MICROFINANCE RISK MANAGEMENT HANDBOOKmfi-resources.org/.../Risk_Management_Handbook.pdf · 2014. 10. 3. · ll microfinance institutions (MFIs) are vulnerable to risks like those

MICROFINANCERISK MANAGEMENT

HANDBOOK

Craig Churchill and Dan Coster

With Contributions from:Victoria White, Terrence Ratigan, Nick Marudas,

Emily Pickrell and Calvin Miller

2001

TABLE OF CONTENTS

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Table of Contents

Table of Contents ............................................................................................................... i

M Risks M .........................................................................................................................1

Introduction ....................................................................................................................... 2What is Risk Management?....................................................................................................................................2Structure of the Handbook and How to Use It...............................................................................................4

Chapter 1: Risk Assessment Framework ......................................................................... 61.1 Institutional Risks...............................................................................................................................................6

1.1.1 Social Mission .................................................................................................................................................71.1.2 Commercial Mission........................................................................................................................................71.1.3 Dependency......................................................................................................................................................7

1.2 Operational Risks...............................................................................................................................................81.2.1 Credit ..............................................................................................................................................................81.2.2 Fraud..............................................................................................................................................................81.2.3 Security............................................................................................................................................................8

1.3 Financial Management Risks...........................................................................................................................91.3.1 Asset and Liability .........................................................................................................................................91.3.2 Inefficiency .......................................................................................................................................................91.3.3 System Integrity ...............................................................................................................................................9

1.4 External Risks .....................................................................................................................................................91.4.1 Regulatory .......................................................................................................................................................101.4.2 Competition...................................................................................................................................................101.4.3 Demographic..................................................................................................................................................101.4.4 Physical Environment....................................................................................................................................101.4.5 Macroeconomic...............................................................................................................................................10

1.5 Conclusion.........................................................................................................................................................10

Chapter 2: Institutional Risks and Controls...................................................................142.1 Social Mission Risk..........................................................................................................................................14

2.1.1 Mission Statement.........................................................................................................................................152.1.2 Market Research...........................................................................................................................................162.1.3 Monitoring Client Composition and Measuring Impact .................................................................................172.1.4 Managing Growth.........................................................................................................................................18

2.2 Commercial Mission Risk..............................................................................................................................192.2.1 Setting Interest Rates.....................................................................................................................................202.2.2 Designing the Capital Structure.....................................................................................................................202.2.3 Planning for Profitability...............................................................................................................................212.2.4 Managing for Superior Performance...............................................................................................................222.2.5 Monitoring for Commercial Mission Risk .....................................................................................................23

2.3 Dependency Risk .............................................................................................................................................242.3.1 Strategic Dependence......................................................................................................................................252.3.2 Financial Dependence....................................................................................................................................262.3.3 Operational Dependence ................................................................................................................................27

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Cash Management........................................................................................................................................... 27CARE Core Costs: “PN 85”.......................................................................................................................... 27Institutional Culture........................................................................................................................................ 28Technical Assistance ....................................................................................................................................... 29

2.3.4 Dependency Risk Controls.............................................................................................................................30Exit Strategy..................................................................................................................................................... 30Independent Structure .................................................................................................................................... 31

Recommended Readings......................................................................................................................................32

Chapter 3: Operational Risks and Controls................................................................... 343.1 Credit Risk .........................................................................................................................................................35

3.1.1 Credit Risk Controls.....................................................................................................................................35Loan Product Design...................................................................................................................................... 36Client Screening............................................................................................................................................... 38Credit Committees .......................................................................................................................................... 42Delinquency Management.............................................................................................................................. 43

3.1.2 Credit Risk Monitoring.................................................................................................................................453.2 Fraud Risk..........................................................................................................................................................46

3.2.1 Types of Fraud..............................................................................................................................................463.2.2 Controls: Fraud Prevention ...........................................................................................................................48

Excellent Portfolio Quality............................................................................................................................. 48Simplicity and Transparency .......................................................................................................................... 49Human Resource Policies............................................................................................................................... 50Client Education.............................................................................................................................................. 51Credit Committees .......................................................................................................................................... 51Handling Cash ................................................................................................................................................. 52Collateral Controls .......................................................................................................................................... 54Write-off and Rescheduling Policies ............................................................................................................. 54

3.2.3 Monitoring: Fraud Detection.........................................................................................................................55Operational Audit ........................................................................................................................................... 55Loan Collection Policies ................................................................................................................................. 56Client Sampling ............................................................................................................................................... 57Customer Complaints..................................................................................................................................... 58

3.2.4 Response to Fraud.........................................................................................................................................59Fraud Audit...................................................................................................................................................... 59Damage Control.............................................................................................................................................. 60

3.3 Security Risk ......................................................................................................................................................60Recommended Readings......................................................................................................................................62

Chapter 4: Financial Management Risks and Controls ............................................... 634.1 Asset and Liability Management..................................................................................................................63

4.1.1 Interest Rate Risk .........................................................................................................................................644.1.2 Foreign Exchange Risk.................................................................................................................................654.1.3 Liquidity Risk ..............................................................................................................................................67

4.2 Inefficiency Risk...............................................................................................................................................694.2.1 Inefficiency Controls .......................................................................................................................................69

Budgeting......................................................................................................................................................... 69Activity Based Costing.................................................................................................................................... 71Reengineering .................................................................................................................................................. 72

4.2.2 Inefficiency Monitoring...................................................................................................................................73Efficiency and Productivity Ratios................................................................................................................ 73Monitoring Human Errors............................................................................................................................. 75

4.3 Systems Integrity Risks...................................................................................................................................75Recommended Readings......................................................................................................................................76

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Chapter 5: External Risks ............................................................................................... 775.1 Regulatory Risks...............................................................................................................................................78

5.1.1 Banking Regulations .....................................................................................................................................78Usury Laws....................................................................................................................................................... 78Financial Intermediation................................................................................................................................. 79

5.1.2 Other Regulatory Risks.................................................................................................................................80Directed Credit ................................................................................................................................................ 80Contract Enforcement.................................................................................................................................... 80Labor Laws ...................................................................................................................................................... 80

5.1.3 Regulatory Monitoring and Response.............................................................................................................815.2 Competition Risks............................................................................................................................................81

5.2.1 Monitoring Competition Risks ......................................................................................................................815.2.2 Competition Risk Responses..........................................................................................................................82

5.3 Demographic Risks .........................................................................................................................................825.4 Physical Environment Risks..........................................................................................................................845.5 Macroeconomic Risks.....................................................................................................................................84Recommended Readings......................................................................................................................................86

Chapter 6: Management Information Systems ............................................................. 876.1 System Components: What Does an MIS Include?...............................................................................87

6.1.1 Accounting Systems .......................................................................................................................................88Chart of Accounts........................................................................................................................................... 89Cash vs. Accrual Accounting......................................................................................................................... 90Fund Accounting ............................................................................................................................................ 90General Software Design Consideration ...................................................................................................... 90

6.1.2 Portfolio Management Systems ......................................................................................................................916.1.3 Linking Accounting and Portfolio Systems....................................................................................................92

6.2 Financial Statement Presentation.................................................................................................................936.2.1 Voucher Preparation.....................................................................................................................................936.2.2 Frequency of Financial Statements.................................................................................................................936.2.3 Financial Statement Adjustments..................................................................................................................94

Accounting Adjustments ............................................................................................................................... 94Adjusting for Inflation and Subsidies ........................................................................................................... 98

6.2.4 Constant Currency...................................................................................................................................... 1006.3 Reporting ........................................................................................................................................................ 100

6.3.1 Key Issues in Report Design ....................................................................................................................... 1006.3.2 Reporting Framework................................................................................................................................. 101

Recommended Readings................................................................................................................................... 103

Annexes...........................................................................................................................104Annex 1: Checklist by Category of Risk ...................................................................................................... 105Annex 2: Sample Chart of Accounts Inflation and Subsidy Adjustment Worksheet....................... 109Annex 3: Inflation and Subsidy Adjustment Worksheet ........................................................................ 112Annex 4: Sample Balance Sheet and Income Statement........................................................................... 113

Bibliography ................................................................................................................... 115


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Table of Figures

Figure 1: Three-step Risk Management Process ...................................................................................................3Figure 2: Categories of Microfinance Risks ............................................................................................................7Figure 3: Organization of Microfinance Risks by Chapter...............................................................................11Figure 4: The Four Ms of Controlling Social Mission Risk..............................................................................15Figure 5: Market Research Tools.............................................................................................................................17Figure 6: Monitoring Client Composition.............................................................................................................18Figure 7: Evolution of Capital Sources for a Microfinance Program ...........................................................21Figure 8: Sustainability and Profitability Ratios...................................................................................................24Figure 9: Types of Operational Risks .....................................................................................................................34Figure 10: Reducing Credit Risk through Product Design Features..............................................................37Figure 11: The Five C’s of Client Screening .........................................................................................................38Figure 12: Methods for Screening Client’s Character ........................................................................................40Figure 13: Alexandria Business Association: Delinquency Penalties .............................................................44Figure 14: Portfolio Quality Ratios.........................................................................................................................46Figure 15: Examples of Microlending Fraud .......................................................................................................47Figure 16: Controls in Handling Loan Repayments...........................................................................................53Figure 17: Loan Collection Policies.........................................................................................................................57Figure 18: Example of Currency Devaluation Impact ......................................................................................66Figure 19: Budget Comparison Report..................................................................................................................70Figure 20: The Parts of an MIS ...............................................................................................................................88Figure 21: Chart of Accounts Structure.................................................................................................................89Figure 22: Criteria for Evaluating Loan Tracking Software.............................................................................92Figure 23: Key Reports by Shareholder Category ........................................................................................... 102

INTRODUCTION

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M Risks MUnder pressure to expand her portfolio, Faith skipped important steps in the loan approval process such asvisiting the applicants’ businesses. When the group did not show up on their first repayment day, Faithstarted looking for them, but to no avail. They were gone.

A cholera epidemic in the township resulted in a complete ban on public meetings. Without meetings, therewere no repayments; and without repayments, portfolio quality plummeted.

Jose the loan officer had quite a scam going. He printed up a fake receipt book and went door-to-doorcollecting late payments. He kept telling his branch manager that he couldn’t find the people or that they werehaving difficulties because of illness in the family or business problems. In the meantime, he was using thecash to set himself up as a moneylender, charging twice the rates of his employer.

The NGO, Loans-R-Us, wasn’t willing to charge a high enough interest rate to cover costs, and yet it wasn’timproving efficiency enough to bring costs down. It was regularly losing money and eventually the donors gottired of subsidizing it. When the door was finally closed, 50 people were out of jobs and 10 communities nolonger had access to the financial services that they depended on to help grow their businesses.

A gang had surreptitiously watched the repayment process for weeks and knew exactly when to intervene andgrab the bag of money. The money and the thieves were gone before anyone realized what happened.

Management at the Micro Credit Trust (MCT) knew that many of its clients would have preferredindividual loans, but believed that the group was such an efficient delivery mechanism that the organizationdidn’t do anything about it. Then People’s Bank appeared on the scene, offering individual loans at lowerinterest rates, without having to attend numerous meetings and training sessions. Before MCT could react, ithad lost half of its clients to the competition.

People’s Bank grew much faster than it had projected. Before long, it had a stack of loan applications andnot enough money to satisfy the demand. When delays started creeping into the disbursement process, wordgot around fast and borrowers stopped repaying.

Help Yourself was a new Microfinance Institution that was absolutely determined to become self-sufficientand independent of donors and international NGOs. Subsequently, it established a very strong Board ofDirectors comprised of influential people from the business and government community. The board fullycontrolled Help Yourself’s relatively weak executive staff and before long was forcing staff to give large loansto its friends and relatives, who assumed that the MFI was not serious about actually collecting loanrepayments.

Under political pressure to help the poor, the government passed a usury law to cap interest rates at 25percent. No financial institution in the country could cover their costs of issuing $50 or $100 loans at thatrate, so rather than helping the poor, this misguided policy reduced the availability of institutional financialservices to the very people it was trying to help.


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Introductionll microfinance institutions (MFIs) are vulnerable to risks like those described on theprevious pages. While MFIs cannot eliminate their exposure to risks, through aneffective risk management process, they can significantly reduce their vulnerability.

CARE’s Microfinance Risk Management Handbook provides guidance for managers ofCARE affiliated microfinance programs to develop a risk management system. Thehandbook describes institutional structures, management systems, and internal controls thatshould be in place in all microfinance programs. It outlines required and suggested policiesand procedures for managing and governing MFIs in a waythat minimizes an organization’s vulnerability and maximizesthe chances of fulfilling its potential.

The overriding objective of this handbook is to foster goodmanagement and accountability. This will encourage cost-effectiveness, high portfolio quality, and minimal risk of loss or misuse of funds. Theprimary audience for this handbook is MFI managers and board members, who areresponsible for maintaining the health of a microfinance institution. CARE SEAD ProjectManagers and their supervisors, internal and external auditors, as well as project evaluatorsshould also find the handbook helpful.

What is Risk Management?A risk is an exposure to the chance of loss. Risks are not inherently bad. Sometimes, it isnecessary to take risks to accomplish worthy and meaningful goals. This is especially true inmicrofinance where loan officers take risks every day by lending money to people withoutcredit histories, without business records and often without collateral. One has to take risksto operate a successful microfinance institution—but it is important to take calculated risks.

Risk management, or the process of taking calculated risks, reduces the likelihood that a losswill occur and minimizes the scale of the loss should it occur. Risk management includesboth the prevention of potential problems and the early detection of actual problems whenthey occur. As such, risk management is an ongoing three-step process: 1

1 For a six-step version, see Campion (2000).

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This handbook isintended to fostergood managementand accountability

INTRODUCTION

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Figure 1: Three-step Risk Management Process

1. Identify Vulnerabilities: Before managing risks, it is necessary to identify theorganization’s vulnerability points, both current and future. An important aspect ofassessing risk is to predict exposure in the short, medium and long term. To helpMFIs identify their vulnerabilities, this document contains a risk assessmentframework that addresses financial and institutional development issues.

2. Design and Implement Controls: Once an MFI has identified its vulnerabilitypoints, then it can design and implement controls to mitigate those risks. BecauseMFIs operate in different environments, and because CARE works with a diverse setof microfinance partners, the controls outlined in this handbook tend not to bespecific or prescriptive. By understanding why a certain control should be in place,MFI managers and directors can tailor the control to their local environment. Forexample, taking collateral to control credit risk may be appropriate in some markets,whereas in other markets a group guarantee is a more appropriate control.

3. Monitor Effectiveness of Controls: Once the controls are in place, then the MFIneeds to monitor their effectiveness. Monitoring tools consist primarily ofperformance ratios that managers and directors need to track to ensure that risks arebeing managed.

This three-step risk management process is ongoing because vulnerabilities change overtime. Risks also vary significantly depending on the institution’s stage of development. AnMFI with 2,500 borrowers will experience different challengesfrom an organization with 25,000 outstanding loans. Asparticipants in a new industry, MFIs cannot afford to becomecomplacent if they want to avoid being toppled by innovations,competition, and new regulations among other things. How oftenis “ongoing”? That will vary by country context, but at the veryleast the board should conduct an annual risk assessment update.

Identify Currentand Future

Vulnerabilities

Design andImplementControls to

Mitigate Risks

MonitorEffectivenessof Controls

Risk managementis ongoingbecausevulnerabilitieschange over time


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Besides analyzing the current state of the organization, risk management involves using acrystal ball to anticipate possible changes in the internal and external environment during theshort-, medium- and long-term. Since no one can accurately predict the future, it isrecommended that you consider best, worst and average case scenarios for each of the threetime periods. While it is probably excessive to prepare for the absolute worst-case scenario,risk management involves taking a conservative approach in preparing for potentialoutcomes. Managers and directors who only plan for best-case scenarios are deludingthemselves and are setting their organization up for perpetual disappointments.

It is important to note that microfinance institutions cannot completely eliminate theirexposure to risks. Any effort to do so would be prohibitively expensive, thus creating avulnerability to another set of risks. Managing risk involves the search for the appropriate,though elusive, balance between the costs and effectiveness of controls, and the effects thatthey have on clients and staff.

Structure of the Handbook and How to Use ItThe Handbook is divided into six chapters. The first chapter presents a framework forconceptualizing microfinance risks, and the next four chapters discuss the controls requiredto mitigate the four major categories of risks: institutional risks, operational risks,financial management risks, and external risks. The final chapter describes theaccounting and other systems required for effective risk management.

At the end of most sections is a set of questions that can be used as a control checklist. Thischecklist may be useful for managers and board members in conducting a self-assessment ofwhether sufficient controls are in place to mitigate various risks. External technical supportagents, like CARE, can also use the checklist to conduct risk management assessments oftheir partners. These checklists are summarized and cross-referenced in the appendix by theindividuals responsible for ensuring that the controls are in place. At the end of eachchapter is a list of resources and recommended readings, which is also summarized in thebibliography that follows the annexes.

The handbook can be used as a mentoring-training guide, a reference manual and a self-assessment tool. For example:

ê The board of directors can use this handbook as a framework for conducting a riskassessment of the organization, which is one of its major responsibilities.

ê MFI managers can use the handbook to learn why various controls and systems areneeded and apply the suggested guidelines to their local circumstances. There is not oneway of doing things, so the handbook provides recommendations rather than hard andfast policies.

ê Supervisors and auditors could use the handbook as a checklist of procedures andsystems that should be in place. Checklists have been inserted at the end of most sectionsto remind readers of key systems, controls and procedures.

INTRODUCTION

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ê Project designers should use the handbook to describe expected controls and proceduresthat will exist by the end of a project.

This document is a work in progress. Just as microfinance is a constantly evolving arena, sowill its subsequent risks, controls and monitoring mechanisms change over time. If you findthat sections have become outdated, or new risks and controls have emerged, please bringthis to the attention of CARE’s SEAD Unit so they can make necessary revisions.


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Chapter 1: Risk Assessment Framework

ost microfinance institutions are small and unprofitable, and they operate withoutsystems that adequately reduce risk. Although the microfinance literature focuseson success stories, such as BancoSol in Bolivia or BRI’s microfinance units inIndonesia, these organizations are exceptional. For microfinance programs

striving to fulfill their dual mission of sustainability and outreach to the poor, CAREsuggests implementing the risk assessment framework that addresses two agendas:

1. Financial Health2. Institutional Development

A standard risk assessment of a financial institution typically addresses the first issue only.In assessing the financial health of a bank or other financial institution, one would considerthe organization’s asset and liability management, including credit risk, as well as operationalrisks such as fraud and inefficiency.

Microfinance risk assessment also needs to embrace an institutional developmentperspective. As MFIs evolve from donor dependency to commercial independence, clearvision, reliable systems, effective governance and staff capacity become critical in their abilityto manage risk.

This integrated risk assessment framework for MFIs, which analyzes institutionaldevelopment and financial health issues, is organized into four categories of risk:institutional, operational, financial, and external (see Figure 2). This framework providesmanagers and directors of microfinance institutions with a step-by-step means of assessing theirorganization’s current and potential vulnerabilities.

1.1 Institutional RisksMicrofinance success is defined as an independent organization providing financial servicesto large numbers of low-income persons over the long-term. An assessment of risks againstthis definition results in three categories of institutional risk: social mission, commercialmission, and dependency.

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Figure 2: Categories of Microfinance Risks

1.1.1 Social MissionWhile all MFIs do not have the same mission statements, in general they have a dualmission: a social mission and a commercial mission. Their social mission is to providevalued financial services to large volumes of low-income persons that will enable them toimprove their welfare. Microfinance institutions are vulnerable to social mission risk if theydo not have a clearly defined target market and monitoring mechanisms to ensure that theyare providing appropriate financial services to their intended clientele.

1.1.2 Commercial MissionThe commercial mission of MFIs is to provide financial services in a way that allows theorganization to be an on-going concern; that is, to exist for the long-term as a self-sufficientorganization. MFIs are exposed to commercial mission risk if they do not set interest rateshigh enough to cover costs and if they are not managed as a business.

The social and commercial missions sometimes conflict with each other. For example,offering larger loans might make it easier to become sustainable, but this could underminethe social mission to serve low-income and harder-to-reach people who traditionally demandsmaller loans. The microfinance challenge is to balance the social and commercial missionsto achieve them both.

1.1.3 DependencyDependency risk is similar to commercial mission risk, but it is most pronounced for MFIsstarted and supported by international organizations such as CARE, particularly when the

FinancialManagement Risks

Asset and LiabilityInefficiency

System Integrity

External RisksRegulatoryCompetitionDemographic

Physical EnvironmentMacroeconomic

Operational RisksCreditFraud

Security

Institutional RisksSocial Mission

Commercial MissionDependency


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microfinance activities are operated as a project rather than as an independent organization.These MFIs are vulnerable to dependency on support provided by the external organization.While this support may initially seem like an advantage, it can significantly undermine effortsto build an independent institution that will exist for the long-term.

1.2 Operational RisksOperational risks are the vulnerabilities that an MFI faces in its daily operations, includingportfolio quality (credit risk), fraud risk and theft (security risk).

1.2.1 CreditAs with any financial institution, the biggest risk in microfinance is lending money and notgetting it back. Credit risk is a particular concern for MFIs because most microlending isunsecured (i.e., traditional collateral is not often used to secure microloans).

To determine an institution’s vulnerability to credit risk, one must review the policies andprocedures at every stage in the lending process to determine whether they reducedelinquencies and loan losses to an acceptable level. These policies and procedures includethe loan eligibility criteria, the application review process and authorization levels, collateralor security requirements, as well as the “carrots and sticks” used to motivate staff andcompel borrowers to repay. In addition to analyzing whether these policies and proceduresare sound, it is also necessary to determine whether they are actually being implemented.The best policies in the world are meaningless if staff members are not properly trained toimplement them or choose not to follow them.

1.2.2 FraudAny organization that handles large volumes of money is extremely vulnerable to fraud, avulnerability that tends to increase in poor economic environments. Exposure to fraud isparticularly acute where money changes hands. These vulnerabilities in a microfinanceinstitution can be exacerbated if the organization has a weak information managementsystem, if it does not have clearly defined policies and procedures, if it has high staffturnover, or if the MFI experiences rapid growth. The management of savings deposits,particularly voluntary savings, creates additional vulnerability in that a failure to detect fraudcould lead to the loss of clients’ very limited cash assets and to the rapid deterioration of theinstitution’s reputation. In the detection of fraud, it is critical to identify and address theproblem as quickly as possible to send a sharp message to staff before it gets out of hand.

1.2.3 SecurityAs with vulnerability to fraud, the fact that most MFIs handle money also exposes them totheft. This exposure is compounded by the fact the MFIs tend to operate in environmentswhere crime is prevalent or where, because of poverty, temptation is high. For example, inhigh volume branches the amount of cash collected on a repayment day can easily exceedthe average annual household income in that community.

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1.3 Financial Management Risks

1.3.1 Asset and LiabilityThe financial vulnerability of an MFI is summarized in asset and liability risks, which includeinterest rate, liquidity, and foreign exchange risks. Interest rate risk rises when the termsand interest rates of the MFI’s assets and liabilities are mismatched. For example, if theinterest rate on short-term liabilities rises before an MFI can adjust its lending rate, thespread between interest earnings and interest payments will narrow, seriously affecting theMFI’s profit margin. MFIs operating in inflationary environments are particularly vulnerableto this type of risk. Liquidity risk involves the possibility of borrowing expensive short-term funds to finance immediate needs such as loan disbursement, bill payments, or debtrepayment. MFIs are most vulnerable to foreign exchange risk if they have to repay loansin a foreign currency that they have converted to local currency and therefore are earningrevenue in the local currency.

1.3.2 InefficiencyEfficiency remains one of the greatest challenges for microfinance institutions. It reflects anorganization’s ability to manage costs per unit of output, and thus is directly affected by bothcost control and level of outreach. Inefficient microfinance institutions waste resources andultimately provide clients with poor services and products, as the costs of these inefficienciesare ultimately passed on to clients through higher interest rates and higher client transactioncosts.

1.3.3 System IntegrityAnother aspect of financial management risk is the integrity of the information system,including the accounting and portfolio management systems. An assessment of this riskinvolves checking the quality of the information entering the system, verifying that thesystem is processing the information correctly, and ensuring that it produces useful reportsin a timely manner.

1.4 External RisksAlthough MFI managers and directors have less control over external risks, they shouldnonetheless assess the external risks to which they are exposed. A microfinance institutioncould have relatively strong management and staff, and adequate systems and controls, butstill be prone to major problems stemming from the environment in which it operates.External risks are usually outside the control of the MFI, however it is important that theserisks are perceived as challenges that the MFI should address, rather than excuses for poorperformance.


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1.4.1 RegulatoryPolicy makers, banking superintendents and other regulatory bodies are becomingincreasingly interested in, and concerned about, microfinance institutions. This concern isheightened when MFIs are involved in financial intermediation—taking savings from clientsand then lending them out to other clients or institutions. Regulations that can createvulnerability in an MFI include restrictive labor laws, usury laws, contract enforcementpolicies, and political interference.

1.4.2 CompetitionIn some environments, microfinance is becoming increasingly competitive, with new players,such as banks and consumer credit companies, entering the market. Competition risks stemsfrom not being sufficiently familiar with the services of others to position, price, and sellyour services. Competition risk can be exacerbated if MFIs do not have access toinformation about applicants’ current and past credit performance with other institutions.

1.4.3 DemographicSince most MFIs target disadvantaged individuals in low-income communities, microfinancemanagers need to be aware of how the characteristics of this target market increase theinstitution’s vulnerability. In assessing demographic risks, consider the trends andconsequences of illness and death (including HIV/AIDS), education levels, entrepreneurialexperience, the mobility of the population, social cohesiveness of communities, pastexperience of credit programs, and local tolerance for corruption.

1.4.4 Physical EnvironmentSome areas are prone to natural calamities (floods, cyclones, or drought) that affecthouseholds, enterprises, income streams and microfinance service delivery. In addition, thephysical infrastructure—such as transportation, communications, and the availability ofbanks—in the MFI’s area of operations can substantially increase its vulnerability.

1.4.5 MacroeconomicMicrofinance institutions are especially vulnerable to changes in the macroeconomicenvironment such as devaluation and inflation. This risk has two facets: 1) how theseconditions affect the MFI directly and 2) how they affect the MFI’s clients, their businessoperations, and their ability to repay their loans.

1.5 ConclusionThe management and board of a microfinance institution should consider each of the risksidentified in this chapter as vulnerability points. It is their responsibility to assess theinstitution’s level of exposure, prioritize areas of greatest vulnerability, and to ensure thatproper controls are in place to minimize the MFI’s exposure. The next four chapters'

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address the controls and monitoring tools required to manage each of these four categoriesof risk.

Figure 3: Organization of Microfinance Risks by Chapter

Chapter 2 Institutional Risks Social MissionCommercial MissionDependency

Chapter 3 Operational Risks CreditFraudSecurity

Chapter 4 Financial Management Risks Asset and LiabilityInefficiencySystem Integrity

Chapter 5 External Risks RegulatoryCompetitionDemographicPhysical EnvironmentMacroeconomic

Chapter 6 then presents the accounting and portfolio management systems required creatingan effective risk monitoring system. The fact that it comes at the end of this documentshould not lessen its importance. The implicit basis for effective risk management istransparency. If an MFI does not have accurate and timely information that it can analyzethrough a variety of different lenses, then it cannot manage its risks. Chapter 6 providesguidance in how to enhance transparency through information systems.


