Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112.
RISK MANAGEMENT IN MICROFINANCE INSTITUTIONS OLUYOMBO, ONAFOWOKAN ONABANJO and OLABISI, JAIYEOLA Department of Financial Studies Redeemer’s University Km. 46, Lagos – Ibadan Expressway Redemption Camp Post Office Ogun State, Nigeria. E-mail:
[email protected]
Abstract Microfinance is fast becoming a household name globally due to its acceptance as a means of reaching those that were not served by the conventional big banks.
The survival of
microfinance institutions in any country depends majorly on the overall political and economic environment of such a nation. However, the greatest challenge the microfinance institutions will face globally in pursuance of its financial intermediary role is how best to manage its credit and risk exposures in comparison with the rising competition, sophistication and turbulent economic and social environment especially in developing nations. After examining different concept of microfinance and risk management, this paper focus on those peculiar risks associated with microfinance business and suggested how regulators and operators in the sector can best guide against distress or imminent collapse while striking a balance between profitability and unhealthy risk exposure.
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. JEL Classification: G21
INTRODUCTION Business is all about risk taking. However, the level of risk from one industry to another varies and it depends largely on the nature and services provided by the organization. Banking business world wide is exposed to more risk than any other business concern as a result of their trading in money market instruments. Though, some Microfinance Institutions (MFI) does not take deposit, but operate through grants and donor fund. However, majority of them (MFI) are deposit taking organization just like a conventional bank. Hence, as a result of accepting deposit and giving of credit, the MFI are therefore exposed to risks that are inherent in their line of business. In order to prevent the occurrence of distress in financial sector as experienced by conventional banks in some countries in the past, risk management in MFI need to be considered now. According to Oluyombo and Ogundimu (2006), MFI are not bank, even though, some seems to work like banks while others may be called Microfinance Bank (MFB), but their services and products are peculiar and targeted to the low income earners. Hence, the need for overview of microfinance before risk issue is examined.
CONCEPTUAL CLARIFICATION There is need to examine some concepts like microfinance, features of microfinance, risk and risk management in this paper. Overview of Microfinance
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. According to Asian Development Bank (2000), microfinance is the provision of a broad range of financial services such as deposits, loans, payment services, money transfers, and insurance to poor and low-income households and their micro enterprises. Microfinance services are provided by three types of sources: formal institutions, such as rural banks and cooperatives; semiformal institutions, such as non-governmental organizations; and informal sources such as money lenders and shopkeepers. Institutional microfinance is defined to include microfinance services provided by both formal and semi-formal institutions. Microfinance institutions are defined as institutions whose major business is the provision of microfinance services. Otero and Rhyne (1994) defines microfinance as a revolution that involves the large scale provision of small loans and deposit services to low-income people by secure, conveniently located and competing commercial financial institutions thereby generating the process needed to democratize capital. This definition means that the numbers of microfinance institutions should be enough to meet the needs of low income earners in the nation through the provision of loan facilities and to give room for healthy competition among them. Robinson (2001) described microfinance as small-scale financial services-primarily credit and savings-provided to people who farm or fish or herd; who operate small enterprises or micro enterprises where goods are produced, recycled, repaired or sold; who provide services; who work for wages or commissions; who gain income from renting out small amounts of land, vehicles, draft animals, or machinery and tools; and to other individuals and groups at the local levels of developing countries both rural and urban. This definition is encompassing as it tries to state those who may benefit from microfinance institutions and also inform that developing countries need microfinance institutions more than
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. developed countries and especially, that microfinance is meant for those operating small and micro enterprises. Microfinance has been described as an economic development approach intended to benefit low-income women and men. Ledgerwood (2000). It means that the purpose of microfinance is to reach the low income earners either in the urban or rural areas with financial services that will enable them create wealth without any discrepancy as to the sex of such person. Ndiaye (2005) opined that access to improved financial services – access to more and better ways of turning savings into lump sums – helps poor people from sliding deeper into poverty and helps them lay foundations for their ambitions to better themselves and their families. Microfinance is about providing financial services to the poor who are traditionally not served by the conventional financial institutions. Three features distinguish microfinance from other formal financial products. These are: (i) the smallness of loans advanced and or savings collected (ii) the absence of asset-based collateral, and (iii) simplicity of operations. Central Bank of Nigeria (2005). This give a clue that the CBN is aware that there are people that are not served by the conventional banks because the loan requires by them is very small compare to the activities and loan portfolio of these banks. Microfinance institution is now a growing phenomenon all over the world. It is emerging as a rapidly growing financial services industry worldwide as a solution to the crippling effects of the conventional banks interest on the poor and those operating micro and small scale enterprises (MSSE). Microfinance can therefore be define as an economic approach to take financial services to those that are hitherto un-reached at a reasonable fee that is affordable and economic to the users of such services, and also, using funds from the providers of financial services to generate
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. adequate returns for the users, thereby building up their enterprises and creating employment opportunities which will reduce the poverty level in the economy. Microfinance is a holistic approach that has been used in different countries to alleviate the plight of MSSE both in the rural and urban areas in accessing fund as at when required which was not possible from the conventional banks. Features of Microfinance Institutions The distinguishing features of sustainable finance as totally different from other banking institutions as identified by ADB (2000), CBN (2005), CBN (2006) and Oluyombo (2007) includes the following: i.
