managing risk.pdf

Managing Risk and Creating Value with Microfinance5short-term assets. As a result, to meet its financial obligations, the MFI had to decide whether to liquidate itsassets or obtain more expensive funding.Like liquidity risks, operational risks are within the MFI’s control. They include the risk of loss through faultyinternal processes, poorly trained personnel, and inadequate information systems. Operational manuals, clearterms of reference for key positions, loan officer rotation, checks and balances systems (such as separation ofcertain responsibilities), and internal and external audits all contribute to sound operational systems, and theyhelp to manage those risks.Strategic risks include long-term choices and changes in the business environment. Strategic risks can includeinappropriate business strategies, introduction of riskier products, branch location decisions, choice of strategicalliances, and changes in market structure (caused by new entrants, new laws, and new regulations).Management of the Biggest RisksThe type of MFI can affect the institution’s risk level. 3 State-owned banks engaged in microlending, forexample, can be subject to political pressures to forgive debt or divert credit, both of which can result in poorloan recovery rates. Private commercial banks that undertake microfinance pilots may be limited by regulatorynorms, such as the prohibition on lending without adequate collateral. However, specialized microfinancebanks are better equipped to manage the risks involved in lending to informal sector businesses.Membership-based MFIs develop close and long-term relationships with clients. Financial cooperatives (creditunions and savings and loans cooperatives) provide both savings and credit to members. Multipurpose cooperativesprovide inputs, marketing, transportation, and other services that make it easier for members to sell their productsand to repay their loans on time. Those complementary services tighten the bond between individual membersand the MFI. Community-based financial organizations (such as village banks and self-help groups) also knowtheir members intimately and can respond to needs while managing the accompanying risks.Regardless of the type of institution, the nature of microfinance itself often increases certain risks faced byfinancial institutions, while offering innovative means of dealing with them. The biggest risks include (1) clientselection, (2) product risk, (3) portfolio composition, and (4) loan processing and information management.Client selection riskAdverse client selection occurs when the MFI agrees to loan funds to a risky client because of incompleteinformation. Adverse selection can lead to a decline in the quality of the portfolio because the high-risk clientscannot or will not repay the loans. Adverse selection can also lead to moral hazard, which is the possibility thatclients who know that they are fully protected from risk will act less responsibly and more speculatively thanif they were fully exposed to the consequences of risk taking. For this reason, well-publicized guarantee fundsoften run into serious problems in the early stages; they can attract clients speculating in high-risk ventures.When the MFI enforces loan repayment, it demonstrates to potential clients that the loan contract isa serious commitment of future resources and that there are specific consequences for failure to repaya loan. Easy restructuring and refinancing policies make it difficult for good loan officers to enforce contractswith good clients. After all, why shouldn’t good clients get the same lenient treatment as poor performers?However, additional charges and higher interest rates when loans are restructured improve the incentive to3. For more detailed information on the specific risks of each type of microfinance service provider, see Ritchie (2007: 43–48).