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The Ultimate Risk Management Controls:Good Governance and Quality Human Resources

This handbook contains a host of controls to mitigate the specific risks to which a microfinanceinstitution is exposed. There are two overarching controls, however, that deserve specialmention because they cut across numerous risks and serve as critical building blocks on whichmany of the other controls are based.

Good Governance: The board of directors plays a critical control function in a microfinanceinstitution. One of the board’s key responsibilities is to analyze risks and ensure that the MFI is implementingappropriate controls to minimize its vulnerability. This handbook is a valuable tool for directors tocomprehensively review possible risks and to pinpoint the areas of greatest vulnerability.

Unfortunately, the microfinance industry is not particularly well known for its effectivegovernance, which presents its own set of risks. In the search for effective governance, considerthe following guidelines:

ê The board should be comprised of a group of external directors, with diverse skills andperspectives that are needed to govern the MFI. The composition should balance the dualmission of microfinance, with some directors more concerned with the social mission andothers focused primarily on the commercial mission.

ê It is critical that board members dedicate sufficient time to fulfill their functions. It is notappropriate to appoint directors solely for their “political” value; while it might seem nice tohave the names of famous people in the annual report, if they do not actually attend boardmeetings and play a meaningful role, then they are not providing good governance.

ê There needs to be a clear separation of roles and responsibilities between the board andmanagement. The board oversees the work of senior managers and holds them accountable,which includes setting performance targets and taking disciplinary action if necessary.

ê The board should meet often enough to keep a close eye on the organization. Duringperiods of change, this may mean weekly meetings. In mature, stable MFIs, quarterlymeetings might suffice, especially if there is an executive committee of the board that is inmore frequent contact with management.

ê Boards should be regularly rejuvenated so that new ideas and fresh energy are injected intothe organization. This can be accomplished through term limits and/or a performanceappraisal system that encourages inactive and ineffective directors to step down.

Trained and Motivated Personnel: The other “building block” control is the MFI’semployees. As a service industry, the delivery of microfinance products is just as important asthe products themselves. An MFI can dramatically reduce its vulnerability to most risks if it haswell-trained and motivated employees. This is accomplished through a three-pronged strategy:

ê Hiring: The first step is finding the right people. In hiring field staff, you are probably notgoing to find people with microfinance expertise, so instead you should look for certainvalues (honesty, commitment to the target market, a willingness to get their shoes dirty),personality characteristics (outgoing, team player), and aptitudes (combination of “hard”and “soft” skills). Once you identify the ideal traits of a loan officer, then you can design your

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screening techniques accordingly. When you find a few of the ideal people, then figure outwhere they came from to see if there are more of them out there. Sometimes certain schools,religious groups or social organizations are excellent sources of new employees.

ê Training: Once you have hired the right people, the next step is to train them well. Trainingoften focuses on the nuts and bolts of doing a job—such as what forms do you fill out forwhat purposes—but to serve as an effective control, training should impart much more thanjust technical skills. New staff orientation is the ideal time to indoctrinate your employees, tobathe them in the institution’s culture, to cultivate their commitment to the organization, itsmission and its clients, and to teach and practice the social skills needed to perform their jobs,such as group mediation and facilitation, adult education, customer service, and timemanagement. Training should not end once the loan officer hits the streets. To retain qualitypeople, and to ensure that they grow and develop as the organization evolves, it is necessary toprovide regular in-service training as well. In the search for increased efficiency, MFIs areconstantly looking for ways to streamline operations and cut corners; they should resist anytemptation to short-change the training of new or existing employees.

ê Rewarding : It is difficult to keep employees motivated and enthusiastic about their work.MFIs should view their best employees the same way they view their best customers: once youhave them, do every thing possible to keep them. An MFI that wants to retain staff needs toposition itself as the employer of choice. This involves providing a competitive compensationpackage, but it is much more than just wages. Salaries are already the biggest line item in mostMFI budgets—so it is necessary to find creative ways of rewarding and motivating staff.Other factors that influence an employee’s satisfaction, and therefore their willingness toremain with the employer, include:

ê Benefits such as health insurance and vacation timeê An institutional mission where people feel that they can make a differenceê Workplace design that is comfortable and conducive to productivityê An institutional culture that is unique so that employees feel like they are part of a special

teamê Recognition of individual and group accomplishmentsê Staff development and job enrichment opportunities


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Chapter 2: Institutional Risks andControls

nstitutional risks come in two types. The first type involves the institution’s mission,which has two aspects of its own: the social and commercial. Microfinance is apowerful development strategy because it has the potential to be a long-term means forfighting poverty and inequity. One of the greatest challenges in designing and running

microfinance operation is to balance the dual mission so that your MFI: a) providesappropriate financial services to large volumes of low-income persons to improve theirwelfare (social mission); and b) provides those services in a financially viable manner(commercial mission). Too heavy a focus on one or the other, and microfinance will not liveup to its potential.

The second institutional risk is the dependency of a microfinance program on internationalsupport organizations such as CARE. MFIs that rely on strategic, financial, and operationalsupport from international organizations are at risk because the longer those links continue,the harder it is to break them—yet no one should be under the illusion that those links cancontinue indefinitely. Microfinance programs that were created as CARE projects, ratherthan separate institutions, are particularly vulnerable to dependency risk.

2.1 Social Mission RiskThe social mission of microfinance institutions is to 1) provide appropriate financial services2) to large volumes 3) of low-income persons 4) to improve their welfare. These fourelements are highlighted in the left-hand column in Figure 4. The right-hand column liststhe controls and monitoring tools that MFIs need to mitigate social mission risk.

I

FinancialManagement

Risk

External Risk

OperationalRisk

InstitutionalRisk

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Figure 4: The Four Ms of Controlling Social Mission Risk

Social Mission Controls and MonitoringProvide Appropriate Financial Services Market ResearchTo Large Volumes Managing GrowthOf Low-Income Persons Mission StatementTo Improve Their Welfare Measuring Impact

2.1.1 Mission StatementThe process of controlling social mission risk begins by identifying the target market. In itsmission statement, the governing body of the MFI has to clearly articulate whom theinstitution wants to serve and why it wants toserve them. The mission statement shouldalso indicate that the organization intends toserve this market for the long term as anindependent and self-sufficient institution.This mission statement then serves as aguiding light for managers and employees asthey apply it in their daily activities.

In developing the mission statement, it isimportant to strike a balance between thesocial and commercial mission. If theorganization narrowly defines the targetmarket, then it may have difficulty achievingsufficient scale and efficiencies to fulfill itscommercial mission. For example, if the MFIonly wants to serve refugees or people withHIV/AIDS, then the potential market for itsservices may not be large enough to create asustainable institution, or it may be tooexpensive to identify and deliver services to a market that is geographically disparate, or therisks of serving a narrowly defined target group may be too high.

The composition of the board of directors can contribute significantly toward ensuringthat the institution has a good balance, both in its mission statement and how it goes aboutfulfilling its mission. It is difficult to find individuals who embody the dual mission ofmicrofinance, so boards are often constructed to be balanced, with roughly half of thedirectors personifying a social bias and the other half with a commercial bent. This maycreate some tense board meetings, but it tends to produce appropriate microfinance policy.

Commercial Banks and Social Mission

Do all microfinance institutions have to have asocial mission? Many commercial banks, includingCARE’s partner in Zimbabwe, are beginning toserve the microenterprise market without a strongsense of social mission. Banks may be motivated toserve low-income persons because they have beenpushed down market by increasing competition atthe upper end, or because they see microenterprisesas a profitable niche market, or for public relationsreasons—but they are rarely concerned aboutalleviating poverty. It remains to be seen whethermicrofinance players who only have a commercialmission will be successful. It is logical though thatan organization that deeply cares about its clientsand serves them on a commercial basis will be moresuccessful over the long term than an MFI that ispurely profit-driven.


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ê Does your organization have a clear mission statement that balances the social and commercial objectives andidentifies the target market?

ê Do employees know the organization’s mission statement and use it to help guide their actions?

ê Does the composition of the board reflect the dual mission of microfinance?

2.1.2 Market ResearchOnce the organization identifies its target market, the next step is to understand the needs ofthose persons to ensure that it provides them with appropriate services. If the mission is toserve the poor, an MFI must determine what services the poor want and need. Microfinanceinstitutions should have the capacity to conduct quality market research. This will allowthem to learn about the needs, opportunities, constraints and aspirations of their intendedclients. Market research is not a once-off activity. The needs of an institution’s targetmarket will evolve over time. The MFI needs to keep in touch with those changing needsand to respond accordingly. Microfinance institutions should have an ongoing commitment toimprovement.

Figure 5 provides a summary of the tools used by microfinance institutions to gatherinformation from current, former, and prospective clients to determine whether they areproviding appropriate financial services, and to solicit suggestions regarding how tocontinuously improve those services.

Each MFI has to decide which of these tools are appropriategiven their scale and stage of development. It is unlikelythat all nine will be needed at once, but it is helpful to relyon three or four market research methods to ensure that youare getting consistent and reliable results. Of the nine, exitinterviews are probably the most important. Lostcustomers are a valuable source of information about whatis wrong with your products and services, and sometimes by demonstrating an interest intheir opinions you can even attract those clients back.

One of the main purposes of conducting market research is to collect sufficient informationto tailor an MFI’s products and services to the requirements of the target market. Todetermine if the financial products and delivery systems are designed appropriately, considerthe following questions:

ê Does your organization use appropriate screening mechanisms to ensure that it is serving the intended targetmarket?

ê Are the loan sizes appropriate to the needs of the clients?

ê Do you offer a large enough range in loan sizes so that the best clients do not grow out of the program?

ê Do the requirements for accessing a loan (i.e., collateral, meetings, business plan, forced savings) address theinstitution’s need to control credit risk (see next chapter) without being excessively demanding on clients?

ê Is it convenient for the target market to access services, in terms of the amount of time required, location of services(i.e., branch locations), and the timing of those services (i.e., office hours)?

Lost customers are avaluable source ofinformation aboutwhat is wrong withyour products

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ê How do you conduct useful market research activities on a regular basis to keep in touch with the changing needs ofyour target market?

ê How does your organization demonstrate a commitment to constant improvement?

Figure 5: Market Research Tools

Tool Explanation1. Questions on loan

applicationsCollect information with each loan application from a) new clientsregarding their expectations and their experiences with competitors’products; and from b) old clients about whether their expectationswere met and how the organization can improve

2. Complaint and suggestionssystem

Incorporate customer comment cards and/or a customer servicedesk

3. Customer satisfactionsurveys

Send a short questionnaire to a representative sample of clients, orto all clients who recently purchased a service along with a thankyou note from the loan officer

4. Individual interviews Hire a market research consultant to conduct interviews with asample of current, former and prospective customers

5. Focus groups Gather a small group of clients for an informal discussion on howthe institution can improve its services

6. Client advisory committee Form a committee of client representatives at the branch level togive regular feedback on products and services

7. Mystery shopping Employ “mystery shoppers” to pose as customers and to evaluateyour organization’s customer service

8. Exit interviews Determine why clients are not continuing to access your services byinterviewing or surveying former clients

9. Staff feedback loop Develop a system by which field staff actively solicit complaintsand suggestions; they should regularly (often daily) document thefeedback they receive, both positive and negative, and then thisinformation is centrally collated and analyzed

Adapted from Churchill and Halpern (2001).

2.1.3 Monitoring Client Composition and Measuring ImpactManagement and the board should have some way of determining whether the organizationis serving the market that it is intended to serve and whether its services are having thedesired effect.The two most common indicators used to monitor client composition are average loan sizeand the percent of women clients. It is also useful to track average loan size specifically forfirst time borrowers, because while the average loan size for all clients often rises as the MFImatures the loans to first-time borrowers should remain fairly steady. If this value isrising—certainly if it is rising faster than inflation—then the MFI may be migrating awayfrom its original target market.


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Figure 6: Monitoring Client Composition

Primary Indicators Secondary IndicatorsAverage Outstanding Balance Monthly or Annual Household IncomeAverage Loan Size (disbursed) Household AssetsAverage Loan to 1st Time Clients Enterprise Asset BasePercentage of Women Clients

In the process of choosing appropriate indicators, such as from the list in Figure 6, it isimportant to consider the balance between the social and commercial missions. Some data,such as household income and enterprise asset base, may be easily available because loanofficers need that information to conduct the credit analysis. If loan officers are expected tocollect information that is not essential to make sound credit decisions, however, they mayhave difficulty being efficient and carrying large enough case loads to create a sustainableinstitution.

ê What indicators do you use to ensure that you are serving the intended target market?

ê Is this information collected in a cost-effective manner?

ê How does the board monitor the client composition?

ê What information, if any, does your organization consistently collect regarding the impact of your services onclients?

ê How often does senior management go to the field to talk with clients and staff?

2.1.4 Managing GrowthWhile many MFIs are interested in serving large volumes of people, in their efforts to do so,they commonly encounter three types of problems:

1) Capacity Constraints: Some MFIs operate in markets with a large pent up demandfor microfinance. To respond to the demand, an organization may grow veryquickly, only to realize that it does not have the capacity or the systems to satisfythe demand. These MFIs often experience bottlenecks in the disbursementprocess and risk losing credibility in the market place. Before expanding, MFIsneed to ensure that they have the systems to cope with the projected volume ofapplications. If the demand exceeds expectations, and it is not possible toexpand capacity, then the MFI needs to find a way of tempering demand,perhaps by raising interest rates, lengthening the pre-loan process, or limiting thenumber of applications a loan officer can submit each month.

2) Premature Expansion: Other organizations operating in similar environmentsexpand before they have fine-tuned their lending methodology, only to find outafter it is too late that they have large volumes of poor quality loans on thestreets. MFIs must ensure that their loan product is well designed and that thelending methodology is working before they step on the gas and expand. It isalso important that they resist pressure from donors and others to grow beforethey are ready.

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3) Reaching a Plateau: The opposite growth problem is also prevalent: some MFIs hita growth plateau where they get stuck. No matter how hard they try, they cannotseem to push their expansion to the next level even though they have notsaturated the market. Some get stuck at the 2500 to 3000 active client mark.Others get stuck at the 5000 to 6000 mark. In some cases, these organizationsneed to improve their marketing efforts. A closer examination, however, willoften indicate that the organization has a client retention problem, which willsuggest that the product is not designed appropriately for the market.

To monitor for this third risk, MFIs should tracktheir client retention rates on a monthly basis.For the length of the period, annual is mostcommonly used, even for short-term loans,because a 12-month period neutralizes the affectof seasonal fluctuations. There is no industrybenchmark that would be particularly useful withthis indicator. It is more important for theinstitution to monitor its retention rate trend. Aswith other performance indicators, it is useful to disaggregate the retention rate by type ofproduct, loan cycle and branch to determine if desertion is a bigger problem in certainsegments of the institution’s client base.

ê How has your retention rate changed over the past year and what are the primary reasons for that change?

ê Does your organization currently have excess capacity, which suggests that you should be poised for growth, or doyou need to build capacity before continuing to expand?

2.2 Commercial Mission RiskAlthough intended to serve the poor, microfinance is a business operation that must run onbusiness principles. This means that a microfinance institution should make decisions basedupon sound business rules, not on charitable sentiment. If an institution’s managers andboard members do not share a business-like perspective, the MFI will be extremelyvulnerable to commercial mission risk.

It seems counter-intuitive that an organization dedicated to helping the poor needs to chargehigh interest rates and strive for profitability. The commercial approach makes sense,however, if you adopt a long-term view. Many of CARE’s development initiatives are short-term projects with a specific end date. Microfinance, on the other hand, has the uniqueability to provide developmental services on an ongoing basis if it is designed andimplemented properly. With microfinance activities, it is critical to adopt a long-termperspective because clients do not just want loans for the next three to five years. Theywant—and deserve—a safe place to save their money and a convenient place to borrowfunds indefinitely. The only way to provide them with this extremely valuable service overtime, and generate its important development benefits, is by fulfilling the commercialmission of microfinance.

Retention Rate:

(# of Loans Made during the Period – Numberof First Time Borrowers)

/(Active Clients (beginning of period) + # of

Loans Made – Active Clients (end of period))


20

Controls for commercial mission risk include: setting interest rates, designing the capitalstructure, planning for profitability, and managing for superior performance.

2.2.1 Setting Interest RatesIn determining their interest rates, MFIs, like all financial institutions, need to cover four setsof “expenses”:

a) Operating expensesb) Cost of capital (including adjustments for inflation and subsidies)c) Loan lossesd) Intended surplus (for retained earnings and/or dividends to shareholders)

If, for example, operating costs amount to 20 percent of average outstanding portfolio, thecost of capital is 10 percent, and loan losses are 2 percent, then the MFI has to charge aneffective interest rate of 32 percent just to break even. In fact, it should charge a slightlyhigher rate so that it can generate a small surplus (perhaps 5 to 15 percent) that can be usedto replace old equipment, open new branches, develop new technologies, etc.

Many mature MFIs are not charging interest rates that are high enough to cover these fourcosts, and therefore they have to be subsidized. In fact, many MFIs do not have a clearunderstanding of each of these costs. In effect, they are passing their subsidy on to theirclients in the form of an interest rate that is lower than the cost of providing the loan. Whileit is nice to give poor people a break, that is not the purpose of microfinance and it is notsustainable. Microfinance programs need to charge appropriate interest rates that cover thefull costs of providing the services.2

2.2.2 Designing the Capital StructureThe social mission drives some MFIs to provide appropriate financial services to large volumesof low-income persons. To provide a large number of loans, even very small loans, itrequires a large amount of capital for the loan portfolio, as well as ongoing investments intothe MFI such as upgrading the information system. This raises the question, where do MFIsget the funds they need to build an institution and fuel the growing demand for microcredit?

Initial capital often comes in the form of grants from donors. Donor grants are anexcellent source of capital for new programs, but are not a long-term solution. Donorcapital is finite and fickle. Concessionary loans are a related source of capital that alsohave their time and place, but again are not a reliable source for the long-term.

Retained earnings are another common source of capital. For MFIs that are generating asurplus of income over expenses, they can plow their “profits” back into their loanportfolios (or make other necessary investments). This requires being able to generate a

2 It is unrealistic to expect new MFIs to charge an interest rate that is high enough to cover its costs.Microfinance institutions need to reach certain economies of scale (roughly five to ten thousand clients)before they can become profitable. A start-up therefore needs capital to pay for operating deficits until itreaches break-even, perhaps in the form of investor equity, high risk debt, or grants.

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surplus in the first place, and it is unlikely that MFIs will produce such a large surplus tocompletely fund their growth.

Commercial loans are available to some microfinance programs. These are usuallyavailable to unprofitable programs only with some form of external guarantee, such as adonor-supported loan guarantee fund. Once MFIs become sustainable, they may be able toaccess commercial loans using their portfolio or other assets as collateral. As non-profitorganizations, however, MFIs cannot typically get commercial loans at very favorable ratesor in large enough amounts to fund their growth. Consequently, many microfinance NGOsare considering establishing regulated financial institutions.

Figure 7: Evolution of Capital Sources for a Microfinance Program

The transformation into a regulated financial institution creates opportunities for an MFI toaccess two other sources of capital. First, it may allow them to attract equity fromshareholders, which more favorably leverages commercial loans. Second, as a regulatedfinancial institution, the MFI may be able to accept savings for financial intermediation.Many MFIs accept savings from their clients, but unless they are regulated financialinstitutions, they should not be using that pool of funds for lending.

Figure 7 depicts a common evolution of an MFI’s source of funds, starting with grants andeventually weaning away from donor-supported funding sources. To monitor itseffectiveness in controlling commercial mission risk (i.e., achieving financial self-sufficiency),MFIs should properly account for and recognize subsidies in their financial statements.Chapter 6 provides guidance on making appropriate subsidy adjustments.

It is important to note that, while transformation opens up opportunities for MFIs to accessadditional and perhaps more stable sources of capital,CARE does not expect all of its partners to createregulated financial institutions. It is not an appropriatesolution in all-regulatory environments or for allinstitutions that provide microfinance services.

2.2.3 Planning for ProfitabilityIt takes a considerable amount of planning to produce aprofitable microfinance institution and mitigatecommercial mission risk. The first step in the planningprocess is a strategic plan that outlines where theorganization is going over the next three to five years,

GrantFunds

ConcessionaryLoans

Commercial Loanswith Guarantees

RetainedEarnings

InvestorEquity

CommercialLoans andCustomerSavings

Transformation

Creating Ownership: Planning fromthe Bottom Up

Since most targets and ratios highlightedin the business plan need to be achievedby the field staff, it is essential that theyare involved in the process of identifyingwhat they think are realistic andachievable goals. Branch managers andtheir teams will feel more motivated toachieve targets if they are involved insetting them.


22

and why. Typically the board is actively involved in the strategic planning process. Thenmanagement creates a business plan that answers the question: how will the organizationaccomplish its strategic plan? While the business plan may cover the same length of time asthe strategic plan, it will be much more detailed in Year 1 than it will be for subsequentyears.

The Year 1 details then serve as the foundation for the annual budget. The business planalso produces a monthly or quarterly work plan that management reviews regularly andupdates and adjusts accordingly. This ensures that the business plan is not just a nice reportthat collects dust on the shelf, but rather a working document that guides and propels theorganization forward. As time passes, the initial projections should be updated with actualnumbers to help managers adjust their plans and budgets accordingly.

The business plan should include a detailed projection model that predicts when theorganization will achieve self-sufficiency and under what circumstances. These projectionsare not only important to help set targets, but they can also be used to explain to allemployees that the organization can afford to cover its costs, but to do so it needs to fulfillcertain assumptions. For example, the projection model can help identify how manyborrowers, what size portfolio, what average loan size and term, etc. that organization willneed to achieve self-sufficiency. This process can also help determine how many loans needto be processed per week and how many clients each credit officer needs to maintain. Withthis information in hand, MFI management should take a careful look at its systems,documentation requirements, the paper trail and approval processes, and aspects of itslending methodology to determine how to streamline things to make self-sufficiency areality.

2.2.4 Managing for Superior PerformanceTo reduce the institution’s vulnerability to commercial mission risk, management needs todrive the organization to achieve superior levels of performance. Managing for superiorperformance allows an MFI to get the most out of its employees. This is critical in achievingboth the social and the commercial mission. If the MFI has highly productive and efficientstaff members, the institution will be able to generate more revenue for a fixed set ofexpenses, while maintaining small average loan sizes. Once the organization is profitable—revenue is greater than expenses—then any additional improvements in productivity andefficiency can allow it to lower its interest rates.

The process of managing for superior performance involves collectively settingperformance targets at all levels within the organization, monitoring the achievement oftargets, and rewarding accomplishments. You can only manage well if you have a system tomeasure the effectiveness of what is being managed.

To fulfill the institution’s commercial mission, the retention ofquality staff members is even more important than retainingclients. Try to calculate the costs of losing good people, whichincludes hiring and training replacements, higher loan losses andlower productivity of green employees, and the negative impactstaff turnover has on customer loyalty. While this estimation will

The retention ofquality staffmembers is evenmore importantthan retainingclients

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rely heavily on educated guesses, it will probably show that an MFI cannot afford to lose itsbest employees. And if employees leave to work for another MFI, you are in effectsubsidizing the competition.

Managing for superior performance also involves mitigating the effects of certain humanresource risks, such as:

ê A Thin Labor Market: Not being able to find enough affordable employees with therequisite skills

ê The Peter Principle: Promoting people to their level of incompetence (good loan officersdo not necessarily make good branch managers)

ê Which Comes First? If the MFI is not financially secure and stable, it may have difficultyattracting the quality of staff that it needs, but if it cannot attract the right people, it willhave difficulty achieving self-sufficiency

To determine whether your human resource policies and systems are effective, consider thefollowing controls:

ê Develop a means of regularly identifying employee development and motivational needs

ê Invest heavily in your employees by providing quality staff training and sending them onobservation visits to MFIs in other countries

ê Establish a family-like institutional culture in which the employee and the institution arefully committed to each other

ê Create internal communication channels such as a two-way performance review process,regular employee satisfaction surveys, and an employee advisory committee to advise thehuman resource department

ê Monitor employee turnover ratios

ê Conduct exit interviews with departing staff members to determine the real reasons whythey are leaving

2.2.5 Monitoring for Commercial Mission RiskTo monitor whether an MFI is sustainable and generating a surplus, CARE recommendsthat organizations monitor the sustainability and profitability ratios summarized in Figure 8.Efficiency and productivity indicators are also important; these are addressed in Chapter 4.


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Figure 8: Sustainability and Profitability Ratios

SustainabilityOperational Sustainability Operating income / (Operating expenses + provision for loan losses

+ financing costs)

Financial Sustainability Operating income / (Operating expenses + provision for loan losses+ adjustments for inflation and subsidies)*

Interest Spread (GrossFinancial Margin)

(Operating income – financing costs) / Average performing assets

ProfitabilityReturn on Assets Net income / Average assets

Return on Equity Net income / Average equity*For more details about adjusting for inflation and subsidies, see Chapter 6.

ê Is the interest rate set high enough to cover the MFI’s full costs?

ê Do you have a business plan to achieve self-sufficiency in a reasonable amount of time?

ê Do you update the plan and use it regularly to make management decisions?

ê What steps do you take to ensure that your employees are motivated and enthusiastic about their work?

ê Is your human resource system effective and how do you know?

ê Do you have job descriptions and annual performance appraisals for all employees, including senior management?

ê Does your organization set challenging, yet achievable, performance targets for all layers of the organization, anddoes it monitor and reward achievement of these targets?

ê Do you monitor sustainability and profitability indicators, and if so are they trending in the right direction?

ê Are you moving toward accessing commercial sources of capital and reducing reliance on subsidized fundingsources?

ê Do you properly account for subsidies and in-kind donations?

2.3 Dependency RiskThe objective of CARE SEAD program managers is to create independent, sustainablemicrofinance institutions. But how does an institution define independence? CARE is arobust international organization, yet there is continual concern over potential dependenceon one or two major donors. The dependency risk is greatest for any MFI that begins life asa project of CARE, but the risk also exists for MFIs that are legally independent of CARE.The risk of dependency can be evaluated at three levels: 1) strategic planning, 2) financialresource mobilization, and 3) operational management. For any given MFI the dependencyrisk may be focused in one or more of these areas, but a truly independent organization mustbe the master of all three.

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2.3.1 Strategic DependenceCARE is a multi-sectoral relief and development agency, not a specialized microfinanceorganization. The decision to pursue microfinance in a given country is based on a Long-Range Strategic Plan (LRSP) that matches CARE’s many comparative and competitiveadvantages within the development context of the host country. Microfinance is never theonly activity for a CARE country office (CO). CARE program managers often viewmicrofinance as a component of a larger development strategy. There are certain advantagesto this approach at an analytical level, but there are also several risks that MFI and CAREmanagers must keep in mind.

First, country office program managers may view the MFI strategy as subordinate tothe short and medium-term objectives of other programs in the CARE portfolio. Forexample, an MFI could be pushed into extending credit to farmers in rural areas tomeet the needs of participants in a CARE development project even though ruralloans could undermine the long-term financial and institutional sustainability of theMFI.

Second, there may be a timing mismatch between CARE’s “long range” strategicplanning process and the time it takes for an MFI to achieve financial sustainability.Changes in country office and regional management during and between LRSP periodscan add insecurity and inconsistency to the business planning cycle of an MFI thatdepends on CARE for financial or technical support.

Finally, when CARE is the actual or effectively the owner of the MFI, local managersand board members can be marginalized by the dominant position of CARE withinthe governance structure. Board members with little personal stake in the MFI andeven less experience in microfinance may be easily persuaded to defer to CARE forstrategic and operational decisions.