The smallness of loans advanced to their customers
ii.
Savings from the customers are very small
iii.
The absence of asset-based collateral
iv.
Simplicity of operation
v.
The extension of banking services beyond economic to social and cultural upliftment of the people.
vi.
Development of good inter-personal relationship between the bank and her customers which lead to high degree of trust and openness on both parties.
vii.
Their products and services are targeted towards MSSE in their locality.
Risk Risk can be examined both internally (within the MFI operations) and externally (factors beyond the control of the MFI). Van Horne (1983) defines risk as the possibility that the actual return will deviate from that which was expected. It means that result realized from an
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. investment may differ from the actual plan. Hence, risks evolve because there is plan that is not met due to unfavourable circumstances or conditions. Risk was also defined as the chance of a loss, or the loss itself. Dunn, Kalaitzandonakes and Valdivia (1996). According to Adewunmi (2005) to survive in today’s very competitive and turbulent economic and social environments, business and financial institutions in particular must learn to live with risks by intelligently and professionally managing them (risks). Risk is the probability that the consequence of an event will be different from the original plan due to certain factors and that the outcome may not be in the interest of the planner. It should be noted that there would be no risk where there is no exposure and uncertainty. Where outcome of a decision can be predicted with 100% level of accuracy without any exposure, then risk will be absent. However, in today’s business world, the outcome of any plan and/or decision is based on many parameters and economic factors such that MFI are exposed to outsider and there is no guarantee that all loans and advances will be paid as at when due, hence risk is present in MFI.
RISKS IN MICROFINANCE BUSINESS Like any other business organizations, those involved in microfinance business are also exposed to some peculiar risk. Although, their (risks) names may seems to be the same with other sector of the economy. However, these risks affected MFI in different ways. Risk Factors of Microfinance Institutions The following factors brought about a different risk for MFI compared to other conventional banks. i.
MFI services and products are targeted to the poor and low income earners in the society.
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. ii.
Most clients of MFI do not have physical assets (house, land, automobile, plant and machinery) and financial assets (share, bond, stock and debenture certificates) to pledge as collateral for loans and advances collected.
iii.
There is no supportive regulatory and supervisory policy framework on the part of some government which lead to physical and economic challenges for MFI.
iv.
Where regulatory framework exists, the peculiarity of MF business in most cases is not taken into consideration. In such country, MFI and other banks are regulated under the same policy.
v.
The ownership structure of MFI is dominated by donors in many countries instead of private investors as owners. (MFI are dominated by private ownership in Nigeria).
Major Risks in Microfinance Sector Haven’t considered the risk factor of MFI, the question that follow is what are these risks? Berenbach and Churchill (1997) and Ledgerwood (2000) identified four main areas of risks that are peculiar to MFI as: Portfolio risk, Ownership and governance risk, Management risk and New industry risk. Adewunmi (2005) recognized risks like: Credit risk, Operational risk, Interest rate risk and Liquidity risk as those affecting financial institutions. However, this paper is of the opinion that Liquidity risk, Credit risk, Foreign exchange risk, Ownership return risk and Operational risk are those that affect MFI directly and they are discussed below.
