managing risk.pdf

Managing Risk and Creating Value with Microfinance3In business, the only constant is change. In a world of change, successful businesses and financial institutionshave learned that it is wise to be prepared for unexpected events, in other words, to manage risk. Whilerisk management has been a part of business planning for large businesses and financial institutions for sometime, it is a fairly new discipline among microfinance institutions (MFIs). This new focus is the result ofrecent crises and experiences and represents a new understanding of the importance of anticipating unexpectedevents, rather than merely reacting to them. This chapter reviews risk categories and measurement for financialinstitutions, additional risks confronting MFIs, ways to develop a risk management system, and special risksfaced by rural MFIs. 1In the wake of recent tragedies, MFIs around the world have had to cope with an array of financial, political,and weather-related crises, and MFI managers have learned the importance of risk management. For example,hurricanes in Nicaragua, floods in Poland, and currency crises in the Russian Federation and Indonesia have haddevastating effects on the microfinance industries in those countries. Whatever the emergency or the country,the effects are the same: higher costs, liquidity problems, and loss of assets. MFIs with risk management plansin place before the emergency are more likely to survive, remain stable, continue serving their clients, and evenprosper.Risk CategoriesThe most common risks can be included in three categories: financial, operational, and strategic. In addition,risks are either internal or external to the institution. Internal risks are largely within the MFI’s control—related to operational systems and management decisions. External risks are largely outside the MFI’s control.Table 1.1 illustrates the risks an MFI might confront. 2Because an MFI’s loan portfolio is its most valuable asset, the financial risks—credit, market, and liquidity—are of greatest concern. Financial risks begin with the possibility that a borrower may not pay the loan ontime with interest (credit risk). They include the possibility that the MFI might lose a significant part of thevalue of its loan portfolio as a result of an economic downturn, hyperinflation, and other externally generatedcauses (market risk). Financial risk can also include changes in interest rates of government lending programs(as in Bolivia and the República Bolivariana de Venezuela) or the possible enforcement of old usury laws (asin several Latin American countries). Market risks include lower prices for borrowers’ products and services,which could directly affect their ability or willingness to repay an outstanding loan.1. This chapter is based on the December 2006 dialogue with Rochus Mommartz (Boulder Institute of Microfinance), HansDellien (Women’s World Banking), and Fernando Fernández (Development Alternatives Inc.).2. Because of the different ways of understanding risk, an institution might organize risks differently from the presentation in table 1.1.See, for example, van Greuning and Bratanovic (2000: 257–60).