ê Do you have an independent governing body?

ê Does your organization have a plan to establish itself with an independent legal structure?

ê Do you share clients with other CARE programs? If so, is the strategy driven by the business plan of the MFIand does it contribute to long-term sustainability or do projections show a continuing need to cross-subsidize thispopulation?

ê Does your organization have the capacity and commitment to develop its own business plan?

ê Is CARE’s role in the governance and management structure best described as supportive or dominating?


26

2.3.2 Financial DependenceA CARE country office has a distinctly different strategy for mobilizing financial resourcesthan an independent microfinance institution. The two strategies can find themselves inconflict. This conflict may be hidden by a high degree of apparent consent between CAREand the MFI, yet financial dependence, however agreeable to the MFI, will ultimatelyundermine the long-term objective of self-sustainability.

CARE generates the bulk of its financial resources by developing project proposals andwinning grants from institutional donors. Larger, more complex projects typically winbigger grants and pay for a greater percentage of core costs for the CARE country office.But microfinance projects have the opposite tendency. As a successful MFI grows in scaleand profitability, the need for donor subsidies diminishes towards zero. CARE may receivegrant funding to continue a technical partnership, but the contribution to core costs quicklybecomes negligible. While CARE does not encourage dependency simply to secure grantfunding, the lost donor income will have an impact on the viability of the country office. Ata minimum it can be said that there is no business incentive for a CARE country office topush a young MFI towards independence.

The MFI may also be reluctant to see a reduction in CARE’s grant funding. Ideally anindependent microfinance institution will acquire its financial resources through retainedearnings, equity investments, or taking on commercial debt. Yet CARE’s ability to raisemoney may discourage MFI managers from aggressively pursuing a more sustainablefinancial management strategy. At worst, CARE financial support may be seen as insurance

Responsibilities of an Independent Board of Directors

The board’s responsibilities consist of five categories of activities:

Legal obligations: The board ensures that the MFI fulfills its legal obligations and protects itfrom unnecessary liability and legal action.

Strategic direction: The board ensures that the institution’s mission is well defined, reviewedperiodically, and respected over time. The board works to enhance the image of the institutionand ensures that an appropriate planning process takes place.

Fiduciary: The board serves as the institution’s steward. It should ensure that the institution hasadequate resources to implement agreed-on plans. The board guarantees the long-term viabilityof the institution.

Oversight: The board governs, not manages. It appoints and oversees the managing director.The board monitors operations and business performance. The board evaluates the institution’sperformance in relation to other MFIs. The board assesses and responds to internal and external risks,and protects the institution in times of crisis.

Self-assessment and renewal: The board should regularly assess its own performance. Boardrenewal is one of the most important outcomes of the self-assessment process.

Adapted from Campion and Frankiewicz (1999).

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against losses due to mismanagement or inefficiency and directly inhibit the MFI fromachieving optimal levels of performance.

ê What percentage of your operating expenses is covered by money received from or through CARE?

ê Do you have an independent contract for financial resources from a donor or commercial lender?

ê Is your organization reducing its dependence on donor/CARE subsidies by as much as estimated in the businessplan? If not, why not?

ê Is CARE the only entity that has raised investment capital and operational subsidies for your organization?

2.3.3 Operational DependenceOperational dependence has both functional and cultural aspects. A functionaldependence occurs when a routine task of the organization is performed or authorized bystaff outside the MFI’s management structure. For example, if the CARE financedepartment manages important treasury functions, a functional dependence exists.Functional dependence is normally easy to spot and efforts should be made to estimate thefair market value of any services provided by CARE to the MFI. But the MFI should have aplan to assume responsibility for all CARE functions within the shortest possible time,preferably from the start of operations.

For MFIs that operate as projects of CARE the functional dependence can be assumed to benearly complete as all authority for MFI activities is derived from CARE management.However, even in these cases the functional dependence can be reduced if the MFI developsthe internal capacity to complete all tasks incumbent on any private business enterpriselacking only the legal authority to do so independently.

Cash ManagementCash management issues can arise in projects with CARE-owned MFIs, when the MFIfinancial management system is not separated from the CARE CO system. In these casesthe CARE Financial Controller is likely to make cash management decisions regarding cashflows through the MFI, rather than allowing the MFI to manage its own cash. As a result,cash management decisions may be made in the best interests of the CARE CO, to thedetriment of potential MFI revenues. Additionally, MFI managers become dependent onCARE financial managers to manage their cash. Regardless of structure or relationship withCARE, it is imperative that MFIs manage their own cash, as an internal treasurymanagement capacity is essential for institutional survival.

ê Does your organization have its own independent financial system?

ê Do you make cash management decisions independently from CARE?

CARE Overhead Core CostsCARE, as well as other development organizations, must cover its core operational costs. Asa decentralized organization, it operates on the principle that every country office must be


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able to pay for its own management structure from the country office revenues. A countryoffice must keep central management costs to an efficient minimum and maintain a projectportfolio that is large enough to cover these shared costs.

Within CARE, project costs are generally shared among projects on a prorated basis. Effortmust be made to ensure that the costs reflect fair fees in relation to the services provided tothe project. This is especially important for MFIs since many of the overhead supportactivities typically done by CARE within a project are (and should be) directly handled by theMFI such as general management, financial management of day-to-day operations, etc.Even for projects that are not fully independent, their operations should be structured andmanaged as an MFI and not as a part of the CARE Country Office.3 The EconomicDevelopment Unit advocates that the project constructs financial reports (balance sheet andincome statement) to represent the financial position of the MFI apart from CARE and theproject.

ê Does the MFI have its own financial system?

ê Are the financial and programmatic reporting expectations and procedures clear between the MFI andCARE?

ê Are the CARE country office core costs reasonable?

ê Is there a written and well-understood agreement between the MFI and the CARE country office on feesto be paid for support services provided by CARE?

Institutional CultureOperational dependency may also manifest itself in the institutional culture of the MFI. Thecorporate culture of CARE as a relief and development NGO is necessarily different thanthe business-orientation of a successful microfinance institution. In many countries CAREstaff are paid better than equivalent jobs in the government or even the private sector, largelyto compensate for the insecurity of working for a grant-dependent, non-profit organization.CARE is not required to operate projects at a profit, but merely needs to negotiate sufficientdonor support to pay for budgeted costs. Therefore, CARE employees do not necessarilyhave a personal stake in holding down operational costs and there is no universal measure ofefficiency.

By contrast, the survival of a business-oriented MFI depends on employees feeling a realsense of ownership over the activities and assets of the institution. In most cases, salariesand benefits have to be set below the norms established for CARE staff, consistent with theMFI’s need for profitability and the promise of more stable, long-term employment.Success (and job security) or failure (and potential unemployment) is as clear as the MFI’sprofit and loss statement.

3 For specific financial guidelines on how to account for Country Office overhead costs, please refer to theCARE Financial Guideline Manual.

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Not surprisingly many employees of MFIs are tempted by the CARE culture. This tendencyis particularly difficult to manage when the MFI is legally a project of CARE. It is verydifficult to convince personnel who were hired by CARE that they should later becomeemployees of a fledgling local organization. CARE country office regulations may stipulatesalary and benefit structures that cannot be sustained by the MFI. SEAD program managersmust have the flexibility to create an independent compensation schedule, staff incentives, and human resourcemanual based on the need for institutional profitability, the market realities of the localenvironment, and the dignity and performance of the individual employees.

Institutional culture is also influenced by the image or brand name recognition of aninstitution. Some employees may find it easier to use CARE’s name with clients andcounterparts than work to establish the identity of a new microfinance institution. This canhave a negative effect on repayment discipline, especially if CARE has distributed gratuitousrelief during emergencies in communities served by the MFI.

ê Do field staff members consider themselves employees of CARE or the MFI? If it is the former, what are theimplications?

ê What percentage of their time do loan officers spend in the field? If it is less than half of their time, does theassociation with CARE somehow make them think that they have administrative positions and should be sittingbehind a desk rather than getting their shoes dirty?

Technical AssistanceA person learns to drive a car by being behind the steering wheel. S/he needs instruction onits operation and its controls prior to turning on the ignition. However, the process oftraining continues after the car is under the control of the new driver. Technical assistance(TA) is needed to mentor the driver through difficulties. Mentoring as a means of technicalassistance can be much more difficult and challenging than actually driving. One of thechallenges in the mentoring process is gradually decreasing the involvement of the mentor soas to reduce the potential for dependency.

Technical assistance is normally focused on four primary aspects, which are:ê Tools: Having the things needed to operate, such as adequate staff, systems, proceduresê Training: Developing the skills of management and staffê Coaching and mentoring: Using the ongoing operations as a setting for learning and dialogue

(apprenticeship)ê Monitoring: Ensuring accountability through follow-up on clear expectations and joint

analysis of the results

Technical assistance plays a fundamental role during early operations. Effective TA resultsin a transfer of skills and systems, and builds local capacity so that the MFI can advancetoward independence. The role of the technical assistance provider should decrease overtime so that the institution becomes less vulnerable to dependency risk.

Microfinance managers and directors should not assume, however, that once they learn howto run an MFI, they no longer need technical assistance. MFIs often reach capacity plateaus,or they encounter unforeseen and intractable difficulties. If they want to make the leap from


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10,000 to 20,000 clients, or introduce a new product, or use technology to create efficiencies,then they may benefit from external expertise. If client retention rates are plummeting ordelinquency rates are rising, they may want to hire a consultant to get to the bottom ofthings. CARE may provide this external technical assistance, or it may come from other TAproviders, either local or international.

While CARE may take the lead role in training MFI staff at the start of the project,eventually the MFI must determine its own staff needs and develop its capacity to hire, train,and mentor its own staff. This implies the need for strong in-house training capacity thatcan replenish skills as staff move on and respond to a changing market environment.

There is an important difference between using technical assistance and being dependent onit. To avoid dependency risk, MFIs should be the ones to determine the role of the TAproviders. The TA contract should be for a specific time period and every effort should bemade to transfer skills from the TA provider to local staff.

ê Is your organization building its capacity to operate independent of ongoing technical assistance?

ê Does your organization have the ability to identify its own needs and to contract appropriate technical expertise toaddress those needs on its own terms?

2.3.4 Dependency Risk Controls

Exit StrategyThe risk of dependency is greatly increased in the absence of a clear vision of where one isgoing. If an external organization like CARE provides services to a microfinance institution,it should include an exit strategy to withdraw its support over a specified period of time.Without this strategy, the risk is for CARE to take its MFI partner(s) down a path ofdependency, which is not healthy for partner organizations.

Since CARE supports microfinance activities in a variety of different environments, there isnot a general “blueprint” for organizational evolution. It may be appropriate to create acredit union in one country, a bank in another, and an NGO in a third. But there is onebasic principal that should be followed to minimize the potential for dependency: localownership. This does not have to mean ownership in an economic sense. At a minimum,ownership means that local personnel have the skills, resources and motivation to continuemanaging operations in CARE’s absence.

This principle does not mean that CARE must absolve itself of all ownership and links inorder to complete the process of transfer. In many cases the best approach for CARE maybe to remain involved as a board member, investor and/or possible lender to the MFI.

It would be a serious mistake for CARE to transfer ownership and especially funds to anorganization that is not equipped to manage its operations without oversight. The CARE“donor project” mentality often creates pressure to do exactly that as the project fundingcycle winds down. This can be detrimental to the long-run health of the MFI.

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ê Does CARE have an exit strategy?

ê Are there clear indications of local ownership such thatmicrofinance service operations will likely continue inCARE’s absence?

Independent StructureA very critical first step toward the developmentof a self-sufficient microfinance institution is toseparate the microfinance activities from theCARE structure as soon as possible, preferablyfrom inception. To be classified as independent,a structure should have the following fourelements: a separate financial system, a distinctgoverning body, human resource department,and an independent legal structure.

Generally, no loans should be issued and nosavings generated until the program or projecthas its own independent financial system. It isbetter to maintain accounting and loan ledgersby hand in an independent local structure thanto use computerized systems in a project that isrun by CARE.

An independent MFI must have a designated ordefined governing body. This may take the form of a board of directors, or the electedofficials of a cooperative or association, or if the project is not yet a legal entity, an “ad hoc”advisory board that assumes oversight responsibilities and expects to evolve into a board ofdirectors. If possible, CARE should be a part of this governing body at the beginning, butthe local management should make operational decisions.

A microfinance institution consists primarily of people: lots of loan officers and perhapstellers, a handful of middle managers, some back office personnel, and senior management.For these people to have the appropriate skills and motivation, the MFI must have anindependent human resource department that writes job descriptions, recruits and screensapplicants, designs compensation systems, orients and trains new staff, provides ongoingtraining and staff development, coordinates a performance review process, and promulgatesthe institution’s culture.

It may not be possible or advisable for the local institution to form an official legalstructure in the early stages, but it should at least articulate a general organizationaldevelopment plan. The transfer of legal ownership is relatively easy if the other twopieces—the MFI’s financial systems and governing body—are independent of CARE, and ifcheckpoints for eventual transfer of ownership are clearly outlined. Legality is less an issuein mitigating dependency risk than the mindset of employees, management, and directors.Consequently, if legally possible, employees should be hired by the MFI, not by CARE.

Identity and Institutional Culture

MFIs that begin as CARE projects may struggle toestablish an independent identity and distinctcorporate culture.

1. Name: The MFI should choose a separatename as soon as possible and avoid thenecessity of identifying itself as “CARE”

2. Office Space: The MFI should not share spacewith other CARE projects.

3. Recruitment: At startup the MFI may want torecruit some experienced CARE staff, butcaution should be used in such cases as a largenumber of transfers from CARE projects mayhinder efforts to establish a fresh, business-oriented corporate culture.

4. Orientation and Training: Newly hired staffshould receive a thorough orientation designedto instill a sense of the vision, purpose andprinciples of the MFI, not CARE.

5. Quality of Leadership: MFI directors andmanagers must reinforce corporate values andlead by example.


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Recommended ReadingsSetting Interest RatesCastello, Carlos, Katherine Stearns and Robert Peck Christen (1991). Exposing Interest Rates: Their True

Significance for Microentrepreneurs and Credit Programs. Discussion Paper No. 5. Somerville, MA:ACCION International. Website: www.accion.org.

Rosenberg, Richard (1996). Microcredit Interest Rates. CGAP Occasional Paper, No. 1. Washington, DC,USA: Consultative Group to Assist the Poorest. Website: www.cgap.org.

Performance RatiosBartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios I: Analyzing

Profitability in Microcredit Programs. GEMINI Technical Note No. 7. Bethesda, MD: DevelopmentAlternatives, Inc. Website: www.mip.org.

Christen, Robert Peck (1997). Banking Services for the Poor: Managing for Financial Success. Somerville, MA:ACCION International. Website: www.accion.org.

Ledgerwood, Joanna (1999). M icrofinance Handbook: An Institutional and Financial Perspective. WashingtonDC: The World Bank. Email: [email protected]. See pages: 205 – 232.

Ledgerwood, Joanna and Kerri Moloney (1996). Financial Management Training for Microfinance Organization:Accounting Study Guide. Toronto: Calmeadow. Website: www.calmeadow.org. Available from PACTPublications.

SEEP Network and Calmeadow (1995). Financial Ratio Analysis of Micro-Finance Institutions. New York:PACT Publications. Email: [email protected].

The MicroBanking Bulletin. A semi-annual publication. Email: [email protected].

Governance and ManagementCampion, Anita and Cheryl Frankiewicz (1999). Guidelines for the Effective Governance of Microfinance

Institutions. Occasional Paper No. 3. Washington DC: The MicroFinance Network. Email:[email protected]. Available from PACT Publications. Email: [email protected].

Rock, Rachel, Maria Otero and Sonia Saltzman (1998). Principles and Practices of Microfinance Governance.USAID’s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc.Website: www.mip.org.

SEEP Network (1993). An Institutional Guide for Enterprise Development Organizations. New York: PACTPublications. Email: [email protected].

Market ResearchBrand, Monica (1998). New Product Development for Microfinance: Evaluation and Preparation. USAID’s

Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website:www.mip.org.

Brand, Monica (1999). New Product Development for Microfinance: Design, Testing and Launch. USAID’sMicroenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website:www.mip.org.

Churchill, Craig F. and Sahra S.Halpern, (2001). Building Customer Loyalty: A Practical Guide for MicrofinanceInstitutions. Technical Note No. 2. The MicroFinance Network: Washington DC. Email:[email protected]. Available from PACT Publications. Email: [email protected].

SEEP Network (2000). Learning from Clients: Assessment Tools for Microfinance Practitioners. USAID AIMSProject. Draft Manual. Website: www.mip.org.

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Waterfield, Charles and Ann Duval (1996). CARE Savings and Credit Sourcebook. Available from PACTPublications. Email: [email protected].

Business Planning and Managing GrowthChurchill, Craig F. (1997). Managing Growth: The Organizational Architecture of Microfinance Institutions.

USAID’s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc.Website: www.mip.org.

Sheldon, Tony and Charles Waterfield (1998) Business Planning and Financial Modeling for MicrofinanceInstitutions. Washington, DC, USA: Consultative Group to Assist the Poorest. Website:www.cgap.org.


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Chapter 3: Operational Risks and Controls

perational risks are the vulnerabilities confronting a microfinance institution in itsdaily operations that can ultimately result in the loss of its assets. At its core, anoperational risk is the concern that an MFI will lose its money through bad loans,fraud and theft. This chapter describes controls and monitoring activities to reduce

the three types of operational risks summarized in Figure 9.

Figure 9: Types of Operational Risks

Operational Risk Type of Loss Primary Perpetrator

1) Credit Risk Loss resulting from poor portfolio quality Clients

2) Fraud Risk Loss resulting from deceit MFI staff members

3) Security Risk Loss resulting from theft Non-MFI persons

To reduce vulnerability to operational risks, microfinance institutions develop policies andprocedures that form the core of the organization’s internal control system. These controlsusually include preventive and detective aspects. Preventive controls inhibit undesirableoutcomes from happening. Examples of preventive controls include:

ê Hiring trustworthy employees who can make good credit decisionsê Ensuring that loans are backed by appropriate collateral or collateral substitutesê Segregating staff duties to prevent intentional wrongdoingê Requiring authorization to prevent improper use of resourcesê Maintaining proper record keeping procedures to deter improper transactionsê Installing sufficient security measures (i.e., locks, guards, safes) to protect cash and other

assets

O

FinancialManagement

Risk

External Risk

OperationalRisk

InstitutionalRisk

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Detective controls identify undesirable outcomes when they do happen. Examples ofdetective controls are: ê Reconciling bank statements with cash receiptsê Monitoring early warning signals for signs of pending portfolio quality problemsê Implementing delinquency management policies to prevent late payments from

escalating into bad debtsê Monitoring staff performance to ensure policies and procedures are followedê Visiting clients to ensure that their loan and saving account balances and transaction

dates correspond with the MFI’s records Arriving at the appropriate balance of preventive and detective controls involves judgment.Preventive controls avoid problems before they occur, but detective controls are generallyeasier to implement. For example, it is easier to do monthly bank reconciliation than toprevent employees from pocketing repayments.

There are also important cost implications to consider. MFIs cannot eliminate losses due tooperational risks. Some loans are bound to go bad and some staff members willundoubtedly succumb to temptation. Controls designed to minimize the losses fromoperational risks need to be carefully analyzed for their cost-effectiveness—some controlsmay be more expensive than they are worth.

3.1 Credit RiskCredit risk, the most common and often the most serious vulnerability in a microfinanceinstitution, is the deterioration in loan portfolio quality that results in loan losses and highdelinquency management costs. Also known as default risk, credit risk relates to clientfailure to meet the terms of a loan contract.

One microloan does not pose a significant credit risk because it is such a small percentage ofthe total portfolio. Since most microloans are unsecured, however, delinquency can quicklyspread from a handful of loans to a significant portion of the portfolio. This contagiouseffect is exacerbated by the fact that microfinance portfolios often have a high concentrationin certain business sectors. Consequently, a large number of clients may be exposed to thesame external threat, like a crackdown on street vending or a livestock disease. These factorscreate volatility in microloan portfolio quality, heightening the importance of controllingcredit risk.

3.1.1 Credit Risk ControlsCredit risk management can be divided into the preventive steps lenders take before issuing aloan and the use of incentives and disincentives after loan disbursement to extract timelyrepayment. Prior to issuing a loan, a lender reduces credit risk through controls that reducethe potential for delinquency or loss, such as loan product design, rigorous client screening,and client orientation to expectations and procedures. Once a loan is issued, a lender’s risk


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management expands from controls that reduce the potential for loss to controls that reduceactual losses. As such, delinquency management procedures are key components of creditrisk management. This section addresses four key credit risk controls: (1) loan productdesign, (2) client screening, (3) credit committees, and (4) delinquency management.

Loan Product DesignMFIs can mitigate a significant portion of default risk by designing loan products that meetclient needs. Loan product features include the loan size, interest rate, repayment schedule,collateral requirements and any other special terms. Loan products should be designed toaddress the specific purpose for which the loan is intended. For example, a loan to purchaseinventory for a neighborhood grocery store might have a different repayment schedule anduse different collateral than a loan for a sewing machine. A loan for purchasing seeds andfertilizer to grow maize may have another structure, perhaps with repayment coming in alump sum at harvest time. Loan products for non-business purposes, such as housing,emergency, education, and consumption smoothing, also require different design features.

In designing loan products to minimize credit risk, consider the characteristics summarizedin Figure 10. For new clients, MFIs commonly adopt conservative product design features,

In Search of the Right Balance:The Costs of Credit Risk Controls and their Effect on Customer Satisfaction

Microfinance institutions should strive to find the appropriate balance between managing credit(and fraud) risks, the costs and effectiveness of each control, and the attainment of customersatisfaction.

For example, many MFIs require new clients to repay their loans in weekly installments. This isconsidered an important control for credit risk because smaller installment sizes are easier torepay and frequent repayments are easier to monitor. But how much more effective incontrolling credit risk are weekly repayments than biweekly? Is it effective enough to endurethe costs of having twice as many repayment transactions? Does the benefit of assumed lowerloan losses justify the high costs (time and money) to clients in the form of travel and lostbusiness? What effect does this control have on customer satisfaction and loyalty?

MFIs should explore the same series of questions for all of their credit risk controls, such asforced savings, staggered disbursements, months of pre-loan training, etc. in an effort tosignificantly reduce the costs to both the client and the institution while hopefully improvingthe effectiveness of the controls. Often MFIs assume that certain controls are necessary toexact timely repayment, but they have not determined exactly how important they are, nor havethey analyzed whether they are worth the cost.

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such as small loan amounts, short loan terms, and frequent repayment periods. This isparticularly true if clients lack business records (i.e., they cannot provide evidence of theircapacity to repay) and cannot offer collateral.

Once the client establishes a track record with the lender, the MFI often increases theflexibility in loan terms to make the product more appropriate to client needs. This changereflects a balance between risk and control. New clients are categorized as high risk. Oncethey establish a credit history with the MFI, they can be considered a lower risk and thelender can reduce some of its controls.

Figure 10: Reducing Credit Risk through Product Design Features

EligibilityRequirements

Many MFIs require that applicants meet certain criteria that are known to reduce creditrisk. For microenterprise loans, for example, prospective borrowers are often expectedto have been in business for at least six months to demonstrate that they have acommitment to their businesses and some experience. Other eligibility requirementsinclude business documentation (i.e., bank statements, sales receipts) and a businessplan.

Loan Amounts

MFIs must ensure that the loan amount is within the client’s capacity to repay. One ofthe most common product design flaws in microfinance is automatically increasing loansizes. A second issue, though less common, is issuing multiple loans (where the clientaccesses loans from multiple sources) with an aggregate installment beyond clientcapacity to repay.

Loan Terms

One way to address the capacity issue is to extend the loan term to make installmentssmaller. This approach, however, has to be balanced with the fact that access to thenext loan is a primary repayment incentive. If the prospect of a next loan is too faraway, some clients may lose a key incentive to continue repaying this loan.

RepaymentFrequencies

Repayment frequency (i.e., weekly, monthly) allows the MFI to control credit risk. Themore frequent the repayment, the more in-tune the institution is to its portfolio quality.The discipline of frequent repayments allows the MFI to more tightly control credit risk.However, repayment frequency must be balanced with transaction costs to the clientand the institution, as well as the type of loan.

CollateralRequirements

Collateral is the primary mechanism lenders use to reduce credit risk. However,microfinance clients often do not have traditional collateral, such as property deeds.Instead, MFIs use non-traditional collateral (i.e., personal guarantees, household assets,forced savings) and collateral substitutes (i.e., peer group lending methods) to reducecredit risk.

Interest Ratesand Fees

The price of the loan reflects a balance of various issues, including costs of delivery andrisk level. In general, loans that are more costly and riskier require higher rates ofinterest. MFIs that price their products too low will not be able to cover their costs,and eventually will go out of business. If they price their products too high, however,they may have difficulty attracting sufficient lower-risk clients to maintain a healthyportfolio.

The process of loosening these controls also rewards timely repayment. The MFI shouldinform clients from day one that their ability to access more accommodating servicesdepends on their repayment history. If they repay on time, they can access preferred


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product features such as larger loan sizes, lower interest rates, and less frequent repaymentperiods.

Another positive benefit of reducing controls for low risk, repeat borrowers is that it helpsto reduce client desertion. Desertion refers to clients who choose not to take a new loanafter paying off an existing loan. Some of these clients may leave your organization becausea competing MFI offers loan products better suited to their needs. MFIs that do not makeappropriate accommodations for these clients find that they lose the borrowers they mostneed to keep. It is very important that an MFI conduct “exit interviews” with at least aportion of clients that do not apply for a new loan. The MFI needs to know if there is agrowing trend of client desertion because of certain undesirable characteristics of MFIservices or positive characteristics of competitor services, either of which may necessitatechange in product design or service delivery.

ê What characteristics of the product design are intended to control credit risk?

ê Are those characteristics appropriate for different segments of the target market (i.e., new clients and repeatclients)?

ê Are the features of the loan product reviewed regularly to determine if they should be modified?

ê Are exit interviews conducted with clients who are leaving client groups or discontinuing to use the MFI services?

Client ScreeningThe first step in limiting credit risk involves screening clients to ensure that they have thewillingness and ability to repay a loan. When analyzing client creditworthiness, microfinanceinstitutions typically use the five Cs summarized inFigure 11. If any of these components is poorly analyzed, credit risk increases. To limit thisrisk, institutions develop policies and procedures to analyze each component.

Figure 11: The Five C’s of Client Screening

(1) Character An indication of the applicant’s willingness to repay and abilityto run the enterprise

(2) Capacity Whether the cash flow of the business (or household) canservice loan repayments

(3) Capital Assets and liabilities of the business and/or household

(4) CollateralAccess to an asset that the applicant is willing to cede in caseof non-payment, or a guarantee by a respected person to repaya loan in default

(5) ConditionsA business plan that considers the level of competition and themarket for the product or service, and the legal and economicenvironment

These five components are relevant to all types of lending institutions. The weight assignedto each component will vary depending on the lending methodology (i.e. solidarity group,village banking or individual), the loan size, and whether it is a new or repeat customer.

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Not everyone who applies for a loan is a good credit risk. Regardless of the lendingmethodology, loan officers should be expected to make wise credit decisions.Unfortunately, in some MFIs, staff members act more like loan administrators than loanofficers do. If all of the paperwork is in order and the applicants have fulfilled whateversavings and meeting requirements there might be, then they automatically receive a loan.This often results in poor portfolio quality. Loan officers and their immediate supervisorsshould consider the 5 Cs when making credit decisions and they should be held accountablefor those decisions.