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. Figure 1. Major Risks in Microfinance Sector
Liquidity Risk
Credit Risk
Operational Risk Foreign Exchange Risk
Ownership Return Risk
Liquidity Risk This is the risk associated with meeting regular and unplanned high withdrawals by large depositors who are always few in numbers. Some MFI get funds from mandatory legal deposit from banks and government at different levels. For such MFI, a change of government or change in government policy may reduced available fund to MFI considerably, which posses liquidity risk to them. In Nigerian for example, the CBN encourage each state government to dedicate an amount of not less than 10% of their annual budget for on lending activities of microfinance banks in favour of their residents. Liquidity risk will also arise through donor fund which the donors might call back for some period or suspend forever. In such case, the financial base of such MFI will be threatened.
Credit Risk Olfield and Santomew (1997) opined that credit risk arises from non-performance by a debtor. It may arise from either an inability or an unwillingness to perform in the pre-committed
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. contracted manner. This can affect the lender who underwrote the contract, other lenders to the creditor, and the debtor's own shareholders. This is the risk associated with default in loan repayment as at when due or the uncertainty of meeting financial obligations by client at the right time. This risk is pronounced in MFI as a result of inadequate collateral for loan disbursed if the borrower is unable to pay due to financial constraint and/or complete refusal to pay. Credit risk is not limited to unrepaid loans and advances alone, but extend to those loan applications that were turn down by MFI, because it may hinder their growth and cause reduction in size, earnings and profitability.
Ownership Return Risk It is apparent that MFI can not boast of profit like the conventional banks. Where the owners of MFI are desirous of getting a sizeable return on their investment in a short time, which is common in a private ownership led businesses; this may lead to unhealthy practice in the operation and management of MFI so that appropriate return can be given to the owners.
Actually, this risk is in force from the inception of MFI except the owners see their investment as part of their modest contribution in alleviating the plight of the poor at the short run before dividends could be declared. However, this is not the case because average investors want adequate return from the investment at shortest possible period, or else, the fund will be invested in another line of business with less risk and better return.
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. Operational Risk Adewunmi (2005) defined operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. However, the operational risk of MFI essentially has to do with the employee who works in the organization. In most nations, banks’ employee earns relatively more than many other sector of the economy. If employee of MFI see them self as banker and form their mind set, it will create a disorder and operational breakdown. It is expected that this will lead to agitation for better welfare package and may tend towards unionism which hamper the operation of MFI since they will found it difficult to pay similar remuneration like the conventional banks and other notable financial institutions.
Foreign Exchange Risk Most MFI, especially those in developing countries source for funds from international organization/donor in foreign currency but lend such fund in their local currency. Despite lending in local currency, the repayment to the agencies/donors will always be in foreign currency. As a result of inconsistency in foreign exchange policy in most developing nations, at the time the loan is due for repayment, the exchange rate would have gone up, which will made it impossible for MFI to earn profit from the fund. Repayment may have to be met from another source which may wipe out depositors funds if adequate care is not taken.
RISK MANAGEMENT Risk management (RM) is a term that is synonymous to different area of human endeavours. Risk management was defined by Baffa (1990) as the planning and controlling of all the
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. conceivable elements of risks which are inherent in the daily operations of an organization in order to ensure the organization’s continued existence as well as the realization of its set goals and objectives’. Meyer (2000) opined that in managing risk, banks must decide which risks to take, which to transfer and which to avoid. If banks have options as to their risk exposure, do MFI have such options?
Risk Management Tools Risk need to be managed in MFI to avoid mishaps, hardship and loss of financial and human assets and to guarantee continuous supply of loanable fund to the end user as at when needed. According to Olfield and Santomew (1997), it has been argued that risk is an essential ingredient in the financial sector and that some of this risk will be borne by all but the most transparent and passive institutions. In short, active risk management has a place in most financial firms.
