treasury and market risk managers at Citigroup. At the heart of ShoreBank's risk management function is its Risk Management Committee - a multi-departmental, internal group of senior managers with diverse expertise. Such committees are effective mechanisms for channeling communication and allaying risk. Because risk management is a dynamic process - meaning that hazards need to be continuously identified and addressed-it is useful to have a team dedicated to this task. Creation of such committees has the added benefit of building capacity among the senior management teams of MFIs. Other important institutional structures include Finance or Asset Liability (ALCO) Committees, composed of board members, and an independent Internal Audit function. These structures provide critical oversight of the MFI's operations and management.

Beyond establishing an internal culture of open communication about risk, MFIs must have good management information systems (MIS). A robust MIS is critical to data collection, the bedrock of risk-management measuring, monitoring and reporting. Its importance cannot be over-emphasized.

MFIs should use their MIS to gather certain data, and track this data over time.[3] This information helps MFI managers establish risk-comfort levels and anticipate and test for the impact of future volatility. Sound and long-term historical data is necessary for predicting future stress scenarios against which financial projections can be made. Given the kind of environment in which MFIs often operate, they are particularly vulnerable to operational disruptions such as those created by natural disasters and energy shortages. Protecting their operations through insurance, back-up generators, contingency planning and other measures is crucial.

All risk-management systems should have established limits for risk exposure. Stress-testing scenarios help determine these limits by calculating how far market or other risks can deteriorate and still be absorbed by the financial institution's earnings. Without jeopardizing the business, the institution needs to assess how many months of losses it can sustain.

In order to implement and monitor risk management policies, MFIs may need to upgrade their existing MIS capacity and modify their current reporting procedures. For example, an MFI with compulsory savings will need data on the maturity dates determining clients' access to savings (both individual and aggregate), and MFIs mobilizing voluntary savings might need to track daily balances over time to better understand the stable nature of these deposits and appropriately assess their liquidity needs.

Risk management is a microfinance institution's best means to improve earnings (by protecting against losses), attract capital, gain access to lower-cost capital and instill confidence in investors. It can be conceived as a framework of alarms for triggering management's attention to growing dangers and as an action plan to circumvent pending crises.

WWB's final piece of counsel is perhaps the most important: Updating risk assessment is vital. Risk management structures and procedures must be adaptable on a regular basis to changing conditions, ranging from market factors and portfolio performance indicators to such operational changes as the expansion of an MFI's offering of services. MFIs' boards should review and update their financial policies annually

Private investors are generally more comfortable placing their funds with regulated MFIs. In the absence of such regulation, the importance of strong, institutional risk management structures and policies becomes increasingly important, particularly to capital markets investors. They are very familiar with the benefits of financial risk management and the pitfalls of any shortcomings in this area. As private-sector players enter microfinance, and MFIs enter the private sector, the management of financial risk is a very important focus for all concerned. Even MFIs that have managed financial risk well in the past, but in a somewhat ad hoc manner, will find that many benefits flow from the establishment of explicit, thorough, formalized and well-documented policies on risk management. Not least are the resulting advantages these MFIs will have in their dealings with regulators, rating agencies and investors.