Character: In microfinance, character is the single most important means of screening newapplicants. By assessing a client’s character, the lender gains important insight into theclient’s willingness to repay. Although the MFI does not want to put clients in a difficultsituation, clients with good character will find a way of repaying their loans even if theirbusinesses fail. The importance of character as the key trait to select new borrowers isheightened by the fact that many microenterprises do not have sufficient records todemonstrate their capacity to repay.

Screening for character varies by the lendingmethodology. In group-lending programs, thegroup assumes responsibility for selectingmembers of strong motivation and characterbecause members guarantee each other’s loans.With individual lending, besides interviewingneighbors and opinion leaders in the community,loan officers also need to ensure that informationprovided by the applicant is internally consistent.This is often tested through a three-stage methodwhereby applicants provide information aboutthemselves and their business in a loanapplication. Then the loan officer visits thehousehold and/or business to, among otherthings, verify that the application information iscorrect. Finally, the loan officer checks othersources regarding the reliability of theinformation, such as a landlord regarding the size of rent and the length of residence, or asupplier regarding the frequency and size of inventory purchases.Figure 12 summarizes methods for character screening.

Character Assessment at Bank RakyatIndonesia’s Microfinance Units

At BRI’s microfinance units, most loanrejections are based on character, notbusiness assessment. Rejection occurs if thecredit officer learns that the applicant is notrespected in the community or hasmisrepresented himself in the application.Almost without exception, loan officersidentified the neighbor’s assessment of theapplicant’s character as the most importantmeans of predicting a new applicant’s futurerepayment behavior—more important thanthe business assessment.

Churchill (1999).


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Figure 12: Methods for Screening Client’s Character

ð Check personal and community references to assess the applicant’sreputation.

ð Use peer groups in which clients select other group members who theybelieve are honest and reliable.

ð Maintain a blacklist of past poor performers to avoid repeat lending tobad clients.

ð Interview client to understand his or her motivation for borrowingmoney.

ð Check credit history with suppliers, other credit organizations, or withcredit bureau, if available.

Campion (2000).

Capacity: To assess an applicant’s capacity to repay, loan officers conduct both businessand household assessments. One challenge in determining the business’ capacity to repay isthe fungibility of money: what the client says she will use the loan for and what she actuallyuses the loan for may be different. Because the lines between a microentrepreneur’sbusiness and household activities are often blurred, it is important for the loan officer tounderstand the flow of funds within and between the two.

It is difficult to assess the repaymentcapacity of a low-income applicant.Estimates of income and expenses maynot be reliable, and applicants often donot have supporting financial records.Experienced loan officers developmethods of improving the quality of theseestimates by determining the basis onwhich they are made and then testingwhether the assumptions are valid.However, wide variations may still existbetween estimated and actual cash flow ofa business, even if the applicant is not intentionally misleading the loan officer.

To overcome these challenges, some MFIs assess a client’s capacity to repay without takinginto account the effect of the loan on the business. That means that the current net incomeof the business is a certain multiple of the proposed installment amount; in other words, theapplicant estimates that the business is already generating enough revenue to repay the loan.MFIs also use small initial loan sizes and an ongoing process of collecting information toovercome the challenge of assessing the applicant’s repayment capacity. Initial loan sizestend to be smaller than the applicant requests because the loan officer does not have goodinformation to assess repayment capacity. Clients are then asked to maintain basic businessinformation on income and expenses so that loan officers can make credit decisions basedon more reliable information and tailor subsequent loans to the cash flow of the business.

Loan Use Verification?

Another control to address the fungibility of moneyproblem is for the loan officer to visit the businessafter it has received the loan to verify how the loan wasused. This method may not be recommended as aformal procedure because it can reduce the institution’sefficiency and can be perceived as patronizing. Evenso, it is appropriate for an MFI representative to makespot visits to clients and inquire about the success ofthe business.

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With small loan sizes, it is appropriate that the applicant’s character is the key screeningelement. As loan sizes increase, however, there needs to be a shift from “soft” informationlike character to harder information such as capacity. To make good credit decisions,therefore, it is important that loan officers collect information over time that will allow themto understand of the capacity of their clients’ businesses.

Capital: Besides assessing the cash flow of the business to determine if it has the capacity torepay a loan, many MFIs collect information on the assets and liabilities of the business toconstruct a simple balance sheet. This allows the loan officer to determine if the business issolvent and how much capital the client has already invested in the business. With thesmallest loans, this component is probably the least important, but its significance increasesas loan sizes increase. In some cases, loan sizes are linked to the equity in the business.

Some MFIs also conduct an asset inventory to reduce credit risk. Although they may not sayso explicitly, loan officers convey the message that, if the client does not repay, theinstitution might seize these assets. This is known as implicit collateral.

Collateral: One reason for the development of the microfinance industry is that traditionalbanks do not serve persons who cannot offer traditional collateral. Many microlendingmethodologies use peer groups, restrictive product terms and compulsory savings ascollateral substitutes. Subsequent lending innovations provide microloans with non-traditional collateral, such as household assets and cosigners. Pawn lending and assetleasing are other methods of overcoming collateral constraints.

Perhaps more important than the type of collateral is how it is used. In microfinance,collateral is primarily employed as an indication of the applicant’s commitment. It is rarelyused as a secondary repayment source because the outstanding balance is so small that it isnot cost-effective to liquidate the collateral, much less legally register it if such a service isavailable. Only when clients are not acting in good faith do microlenders take a hard line

Business and Household Assessments

Loan officers visit applicants to observe the business in action, and assess how the applicant interactswith customers and the condition of business equipment. Since microentrepreneurs are unlikely tohave the documentation required by traditional banks, microlenders collect information throughobservation. Rather than take information at face value, through this interview process the creditofficer can probe when responses do not seem realistic or do not have internal consistency.

The process of assessing applicants’ businesses, and in most cases their households as well, achievesfive main purposes. First, the assessment determines if the applicant is creditworthy by collectingobjective data regarding the business, the applicant’s outstanding debts, and the household’s cashflow. Second, it provides information to ensure the product is designed to the applicant’s creditneeds and capacity. Third, the assessment allows the credit officer to collect subjective informationabout the applicant’s character to develop a “gut feel” if the applicant is trustworthy. Fourth, thisprocess plays a role in educating the client about the lender’s motives and mechanisms. Fifth, theassessment helps to forge a positive working relationship between client and loan officer.

Churchill (1999).


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stance and seize collateral. Consequently, MFIs tend to be less concerned about the ratio ofthe loan size to the value of collateral than how the clients would feel if the collateral wastaken from them. As the loan size increases, however, this soft approach to collateral needsto change so those larger loans are indeed backed by appropriate security.

Conditions: The fifth component, conditions, is often the hardest for loan officers toassess. Many MFIs adopt a microenterprise development approach to microfinance, whichmeans that they are as concerned with improving the business as recovering their loan. Assuch, the process of assessing the level of competition, the size of the client’s market, andpotential external threats, can play an important role in helping the client to make smartbusiness decisions and help the loan officer to make good credit decisions.

Since loan officers do not usually have the expertise to analyze the conditions of all types ofbusinesses, the primary means of controlling the credit risk posed by business conditions isto require that applicants be in business for a certain number of months (usually 6 to 12months) before they are eligible for a loan. This requirement means that applicants will havesufficient experience to answer questions about market conditions. The existing businessrequirement also makes it easier to assess repayment capacity and business capital needs.

ê What screening techniques does your organization use to minimize credit risk?

ê How do those screening techniques vary by loan number and loan size?

ê Are those techniques consistently applied in all branches?

ê If it makes secured loans, does the program have appropriate policies and systems for dealing with collateral?

Credit CommitteesEstablishing a committee of persons to make decisions regarding loans is an essential controlin reducing credit (and fraud) risk. If an individual has the power to decide who will receiveloans, which loans will be written off or rescheduled, and the conditions of the loans, thispower can easily be abused and covered up. While loan officers can serve on the creditcommittee, at least one other individual with greater authority should also be involved.

For larger loans, a committee of three or more individuals is appropriate. A creditcommittee typically includes senior and middle managers, but it might also includecommunity leaders, local bankers and even clients. The credit committee has theresponsibility not only for approving loans, but also for monitoring their progress and,should borrowers have repayment problems, getting involved in delinquency management.This way the credit committee lives with the implications of its decisions.

Additionally, MFIs should have written policies regardingloan approval authority. These policies should specifythe loan amounts that can be approved with twosignatures, loan amounts requiring additional signatures,and who has the authority to approve loans. This reducesrisk of loans being inappropriately approved.

With group lending methodologies, the group usually fulfills part of the credit committee’sfunction. Since group members guarantee each other’s loans, it is important that they be

Before recommendingan application, loanofficers have to have ahigh degree ofconfidence that theloan will be repaid

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Creating a Culture of Repayment in Mozambique

The loan officers in CARE’s CRESCE program inMozambique follow up with clients in the evening of thefirst day that a payment is missed. If the client refuses topay, his/her photo is then placed in the window of theMFI office. These tactics, while strong, help build thereputation that the MFI is very serious about payments

being made, and being made promptly.

involved in the approval process. But MFIs should not abdicate all responsibility for loanapproval to the group. Borrowers are unlikely to have the skills to make good creditdecisions, and therefore the loan officer needs to be familiar with the businesses and shouldfacilitate the discussion.

Ultimately, the MFI’s money is at risk, so loan officers and their immediate supervisors needto sign off on all credit decisions and feel comfortable that the money will be repaid. Loanofficers should feel comfortable: a) rejecting entire groups if the members do not know andtrust each other very well or if they do not appreciate the importance of joint responsibility;b) encouraging good group members to expel inappropriate members; and c) promotingsmaller loan sizes that members are confident that they can repay. To act in this way, loanofficers need the tools and the training to conduct business and character assessments, tofacilitate group discussions, and to test the group’s commitment.

ê Are the loan approval policies strictly followed?

ê Does the credit committee have sufficient experience to make good decisions?

ê Is the credit committee involved in loan monitoring and delinquency management?

Delinquency ManagementThe first three types of credit risk control—product design, client screening and creditcommittees—are intended to prevent delinquency and eventual loan losses. However, it isunrealistic to plan on designing an ideal product and selecting ONLY the best clients inorder to avoid loan delinquency. Some loans invariably become delinquent and loan losseswill occur. To minimize such delinquency, CARE’s Economic Development Unitrecommends the following six delinquency management methods:

1) Institutional Culture: A criticaldelinquency management methodinvolves cultivating an institutionalculture that embraces zero-tolerance of arrears and immediatefollow up on all late payments.MFIs can also remind clients whohave had recent delinquencyproblems that their repayment dayis approaching.

2) Client Orientation: A logical first step toward developing a zero-tolerance institutionalculture is to communicate this concept to each new client before she receives a loan. Anorientation curriculum should be prepared along with graphics and teaching aids to simplyand clearly describe the terms of services being offered, the expectations of each client, andprocedures that will be followed in the case of arrears.

3) Staff Incentives: Creating staff involvement in discouraging delinquency, through a staffincentives system, can be effective. Financial incentives entail minimum portfolio qualitycriteria for incentive eligibility and should have a greater weight for portfolio quality than forportfolio quantity. In addition, staff should carry bad debt in their portfolio for a significant


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period of time (at least six months) to ensure that they are held accountable for makingcredit decisions. Non-financial incentives include branch and loan officer competitions andspecial recognition for top performers.

4) Delinquency Penalties: Clients should be penalized for late payment. This could includedelinquency fees pegged to the number of days late and limiting access to repeat loans basedon repayment performance. An example of these types of penalties from the AlexandriaBusiness Association in Egypt is summarized in Figure 13.

Figure 13: Alexandria Business Association: Delinquency Penalties

Number of Days (cumulative) Sanction3+ days late (first loan) A repeat loan is refused

< 5 days late (repeat loan) No consequences

6 to 9 days late (repeat loan) A penalty of one month interest and the next loanamount may be kept constant

10+ days late (repeat loan) A 2nd penalty of one month interest and furtherloans will likely be refused

5) Enforcing Contracts: An MFI will quickly lose control of portfolio quality if it fails to enforceits contracts. MFIs should not have any policies in their contracts that they are not preparedto enforce. While certain accommodations can be made for borrowers who are willing butunable to repay, any uncooperative behavior from delinquent clients should quickly escalateto the most severe penalties that the MFI could enforce, including the use of the localjudicial system if appropriate. Clients should be oriented to penalties and delinquencyprocedures before receiving their first loans, so they know exactly what to expect if theirloans become delinquent.

6) Loan Rescheduling: Given the vulnerability of the target market, it is common for borrowersto be willing but unable to repay. After carefully determining that this is indeed the case (i.e.,concluding that clients are not cleverly pulling on one’s heartstrings), it may be appropriateto reschedule a limited number of loans. Only done under extreme circumstances, this mayinvolve extending the loan term and/or reducing the installment size. MFIs must betransparent about their rescheduling policies and they must report their portfolios

The Carrot Approach: Repayment Incentives

The stick of delinquency management needs to be balanced with the carrot of repaymentincentives. The primary incentive microlenders use is to reward clients in good standing withaccess to subsequent loans, which often means larger loans. Preferred services for repeatclients may also include lower interest rates, faster loan approval, and access to parallel creditproducts such as seasonal loans.

The most tangible incentive is interest reimbursement. For example, the BRI units offer aprompt payment incentive for clients who pay on time for six consecutive months, whichamounts to one quarter of the interest payment during that period. In effect, the units chargethe delinquency fee up front, and then reimburse clients who repay on time.

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accordingly. Portfolio quality indicators and provisioning requirements should clearlydistinguish between regular and rescheduled loans.

ê Does the program have a culture that is intolerant of delinquency?

ê Is there a formal orientation of clients and staff to expectations, policies and procedures?

ê Are loan officers well trained in effective delinquency management strategies?

ê Are delinquency penalties and loan contracts enforced?

ê Are staff members properly rewarded to maintain high standards of portfolio quality?

ê Does the MFI have an appropriate and transparent rescheduling policy?

3.1.2 Credit Risk MonitoringTo monitor portfolio quality, CARE’s EDU recommends, at a minimum, that an MFImonitor portfolio quality ratios on a monthly basis. These include Portfolio at Risk, LoanLoss Ratio and Reserve Ratio. Additionally, an MFI should be aware of the number andvalue of loans that have been rescheduled and should maintain an aging of delinquency report.The recommended ratios are listed in Figure 14.

Agriculture Lending

Most successful MFIs serve primarily traders—people who have a stall in a market place or a smallgrocery shop attached to their house. This is because there is a good fit between their businesses’needs and the standard microcredit product (i.e., small amounts that gradually increase over time,short loan terms, frequent repayments). Some MFIs have also figured out how to modify thisproduct to meet the working capital needs of manufacturers.

Few MFIs, however, have successfully adapted a microloan product to manage the credit risksassociated with lending to small farmers. While this is certainly an important market in manyregions, it is recommended that extreme caution be taken by MFIs trying to lend for agriculturalpurposes. Some tips include:

• Carefully monitor the percentage of agriculture loans in the portfolio (not more than10 to 20 percent)

• Diversify away from single crop lending• Avoid relying on balloon payments at the end of the term• Consider the entire household’s cash flow when making a credit decision, not just the

farm income


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Figure 14: Portfolio Quality Ratios

Portfolio at Risk: this ratio should be used as theprimarily indicator for monitoring portfolio quality.

Value of outstanding balances of all loans in arrears______

Value of loans outstanding

Loan Loss Ratio: indicates the extent of unrecoverableloans over the last period. Amount written off______

Average loans outstanding

Reserve Ratio: indicates adequacy of reserves inrelation to portfolio. Loan loss reserve_______

Value of loans outstanding

Loan Rescheduling Ratio: indicates the extent ofloans that have been rescheduled in the last period. Amount of loans rescheduled___

Average loans outstanding

Because of the small loan sizes, microfinance portfolios are not typically exposed to thesame concentration of risk as traditional banks, where individual loans should not representa significant portion of the portfolio. However, MFIs need to monitor their loan portfoliocomposition and quality by region, business sector, loan cycle number and loan size toreduce the institutions' vulnerability to external threats that may affect a large portion oftheir clients. For example, if 25 percent of the portfolio goes to coffee farmers and the priceof coffee beans drops, a quarter of the portfolio will likely be at risk.

3.2 Fraud RiskAll microfinance institutions will at some point experience fraud perpetrated by staffmembers, perhaps in cahoots with clients. Wherever there is money, there is an opportunityfor fraud. MFIs should not assume that they could eliminate fraud. However, throughproper controls they can reduce their vulnerability to fraud. This section first summarizescommon types of fraud, and then discusses controls for preventing and detecting fraud.

3.2.1 Types of FraudPreparing a complete list of possible fraudulent acts is not possible. However, it is useful tocategorize fraudulent activities by the lending process in which they can occur:1) loan disbursement,2) repayment,3) collateral procedures, and4) Closure activities.

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Figure 15: Examples of Microlending Fraud

Disbursement Repayment Collateral Closureð Loan officer issues

loans to “ghost”clients.

ð Cashier makesloan to himself.

ð Loan officercharges clients anunofficial “fee” toapply for a loan.

ð Loan officercollects payment,issues receipt, butdoes not deposit.

ð Agents collectingloan payments donot deposit themin a timely manner.

ð Loan officercharges unofficialdelinquency fees.

ð Loan officercollects collateralbut does notdeposit it instorage area.

ð The storekeeperappropriates thecollateral andconceals it bymaking falseentries in thewarehouserecords.

ð Forced savingsrefunds do notfind their way backto the clients, andborrowers forgetto ask for them.

ð Loan officercollects paymentson loans that havebeen officiallywritten off.

Microfinance fraud certainly is not limited to the organization’s lending activities. In fact, anMFI may be even more vulnerable to fraud associated with savings because it is harder todetect. Fraud can also occur in managing the business operations of the branch, such asmisuse of petty cash, false claims for travel reimbursement and kickbacks from procurementcontracts.

Internal control policies and procedures are designed to cost-effectively reduce the risk offraud committed by an employee on his own, but they are generally not cost-effective inreducing risk stemming from collusion among employees or from “management override.”The latter occurs when a high level employee uses his/her authority to incite a lower levelemployee to violate control policies or procedures, enabling the high level employee tocommit fraud. An example is a finance manager ordering the cashier to give him the key tothe safe for some reason.

Risk of fraud stemming from collusion among employees or from management override isusually reduced through “soft” controls, instead of formal control policies and procedures.Examples of “soft” controls include senior management emphasizing and demonstratingethical conduct and high levels of control consciousness, an environment of opencommunication, and swift action against anyone committing fraud.

It is important to note most fraud is detected by employees ofthe operation where the fraud is committed, and not by auditors.Therefore, MFIs should create a work environment that providesincentives for employees to report suspected fraud to theappropriate level of management. MFIs should also establishformal policies and procedures on how and to who to reportsuspected fraud. There are a number of “red flags” that make MFIs more vulnerable tofraud, such as:4

4 Adapted from Valenzuela (1998).

Coworkers, notauditors, detectmost instancesof fraud


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ð An MFI with poor portfolio quality will have difficulty distinguishing between bad loansand fraudulent loans because of the large number of loans in arrears.

ð A weak information system exposes the institution to fraud. If an MFI cannot detectdelinquency at the loan officer level then it could have significant problems withfraud.

ð A change in the information system is a time of particular vulnerability. To protect againstfraud when an MFI introduces a new MIS, it is common practice to run the old andthe new system in parallel until both have been audited.

ð Weak internal control procedures create an environment in which fraud can be prevalent.Many MFIs do not have an internal audit function and their external auditors do notvisit branches, much less confirm client balances. In these MFIs, fraud is likely to berampant.

ð MFIs are vulnerable when they have high employee turnover or when staff members areon leave. When a MFI fires an employee or an employee resigns, the organization isalso vulnerable to that person collecting money from his former clients.

ð If the organization offers multiple loan products, or if its products are not standardized,staff and clients have an opportunity to negotiate mutually beneficial arrangements.

ð If loan officers handle cash and clients do not understand the importance ofdemanding an official receipt, the MFI is vulnerable to wide scale, petty fraud.

ð When an institution experiences rapid growth, it is difficult to cultivate the depth ofintegrity that is required among staff.

ê Has your organization experienced fraud? If so, what conditions made your organization vulnerable to fraud?

ê What have you done to try to reduce your vulnerability?

3.2.2 Controls: Fraud PreventionThe CARE EDU suggests the following eight categories of MFI operations controls toreduce operational performance that can lead to fraud:1. excellent portfolio quality;2. simplicity and transparency;3. human resource policies,4. client education,5. credit committees,6. handling cash,7. handling collateral, and8. write-off and rescheduling policies.

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Excellent Portfolio QualityIf very few loans are in arrears, the chances that the MFI is experiencing fraud in its lendingactivities are significantly reduced. The handful of delinquent loans can be easily checked todetermine if they are fraudulent. But when large volumes of loans are in arrears, anddelinquency management systems get overloaded, then fraudulent loans may go undetectedfor long periods of time, which will breed more fraudulent loans.

ê Which branch has the worst portfolio at risk?

ê Could this branch be experiencing fraud?

Simplicity and TransparencyIf an MFI’s products and delivery systems are simple and straightforward, it will go a longway toward preventing fraud. As an organization becomes more complicated and diversifiesits services, there is a much greater likelihood that fraud will proliferate. Fraud is a particularconcern in MFIs where loan officers have significant discretionary authority, such asdetermining loan sizes, accepting collateral, and setting interest rates. In this way, an MFIhas to balance being responsive and customizing its services to client needs with the concernthat this will expose the organization to fraud.

A particular area of vulnerability is the discretion that field staff may have regarding theimposition of delinquency fees. MFIs often charge a delinquency fee for late payment, yetwaive the fee if clients have a good reason for being late. Consequently, it is difficult to

Flexibility: The Double-edged Sword

One of the criticisms of microfinance is that the loan products are so rigid that they do not meetthe needs of the target market. This rigidity results in high client desertion and reduces theimpact that microfinance could have.

In an ideal world, microfinance products could be flexible and customized to individuals’ needs.But there are some challenges involved in accomplishing the ideal:

ê Efficiency: One of the reasons why microloan products tend to be rigid is to increase theefficiency of delivering these services. With very small loans, it will not be cost effective tocustomize them to each person’s needs.

ê Staff Skills: Many MFIs hire relatively inexpensive labor that can handle routine or rote taskswithout too much difficulty, but may not have the skills to deliver flexible financial services.

ê MIS: The information systems in many MFIs have difficulty coping with straightforwardmicroloan products. Flexible loan products exacerbate the MIS challenge.

ê Fraud Risk: As an MFI increases the complexity of its financial services, it greatly increases itsvulnerability to fraud risk.

How should MFIs deal with this double-edged sword? There is no easy answer, but by beingaware of the importance of flexibility and the challenges of being flexible, an MFI can try to forgea middle ground.


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monitor whether fees are being paid and pocketed, or whether they are regularly beingwaived, in which case they are not serving their purpose. To reduce exposure to fraud,MFIs should either make the fees mandatory regardless of the reason, or find another wayfor penalizing late payers like creating a repayment incentive for those who pay on time.

ê Are loan officers allowed any discretion, such as lowering interest rates, requesting loan size exemptions or waivingdelinquency fees? If so, how do you control for fraud in these circumstances?

Human Resource PoliciesAn MFI’s human resource policies include hiring, training, compensating, and terminatingstaff members. All four activities serve as potential controls for preventing misappropriationof assets.

Hiring: Microfinance institutions should identify sources of prospective staff members withhigh moral integrity, such as certain schools or religious communities, and actively recruitnew staff members from these sources. In addition, MFIs should use staff screeningmechanisms, like personality tests and employee references, to ensure that they are hiringupstanding citizens. They should also consider conducting background checks.

Training: A critical aspect of bringing on new recruits is to indoctrinate them into theinstitution’s culture. This is the ideal opportunity to promote the organization’s core valuesof honesty and integrity, and demonstrate the zero-tolerance policy by making examples offallen employees who succumbed to temptation and suffered the consequences.

Compensation: Employees should have a strong incentive to perform their job in a responsibleand competent manner. Employees who do not feel sufficiently compensated will be muchless likely to carry out their responsibilities with the needed thoroughness and attention todetail. Likewise, they are much more vulnerable to committing fraud, especially ineconomies where sums that they handle daily represent months or even years of salary. Acompetitive salary is a strong preventive control indeterring sloppy or fraudulent employee behavior.

Termination: Employees’ awareness of potentialnegative consequences for inadequate jobperformance can also be a preventive control,especially for employee fraudulent activity. Thereshould be a clear message that staff members willbe immediately terminated, lose their valuablesource of income and benefits, and be taken tocourt (if possible) if they perpetrate fraud. Swiftand permanent action in response to even the leastconsequential fraudulent activity sends a clearmessage to employees that the MFI does nottolerate fraud of any type. PULSE, a CAREmicrolending program in Zambia, attempts toostracize former employees by placing their picturein the office window.

Rotating Staff?

Some MFIs regularly rotate staff membersbetween branches as a means of controllingfraud risk. Staff rotation makes it possible fordifferent employees to interact with each client,which should discourage collusion and exposeany fraud that has taken place. While this may be an effective way ofcontrolling and detecting fraud, it is notrecommended because it undermines therelationship between a loan officer and the client.One of the reasons why clients repay their loansis to avoid disappointing their loan officer. Loanofficers should have a close rapport with theirclients to encourage them to keep coming backand to discourage them from not paying theirloans.

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Every loan must beapproved by at leasttwo persons who haveboth met the applicant

ê Are your hiring procedures designed to attract individuals who are honest and well motivated?

ê Are new employees oriented to the MFI culture of honesty andzero-tolerance?

ê Are staff compensation levels reasonable and competitive?

ê Is there an immediate termination policy for staff fraud ordishonesty?

Client EducationInforming clients of their rights and responsibilities in the loan process is another strongpreventive control. Because target clients tend to be illiterate and/or under-educated, theyare more vulnerable to being defrauded by loan officers, and to not catching errors in theloan process. This is especially problematic because the loan officer-client relationship is keyto the ultimate success of an MFI. Thus, an essential control for preventing errors andpotential fraud is to actively educate clients of their rights and responsibilities, including: ê Demanding an official, pre-numbered receipt whenever money or collateral changes

hands.ê Only giving or receiving money from a designated MFI employee – if possible, this

should always be the cashier.ê Knowing the appropriate channels to voice complaints and concerns.

Well-publicized campaigns to this effect will not only educate clients, but also makeemployees think twice about taking advantage of their customers. In group-lendingprograms, it can be reinforcing to have clients provide peer orientations around these issuesto new clients entering the program.

ê Does the institution have an ongoing client education campaign?

ê Are clients aware of their rights?

ê What channels do clients have to voice complaints?

Credit CommitteesCredit committees not only play an important role in reducing credit risk, but also are anessential element of an operational integrity and fraud prevention strategy. Every loan must beapproved by at least two persons . With small loans, the signatures typically come from the loanofficer and the branch manager. The branch manager must take this responsibility veryseriously. When reviewing applications, the branch manager ensures that they comply withMFI policy and do not contain unreasonable information, such as monthly income levelsthat are unrealistic for a particular type of business. To reduce the chances that loan officersare creating “ghost” borrowers, the branch manager should meet all applicants, preferablybefore they receive the loan.