Risk management is an integral part of monitoring and evaluating both liquid and illiquid assets and depositors liabilities of MFI to ensure the sustainability of the industry. It should be understood from the outset that risk can not be managed in any MFI if the management did not set a goal in that direction. Therefore, the first thing to be done is that there must be a written goal and drive from the owners and managers as to the need to manage risk on daily basis before they arise and/or as they become known. Furthermore, the management should put in place a risk management policy and procedures covering all areas of their microfinance business, including those areas they (MFI) intend to venture into in the nearest future. The policy should be followed in managing risks as they are
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. identified in the industry or in their own location, but not necessarily until it affect the business negatively. Management should also be ready to review the RM policy and procedures at regular interval especially when there is change in regulation, economic policy and other indicators that may affect their business locally and internationally. The need for investment strategies and guidelines can not be over emphasized, because this will help considerably to manage credit risk. Not all investment opportunity presented to MFI should be financed as a result of the volatile of the industry or trade that may be involved. In this case, selected trading should be identified, especially those with low risk profile. However, this depends on the deposit base of the MFI, location and her source of fund. A motivated employee is the one that will defend the course of his or her employer. Risk can never be managed without the employee, hence MFI management should be ready and willing to properly remunerate and motivate the workforce. The motivation should not be limited to financial reward alone, but it should include an open acknowledgement of the employee who works very well in the reduction of the firms risk without compromising the business ethics. From economic point of view, risk should be prioritized using a simple scale of preference in handling them (risk). Although, all form of risk should be managed, but the impact of these risks on MFI business differs considerably, hence these risks should be analysed and given their appropriate scale. For example, ownership return risk must be given higher priority, if not; all other risk can not be managed if the owners agitate for more return on their investment. Prioritization of risk will help the MFI management to know the level of resources that will be deployed to each risk and
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. the likely effect on their business. If this is done, the owners and management will not be caught unaware when these risks are about to occur and/or increase. Sound internal control system (ICS) is another tool for risk management which has proved to be necessary and reliable in any financial institution. The ICS should be able to monitor, review and evaluate all business processes on regular basis to be able to determine the effectiveness or otherwise of the processes in tracking risk. This process is very essential because risks are assumed out of the daily business operation as a result of mistake, incompetence, fraud and lack of concentration by one or more personnel that do not do one thing or the other during or after the business process. However, with sound ICS, some or all of the processes left undone can be detected early enough so that corrective measures can be taken on time before the risk is passed to the MFI.
CONCLUSION Risk is a daily phenomenon in every area of life and business. The management of these risks is therefore important to reduce to the barest minimum the untold hardship of not recognizing and managing the risk. MFI are therefore enjoyed to rise above board in their risk management strategies and procedures to protect the industry and also to encourage the generous national and international donors who are eager to see many people lifted above the poverty level. If the owners and management of MFI are not proactive and fully committed in their risk management, the future of many poor people around the world will be jeopardized.
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. References Adewunmi, Wole (2005) Perspective of Risk Management. The Journal of
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Oluyombo, O. O. and Olabisi, J. B. (2008) Risk Management in Microfinance Institutions. Journal of Applied Economics, Vol. 1 No. 1, pp 104-112. Ndiaye, Fode (2005) Microfinance as a Strategy for Poverty Reduction in Africa. Paper delivered at Expert Group Meeting on Poverty Eradication. Bangkok, 6 – 7 July Oldfield, George S. and Santomew, Anthony M. (1997) The Place of Risk Management in Financial Institutions. Wharton Centre for Financial Institutions Working Paper Number 95-05-B. Oluyombo, Onafowokan (2007) Regulatory and Supervisory Framework for Microfinance Institutions in Nigeria. Paper presented at 4th International Finance Conference, Tunisia. March 15 -17 Oluyombo, Onafowokan and Ogundimu, Kayode (2006) “Microfinance as a Strategy for Poverty Alleviation in Nigeria” Journal of Business Management. Vol. 1, No. 1 Otero, M and Rhyne, E. (1994) The New World of Microenterprise Finance: Building Healthy financial Institutions for the Poor. West Hartford: Conn Kumarian Press. Robinson, Marguerite S. (2001) The Microfinance Revolution: Sustainable Finance for the Poor. USA: IBRD. Van Horne, C. James (1983) Financial Management and Policy (6th ed). India: Prentice Hall of India Private Limited
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