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Types of Risks faced by Microfinance Institutions – Part 1

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Types of risks faced by Microfinance Institutions – Read Part 2 here

There are number of risks that an MFI has to face these risks could be of delinquencies, frauds, staff turnover, interest rate changes, liquidity, regulatory etc.

Of the above four categories Credit risk and Market risk are directly of financial nature and hence are called Financial risks while Operational risk and Strategic risk are of non-financial character and result mainly from human errors, system failures, frauds, natural disasters or through regulatory environment, weak board, poor strategy, etc. However, it must be remembered that operational and strategic risk, as and when materialize will also translate into financial losses for the organisation.

Risks faced by Microfinance Institutions

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Credit risk is directly related to the portfolio of the organistion and is one of the most significant risks from an MFI perspective. Whenever an MFI lends to a client there is an inherent risk of money not coming back, i.e. the client turning into a defaulter, this risk is called the Credit risk. Credit risk is simply the possibility of the adverse condition in which the clients does not pay back the loan amount. Credit risk is the most common risk for the MFI. The risk is of greater significance for MFIs as it has to deal with large number of clients with limited literacy. Further, MFI provides unsecured loans, i.e. loans without any collateral. In case a client default the MFI does not have any asset to meet its loss, which makes the credit even riskier.

MFIs fund their portfolio through external borrowings, through their own capital and through client savings that the MFI has mobilized. By giving a loan, an MFI also attracts risk to these sources of funds. It is therefore said that an MFI deals in public funds, acquired through banks, clients savings or through donors who trust the MFI to carry out its activities effectively. If an MFI loses money it may not be in a position to meet its own financial obligations to its depositors or lenders thereby becoming a defaulter itself. This results in loss of confidence of the funders and the direct financial loss for the MFI as the organisation loses not only interest but also its principal amount.

We have discussed why risk is inherent to the financial activities that financial institutions undertake. MFIs can neither afford to be too conservative on their lending as it will restrict their growth nor can they be over enthusiastic which will result in losses. Hence, an MFI need to have effective risk management system to have reasonable growth without letting the risk cross the thresholds of acceptable limits.

Credit risk emanates from internal as well as external factors. GTZ, a German development agency with a strong financial sector department, in its Risk Management Framework has classified Credit risk into two broad categories.

a. Transaction risk: which is related to the individual borrower with which the MFI is transacting. A borrower may not be trustworthy and capable of repaying loan which will result in loss of loan. All loss of loan related to delinquency of individual clients which can be because client’s migration, willful defaulting,

business failure etc is called transaction risk.

b. Portfolio risk: Portfolio risk is related to factors, which can result in loss in a particular class or segment of portfolio. For example an MFI may lose a portfolio with a particular community, locality or a particular trade due to some external reasons. These reasons could be political, communal, failure of an industry /trade, etc.

Indicators of Credit Risk

Although credit risk is inherent to all loan of the MFI, it materializes in the loans which start showing overdues. An amount is called ‘overdue’ if it is not received by the MFI on its scheduled time. Every loan that an MFI provides have fixed schedule for repayment. This is called Repayment schedule, which provides the schedule of payment and acts as the reference point for the MFIs to estimate their overdues.

At the time  of loan disbursement every client is given a repayment schedule, which shows the amount to be paid in each installment and the date of payment. If the amount is not received on or before the schedule date it is called overdue. If any loan has any amount overdue it is termed as a Delinquent loan or a case of delinquency.

MFIs try to have an objectives view of their credit risk and want to measure the extent of credit risk, which is the risk on their portfolio. There are various indicators, which help in measuring the credit risk profile of an MFI. Of these indicators portfolio at risk or commonly known as PAR is considered to be the most effective and is now very common indicator across MFIs. Apart from PAR, Repayment rate and Arrear rate are other ratios, which also provide information about the portfolio quality of an MFI.

PAR; Portfolio at risk or PAR tries to measure the amount of loan outstanding that the MFI stands to lose in case an overdue client does not pay a single installment from the day of calculation of PAR. PAR is the proportion of loan with overdue clients to the total loan outstanding of the organization.

PAR% = (Loan outstanding on overdue loans/Total loan outstanding of the MFI) x 100

PAR is further refined by MFIs to make it meaningful by including ageing in ilt. So MFIs often calculate PAR30, PAR 60, and PAR 90 etc. PAR30 means outstanding of all loans, which have overdues greater than 30 days as a proportion of total outstanding of the MFI, similarly PAR60 means outstanding of all loans, which have overdues greater than 60 days as a proportion of total outstanding of the MFI and so on and so forth.

One thing noticeable here is that overdue amount is not used anywhere in the formula. Overdues are simply taken as indicators to identify risky loans. Loan outstanding is used in the formula, as it is the maximum amount an MFI stands to lose if a client defaults. For example an MFI has five clients, each has taken 10,000 loan and have to repay on monthly basis and loan term is 10 months.

Therefore each month each one of them makes principal repayment of Rs 1,000. After five months of loan disbursement, it is necessary than 5 installments had to be paid which means each client should have paid back Rs 5,000 of principal amount. But say the actual repayment was as shown in the table below.

Category: Payday loans

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