Loan approval authority levels also reduce MFI exposure to fraud. The authority levelsmight look like this: all loans below $500 require two signatures (loan officer and branchmanager); loans between $500 and $2,000 require three signatures (previous two plus an


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external chair of the credit committee); and loans above $2,000 require five signatures (theprevious three plus the operations manager from the head office and a member of the boardof directors). Therefore, if the branch manager and loan officer collude to defraud thecompany, they would only be able to steal $500 at a time.

Any person who places his/her signature on an application must realize the significance ofthat action. Too often, signing applications, vouchers or other documentation is not takenseriously. Sometimes senior people do not even look at what they are signing because theyhave to approve so many items. This behavior obviously defeats the purpose. If anorganization suffers from this “blind signing,” it needs to revisit its authority levels.

If five signatures provide greater protection from fraud than two, then why does the MFInot require five signatures for all loans? A fraud prevention and detection strategy needs tobalance the costs of minimizing fraud with the need to reduce vulnerability. The morepeople involved in the application review process, the more expensive it is to issue loans.Since the smallest loans generate only a tiny amount of revenue, the organization wouldprobably lose money issuing them if five people, including several with higher wage levels,had to review the applications. To reduce approval costs, some organizations set variableauthority levels for branch managers depending on their level of seniority and their portfolioquality.

The other factor determining approval authority is quality of customer service. The morepeople involved in the review process, the longer it takes to turn around loan applications.For MFIs to provide prompt service, they need to cut out unnecessary approval layers.

ê Do at least two people meet all applicants and approve all applications?

ê Does the loan approval authority structure balance efficiency, customer service and fraud control?

ê Do managers avoid and actively discourage “blind signing”?

Handling CashMFIs face the greatest risk of misappropriation when money changes hands, such as whenthe loan is disbursed, repayments are made, and deposits are placed in a savings account.Here is a list of 12 basic controls recommended to reduce risk of misappropriation for MFIsthat disburse loans directly to clients. If the disbursement is made by a bank or into theclient’s account, certain modifications are required.

1. Use standardized, pre-printed, pre-numbered loan agreement forms, reviewed andapproved by local legal counsel.

2. Prepare loan agreements in quadruplicate, maintaining one copy at the branch, givingone to the borrower, and sending two to the accounting department.

3. Loan agreements should include borrower name and identification number, uniqueloan reference number, loan amount, interest rate, payment schedule, description ofcollateral (if applicable), definition of late payment, and penalty for late payment.

4. Access to blank loan agreements should be restricted and carefully safeguarded.

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5. Accounting determines whether the agreement is properly completed. If so,Accounting prepares and approves a disbursement voucher, and gives it to thecashier along with a copy of the loan agreement.

6. Before disbursing funds, the cashier matches the loan amount on the agreement withthe amount on the disbursement voucher and determines whether the loanagreement contains necessary signatures.

7. The cashier prepares, in duplicate, an official pre-numbered disbursement receipt,containing date, amount, and payee name and signature.

8. The cashier retains one copy of the disbursement receipt and gives the other to thepayee.

9. In disbursing funds directly to the borrower, the cashier checks for evidence that theperson accepting funds is the borrower named in the loan agreement by inspecting apicture ID and/or comparing the person’s signature to borrower’s signature on theloan agreement.

10. If compensating controls are not in place to reduce the risk of a cashier keeping loandisbursements and making loan payments himself, then an accountant shouldcompare payee signatures on loan disbursement receipts to signatures of borrowerson loan agreements.

11. If the cashier disburses loan funds to an agent who then gives funds to borrowers,such disbursements are recorded as advances to agents. The advances are liquidatedwhen agents present disbursement receipts containing correct loan amounts andborrower signatures to the accounting department.

12. Accountants must not have access to funds, and cashiers must not have access tochanging accounting records.

Figure 16 provides a list of seven recommended controls for reducing the risk ofirregularities or fraud in the repayment process.

Figure 16: Controls in Handling Loan Repayments

1. Agents collecting loan payments prepare repayment receipts, in triplicate, containing date,amount, and agent’s and payer’s signatures.

2. Agents retain two copies and give the other to payers.3. Agents deposit funds to designated accounts in a timely manner. MFIs should have a

policy on where to deposit funds and on the definition of “timely”.4. Agents request a deposit slip containing date, amount, and signature of person accepting

funds for every deposit made.5. Agents submit to the accounting department a copy of receipts documenting borrower

payments and deposit slips documenting deposits.6. Accounting staff match amount of deposit slip with amount of borrower receipt and record

interest and principal based on loan agreement and payment amount on borrower’s receipt.7. Accounting staff reconciles amount of cash deposited per bank records with cash received

per the accounting records on a monthly basis.


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Organizations that offer voluntary savings services are particularly vulnerable to fraud.This is partly because of the high volume of transactions, and also because the depositamounts and frequencies are unpredictable. With loan repayments, the organization knowshow much and when they are expected, so if the amounts or dates are different thanexpected, they can be investigated. Savings accounts do not have a similar early warningsignal. Yet it is absolutely critical to reduce the potential for savings fraud because it couldundermine customer confidence in the banking institution.

To control for savings fraud, clients must have savings records (i.e., passbooks) that theykeep in safe places. The MFI should have a signature card and a copy of the client’sidentification. The signature on the deposit/withdrawal slip needs to match that on theclient’s savings book and the organization’s account record. A tighter review of largerwithdrawals is also recommended.

ê Are loan officers allowed to collect repayments when in the field?

ê Does the MFI have appropriate polices for handling cash in its loan disbursement and collection procedures? Arethese policies followed?

ê What systems are in place to minimize the potential for fraud with savings accounts?

Collateral ControlsIf an MFI secures its loans with collateral, it is vulnerable to potential irregularities or fraudin the collection, storage and return of collateral. The assigned staff person may collectcollateral but not deposit it in the designated storage area, or collect the wrong type ofcollateral, or neglect to collect it at all. Risk associated with collateral can be mitigatedthrough the following steps:

ð MFIs must have policies and procedures on when to require collateral, whether toassume custody of collateral versus allowing borrower to maintain custody, where todeposit and store collateral, and how to value collateral.

ð If the borrower maintains collateral, the loan agent periodically inspects the collateralfor impairment. The loan agreement includes a detailed description of the collateraland serial or other identifying number of the property, and requires that collateralmust not be sold without prior notice to the loan officer.

ð Procedures must be clearly stated for returning collateral to the borrower upon fullrepayment of the loan.

ð Procedures should be recommended to improve the chances that liquidation ofcollateral is at the best available price, and that proceeds from liquidation aredeposited intact into the bank.

ê Do you have adequate policies and procedures on collateral control?

ê Are these policies followed?

Write-off and Rescheduling PoliciesAnother area of risk is loan write-off or rescheduling. While MFIs usually have stringentrequirements and carefully followed policies for receiving loans, they tend to be more lax infollowing up delinquent loans and ensuring that procedures are carefully followed. Loan

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write-off and rescheduling should follow similar procedures: the credit committee shouldmake all decisions and multiple signatures should be required for a write off or reschedulingto be authorized.

In the write-off process there are two primary fraud vulnerabilities. First, the MFI needs tomake sure that it is not writing off a fraudulent loan. To control for this risk, each personinvolved in the process of recovering the loan needs to document the steps that they took.This documentation, in a delinquency management log,provides evidence that proper steps were taken by severalpeople, and this was indeed a bad loan not a fraudulentone. Second, once a loan has been written off, the MFI isstill vulnerable to the unauthorized collection of theoutstanding balance by its employees. This risk is oftencontrolled by handing over bad debts to a workoutdepartment or an external debt collector whose collection activities may reveal unauthorizedefforts.

ê Does your institution have clear write-off and rescheduling policies that are consistent with a fraud preventionstrategy?

ê Are those policies followed?

ê How do employees document their delinquency management steps?

3.2.3 Monitoring: Fraud DetectionThe best prevention strategies in the world are not going to eliminate fraud. This is partlybecause the policies may be ignored or flaunted; and partly because, in an effort to balancethe costs of the controls with the potential exposure, the organization is still going to haveareas of vulnerability.

Whenever fraud occurs within an organization, it reflects poorly on the whole MFI andeveryone who works there. Fraud detection is therefore the implicit responsibility of all staffmembers, from the chairman of the board and executivedirector down to the cleaners and drivers. Once anorganization reaches a certain scale (around 100 employees),it can justify having a person or department dedicated to thefunction of fraud detection. This responsibility is tasked toan internal auditor or internal audit department, whichshould report directly to the board of directors (or the auditcommittee of the board).

Fraud detection involves the following four elements: 1) operational audit; 2) loan collectionpolicies; 3) client sampling; and 4) customer complaints.

Operational AuditAfter creating appropriate controls, the first step in fraud detection is to ensure that thosecontrols are implemented. Microfinance managers at all levels of the organization mustmake sure that persons working under them follow institutional policies. In addition, MFIs

Fraud detection is theresponsibility of allstaff members, fromthe chairman of theboard down to thecleaners and drivers

Everyone involved inthe delinquencymanagement need todocument the stepsthat they took torecover the loan


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The internalauditor shouldreport to the boardof directors

should consider conducting regular operational audits to confirm that policies are beingfollowed. When policies are not followed, it is usually for one of three reasons: 1) theemployee was involved in some sort of fraudulent activity;2) the employee did not know about the policy or didn’tunderstand it; or 3) the employee believed that the policywas unreasonable. So while an operational audit mightdetect fraud, it will also identify staff training needs as wellas certain policies that may need to be reevaluated.

An operational audit is a review of all operational activities, procedures and processes,including human resources, procurement, finance, information systems and any otheroperational areas. Internal auditors usually perform operational audits, as they will havemore experience with the general operations of an organization, and will be better preparedto analyze the structure of operations critically. If an external audit firm is used,management should be very careful, prior to engaging the firm, to gauge what level ofexperience and understanding the external firm has with the organization, microfinance ingeneral, and operational auditing.

For organizations that are large enough to hire an internal auditor, it is important that thisperson or department report to the board of directors, not to management. Withoutsufficient independence from management, internal auditors cannot conduct an objectivereview of the MFI’s entire operations. By reporting directly to the board, it ensures theboard’s involvement in the internal audit process and it gives credibility and legitimacy tointernal auditors as they conduct their reviews.

Loan Collection PoliciesWhile loan collection policies are primarily seen as a response to credit risk, they also have avery important role in fraud detection. By involving several different persons in thecollection process, MFIs not only escalate the pressure on the client, but also help to identifyinstances of fraud. If the loan officer is the only person who ever interacts with a delinquentborrower, he could easily be pocketing repayments. Figure 17 provides an example of loancollection policies designed to detect such a situation.

Audit Committee of the Board

Some MFIs assign specific board members to an audit committee to oversee internal andexternal audits. The audit committee reviews internal and external audit reports and, based onthese findings, assesses the integrity of the financial statements and adequacy of internalcontrols. The audit committee reviews the procedures, reports and recommendations that aregenerated by the internal audit department and ensures that management takes correctiveactions. In addition, the audit committee reviews the external audit and regulatory reports toassess the MFI’s overall control environment, and reports its findings and observations to thefull board of directors.

Campion (2000).

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Figure 17: Loan Collection Policies

ð Senior management establishes written policies on past due loans that includes when to takecollection efforts and what efforts to take. (make efforts or take actions – not take efforts)

ð Those assigned to collect loans should not have access to changing the accounting records.ð The loan officer who issued the loan should conduct the first delinquency visit.ð If that proves unsuccessful, a different agent (usually the branch manager) should perform

the next collection visit.ð If that visit is unsuccessful, ideally another, more senior person should make the third visit.

This sends the message to the client that the institution’s concern is escalating. It also playsan important control function since subsequent personnel can make sure that a collectionagent was not pocketing some or all of a past due payment.

Client SamplingA main aspect of fraud detection is to visit clients to ensure that client and the MFI recordsare in agreement. Given the large volumes of customers, internal auditors use selectivesampling of borrowers to identify clients for balance confirmation so that the visits arebiased toward loans that are more likely to be fraudulent. For example, an internal auditormay select all clients with more than three payments in arrears, 50% of clients with morethan 2 payments in arrears, and 25% with 1 payment in arrears, as well as a number of clientswho are up-to-date. If the MFI reschedules loans, the internal auditor should also visit ahigh percentage of those clients as well.

While this sampling technique primarily selects customers who are in arrears, it is importantto also include clients whose loans are current. The internal auditor may find majordiscrepancies between information in the client’s file and the reality in the field, which couldexpose the organization to credit or fraud risk. Loan officers also might be receivingkickbacks on loans that do not show up in a delinquency report.

Selective sampling is not possible with voluntary savings accounts because there isn’t awarning sign that some accounts are more vulnerable to fraud than others. Consequently,the sample of depositors will probably be larger than the sample of borrowers.

Prior to visiting the specific clients, the internal auditor reviews their files to ensure that thedocumentation conforms to the organization’s policies and procedures. When visitingborrowers for example, the internal auditor compares the disbursement and repaymentinformation in the MFI’s records with the client’s records,including current balances, and the amount and date of eachtransaction, and the collateral that was pledged. It is alsoimportant to compare the information in the file with the actualbusiness, including address, type of business, purpose of theloan, assets, etc. If there was false documentation, then eitherthe client took advantage of the loan officer, or they collaborated to give a loan to someonewho was not worthy.

While these visits are primarily for internal audit purposes, they can fulfill other importantfunctions such as delinquency management, gathering information on customer satisfaction

Internal auditorsspend the vastmajority of theirtime in the field


58

and market trends, and identifying staff training needs. An internal auditor may not be themost popular person in an MFI, but he can play one of the most critical functions if his jobis well designed, if he has the skills to fulfill multiple roles, and if he spends the majority ofhis time in the field.

Customer ComplaintsBecause the customers of MFIs tend to be poor and uneducated, they are particularlysusceptible to being victims of fraud. But these people are not stupid, and they often realizethat someone is trying to take advantage of them. The problem is that they may not feelempowered to do anything about it. Even if they want to do something, they may not knowhow since their primary contact with an MFI may be the person who is causing the problem.

Another important method for detecting fraud, and for improving customer service, is toestablish a complaint and suggestion system that creates a communication channel throughwhich clients can voice their opinions. If it is easy for clients to complain, and if theircomplaints can by-pass the local branch office, then they will be more likely to reportquestionable conduct of loan officers and other field staff. It is then important that thisconduct is investigated by MFI management to address issues and determine if there isfraud.

ê Does senior management consistently monitor portfolio quality?

ê Does the MFI have standard procedures for delinquency follow up?

ê Are these procedures followed?

ê Does your organization regularly sample clients to confirm savings and loan balances?

ê Does a reliable firm audit the MFI annually?

ê Does the MFI have an internal audit function?

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ê Are internal audits conducted regularly?

ê What is the process by which your organization confirms client savings and loan balances?

ê Do you have a system for collecting, analyzing and following up with customer complaints?

3.2.4 Response to FraudIf fraud is suspected, in most cases the MFI should conduct a fraud audit and thenimplement damage control proceedings.

Fraud AuditA fraud audit, sometimes called a forensic audit, has the specific aim of determining whetherirregularities have occurred and, if so, their magnitude. A fraud audit generally consists of anextension of ordinary audit procedures, as proposed by the auditors and, in some instances,agreed to by the client. The decision to conduct a fraud audit involves considerablejudgment. Two important factors in this decision are the potential magnitude of the fraudand the extent of evidence of a fraud. Frauds involving potentially very large amounts ofcash with scant evidence are more likely to require a fraud audit than frauds involving smallamounts with considerable evidence. Fraud audits should be conducted by auditors withspecialized training in forensic auditing. Contrary to common belief, most auditors do nothave the training to conduct an effective fraud audit.

Risk Management and Scale

As mentioned in the Introduction, risk management is an ongoing process. Vulnerabilitieschange over time partly because the institution matures and grows. Many of the controls foroperational risks described in this chapter may be relevant for large MFIs, but are not asapplicable to small organizations or start-ups. In designing a risk management strategy, it isnecessary to determine what is appropriate for the scale of your operations.

For credit risk, for example, a new organization with small loans will rely more on character inthe loan assessment process, but when the loan size increases a collateral based approach is moreappropriate. In a new MFI, the “credit committee” may just consist of the loan officer and hersupervisor, but for larger loans the organization should formalize the review process.

One of the major methods for controlling fraud is through the corporate culture, yet this toochanges as the MFI grows. In a small organization, the managing director sets an example andpersonifies the core values of honesty and transparency. This value-driven approach to internalcontrol must evolve into formal policies and procedures. Managers will assume the auditingfunction initially, and then once the organization achieves a certain scale, it can justify hiring aninternal auditor.

Methods for managing security risk depend on the volume of money that passes through thebranch on a daily basis and on the local environment. Even in the safest locations, greaterprecautions should be taken as the number and size of the transactions increases.

For new MFIs, it is important to adopt a risk management approach to their operations. Whilethis approach will probably rely on informal control methods to start, by adopting a riskmanagement mindset from the beginning it will make it easier to implement more formal systemsas the organization grows.


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Damage ControlIf fraud is identified, the MFI needs tomove into a damage control mode. Forthis to happen quickly, organizationsshould consider developing contingencyplans that can be dusted off and put intoaction when the need arises. Thiscontingency plan should include thefollowing elements:

ð What action will the MFI takeagainst the perpetrator (i.e.,termination, legalproceedings, efforts torecoup losses)?

ð What approach will theorganization take with clients who were victimized?

ð How can the MFI diminish the negative effects of fraud on its reputation, oreven turn this public relations nightmare into a coup?

ð What changes to the internal control policies need to be made to prevent thisfrom occurring again?

Some MFIs require new employees to pay a security deposit, which they will lose if they areinvolved with fraud.5 This serves both as a deterrent to fraud as well as a means of reducingthe MFI’s vulnerability to losses.

ê Do you have a contingency plan in place so that you can quickly mitigate the damage caused by fraud when itoccurs? If so, what does the plan consist of?

3.3 Security RiskThe third form of operational risk is the exposure of an MFI to theft. Some MFIs neverhave difficulty with security risk, whereas others are extremely vulnerable. This risk has twobasic elements:

1) Safety of Cash: Any MFI that disburses and receives money directly is vulnerableto theft. They need to ensure that cash is protected from theft during officehours, after office hours and in transit.

2) Safety of Office Assets: Although thieves usually prefer cash, it is not the only assetthat is vulnerable. MFIs need to ensure that they are protecting their computers,fax machines, photocopiers, and even office equipment like desks and chairs,from theft.

5 Employees may also lose their security deposit if they leave the organization within a specified period oftime, often 12 to 24 months. If employees leave earlier, their security deposit is used to pay for theirtraining.

Fraud and Group Lending

MFIs that use a group lending approach mayexperience instances when group membersdefraud each other. This occurs most frequentlywhen a group representative is responsible forsubmitting the repayments for the entire group,and then chooses to hold on to them for a while.Some programs control this risk by having allgroup members make their own repayments, butthis adds transaction costs to the clients, especiallyif the deposit location is not nearby.Alternatively, group members can be educated toask to see the official receipt when therepresentative returns.

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The most effective control to safeguard cash is not to handle it. Many microfinanceprograms conduct all their financial transactions (disbursements, repayments, and savings)through local banks. This control dramatically reduces the threat of theft, but it also limitsthe MFI’s ability to provide valuable services to its customers. They are constrained by thelocation of banks, their hours of operation, and their willingness to process large volumes ofsmall transactions.

For MFIs that do handle cash, they should consult with local security experts and bankingofficials regarding controls for reducing vulnerability to theft. Appropriate responses mayvary significantly from branch to branch. Some of the security measures to considerinclude safes, vaults, window bars, door locks, teller shields, interior and exterior lighting,security guards (armed or unarmed), and security alarms and cameras.

MFIs also reduce their exposure through liquidity policies that stipulate the maximumamount of cash that can be kept in the branch over night. Liquidity policies require aneffective system for transporting money to a central depository and then delivering sufficientcash to each branch in the morning.

In addition to the systems designed to protect cash, MFIs should also have a fixed assetregister that lists all the organization’s assets, description, date and price of purchase, andserial number (if applicable). When the internal auditor visits the branch, he should comparethe equipment in the branch with the asset register to ensure that equipment has not beentaken (temporarily or permanently).

ê Has your organization contracted an expert to analyze your security needs on a branch-by-branch basis?

ê What are your organization’s major vulnerabilities to theft, and how are you addressing them?


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Recommended ReadingsLending MethodologiesBerenbach, Shari and Diego Guzman (1992). The Solidarity Group Experience Worldwide. Monograph No. 7.

Washington DC: ACCION International. Website: www.accion.org.

Churchill, Craig F. (1999). Client-Focused Lending: The Art of Individual Microlending . Toronto: Calmeadow.Website: www.calmeadow.com. Available from PACT Publications. Email: [email protected].

SEEP Network (1996). Village Banking: The State of the Practice. New York: United Nations DevelopmentFund for Women. Website: www.seepnetwork.org.

Yaron, Jacob, McDonald Benjamin, and Gerda Piprek (1997). Rural Finance Issues, Design and Best Practices.Washington DC: The World Bank. Email: [email protected].

Product DevelopmentBrand, Monica (1998). New Product Development for Microfinance: Evaluation and Preparation. USAID’s

Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website:www.mip.org.


Internal ControlCampion, Anita (2000). Improving Internal Control: A Practical Guide for Microfinance Institutions. Technical

Note No. 1. Washington DC: MicroFinance Network. Email: [email protected]. Available fromPACT Publications. Email: [email protected].

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Chapter 4: Financial Management Risksand Controls

he risks associated with financial management represent a third area of vulnerabilityfor microfinance institutions. Distinct from institutional and operational risks,financial management risks are inherent in the range of strategies and proceduresused by microfinance managers to optimize financial performance. Key risk areas

that emerge from these strategies include:

1) Asset and Liability Management Risks

2) Inefficiency Risks

3) System Vulnerability Risks

This chapter will define each of these key risk areas and provide guidance on how toadequately monitor and control these risks.

4.1 Asset and Liability ManagementIn the banking world, asset/liability management (ALM) refers to the management of thespread, or the positive difference between the interest rate on earning assets and the cost offunds. Successful management of this spread requires control over: a) interest rate risk, b)foreign exchange gap, c) liquidity, and d) credit risk. Credit risk is normally the mostimportant of risk categories for MFIs and was addressed in Chapter 3; the other three arepresented in this chapter.

T

FinancialManagement

Risk

External Risk

OperationalRisk

InstitutionalRisk


64

A microfinance institution is only vulnerable to these three risks if it has one of the followingcharacteristics:

ê It borrows money from commercial sources to fund its portfolio;ê It funds its portfolio from client savings;ê It operates in a high inflation environment; orê It has liabilities denominated in a foreign currency.

If none of these characteristics apply to your organization, and you do not expect that theywill in the near future, you can skip ahead to Section 4.2.

These components of asset and liability management need to be considered carefully. Informal financial institutions, a management committee normally carries out ALM, as itinvolves both operations and treasury activities. Because most MFIs do not have this kindof management depth, however, the executive director and financial manager will most likelycarry out ALM within an MFI, with perhaps some support from a board member who hasexpertise in this area.

4.1.1 Interest Rate RiskInterest rate risk arises when assets and liabilities are mismatched, in terms of interest ratesand terms. Interest rate risk is particularly problematic for MFIs operating in highinflationary environments. If inflation rises, the interest rate on loans may not be sufficientto offset the effects of inflation. An MFI’s ability to adjust interest rates on its loans isdetermined by the degree to which short-term liabilities are used to fund longer-term assetswithin the portfolio. If the rates on short-term liabilities rise before an MFI can adjust itslending rates, the spread between interest earnings and interest payments will narrow,seriously affecting the MFI’s profit margin.

MFIs should monitor interest rate risk by (1) assessing the amount of funds at risk for agiven shift in interest rates, and (2) evaluating the timing of the cash flow changes given aparticular interest rate shift.

All types of assets and liabilities do not respond to a change in interest rates in the samemanner. Some are more sensitive to interest rate changes than others, a characteristic knownas interest rate sensitivity. For example, small scale savings accounts tend not to be veryinterest rate sensitive, as low income clients typically maintain savings accounts more forreasons of liquidity and safety, than for rate of return. For this reason, if the interest ratefalls, such clients will not necessarily withdraw their savings. On the other hand, bankcertificates of deposit are usually highly interest rate sensitive. Certificates of deposit, orother time deposits, are usually purchased by investors who are concerned with the rate ofreturn on their investment, and will thus be more likely to withdraw their savings in theevent of a decrease in interest rates. In other words, such investments tend to be moreinterest rate sensitive than small-scale savings accounts. This type of interest rate sensitivityanalysis is important for microfinance institutions that mobilize funds from a variety ofsources.

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For MFIs that serve primarily low-income clients, interest rate sensitivity may be lessimportant than responding to the timing of any cash flow shifts. Determining the gapbetween rate-sensitive assets and rate-sensitive liabilities, or gap analysis, provides amechanism for identifying the timing of cash flow shifts. Rate-sensitive assets or liabilitiesare those that can be priced either upward or downward over the next few months.

A useful indicator for monitoring interest rate risk is the net interest margin, commonlycalled the spread. This ratio calculates the incomeremaining to the institution after interest is paid onall liabilities, and compares the result with either thetotal assets or the performing assets of theinstitution.

A variation of this ratio is (interest revenue – financialexpenses) / average assets, where financial expenses include interest expense, inflationadjustment, exchange rate depreciation expense, and a subsidized cost of funds adjustment.(See Chapter 6, Adjusting for Inflation and Subsidies, for guidance on how to calculate imputedcosts.) This second ratio may be more useful than the first for MFIs with large equity bases(capitalized by donor funds) or subsidized loans. It is particularly useful to compare thisratio to the operating expense ratio—total operating expenses / average total assets—toassess whether the interest rate margin is sufficient to cover operating costs. (See InefficiencyRisks below for further discussion on the operating expense ratio.)

ê Is the MFI susceptible to interest rate risk?

ê For those MFIs operating in highly inflationary environments, is gap analysis conducted regularly?

ê What is your net interest margin?

4.1.2 Foreign Exchange RiskForeign exchange risk occurs when an MFI holds cash or other investments (assets) or debt(liabilities) in foreign currency. The devaluation or revaluation of these assets or liabilitieshas the same effect as interest rates in exposing MFIs to potential gain or loss. If the localcurrency has devalued against the foreign currency used, the MFI will have to make up thedifference. This difference constitutes an additional “interest rate” that must be generatedby the institution through its operating income.6 Likewise, if the local currency revaluesagainst the foreign currency used, the MFI stands to profit from a potential gain.

MFIs primarily need to be concerned about foreign exchange risk when they assumeliabilities denominated in a foreign currency and convert these funds into assetsdenominated in a local currency. For example, many MFIs fund their local currency loanportfolios with dollar denominated loans from donors or commercial sources. When theassets are converted back to dollars, the MFI faces the effects of foreign exchange risk.Assume an MFI receives $100,000 as a loan from a commercial bank, and converts thesefunds into South African Rand (R) at R6 to the dollar to on-lend to clients. When theliability comes due, the MFI will have to convert the Rand assets back into dollars. If the

6 Christen (1997), p. 139.

Net Interest Margin:(Interest Revenue-Interest Expense)

/Average Total Assets


66

Rand has devalued against the dollar so that therate is now R7 to the dollar, the MFI could besusceptible to foreign exchange losses. Figure 18highlights the impact of this risk on an institution’sbottom line by comparing a stable currencysituation with a devalued currency. Assuming theMFI does not adjust its interest rates in time toaccommodate currency devaluation, the MFI willincur a loss when repaying the $100,000 liability.

In general, MFIs that are not operating in amultiple currency environment should avoid taking on foreign denominated debt to avoidthis kind of foreign exchange risk. However, if the economy is dollar denominated andclients conduct transactions in dollars, it may be appropriate for an MFI to offer loans indollars, and thus to fund these dollar assets with dollar liabilities. Unless the MFI can matchforeign liabilities with foreign assets of equivalent duration and maturity, the MFI should seek to avoidfunding the portfolio or lending in foreign currency.

Figure 18: Example of Currency Devaluation Impact

Amount lent: $100,000 at 20% USD Scenario 1 - SAR(no devaluation)

Scenario 2 - SAR(devaluation)

Amount lent 100,000 600,000 600,000

Exchange rate at due date - R6/USD R7/USDAmount due 120,000 720,000 840,000 Principal 100,000 600,000 700,000 Interest 20,000 120,000 140,000 Actual cost of funds* 20,000 120,000 240,000

Client revenue** 420,000 420,000Operating costs*** 240,000 240,000 Net difference 180,000 180,000

Profit / (Loss) 60,000 (60,000)* Includes interest expense, revaluation of principal, and revaluation of interest expense** Assume interest rate of 70%*** Assume operating cost ratio of 40%

For MFIs with foreign currency exposure, appropriate control mechanisms should beestablished. If the devaluation is relatively constant and foreseeable, options include:

1. Add the expected devaluation rate to the nominal local interest rate in any loans offered.An MFI in Latin America, for example, charges 3.5 percent per month on loans in USdollars and 4.0 percent a month on local currency loans.

2. Include a provision for devaluation expense on the balance sheet and income statement.

3. Index the interest rate on local currency loans to foreign currency, so that if the localcurrency devalues, the value of the loan in the foreign currency must still be repaid.

Guarantee FundsIn Egypt, CARE uses a guarantee fund tominimize foreign exchange risk. In thisexample, CARE places a Certificate ofDeposit in U.S. dollars in a bank inEgypt. The bank makes a loan toCARE’s microfinance partner in the localcurrency, thus eliminating foreignexchange risk for the microfinanceinstitution and for CARE.

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(Note that this passes on the risk of depreciation loss to the client, which may ultimatelylead to increased credit risk).

In cases where devaluation occurs suddenly due to shocks to the local financial system, MFIsthat have not appropriately matched their exposure could face bankruptcy.

A key monitoring ratio for institutions facing currency exposure is the currency gap riskratio. This ratio helps identify a high exposure ifthe MFI has borrowed funds denominated inforeign currency that it lends out in localcurrency.

ê For MFIs that hold assets or liabilities in foreign currency,are appropriate control mechanisms in place to mitigateforeign exchange risk?

4.1.3 Liquidity Risk7

Liquidity refers to an MFI’s ability to meet its immediate demands for cash, such as loandisbursements, bill payments and debt repayment. Liquidity risk arises when an MFI isunable to cover a liquidity shortfall. Due to the unique nature of microlending, a temporarylack of access to adequate loan capital can be serious. Inmicrolending, a primary reason why borrowers repay theirloans is to receive subsequent loans. If the institution cannotmeet disbursement requests, repayment rates could plummet,as borrowers no longer perceive this incentive to repay.While some MFIs can access short-term funds to cover theseliquidity shortfalls, these funds are usually expensive and notalways reliable. Given these circumstances, microfinance managers should generally err onthe side of conservative liquidity management.

Effective liquidity management requires MFIs to achieve a balance between maintainingsufficient liquidity for sudden cash demands and earning revenue through longer-terminvestments. While liquidity management and cash flow management are often usedinterchangeably, liquidity management includes the management not only of cash, but alsoof short-term assets and liabilities.

A key control for mitigating liquidity risks is cash flow management. Cash flowmanagement refers to the timing of cash flows to ensure that cash inflow is equal to orgreater than cash outflow. Due to the cyclical nature of credit demand in many countries(particularly high around holidays, for example) and the propensity for young MFIs toexpand quickly in their early years, an MFI can experience peak loan demand in spurts. Tocontrol for these high demand periods, finance managers need to establish a sound cash flowmanagement program. This program should ensure that:

7 This section adapted from Ledgerwood (1999), p. 255-256.

Currency Gap Risk:(Assets in Specified Currency - Liabilities

in Specified Currency)/

Performing Assets

A temporary lack ofloan capital canresult in a dramaticspike in portfolioquality problems


68

ð Liquidity needs are planned on the basis of worst-case scenarios to limit the potentialfor liquidity crises

ð Policies are set for minimum and maximum cash levelsð Cash needs are forecast (see budgeting section below)ð Cash budgets are continuously updatedð Surplus funds are invested or disbursed as loansð Cash is available for savings withdrawals and loans

MFIs with strong track records often manage liquidity by establishing a line of credit with alocal bank. If there is a spike in demand, they can draw down on their line of credit to meetdisbursements. This allows the organization to only incur financial expenses when the fundsare used.

Besides the cash flow projections, the liquidity indicator most appropriate for an institutiondepends on the institutional type. If the institution mobilizes voluntary savings, for example,it will need to ensure adequate liquidity to meet client withdrawalrequests and debt service payments, using an indicator such asthe quick ratio. The quick ratio numerator should exclude anyliquid assets that are restricted by donors for certain uses, as theywill not be able to meet savings withdrawal needs.

MFIs can further monitor their overall cash flow by using the liquidity ratio. The liquidityratio helps institutions determine if there isenough cash available for disbursements andalso whether there is too much idle cash. Itshould always be greater than 1. Cash inflowsand outflows should be projected on amonthly basis and should include only actualcash items. Depreciation, provisions for loanlosses or subsidy and inflation adjustments do not affect cash flow.

Finally, MFIs should monitor the allocation between cash and other income generatingassets on a regular basis. The idle funds ratio measures the ratio between funds that are notearning any revenue (cash and near cash) and incomegenerating funds. Near cash refers to deposits that earn avery low rate of return, with a maturity of three months orless. For liquidity purposes, a certain amount of idle funds isnecessary. However, too great an amount will depress theMFI’s overall return on assets. The appropriate amount willdepend on a number of factors, including the institution’slevel of maturity, other short term investment opportunities, and whether or not theinstitution is a regulated financial intermediary and therefore subject to reserve requirements.

ê Does your organization follow a cash flow management program, i.e. cash needs forecasting, budgeting, etc.?

ê Do you monitor its liquidity risk through consistent monitoring of key ratios: quick, liquidity, idle funds?

Liquidity Ratio:(Cash + Expected Cash Inflows In The Period)

/Anticipated Cash Outflows In The Period

Idle Funds Ratio:(Cash + Near Cash)

/Total Outstanding Portfolio

Quick Ratio:Liquid Assets

/Current Liabilities

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4.2 Inefficiency RiskThe first great challenge in microfinance was to minimize the credit risk associated withproviding unsecured loans. Many MFIs have largely succeeded in overcoming this obstacleand have now set their sights on the next major challenge: improving efficiency. It involvesan organization’s ability to manage costs per unit ofoutput, and thus is directly affected by both cost controland level of outreach. Inefficient microfinanceinstitutions waste resources and ultimately provide clientswith poor services and products, as the costs of theseinefficiencies are passed on to clients through higherinterest rates and transaction costs.

MFIs can improve efficiency in three ways: (1) increase the number of clients to achievegreater economies of scale, (2) streamline systems to improve productivity, and (3) cut costs.The first two goals are closely related; both seek to increase the number of clients, or unitsof output, the MFI serves by having staff work harder or, preferably, smarter. Inmicrofinance organizations that are not managed in a business-like manner, employees oftenhave excess capacity. And yet, as is human nature, they find ways of filling their days so theyend up being very busy doing things that are not particularly important. A close analysis oftime allocation and time management will often reveal waste.

The third goal addresses the cost side of the equation. Administrative costs, includingsalaries and other operating expenses, represent the greatest component of the cost structureof an MFI. Reducing the delivery costs associated with providing financial services improvesoperating efficiency. If these costs can be reduced, the savings can be passed on to clientsthrough more competitively priced products, ultimately improving customer satisfaction.

4.2.1 Inefficiency Controls

BudgetingThe budget represents the master plan of all expenses that it will take for the MFI to maintainits operations and all sources of capital used to meet expenses. The budget should besufficiently detailed to isolate the cost structure of each element of its operations (branchoffice, support unit, senior management, etc.). In a multi-branch MFI, treating branches asprofit centers, which includes providing them with decision-making authority to managetheir own efficiency, is a key building block toward improving efficiency for the entireorganization. Decentralizing day-to-day decision making to branch managers and unit headsis an effective way to increase efficiency and to spread the responsibility throughout the MFIfor managing costs.

Improving efficiencyis the next majorchallenge for themicrofinance industry


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Figure 19: Budget Comparison Report

123 Microfinance Institution

Summary Actual-to-Budget Income Statement For the Period Jan 1 to Dec 31 2000

2000 Actual 2000 Budget % Budget

INCOME

Interest income on loans 300,789 380,000 79.2%

Loan Fees and Service Charges 32,000 35,000 91.4%

Late fees on loans 12,000 10,000 120.0%

Total credit income 407,760 425,000 95.9%

Income from investments and other 8,909 5,000 178.2%

Income from other financial services 0 0

Total other income 4,380 5,000 87.6%

Total Financial Income 412,140 430,000 95.8%

FINANCIAL COSTS

Interest on debt 58,000 52,000 100.8%

Interest on deposits 1,900 3,000 119.0%

Total Financial Costs 63,000 55,000 114.5%

GROSS FINANCIAL MARGIN 349,140 375,000 93.1%

Provision for Loan Losses 31,200 30,000 104.0%

NET FINANCIAL MARGIN 317,940 345,000 92.2%

EXPENSES

Salaries and benefits 162,000 157,000 103.2%

Administrative expenses 120,000 118,000 101.7%

Depreciation 3,000 3,000 100.0%

Other 300 500 60.0%

Total Operating Expenses 285,300 278,500 102.4%

NET FINANCIAL SERVICES OPERATING MARGIN 32,640 66,500 49.1%

GRANT INCOME 18,700 25,000 100.0%

Total grant income for Financial Services 20,000 25,000 80.0%

NET INCOME FOR SERVICES 52,640 91,500 57.5%

EXCESS OF INCOME OVER EXPENSES 54,140 81,400 66.5%

Subsequently, the budget needs to be developed, understood and “owned” by a wide rangeof senior staff in the MFI. Senior managers need to be oriented to think, plan and operateroutinely from a budget perspective to enable the MFI to become commercially minded andefficient. Toward this end, it is essential for senior managers to participate in reviewingactual expenses and revenues compared to the budget to develop a working understandingof the cost structure of the operations and to be held accountable for achieving the targetsset forth on their own budget worksheets.

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A budget comparison report (see

Figure 19) compares the actual income and expense to the budgeted amount for the timeperiod (usually either monthly or year-to-date). A third column indicates the variance or thepercentage of the actual to the budgeted amount. The primary purpose of this report is toallow the board and staff to monitor performance relative to the approved budget.

Managers need to carefully monitor income and expenses relative to budget on a monthlybasis. Major discrepancies may call for mid-year adjustments or even urgent revisions to theannual operating plan. Since the budgeting process generally follows the chart of accounts,so does this report format.

Activity Based CostingAs MFIs mature, they often introduce new financial products to meet the evolving needs oftheir target market. When they do so, they should seriously consider establishing an activitybased costing (ABC) system that allocates both thedirect and indirect related costs to a specific revenuegenerating activity. Information about the allocationof expenses gives a more accurate picture of how costsand revenues relate to each other. ABC providesinformation to understand the relative costs to deliverdifferent products and to identify which productsgenerate the highest profit and which are relativelywasteful.

This information is invaluable in pricing products anddeveloping risk management strategies. For example,an MFI may decide to employ a loss-leader pricingstrategy that intentionally under-prices one productthat will attract customers, who will then hopefullypurchase other, more profitable products.

Even an MFI that only offers one product can benefitfrom an ABC analysis if the “activity” is defined morenarrowly. Instead of comparing the costs between twoor more products, you can analyze the costs of different aspects of one product. Forexample, you may want to determine the costs that go into marketing, screening, disbursingand repaying the loan to see if there are ways to streamline the delivery and repaymentprocess. Or you may want to compare the costs of serving new clients vs. repeat borrowers,measure the additional costs required to manage delinquent loans, or compare the costs ofdelivering the same service from different branches.

Activity based costing is also an appropriate means of analyzing product pilots. Forexample, an MFI may want to test the effectiveness of three sets of controls designed tomanage credit risk. In this case, effectiveness involves comparing the costs of the controlswith the resulting portfolio quality.

Conducting ABC

To measure activity-based costs, oneallocates administrative expensesbased on the amount of time spent onan activity in a representative month.This information, collected from staffmembers at all levels within theorganization, is gathered eitherthrough employee interviews orthrough time sheet documentation.The next step is to multiply eachperson’s time ratios by their direct andindirect costs. When the calculationsare completed, all administrative coststhat appear on the income andexpense statement must be allocated.

Adapted from Gheen et al (1999).


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Reengineering8

Most MFIs have systems and procedures that may have made sense at one stage in theorganization’s development. As the MFI grew and diversified, those practices continuedbecause “that’s what we’ve always done,” without a thoughtful and holistic analysis of whatmakes sense today, in the current market environment, given the MFI’s current andprojected structure. Consequently, the MFI has inefficiencies eroding its bottom line thatneed to be cleaned up.

The process for cleaning up inefficiencies is called reengineering, or redesigning businessprocesses through streamlining, consolidating, reorganizing roles and responsibilities, andautomating. Reengineering varies widely in scope and form. It can involve the entireorganization or select units, though it works best when approached holistically.Reengineering can focus on a specific business process (such as customer service or newproduct development) or the institution’s entire operations. The depth and breadth dependson the extent of the problem and management’s willingness to undertake meaningful, andoften painful, change.

In designing a reengineering process, it is useful to establish phases because it allows an MFIto test its modified processes and benefit from lessons learned before implementing thechanges institution-wide. One of the major areas of focus of reengineering is on employeeoptimization: organizing tasks and allocating them among different staff levels to maximizeproductivity (see box).

The greatest challenge to successful reengineering is the lack of strong leadership to manageorganizational resistance to change. This resistance often results when the organizationalculture and support systems are not aligned with the new work model, underminingemployee trust and their commitment to change. Initial resistance also stems from residual

8 Adapted from Brand (2000).

Reengineering at Mibanco

In anticipation of increased competition, ACCION International guided its Peruvian affiliate, Mibanco,through a reengineering process so it would be prepared to stave off competitive threats.

An important focus of the reengineering was at the branch level, where an analysis of the daily activitiesof loan officers indicated that they were spending 2/3 of their time in their office, (participating in creditcommittees, underwriting, and processing loan applications) rather than in the field generating newloans. Part of this misallocation of time resulted from the homogenized way that applications wereanalyzed, including the structure and timing of the credit committee.

To address this issue, reengineering established criteria, based on loan size, loan officer experience, anddelinquency track record, to delegate more authority to senior credit officers with low-risk loans. Thisreduced the number of loans that required committee approval. Some administrative functions werepushed down to less expensive administrators. These changes resulted in a better utilization of loanofficers, increasing their time in the field by 65 percent.

Adapted from Brand (2000)

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sentiments of previous change efforts, as well as the misperception that reengineering meansjob loss.

The success of reengineering is tied to how it is undertaken. The most critical factor is seniormanagement’s ability to lead the effort, articulate the desired outcomes, and explain therationale for change. When employees understand the rationale and the road map forreengineering, they can help facilitate, rather than resist, change.

Soliciting employee participation in assessing the problem and generating solutions is criticalfor staff to take ownership of the new business model. Internally generated ideas are usuallycomplemented with external best practices to establish benchmarks and goals.Reengineering often begins with a brainstorming session to identify desired improvementsbefore documenting “as-is” business practices. For this reason, reengineering almost alwaysinvolves outside consultants, who bring the expertise, creativity, and objectivity, to helpimprove ingrained processes and cultures. Finally, a successful reengineering effort leaves inplace a culture of continuous improvement that seeks to regularly enhance the business so thatorganization does not have to undergo a drastic and perhaps painful reengineering processagain.

ê Does your organization develop an annual budget?

ê Is the annual budget used and updated regularly?

ê Do you actively compare the budgeted to actual numbers and identify cost over-runs?

ê (For MFIs that offer multiple products) Do you do activity-based costing?

ê Have you analyzed your systems and procedures to identify and eliminate inefficiencies?

4.2.2 Inefficiency Monitoring

Efficiency and Productivity RatiosBesides institutionalizing mechanisms for controlling costs, MFIs should monitor keyefficiency ratios. To analyze its level of efficiency, an MFI should compare its currentperformance to two other data sets: 1) the organization’s past performance (trend analysis)and 2) similar organizations identified as industry leaders (industry benchmarks). Thefollowing efficiency indicators represent recommended monitoring tools for inefficiencyrisk.9

Operating Expense Ratio: The operating expenseratio gives a general overview of how efficiently theMFI uses assets. The numerator, total operatingexpenses, includes administrative expenses, loan lossprovisions and financial costs. An alternative ratiofor MFIs, particularly those that only offer lendingservices, is total operating expenses to average loan portfolio.

9 For current benchmarks refer to The MicroBanking Bulletin , a semi-annual journal that includesperformance ratios based on data from more than 100 leading MFIs from around the world.

Operating Expense Ratio:Total Operating Expenses

/Average Total Assets


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Administrative Expense Ratio:Total Administrative Expense

/Average Loan Portfolio

Salary Expense Ratio:Salary Expenses

/Average Loan Portfolio

Administrative Expense Ratio: The administrative expense ratio provides a good idea ofrelative efficiency when comparing MFIs becausenon-productive guarantee funds and year-endspikes can cloud comparisons between operatingexpense ratios.

Salary Expense Ratio: Salary expenses, which include direct salaries and staff benefits,tend to represent the largest expense in MFIs,averaging 60 percent of total administrativeexpenses.

Bank Efficiency Ratio: This ratio analyzes theextent to which total income (net interest and other income before loan loss provision) isconsumed by expenses. This helps MFIs tofocus not just on how expenses affectefficiency, but also the impact of revenue. Thisratio shows how many dollars are earned foreach dollar spent. The majority of US financialinstitutions have efficiency ratios at or below 55percent.10

Average Cost Per Client or Per Loan: The average cost per client or per loan isparticularly useful as it identifies transactions costs on a per unit basis. Unlike the otherindicators, which are relative to portfolio or assets, thisindicator helps to show poverty lenders—MFIs withreally small loans—whether their inefficiency is due tohigh costs or small loan sizes.

Number of Clients (or Loans) per Loan Officer (orField Staff, or Total Staff): This basic productivity indicator has numerous variations onthe same theme: how many units can employees manage?

Number of Field Staff (or Loan Officers) as a Percentage of Total Staff: This ratioenables the MFI to ensure that it is focusing its resource on its core business, deliveringfinancial services, without a large back office or overhead.

No one indicator independently captures all of the aspectsof efficiency that need to be monitored, so it is important toreview a set of efficiency and productivity ratios. Since thedenominator for most of the efficiency ratios is either totalportfolio or total assets, one way to improve efficiencymight be to increase the average loan size. While the loan size tends to increase naturallyover time as the client base consists of more repeat clients, an artificial increase in loan size isnot recommended because it leads to two other risks that were discussed above. Assuming

10 Brand and Gerschick (2000).

Cost per Client:Total Administrative Expenses

/Average Number of Clients

Bank Efficiency Ratio:Total Expenses (before taxes)

/Net Interest Income (before provisions)

+ Other Income

Do not artificiallyincrease averageloan size to improveyour efficiency

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that the MFI is offering an appropriate product for its target market, an artificial increase inloan size can overburden them and result in credit risk. Another means of raising averageloan sizes is by providing larger loans to a different segment of the market, which couldresult in mission risk.

Monitoring Human ErrorsOne of the greatest contributors to inefficiency is simple human error. Errors due to haste,carelessness, and poor training occur throughout the paper trail. Even minor mistakes liketransposing a receipt number are expensive to resolve. The extra time that employees taketo make sure they are doing things correctly is usually an enormous investment in efficiency.

MFIs should keep an error log to track the mistakes that occur and the estimated costs thatit took to resolve them. The error log becomes the basis for ongoing training, staffdiscipline, as well as possible reengineering targets.

ê Does the MFI actively monitor its operating efficiency through key ratio analysis?

ê Does your organization maintain an error log that allows it to identify and rectify common mistakes?

4.3 Systems Integrity RisksThe financial health of an institution is primarily monitored through key financial statementsand management reports. The reliability of both source data and the information containedin these financial statements and management reports is critical to this process. Withoutassurances that these key reports are accurate, an MFI is flying in the dark. External auditsprovide definitive assessments of the reliability of financial reports and systems in an MFI.

MFIs should typically have a financial audit conducted on an annual basis. This auditinvolves a review of all financial statements, including the balance sheet, income statement,and cash flow statements to check the accuracy and reliability of accounting records, in orderto safeguard company assets. This type of audit, if done to fulfill regulations orrequirements, must be done by an external audit firm. The financial audit reviews historicaldata, and does not make projections about future financial information.

ê Is the MFI audited annually by a reliable audit firm?


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Recommended ReadingsEfficiency, Activity Based Costing and ReengineeringBrand, Monica and Julie Gerschick (2000). Maximizing Efficiency: The Path to Enhanced Outreach and

Sustainability . Monograph No. 12. Somerville, MA: ACCION International. Website: www.accion.org.

Asset and Liability ManagementBartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios II: Analyzing for

Quality and Soundness in Microcredit Programs. GEMINI Technical Note No. 8. Bethesda, MD:Development Alternatives, Inc. Website: www.mip.org.


Ledgerwood, Joanna (1996). Financial Management Training for Microfinance Organization: Finance Study Guide.Toronto: Calmeadow. Website: www.calmeadow.org. Available from PACT Publications.

Ledgerwood, Joanna (1999). Microfinance Handbook: An Institutional and Financial Perspective. WashingtonDC: The World Bank. Email: [email protected]..

External AuditsCGAP (1999). External Audits of Microfinance Institutions: A Handbook. Technical Tool Series No. 3.

Washington DC: CGAP. Website: www.cgap.org. Available from PACT Publications.

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Chapter 5: External Risks

xternal risks are considerably different than the other sets of risks to which amicrofinance institution is exposed because the organization has less control overthem. Therefore, instead of highlighting monitoring and controls, as has been donewith the other risks, for external risks it is necessary to discuss how to monitor and

respond. The five sets of external risks addressed in this chapter are:

Regulatory Competition Demographic Macroeconomic Natural Environment

A note of caution must be attached to a discussion of external risks. It is fairly common forMFIs that are not doing particularly well to point to external causes for their plight, such asthe following excuses for poor portfolio quality:

ê These clients have never borrowed money beforeê The clients are used to handoutsê Our clients are so poor that it is hard for them to repay their loansê The economy is so bad that it is hurting their businesses

Statements like these indicate a need to better understand microfinance. The purpose ofmicrofinance is to serve poor people who do not have experience with credit and who live indifficult conditions. The rationale behind the design of amicroloan product is to overcome these challenges. If amicroloan product is not working, unless there has been asignificant and recent change in the local conditions, the problemprobably lies with the product or its delivery, not the market.These external risks represent challenges that management andthe board need to identify and respond to, but they are notexcuses for poor performance.

E

External risksrepresent challengesto overcome, but theyare not excuses forpoor performance

FinancialManagement

Risk

External Risk

OperationalRisk

InstitutionalRisk


78

It is also worth noting that, while you may be operating under difficult conditions, there isprobably another MFI out there that has succeeded in overcoming the same challenges. Thelesson from their experiences: challenges can be addressed and overcome.

5.1 Regulatory RisksVarious governmental bodies may have some influence over the activities of microfinanceinstitutions. The regulatory risks discussed in this section are summarized in the followingtable:

Banking Regulations Other Regulatory Risks

Usury Laws Directed CreditFinancial Intermediation Contract Enforcement

Labor Laws

5.1.1 Banking RegulationsIn the last twenty years, MFIs have developed new technologies—such as group lendingmethodologies and streamlined delivery systems—to provide financial services to excludedpopulations. These developments were possible because MFIs had considerable freedom toinnovate and experiment beyond the purview of most regulatory bodies. Now thatmicrofinance institutions are growing in scale and number, regulators and policymakers arebecoming increasingly interested in them.

This attention has the potential to be constructive. Appropriately designed regulations cancreate an enabling environment within which microfinance can blossom. However, theopposite reaction is also a possibility. Microfinance is different from traditional banking inmany ways. Policymakers who do not appreciate the unique characteristics of microfinanceare likely to impose inappropriate regulations that could stifle the industry.

Within this context, there are two areas of banking regulation to which microfinanceinstitutions are particularly vulnerable: usury laws and regulations regarding financialintermediation.

Usury LawsMany jurisdictions have usury laws that limit the interest rate that financial institutions cancharge on loans. These laws tend to put a ceiling on interest rates that is lower than MFIsneed to charge in order to cover their costs.

Microfinance institutions need to charge interest rates high enough that low-incomecommunities can have access to financial services for the long term. Donor subsidies arenot sufficient to meet the global demand for financial services and they are a fickle source onwhich MFIs cannot rely. The only long-term solution is to generate enough income from

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your loan portfolio to cover administrative and financial costs. To do so, most MFIs chargereal annual effective interest rates that range from 20 to 60 percent. This wide range dependson many factors including the local labor market, loan sizes, and the institution’s size. Theserates are typically higher than most usury ceilings.

Financial IntermediationRegulators are primarily responsible for two things: 1) to preserve the integrity of thefinancial system and 2) to protect the savings of depositors. In general, the microfinanceindustry believes that as long as MFIs do not mobilize voluntary savings from the public,they should not be regulated as a banking institution. If the MFI goes bankrupt, it will onlylose the money of donors and investors, neither of whom regulators are obligated to protect.

A gray area emerges when an MFI requires compulsory savings as a part of its lendingmethodology. In this case, as long as it is not intermediating or on-lending those funds, thenthe MFI generally should not fall under the authority of bank regulators. But as amicrofinance institution matures, clients maydemand access to voluntary savings products. Inaddition, the institution may encounter fundingconstraints, in which case it might use the depositsthat it has mobilized as loan capital. If theseconditions occur and the MFI goes bankrupt, thenit could lose the savings of depositors. If it is alarge institution, its poor health could evenundermine the integrity of the financial system.Regulators should be concerned when MFIs startentering the territory of financial intermediation.

Many common banking regulations for financialintermediaries are not applicable to microfinanceinstitutions. For example, security anddocumentation requirements, portfolio examinationmethods, and performance standards arecompletely different for commercial banks thanwould be appropriate for microfinance institutions.MFIs that rush to become regulated so that theycan offer savings services may find banking regulations force them to adopt new policiesthat are prohibitive to serving their intended market.

ê Are there usury laws in the country preventing the MFI from charging cost recovery rates?

ê Is the MFI intermediating savings?

ê Is it legally permitted to do so?

ê Is the regulatory environment appropriate / accommodating?

EDPYME in Peru

In an effort to build the capacity ofmicrofinance NGOs, and to make themeligible to borrow from the government’sline of credit, the Peruvian bankingsuperintendency created a new category offinancial institution called an EDPYME.

For a small minimum capital requirement, itis possible to create a regulated financialinstitution that only provides credit. Oncean EDPYME demonstrates that it is wellmanaged, it can request permission to offerother services like passbook savings.

CARE’s partner, EDYFICAR, became oneof the first EDPYME in Peru.


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5.1.2 Other Regulatory Risks

Directed CreditDirected credit risk is when local policy makers will legislate or otherwise pressure an MFI tolend to certain individuals for political reasons. Successful microfinance institutions, whichtend to have strong community support and significant outreach, may be attractive vehiclesfor policy makers who see the potential to use MFIs for political purposes, sometimes underthe guise of “regulations.” Few things could undermine a microfinance institution fasterthan political pressure to provide credit or other services to particular communities orindividuals. It is imperative that MFIs retain their independence regarding where theyoperate and to whom they lend. MFIs are especially vulnerable during an election periodwhen incumbent politicians may try to use them inappropriately.

Contract EnforcementContract enforcement risk is the possibility that the MFI will not have the legal means ofenforcing its loan contracts in the local legal system. Formicrofinance institutions to be successful lenders, they mustenforce their credit contracts. When borrowers default on theirloans, the MFI goes through several stages of delinquencymanagement to recover its money whereby retribution typicallyescalates. The MFI hopes that it can rely on the legal system tosupport its efforts. If the MFI cannot legally enforce contractsby seizing collateral or taking defaulters to court, then it is deprived of important options inits delinquency management strategy.

Labor LawsLabor law risk is the concern that labor regulations will prevent MFIs from containing salarycosts or dismissing employees, even if it is warranted for cost reasons or for internal controlpurposes. Salaries represent the single largest budget item for most MFIs. The sustainabilityof the organization often depends on its ability to hire inexpensive staff; creditmethodologies are often designed to be implemented by a moderately skilled staff. Inenvironments where labor regulations inappropriately inflate salary costs, MFIs will havesignificant difficulty achieving self-sufficiency.

MFIs also need to be able to take appropriate actions with staff members who do notperform appropriately, particularly when fraud is involved. If the institution cannot dismissstaff members who have committed fraud and is unable to seek appropriate retribution, theMFI will not be able to operate optimally.

ê Is there political pressure to lend to certain target groups?

ê Are contracts easily enforceable?

ê Do labor laws constrain the organization?

ê If unionized, are the union stewards familiar with the MFI’s projection model (i.e., have they been shown theimplications of different salary increases on the institution’s sustainability)?

An MFI needs toenforce its loancontracts to havesufficient “teeth” tomaintain portfolioquality

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5.1.3 Regulatory Monitoring and ResponseRegulatory risks are considered external risks because microfinance institutions, particularlysmall to moderately sized ones, tend to have little influence over the regulatory environment.Individual MFIs tend to only exert authority in the policy arena if they have very influentialboard members who are big players in the local political scene.

However, an industry association or network of MFIs can often have an active and eveninfluential voice in shaping public policy. It is also effective to work through a local bodythat can represent the national microfinance industry. A downside of this active industryrole is the potential to be distracted from the MFI’s operational activities. Therefore acareful assessment of the potential regulatory risks will determine the appropriateinvolvement at the industry level.

To remain in good standing with regulators, it is advisable to conduct a regular complianceaudit to review conformity with external requirements, policies and procedures, andfinancial or otherwise relevant legislation. Compliance audits can be done by internal orexternal auditors, and require a lower audit skill level than operational audit, as complianceauditing requires less need for exercising professional judgment.

5.2 Competition RisksIn some environments, microfinance is becoming increasingly competitive, with new players,such as banks and consumer credit companies, entering the market. The three main sourcesof competition risk are:

ê Lack of knowledge of whether a competitor is providing a similar service to a similarmarket

ê Lack of familiarity with a competitor’s services to adequately position, price and sellone’s own services

ê Lack of sufficient information about clients’ current and past credit performance withother institutions

Without this information, an MFI can experience client desertion and a loss of market share,which can hamper an MFI’s ability to expand.

5.2.1 Monitoring Competition RisksIf an organization has high retention rates, then it is probably protecting itself fromcompetition risks today. But the market can change very quickly if a new competitor arriveson the scene with a more attractive product. To monitor your organization’s vulnerability tocompetition risks, it is imperative that you keep a close watch on other service providers andprospective providers, including banks, consumer credit companies, and suppliers.To monitor for competition risk, it is necessary for an MFI to collect information about itscompetitors. It should ensure that it has current and accurate information about theproducts and services of other institutions in the market. A mystery shopper approach can


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be used to collect product and service details from other MFIs. Some of the other methodsof measuring customer satisfaction can also be used to learn about the service provided bythe competition, such as exit interviews and focus groups.

One of the easiest ways of monitoring the competition is through questions on loanapplications. Some MFIs routinely ask with each loan if the applicant has ever borrowedfrom formal or informal sources, including friends, neighbors, moneylenders, suppliers,banks and other MFIs. If applicants answer affirmatively, they are asked follow up questionsto understand the nature of the other products and the clients’ analysis of the strengths andweaknesses of each.

5.2.2 Competition Risk ResponsesWith feedback from clients and other sources about competitors in hand, the MFI shoulduse that information to reduce its vulnerability to competition risks. The type ofinformation it receives will determine the appropriate response, which might include:

ð Refining its credit products: Longer and/or shorter terms, different loan sizes, lowerinterest rates or fee arrangements, various forms of security

ð Incentives for retention: Provide repeat clients with preferred services, such as fast loanapproval, lower interest rates

ð Offering new products: Introduce new credit and savings products that are designed tomeet a wider range of household needs besides just self-employment

ð Improving access: Change office locations, add satellite offices, extend hours ofoperation

ð Improving service: Train staff on customer oriented service delivery techniques

Another response to market risks is a credit bureau, a mechanism for sharing informationbetween MFIs regarding credit histories and currentlevel of indebtedness. This industry database could be afunction for the local network. If this database exists,then it would also be possible to produce anotherindicator to monitor market risks: market share.

ê Do you track client retention rates?

ê How do you collect information about your competition?

ê Do you routinely collect customer satisfaction information and use that to modify your products and services?

ê Do you have access to an industry-wide bad debtors list or credit bureau?

5.3 Demographic RisksProviding financial services to low-income persons in disadvantaged communities is noteasy. If it were easy, then banks would have done it long ago. It is risky to serve this market

Market Share:Number of Outstanding Loans (or

Clients) of the MFI/

Total Number of OutstandingLoans (or Clients) in the Industry

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because the market itself is risky. The products and services need to be designed tominimize the vulnerability of both the client and the institution.

Best practices in microfinance methodologies tend to be adopted in one region based onwhat was successful in another. When conducting a risk assessment, consider whether theorganization is sufficiently addressing local characteristics that might generate specialchallenges. Several factors should be considered:

ê Education level of clients: If clients lack literacy and numeric skills, they may begreater credit risks and are probably more vulnerable to fraud. Special systems andcontrols should be used in serving illiterate borrowers.

ê Entrepreneurial attitude and aptitude: Some societies have a strong tradition ofinformal markets, such as in West Africa; others, like post-communist countries, do nothave this expertise. Client training may form a larger component of the service delivery inregions that have less entrepreneurial expertise.

ê Social cohesion: Character assessments and peer pressure are important aspects ofmost microlending methodologies, yet the ability to exert pressure or collect goodcharacter information varies significantly from one region to the next, even in the samecountry. In cohesive communities, where everyone knows each other’s business, it iseasier to analyze an applicant’s character and to use the borrower’s standing in thecommunity to exert repayment pressure, even with an individual lending methodology. Itis much more challenging to serve transient populations in communities where people donot know or trust each other very well, and where there is a higher likelihood that aborrower will disappear.

ê Societal attitudes towards fraud: The level of tolerance in the political and businessculture for corruption and lack of transparency must be factored in when determiningappropriate controls for reducing risk.

ê Prevalence of crime: In low-income communities, particularly in urban areas, theprevalence of crime can create a significant challenge for MFIs. The security and controlsrequired to reduce this vulnerability can be quite expensive.

ê Past experiences with NGOs and credit providers: Different countries have differentattitudes and expectations regarding non-governmental organizations. If the MFI isperceived as an extension of an international aid agency, this might create the perceptionthat loans are “gift money,” and appropriate training is needed to dissuade clients of thisnotion. This notion would be reinforced if the market had previous experiences withcredit facilities that were not operated on a commercial basis.

ê Occurrences of illness and death: In some regions, a major cause of credit risk isassociated with the poor health of clients or their family members. This is especially truein HIV/AIDs prevalent countries. To address this issue, some organizations allowrepayment “slides,” in effect rescheduling loans due to illness if the client has a note froma health care professional. Other organizations are entering partnerships with insurancecompanies to either provide clients with health care coverage, or to pay for outstandingbalances in cases of illness and death, or both.


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The demographic risks can also extend to an organization’s employees. One of theimplications of working in an area with minimal levels of education is that recruitment andtraining of MFI staff can be particularly challenging. This has an impact on both theoperating costs (staff may be expensive in relation to their productivity) and also on thedesign of management, information and control systems. This situation creates anotherbalancing act: on the one hand, the MFI wants to be more responsive to its clients byoffering more customized products and services; on the other hand, if the organizationoffers a diverse set of services, the more difficult it will be for field staff to implement andthe greater the exposure to fraud and credit risk.

5.4 Physical Environment RisksThe physical environment of low-income communities exacerbates the risks involved indelivering financial services. The local conditions raise two different sets of issues that needto be considered in a risk assessment:

ê Infrastructure challenges: The infrastructure in which the MFI operates significantlyimpacts the organization’s ability to maintain efficient operations with tight controls. Keyfactors include the availability of electricity, telephone, transportation systems and bankingfacilities. Perhaps the best control to overcome these challenges is to operate in a limitednumber of areas that are near each other. It is extremely difficult to manage risk if youoperate in numerous distant regions with poor communication.

ê Natural disaster risks: Some areas are prone to natural calamities (floods, cyclones, ordrought) that affect households, enterprises, income streams and microfinance servicedelivery. Countries that experience repeated natural disasters will require specific riskmanagement strategies, such as requiring business diversification, accessing disasterinsurance, creating disaster relief funds, encouraging savings, and developing appropriaterescheduling policies.

It is interesting to note that the mitigation strategy for infrastructure challenges could beexactly the opposite of the strategy for natural disaster risks. While poor infrastructure mayencourage an MFI to cluster operations in a small geographic area, this increases thevulnerability to localized natural disasters.

Besides the affect that disasters might have on an MFI’s clients, it is also important toprotect against the affects that they might have on the institution itself. An MFI shouldconsider its own insurance needs, for flood or fire, as well as appropriate protection of itsinformation system and records.

5.5 Macroeconomic RisksMicrofinance institutions are especially vulnerable to changes in the macroeconomicenvironment such as devaluation and inflation. This risk has two facets: 1) how theseconditions affect the MFI directly and 2) how they affect the MFI’s clients, their business

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operations, and their ability to repay their loans. The poor tend to be more vulnerable toeconomic fluctuations than other segments of the population. Microfinance institutionsprotect themselves from these challenges by keeping loan terms short, by pegging interestrates to a relevant index, and/or by lending in foreign currency (and hence passing on therisk to the clients).


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Recommended ReadingsRegulation and SupervisionBerenbach, Shari and Craig Churchill (1997). Regulation and Supervision of Microfinance Institutions: Experience

from Latin America, Asia and Africa. Occasional Paper No. 1. Washington DC: MicroFinance Network.Email: [email protected]. Available from PACT Publications. Email: [email protected].

Rock, Rachel, Maria Otero and Sonia Saltzman (1997). From Margin to Mainstream: The Regulation andSupervision of Microfinance. Monograph No. 11. Somerville, MA: ACCION International. Website:www.accion.org.

Rosenberg, Richard and Robert Peck Christen (2000). The Rush to Regulate: Legal Frameworks for Microfinance.Occasional Paper No. 4. Washington DC: CGAP. Website: www.cgap.org.

Van Gruening, Hennie, Joselito Gallardo and Bikki Randhawa (1998). A Framework for RegulatingMicrofinance Institutions. Working Paper 206. Washington DC: The World Bank. Email:[email protected].

CompetitionChurchill, Craig F. ed. (1998). Moving Microfinance Forward: Ownership, Competition and Control of Microfinance

Institutions. Washington DC: MicroFinance Network. Email: [email protected]. Available fromPACT Publications.

Rhyne, Elizabeth and Robert Peck Christen (1999). Microfinance Enters the Marketplace. Monograph.Washington DC: USAID. Website: www.mip.org.

Challenging EnvironmentsBrown, Warren and Geetha Nagarajan (2000). Disaster Loan Funds for Microfinance Institutions: A Look at

Emerging Experience. USAID’s Microenterprise Best Practices Project. Bethesda, MD: DevelopmentAlternatives, Inc. Website: www.mip.org.

Doyle, Karen (1998). Microfinance in the Wake of Conflict: Challenges and Opportunities. USAID’sMicroenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website:www.mip.org.

Nagarajan, Geetha (1998). Microfinance in the Wake of Natural Disasters: Challenges and Opportunities. USAID’sMicroenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website:www.mip.org.

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Chapter 6: Management InformationSystems

o properly control risks, an MFI needs a strong information system. As discussed inthe introduction, risk management is a dynamic three-step cycle in which MFIs identifytheir risks, design and implement controls to mitigate these risks, and establish systemsto monitor them. These monitoring systems are then used to help identify additional

risks, setting in motion a dynamic process.

Management information systems (MIS) lie at the heart of this dynamic, serving as theprimary link between these three elements. Whether computerized or manual, an effectiveMIS provides critical information for risk identification, acts as a mechanism forsystematizing business processes and controls, and offers a tool for monitoringorganizational performance and pinpointing future risk areas. As such, MIS is thefoundation for effective risk management.

This chapter provides guidance on the following three key issues relating to managementinformation systems:

1. System Components: This section introduces the primary components of an MIS,the accounting and portfolio management systems, as well as related subjects such asthe chart of accounts, cash vs. accrual accounting, fund accounting, and criteria forevaluating loan-tracking software.

2. Financial Statement Presentation: The second section focuses on financialstatements, providing advice on vouchers, frequency of financial statementpreparation, and the key adjustments needed to accurately present the financialposition of an MFI.

3. Report Preparation: The chapter concludes by outlining important considerationsin report preparation, including the key issues in report design and recommendationsfor a reporting framework.

6.1 System Components: What Does an MIS Include?A management information system is the processes and actions involved in capturing rawdata, processing the data into usable information, and disseminating the information tousers.11 As such, MIS includes all the systems used for generating the information thatguides management in its decisions and actions. Good information is essential for an MFIto perform efficiently and effectively. MIS must be accurate and easy to use. By 11 Waterfield and Ramsing (1998) p. 3.

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transforming data, or unprocessed facts, into information through a systematic process,management information systems provide tools for identifying, controlling and monitoringkey risks within an organization. The better the information, the better the MFI can manageits risks.

A microfinance institution typically has two main systems: the accounting system, centeredon the chart of accounts and general ledger, and the portfolio tracking system, coveringthe performance of accounts for each financial product offered by the institution. Thesetwo systems may or may not be linked depending on the human and financial resourcesavailable to maintain them. In addition, an MFI may also have a client database that permitsdetailed impact analysis, as well as a separate human resource module for payroll. Theselatter two systems are not dealt with in this handbook.

Figure 20: The Parts of an MIS

Adapted from Waterfield and Ramsing (1998).

6.1.1 Accounting SystemsThe foundation of any financial management system is accounting. Transactions andaccounting ledgers are part of a larger, complex system for controlling funds and reportingon their sources and uses. Although standard accounting and auditing procedures vary fromcountry to country, there are basic principles and concepts that determine the underlyinglogic of accounting information systems. These include: the structure of the chart ofaccounts, cash vs. accrual accounting, fund accounting, and general design considerations.

InputAccounting data

InputLoan and savings

data

Accounting system Portfolio system

Policies andprocedures

Methodology

Chart ofaccounts

FinancialStatements

Managementreports

Choice ofindicators

Data

Information

Choice ofindicators

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Chart of AccountsTo track the flow of funds in an organization, accountants need a chart (or list) of accounts,which is a structure for posting transactions to different accounts and ledgers. The core ofan institution’s accounting system is its general ledger. The skeleton of the general ledger is, inturn, the chart of accounts. The design of the chart of accounts reflects a number offundamental decisions by the institution. The structure and level of detail determine the typeof information that management can access and analyze. If the chart of accounts capturesinformation at too general a level, it will not provide information precise enough to generatesophisticated indicators needed to adequately track performance. On the other hand,attempting to track too much detail generally means creating too many accounts, resulting ininformation that is so desegregated that management cannot identify and interpret thetrends.

MFIs should design their chart of accounts to meet the needs of management, providinginformation with a degree of detail that is meaningful for managers at all levels. While thedegree of detail will differ among MFIs, CARE’s Small Economic Activity Development(SEAD) Unit recommends the account structure presented in Figure 21 as a starting point.

Figure 21: Chart of Accounts Structure

ABCC-DD-EE-FF, whereABCC = AccountA = Type of account (asset, liability) DD = ProgramB = Group (cash, portfolio receivable) EE = BranchCC = Individual accounts FF = Funder

Waterfield and Ramsing (1998).

The first four digits of each account designate the account number: ABCC.

ê A: The first digit normally refers to the type of account (with 1 indicating assets, 2liabilities, 3 equity, 4 income and 5 expense).

ê B: The second digit loosely identifies a group with common characteristics, such ascash, interest and fees receivable, or fixed assets. General ledger accounts typicallyprogress from assets and liabilities that are most liquid (such as cash-account 1100) tothose that are least liquid (such as fixed assets-account 1700).

ê CC: The next two digits indicate specific accounts in the group, such as petty cash orchecking account, two accounts in the cash group. When possible, related accountsshould have related numbers: for example, if the interest income on rescheduled loans isaccount 4040, the loan portfolio for rescheduled loans could be 1240.

Additional digits can also be added to track by branch office, by program, and by funder,using extended account numbers, such as: DD-EE-FF (see section on Fund Accountingbelow).


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While each MFI’s chart of accounts should reflect its own operations, structure, andinformation needs, the CARE SEAD Unit recommends the sample chart of accountspresented in Annex 1 as a guide for CARE affiliates. In some cases, however, regulatorybodies will require institutions under their jurisdiction to use a specific chart of accounts.

Cash vs. Accrual AccountingAccounting systems can be cash-based (accounting for income and expenses when cashchanges hands), accrual-based (accounting for income and expenses when they are incurred),or modified cash systems (in which most accounting is cash-based, but selected accounts areaccrual-based).

The CARE SEAD Unit encourages all CARE affiliated MFIs to accrue important expenses,such as personnel benefits and interest payable on loans that may require only annual interestpayments. (See section on Accounting Adjustments for more discussion.)

Fund AccountingDonors often require detailed reporting by microfinance institutions on the use of funds theyprovide. For this reason, CARE encouragesits affiliated MFIs to use fund accounting intheir operations. Creating a chart ofaccounts with masking techniques thatinclude or exclude accounts designated bycertain digits in the account number providesextra power in recording and reportinginformation and greatly eases reporting ondonor funds. This setup permits synthesis ofthe accounts from the perspective offinancial management, while maintaining theability to report to each funding source theuse of its particular funds.

For multi-purpose organizations, such asprograms that provide financial and business development services, the chart of accountsmust allow for the proper segregation of the variousactivities. These organizations should clearly separateincome and expenses from financial services (savings andcredit) from non-financial services.

General Software Design ConsiderationIn selecting and evaluating accounting software packages, MFIs should ensure the following:

ê A system that requires a single input of data to generate various financial reports;

ê Software that incorporates rigorous accounting standards (for example, does not acceptentries that do not balance; supports accrual accounting);

Separate income andexpenses formicrofinance activitiesfrom non-microfinance activities

Separate Systems: CARE and MFIs

As a non-profit, CARE uses a non-profit“flow-of-funds” accounting system. Thissystem is not appropriate for MFIs because itonly accounts for the sources and uses offunds. A business operation needs a balancesheet and income statements. For CARE todevelop self-sustaining Savings & Creditprograms, it must root the systems in thebusiness world. This means that microfinanceoperations must have a separate accountingsystem that complies with basic businessprinciples.

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ê A flexible chart of accounts structure that allows the organization to track income andexpenses by program, branch, funding source, etc.;

ê A flexible report writer that allows the organization to generate reports by program,branch, funding source, etc.;

ê The capacity to maintain and report on historical and budgetary, as well as current,financial information – a “user friendly” design that includes clear menu lay-outs, gooddocumentation, and the capacity to support networked operations, if relevant;

ê Reasonably priced local support, either by phone or in person;

ê Relatively modest hard-disk utilization requirements.

6.1.2 Portfolio Management SystemsThe second component of an MIS is the portfolio management system, used for trackingcredit and, if applicable, savings products. While well-established accounting practices arereflected in general ledger software, the variety of lending methodologies, repaymentschedules, pricing policies, and delivery mechanisms used among MFIs has resulted in anumber of portfolio management systems, with varying approaches to the way informationis tracked, the kinds of reports that are generated, and the kinds of features that are included.

Because there are no universal standards for loan tracking systems, and because theinformation tracked and reported is relatively complex, this section will not attempt toidentify specific requirements for portfolio management systems. Instead, Figure 22provides MFIs with a framework for assessing portfolio management software, which willallow them to compare a wide range of systems to their specific needs.


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Figure 22: Criteria for Evaluating Loan Tracking Software

Ease of use Hardware/software issuesDocumentation Programming languageTutorials Data storage formatError handling Network supportHelp screens Operating systemInterface Access speed

Features SupportLanguages Customization availableSetup options TrainingMethodology issues Cost issuesLoan product definition Multiple loan products Reports Principal repayment methods Existing reports Monitoring methods Ease of creating new reports Fund accounting of portfolio Print preview Data disaggregation Printers supported Interest calculations Width of reports Fee calculations Savings SecurityBranch office management and consolidation Passwords and levels of administrationLinkages between accounting and portfolio Data entry and modification

Backup proceduresAudit trails

Source: Waterfield and Sheldon (1997) in Ledgerwood (1999).

6.1.3 Linking Accounting and Portfolio Systems12

Many people expect computerized portfolio and accounting systems to be seamlessly linkedso that all transactions entered in the portfolio system are automatically reflected in theaccounting system. While such a link is ideal, it is expensive and requires maintenance.Small institutions are probably better off not linking client accounts and the general ledgerby computer. A non-linked system provides another level of internal control, offers moreuser flexibility and less computer dependence, and is less expensive because it does notdemand additional programming or software support.

For programs that are not linked, daily reconciliation of the portfolio system with theaccounting system is critical. Transaction reports from thetwo systems should be printed and reconciled on a daily basis,to permit the timely resolution of any irregularities. Even forinstitutions that have linked systems, periodic (at leastmonthly) reconciliation is important to ensure that properinformation is being recorded in both.

12 This section is drawn from Waterfield and Ramsing (1998).

For non-linkedsystems, dailyreconciliation iscritical

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6.2 Financial Statement PresentationTo analyze the financial performance of an MFI properly, independent financial statements(i.e., income statements and balance sheets—see Annex 3 for sample format) should beprepared on a consistent basis and in accordance withgenerally accepted accounting principles. While a number ofCARE’s microfinance projects have relied on CARE’s fundaccounting to generate financial information for them,CARE’s SEAD Unit strongly encourages all microfinanceprograms, regardless of where they are in their progressionfrom project to independent financial institution, to produceand analyze independent financial statements on a regularbasis. Due to the unique structure of many MFIs, a numberof adjustments may be necessary to accurately reflect the institution’s financial position.

This section highlights key issues associated with financial statement preparation, includingvoucher preparation, frequency of financial statement preparation, accounting adjustments,and adjustments for inflation and subsidies.

6.2.1 Voucher Preparation13

Each time a transaction occurs, documentation must be maintained through the preparationof vouchers to ensure a proper paper trail. While each MFI has its own specific proceduresfor voucher preparation, in general, vouchers should be supported by invoices and checkstubs or cash requests and should include the following:

ê Number and nature of voucherê Name of departmentê Date preparedê Account name and number and amount of moneyê Source and description of transactionê Authorized signatureê Attachment of original bills and cash requests

6.2.2 Frequency of Financial StatementsEffective financial management requires frequent review of financial performance. TheCARE SEAD Unit encourages MFIs to produce profit andloss statements for the whole institution on a monthly basis.It may also be useful to generate a partial income statementfor each cost center, such as the branches, even though someprogram costs, such as head office overhead, are notincorporated at this level. In addition, CARE encouragesMFIs to produce a balance sheet at least annually, depending on the size of their operations.

13 This section is drawn from Ledgerwood and Moloney (1996).

Independent financialstatements should beprepared on aconsistent basis,regardless of the MFI’sstage of development

MFIs should producemonthly profit and lossstatements


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6.2.3 Financial Statement AdjustmentsTo analyze the financial performance of your MFI, your financial statements must beconsistent with generally accepted accounting principles. To do this, it may be necessary toadjust the balance sheet and income statement to reflect the institution’s actual financialperformance. There are two types of adjustments required: accounting adjustments, whichare necessary to adhere to proper accounting standards; and inflation and subsidyadjustments, which restate financial results to reflect more accurately the full financialposition of the MFI.

Accounting Adjustments Inflation and Subsidy AdjustmentsLoan losses InflationDepreciation of fixed assets Operating cost subsidiesAccrued interest In-kind subsidiesAccrued expense Concessionary funding

Donated equity

Accounting Adjustments

Accounting for Loan LossesMFIs need to maintain very high portfolio quality to ensure long-term financial viability.Loan delinquency increases costs both through direct losses (assuming the loan is notrepaid, and the loss is passed directly through the income statement as a bad debt), higheradministrative costs (as staff divert time and resources to chasing clients), and reducednet interest margins (by lowering the institution’s interest income and increasing their costof funds).

To reflect the financial performance of an MFI accurately, it is necessary to determine howmuch of the portfolio is generating revenue and how much is likely to be unrecoverable.This is done by examining the quality of the loan portfolio, creating a loan loss reserve, andperiodically writing off loans.

A loan loss reserve (LLR) is the balance sheet reserve account against which bad assets, orportions thereof, are written-off. In most countries, the LLR account appears as a negativeor contra asset on the balance sheet and is netted against loans for financial reportingpurposes. (Some MFIs maintain the account in the liabilities section of the balance sheetwithout netting, a standard that tends to overstate total assets.) The reserve is normallycreated and maintained through a charge to provision expense on the profit and loss (P&L)statement. The reserve for loan losses is synonymous with the allowance for possible loanlosses and the reserve for bad debts.

An MFI’s loan portfolio should be adjusted on a monthly basis to reflect estimates ofpossible loan losses. If an MFI does not maintain a loan loss reserve account, its balancesheet will be overstated, and financial statements will be significantly impacted by any write-off. Conversely, when an LLR account is maintained, the accountant adjusts the balancesheet by subtracting the real loss both from the loan loss reserve and from the loan portfolio

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account. As the LLR account is a contra asset account, this double entry has no net effect onthe total asset figure. In addition, if the loan has been appropriately reserved against, thewrite-off will have no impact on net income.

Provisioning Policies: The most accurate measure of portfolio risk is derived from an assetclassification process, which provides a basis for determining an adequate level of loan lossreserves. Because each MFI has its own history of defaults, classification categories will vary.Normally, financial institutions estimate the amount of expected bad debt they expense tothe loan loss reserve based on the number of days the loan is past due and the institution’sprior experience. Categories are established and a level of required reserves, expressed as apercentage of the total unpaid outstanding balance of a classified loan, is assigned to eachclassification category. The following provisioning schedule—adapted from CGAP’s policyframework—provides an example:

Days Late Provisioned Amount1 – 30 days 10% of unpaid balance31 – 90 days 25% of unpaid balance

91 – 180 days 50% of unpaid balance> 180 days 100% of unpaid balance

Loan terms also influence an institution’s provisioning policy. A product with dailyrepayments will have a different provisioning schedule from a loan with monthlyrepayments. In determining an adequate reserve, MFIs should also consider such factors asreasonableness of credit policies and procedures, prior loss experience, loan growth, thequality and depth of management in the lending area, loan collection and recovery practice,and general trends in the economy.

As an alternative to the classification procedure, an MFI could expense 0.25 percent of thecurrent portfolio at the end of each month and credit this to the loan loss reserve.Institutions that do not have any provision for loan losses should open the reserve with aone-time deduction of five percent of the current portfolio to establish the reserve.

Adjustment for Substandard or Doubtful Loans: The percentage of a loan that must be covered bythe reserve is typically a function of the number of days the loan is past due. A loan with aninstallment over 15 days past due, for example, should have 10 percent of its value “onreserve” in the LLR account, according to the provisioning schedule detailed above. If theamount in the LLR account is insufficient to cover this value, the account needs to betopped up by expensing an amount necessary to achieve this value. This addition to theLLR is charged as provision expense on the P&L and results in reducing the net loan figure.

Adjustments for Loan Losses: Once a loan is classified as a loss, it should be written off theMFI’s balance sheet. In other words, the total value of the loan should be reduced from theloan amount and the amount of the reserve. Such assets are considered non-bankable, butnot necessarily non-recoverable; they may still warrant strong collection efforts.


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Normally, the write-off policy is determined by local accounting custom and requires theinstitution to fulfill legal obligations regarding formal attempts to collect overdue loans. ForMFIs involved in financial intermediation (and thus under jurisdiction of the banksuperintendent), they will need to enter into a dialogue with regulators about provisioningrequirements. The application of traditional provisioning criteria may result in insufficientprovisioning as microfinance loans are typically short term, and can be become non-recoverable within a short period of time. Traditional provisioning may not require the MFIto write off delinquent loans until they are over a year past due. On the other hand, thetraditional reserve requirements for unsecured loans may require the MFI to provision tooconservatively, so it is important to get regulators to recognize the value of peer pressure andother forms of non-traditional collateral.

Accounting for Depreciation of Fixed AssetsDepreciation is an annual expense that is determined by estimating the useful life of eachasset. When a fixed asset, such as property and equipment, is purchased, there is a limitedtime that it will be useful. (Land theoretically does not lose value over time and therefore itis not depreciated.) Many countries set standards for depreciation for different classes ofassets. Depreciation expense is the accounting term used to allocate and charge the cost ofthis usefulness to the accounting periods that benefit from the use of the asset. Like theloan loss provision, depreciation is a non-cash expense and does not affect the cash flow ofthe MFI.

To make the adjustment, when a fixed asset is first purchased, it is recorded on the balancesheet at the current value or price. When a depreciation expense (debit) is recorded on theincome statement, it is offset by a negative asset (credit) on the balance sheet, calledaccumulated depreciation. This offsets the gross property and equipment, reducing the netfixed assets. Accumulated depreciation represents a decrease in the value to property andequipment that is used up during each accounting period.

There are two primary methods of recording depreciation: the straight-line method and thedeclining balance method. The straight-line method allocates an equal share of the asset’stotal depreciation to each accounting period. This is calculated by taking the cost of theasset and dividing it by the estimated number of accounting periods in the asset’s useful life.The declining balance method refers to depreciating a fixed percentage of the cost of theasset each year. The percentage value is calculated on the remaining un-depreciated cost atthe beginning of each year.

Write-Offs

An MFI should not write off loans unless they were carefully determined as losses. There isoften a tendency to write off loans as a means of improving the status of its loan portfolio.

While this may reduce the value of the loans in the doubtful category, it shrinks the balancesheet and does not present an accurate picture of the health of the loan portfolio. The

decision on when to write off a loan should be based on a sound policy established andagreed to by the board members of an MFI.

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For example, assume an MFI has purchased a $2,000 computer, which according to thecountry’s depreciation standards, is assumed to have a useful life of three years and has anestimated value of $500 at the end of three years. Under the straight-line method, itsdepreciation per year is calculated as follows:

Cost – salvage value 2,000 – 500 = $500 depreciation per yearService life in years 3

Under the declining balance method, if the computer were depreciated on a decliningbalance at 33.3 percent a year, the first year’s depreciation would be $666.66 ($2,000 x33.3%). In the second year, the depreciation amount would be applied to the remainingamount, $1333.34. One third of $1333.34 is $444.40, which would be the depreciationexpense for the 2nd year. This continues until the asset is either fully depreciated or sold.

Accounting for Accrued Interest Revenue14

Revenue that has been earned but not yet received in cash is called accrued revenue. For anMFI, accrued interest income represents the most common example (other examples ofincome receivables include consulting earnings that are paid at the completion of theassignment or speaking fees that are paid months after the speaking engagement).Recording interest that has not yet been received is referred to as accruing interest revenue.Assuming that interest will be received at a later date, accrued interest is recorded as revenueand as an asset under accrued interest or interest receivable.

While an MFI’s treatment of accrued interest revenue will vary, the CARE SEAD Unitencourages its affiliates to adhere to the following guidelines:

ð If an MFI does not accrue interest revenue at all and makes loans that have relativelyinfrequent interest payments (such as quarterly or bi-annually), it should accrueinterest revenue at the time financial statements are produced.

ð MFIs that have weekly or biweekly payments need not accrue interest revenue, as itis more conservative not to and may not be material enough to consider.

ð If an MFI has accrued interest on loans that have little chance of being repaid, theamount of accrued interest on delinquent loans should bededucted on the balance sheet by crediting the asset where itwas recorded initially (outstanding loan portfolio or interestreceivable) and reversed on the income statement bydecreasing interest revenue (debit). The best practice for anMFI is not to accrue interest at all on delinquent loans.

ð Some sophisticated accounting software can automatically accrue interest; if such asystem is not available, MFIs should generally avoid accruing interest. In a stable,limited growth institution, where payments are made frequently, the differencesbetween cash and accrual accounting are not significant.

14 This section drawn from Ledgerwood (1999), p. 193.

An MFI should notaccrue interest ondelinquent loans


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Interest revenue is accrued by determining how much interest revenue has been earned butnot yet become due (the number of days since the last interest payment times the dailyinterest rate times the balance outstanding, assuming declining balance calculation) andrecording this amount as revenue (credit) and debiting the asset account accrued interest.

Accounting for Accrued Interest ExpenseLikewise, financial statements may need to be adjusted to reflect expenses that have beenaccrued but not yet paid. Examples of accrued expenses include financing costs onborrowed funds, annual audit fees, and salaries. CARE’s SEAD Unit recommends thatMFIs accrue significant expenses, assuming their accounting system has the capacity.Financing costs can represent such an expense. At year-end, MFIs may owe interest onborrowed funds for the period from the last interest payment to the day the period ends. Ifthe interest expense is not accrued, the MFI’s financing costs at the end of the year will beunderstated, its profitability overstated, and its liabilities understated. To accrue interestexpense, the amount of interest owed as of the date the balance sheet is debited on theincome statement as a financing cost and credited as a liability on the balance sheet in theaccrued interest expense account.

Adjusting for Inflation and SubsidiesAdjustments for both subsidies and inflation should be made to determine the true financialviability of the MFI. While these adjustments may not be required by official accountingpolicies, the CARE SEAD Unit encourages MFIs to perform these adjustments because theycreate a clear picture of the MFI’s ability to maintain the real value of its capital. Theseadjustments also facilitate a benchmarking comparison with other MFIs that have madesimilar adjustments on their financial statements. There are many ways of approximating theeffects of inflation on MFI equity and the effect subsidies have on overall financialperformance. The method suggested here reflects a simplified version of inflation-basedaccounting used by The MicroBanking Bulletin. (See Annex 2 for the adjustment worksheet.)

InflationEven though inflation is not usually reflected in audited financial statements, MFIs shouldtreat it as a real cost that can eat away at the value of their equity. Most of an MFI’s assetsare financial assets (loan portfolio being the largest), which are hit hardest when inflationerodes the value of money. (The value of fixed assets, on the other hand, such as equipmentand land, is assumed to increase with inflation.) As such, the value of an institution’sfinancial assets decreases with inflation, while its operating and financial costs increase.Over time an MFI’s costs increase and its financial assets, on which it earns revenue,decrease in real terms.

Adjustments for inflation result in changes to both the balance sheet and the incomestatement. These include the following:

ð Revaluation of Assets: Because fixed assets do not devalue with inflation, their nominalvalue is increased to the extent of annual inflation. The initial value, net of depreciation,is multiplied by the inflation rate. The result is income that could be received as a resultof inflation, if the assets were to be sold. This revaluation adjustment is registered as

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operating income on the income statement and as an increase in the value of the fixedasset account on the balance sheet.

ð Calculation of the cost of inflation on the real value of equity: The cost of inflation on equity isreflected by multiplying the prior period’s closing capital balance by the current year’sinflation rate. This result is then reflected as an operating expense on the incomestatement and as an increase in the value of the capital account, called accumulatedinflation, on the balance sheet.

SubsidiesThere are four types of subsidies typically received by MFIs:

• Funds donated to cover operational costs• Donations in-kind• Concessionary loans• Donated equity

MFIs should adjust their financial statements to address each of these subsidies. Unliketraditional financial intermediaries that fund their loans with voluntary savings and debt,many MFIs fund their loan portfolios with donated equity or concessionary loans. Manyalso receive in-kind subsidies, such as free office space and equipment. Mature MFIstypically replace the donated equity with market rate debt and find alternative office spaceand equipment. To prepare for these eventualities, an MFI should know the status of itsown financial viability, independent of any current subsidies. This will permit moremeaningful financial analysis and allow comparison with other institutions. Adjustments forsubsidies result in a change in the net income on the income statement equal to the value ofthe subsidies; they do not ultimately affect the balance sheet.

ð Donations for Operating Expenses: Donated funds for operations should be reported belowthe net income line, resulting in a reduction in operating revenue, and therefore, areduction in the amount transferred to the balance sheet as current year net surplus. Anoffsetting credit entry is made to the balance sheet in the accumulated capital – subsidiesaccount. (Note: Only the amount “spent” in the year is recorded on the incomestatement; any amount still to be used in subsequent years remains as a liability on thebalance sheet, referred to as deferred revenue.)

ð Donations In-kind: In-kind donations such as free office space, volunteer staff, oremployees paid by others should be recorded as an expense on the income statementand offset in the equity account on the balance sheet in the accumulated capital –subsidies line.

ð Concessionary Loans: Concessionary loans are loans received by the MFI with lower thanmarket rates of interest. To determine the appropriate market rate to apply, MFIsshould choose the form of funding that would most likely replace these subsidizedfunds. These would include:

• Local prime rate for commercial loans• 90-day certificate of deposit rate• Interbank lending rate• Average deposit rate at commercial banks• Inflation rate plus 3 to 5 percentage points per year


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(Note: The MicroBanking Bulletin uses the deposit rate for each country as a proxy for themarket rate.) Adjustments are made to both the balance sheet and the incomestatement. The amount of the subsidy is entered as an increase in equity (credit) underthe accumulated capital – subsidies account and as an increase in financial costs (debit).

ð Donated equity: Funds donated for loan capital are often treated as equity, in which casethey are adjusted for inflation. For MFIs that treat donations for loan capital as income,a subsidy adjustment is made using a market rate for commercial debt or equity (seeLedgerwood (1999) p. 197 for more information).

6.2.4 Constant CurrencySome MFIs may want to restate their financial statements in constant currency terms.Constant currency means that, on a year-by-year basis, financial statements continuallyreflect the current value of the local currency relative to inflation, permitting year-to-yearcomparisons of the real growth or decline in key accounts. To convert prior year data,amounts are either multiplied by one plus the annual rate of inflation for each year ordivided by the consumer price index for each year (see Christen (1997) pp. 76-80 for moredetails).

6.3 ReportingHaving reviewed the key components of an MIS and key issues related to financial statementpreparation, this chapter concludes with guidance on report preparation. Reports are theprimary means for getting information (the key output of the management informationsystem) to those who need it to perform their jobs and make decisions. This section willexamine two elements of reporting: report design and reporting frameworks.

6.3.1 Key Issues in Report Design15

The way a report is designed will determine how useful the information is to management.If information does not reach staff in a useful form, the MIS loses its value. This sectionidentifies key issues to think about when designing reports.

ð Content: Reports should generally focus on one issue and present all informationpertinent to that issue. (An exception would be a summary operational report.)

ð Categorization and Level of Detail: Present information at different levels of aggregation andprovide comparison information from different branches/units of the institution.

ð Frequency and timeliness: Reports need to be carefully designed around the timing ofinformation needs in the institution.

15 This section adapted from Waterfield and Ramsing (1998), pp. 25-32.

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ð Identifying information: All reports should have:standard headers and footers with importantidentifying information, unique titles, uniquereport numbers; and should display the dateand time of printing, and the timeframe theinformation covers.

ð Trend analysis: Important reports shouldinclude trend information.

ð Period covered: Reports should be generated tocover different time periods.

ð Usability: Ensure report users can easily readand use reports.

ð Graph analysis: Generate key graphs, such asportfolio in arrears and actual and projectedactivity, on a regular basis and display incommon areas.

6.3.2 Reporting FrameworkWhile the number and mix of reports will depend on an institution’s size, level of operations,and range of financial products, this section identifies a minimum reporting framework forall CARE affiliated MFIs. Each MFI has key stakeholders, each of whom will requireinformation on a timely basis and in a useful form. Each of these stakeholders and theircorresponding information requirements need to be identified up-front and continuallyreassessed. Figure 23 identifies six key shareholder categories and 38 reports from sevencategories: A) savings reports, B) loan activity reports, C) portfolio quality reports, D)income statement reports, E) balance sheet reports, F) cash flow reports, and G) summaryoperational reports. For sample reports, see Section 6.3.2 of the CGAP MIS Handbook(Waterfield and Ramsing (1998)).

Rules for Designing Good Reports• Use standard letter-size paper whenever

possible.• Present all information pertinent to an

issue in a single report rather than spreadover several reports.

• Present information at the appropriatelevel of aggregation for the user.

• Include identifying headers and footers inevery report and explanatory legends at theend.

• Study how reports are used andcontinually improve them.

Waterfield and Ramsing (1998), p. 29.


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Figure 23: Key Reports by Shareholder Category

Shareholder Category

Key Reports

Clien

ts

Field

Sta

ff

Bran

ch &

Regio

nal

Man

agers

Seni

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anag

ers

Boar

d

Don

ors a

ndSh

areh

olders

A. Savings ReportsA1. Savings Account Activity X XA2. Teller Savings Report XA3. Active Savings Accounts by Branch and Product XA4. Dormant Savings Accounts by Branch and Product XA5. Upcoming Maturing Time Deposits XA6. Savings Concentration Report X XB. Loan Activity ReportsB1. Loan Repayment Schedule X XB2. Loan Account Activity X XB3. Comprehensive Client Status X XB4. Group Membership Report XB5. Teller Loan Report XB6. Active Loans by Loan Officer XB7. Pending Clients by Loan Officer X XB8. Daily Payments Report XB9. Portfolio Concentration Report XC. Portfolio Quality ReportsC1. Detailed Aging of Portfolio at Risk by Branch XC2. Delinquent Loans by Loan Officer X XC3. Delinquent Loans by Branch and Product X XC4. Summary of Portfolio at Risk by Loan Officer X XC5. Summary of Portfolio at Risk by Branch and Product X XC6. Detailed Delinquent Loan History by Branch XC7. Loan Write-off and Recuperation Report X XC8. Aging of Loans and Calculation of Reserves X XC9. Staff Incentive Report X XD. Income Statement ReportsD1. Summary Income Statement XD2. Detailed Income Statement XD3. Income Statement by Branch and Region XD4. Income Statement by Program XD5. Summary Actual-to-Budget Income Statement XD6. Detailed Actual-to-Budget Income Statement X XD7. Adjusted Income Statement X XE. Balance Sheet ReportsE1. Summary Balance Sheet X XE2. Detailed Balance Sheet XE3. Program Format Balance Sheet XF. Cash Flow ReportsF1. Cash Flow Review X XF2. Projected Cash Flow XF3. Gap Report XG. Summary Operational ReportsG1. Summary Operations Report X X X

Drawn from Waterfield and Ramsing (1998), pp. 32-37

CHAPTER 6

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Recommended ReadingsCGAP (2001). Disclosure Guidelines for Financial Reporting by Microfinance Institutions. Washington

DC: Consultative Group to Assist the Poorest. Website: www.cgap.org.


Ledgerwood, Joanna (1999). Microfinance Handbook: An Institutional and Financial Perspective.Washington DC: The World Bank. Email: [email protected].

Ledgerwood, Joanna and Kerri Moloney (1996). Financial Management Training for Microfinance Organization:Accounting Study Guide. Toronto: Calmeadow. Website: www.calmeadow.org. Available from PACTPublications. Email: [email protected].

Mainhart, Andrew (1999). Management Information Systems for Microfinance: An Evaluation Framework. USAID’sMicroenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website:www.mip.org..

Waterfield, Charles and Nick Ramsing (1998). Handbook for Management Information Systems for MicrofinanceInstitutions, CGAP Technical Tool Series No. 1. Website: www.cgap.org.


104

ANNEXES

ANNEXES

105

Annex 1: Risk Management Checklist by Category of Risk

Risk Page Number QuestionExecutive Director

Institution 14 How does your organization demonstrate a commitment to constant improvement?Institution 14 How often does senior management go to the field to talk with clients and staff?

Institution 14 Does your organization currently have excess capacity, which suggests that you should bepoised for growth, or do you need to build capacity before continuing to expand?

Institution 14 Do you have a business plan to achieve self-sufficiency in a reasonable amount of time?Institution 14 Do you update the plan and use it regularly to make management decisions?

Institution 14 Do you monitor sustainability and profitability indicators, and if so are they trending in theright direction?

Institution 14 Do you have an independent governing body?

Institution 14Do you share with clients of other CARE programs? If so, is the strategy driven by thebusiness plan of the MFI and contribute to long-term sustainability or do projections show acontinuing need to cross-subsidize this population?

Institution 14 Is your organization building the capacity to operate independent of ongoing technicalassistance?

Institution 14 Does the MFI have the ability to identify its own needs and to contract appropriate technicalexpertise to address those needs on its own terms?

Operational 34 Does a reliable firm audit the MFI annually?FinancialManagement

63 Is the MFI audited annually by a reliable audit firm?

External 77 Are there usury laws in the country preventing the MFI from charging cost recovery rates?External 77 Is the MFI intermediating savings?External 77 Is it legally permitted to do so?External 77 Is the regulatory environment appropriate / accommodating?External 77 Is there political pressure to lend to certain target groups?External 77 Are contracts easily enforceable?External 77 Do labor laws constrain the organization?External 77 Do you track client retention rates?External 77 How do you collect information about your competition?

External 77 Does your organization routinely collect customer satisfaction information and use that tomodify your products and services?

External 77 Does it have access to an industry-wide bad debtors list or credit bureau?Executive Director and Board

Institution 14 Does your organization have a clear mission statement that balances the social andcommercial objectives and identifies the target market?

Institution 14 Does the composition of the board reflect the dual mission of microfinance?Institution 14 How does the board monitor the client composition?Institution 14 Does your organization have a plan to establish itself with an independent legal structure?Institution 14 Does your organization have the capacity and commitment to develop its own business plan?

Institution 14 Is CARE’s role in the governance and management structure best described as supportive ordominating, or some other adjective?

Institution 14 What percentage of your operating expenses is covered by money received from or throughCARE?

Institution 14 Does CARE have an exit strategy?

Institution 14 Are there clear indications of local ownership such that microfinance service operations willlikely continue in CARE’s absence?

Finance ManagerInstitution 14 Is the interest rate set high enough to cover the MFI’s full costs?


106

Risk Page Number Question

Institution 14 Are you moving toward accessing commercial sources of capital and reducing reliance onsubsidized funding sources?

Institution 14 Do you properly account for subsidies and in-kind donations?

Institution 14 Do you have an independent contract for financial resources from a donor or commerciallender?

Institution 14 Is your organization reducing its dependence on donor/CARE subsidies by as much asestimated in the business plan? If not, why not?

Institution 14 Is CARE the only entity that has raised investment capital and operational subsidies for yourorganization?

Institution 14 Does your organization have its own financial system?Institution 14 Do you make cash management decisions independently from CARE?Institution 14 Are PN85 costs removed from the cost structure of the MFI?

Institution 14 Does the CARE country office have a means of recovering applicable PN85 charges withoutdirectly charging the MFI?

Institution 14 Is there an agreement between the MFI and the CARE country office on fees to be paid forservices provided by CARE?

FinancialManagement 63 Is the MFI susceptible to interest rate risk?

FinancialManagement 63 For those MFIs operating in highly inflationary environments, is gap analysis conducted

regularly?FinancialManagement 63 What is your net interest margin?

FinancialManagement 63 For MFIs that hold assets or liabilities in foreign currency, are appropriate control

mechanisms in place to mitigate foreign exchange risk?FinancialManagement 63 Does your organization follow a cash flow management program (i.e., cash needs forecasting,

budgeting, etc.)?FinancialManagement 63 Do you monitor its liquidity risk through consistent monitoring of key ratios: quick, liquidity,

idle funds?Human Resources Manager

Institution 14 What steps do you take to ensure that your employees are motivated and enthusiastic abouttheir work?

Institution 14 Is your human resource system effective and how does the organization know?

Institution 14 Do you have job descriptions and annual performance appraisals for all employees, includingsenior management?

Institution 14 Does your organization set challenging, yet achievable, performance targets for all layers ofthe organization, and does it monitor and reward achievement of these targets?

Operational 34 Are loan officers from the community in which they work?Operational 34 Are your hiring procedures designed to attract individuals who are honest and well motivated?Operational 34 Are new employees oriented to the MFI culture of honesty and zero-tolerance?Operational 34 Are staff compensation levels reasonable and competitive?Operational 34 Is there an immediate termination policy for staff fraud or dishonesty?

Operations Manager

Institution 14 Does your organization use appropriate screening mechanisms to ensure that it is serving theintended target market?

Institution 14 Are the loan sizes appropriate to the needs of the clients?

Institution 14 Do you offer a large enough range in loan sizes so that the best clients do not grow out of theprogram?

Institution 14Do the requirements for accessing a loan (i.e., collateral, meetings, business plan, forcedsavings) address the institution’s need to control credit risk (see next chapter) without beingexcessively demanding on clients?

Institution 14 How do you conduct useful market research activities on a regular basis to keep in touch withthe changing needs of your target market?

Institution 14 What indicators do you use to ensure that you are serving the intended target market?Institution 14 Is this information collected in a cost-effective manner?

Institution 14 What information, if any, does your organization consistently collect regarding the impact ofyour services on clients?

Institution 14 How has your retention rate changed over the past year and what are the primary reasons forthat change?

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Risk Page Number Question

Institution 14 Do field staff consider themselves employees of CARE or the MFI; if it is the former, whatare the implications?

Institution 14 Is your interest rate so high that it hurts your clients? How do you know that they can affordthe rates that you are charging?

Operational 34 What are the characteristics of the product design that are intended to control credit risk?

Operational 34 Are those characteristics appropriate for different segments of the target market (i.e., newclients and repeat clients)?

Operational 34 Are the features of the of the loan product reviewed regularly to determine if they should bemodified?

Operational 34 Are exit interviews conducted with clients who are leaving client groups or discontinuing touse the MFI services?

Operational 34 If it makes secured loans, does the program have appropriate policies and systems for dealingwith collateral?

Operational 34 Does the credit committee have sufficient experience to make wise decisions?Operational 34 Is the credit committee involved in loan monitoring and delinquency management?Operational 34 Does the program have a culture that is intolerant of delinquency?Operational 34 Does the MFI have an appropriate and transparent rescheduling policy?Operational 34 Which branch has the worst portfolio at risk?Operational 34 Could this branch be experiencing fraud?

Operational 34Are loan officers allowed any discretion, such as lowering interest rates, requesting loan sizeexemptions or waiving delinquency fees? If so, how do you control for fraud in thesecircumstances?

Operational 34 Does the loan approval authority structure balance efficiency, customer service and fraudcontrol?

Operational 34 Do managers avoid and actively discourage “blind signing”?

Operational 34 Does the Operations Manager, or other senior manager, consistently monitor portfolioquality?

Operational 34 Do you have a system for collecting, analyzing and following up with customer complaints?

Operational 34 Do you have a contingency plan in place so that you can quickly mitigate the damage causedby fraud when it occurs? If so, what does the plan consist of?

Operational 34 Has your organization contracted an expert to analyze your security needs on a branch-by-branch basis?

FinancialManagement

63 Does your organization develop an annual budget?

FinancialManagement

63 Is the annual budget used and updated regularly?

FinancialManagement

63 Do you actively compare the budgeted to actual numbers and identify cost over-runs?

FinancialManagement

63 (For MFIs that offer multiple products) Do you do activity-based costing?

FinancialManagement

63 Have you analyzed your systems and procedures to identify and eliminate inefficiencies?

FinancialManagement

63 Does the MFI actively monitor its operating efficiency through key ratio analysis?

FinancialManagement

63 Does your organization maintain an error log that allows it to identify and rectify commonmistakes?

Operations Manager and Internal Auditor

Operational 34 Has your organization experienced fraud? If so, what conditions made your organizationvulnerable to fraud?

Operational 34 What have you done to try to reduce your vulnerability?

Operational 34 Does your institution have clear write-off and rescheduling policies that are consistent with afraud prevention strategy?

Operational 34 Are those policies followed?Internal Auditor

Operational 34 Does the MFI have appropriate polices for handling cash in its loan disbursement andcollection procedures?

Operational 34 Are these policies followed?Operational 34 Do you have adequate policies and procedures on collateral control?


108

Risk Page Number QuestionOperational 34 Are these policies followed?Operational 34 Does your organization regularly sample clients to confirm savings and loan balances?Operational 34 Does the MFI have an internal audit function?Operational 34 Are internal audits conducted regularly?Operational 34 What is the process by which your organization confirms client savings and loan balances?Operational 34 What are your organization’s major vulnerabilities to theft, and how are you addressing them?

Field StaffInstitution 14 Do employees know the organization’s mission statement and use it to help guide their actions?

Institution 14Is it convenient for the target market to access services, in terms of the amount of timerequired, location of services (i.e., branch locations), and the timing of those services (i.e., officehours)?

Institution 14What percentage of their time do loan officers spend in the field? If it is less than half of theirtime, does the association with CARE somehow make them think that they have administrativepositions and should be sitting behind a desk rather than getting their shoes dirty?

Operational 34 What screening techniques does your organization use to minimize credit risk?Operational 34 How do those screening techniques vary by loan number and loan size?Operational 34 Are those techniques consistently applied in all branches?Operational 34 Are the loan approval policies strictly followed?Operational 34 Is there a formal orientation of clients and staff to expectations, policies and procedures?Operational 34 Are loan officers well trained in effective delinquency management strategies?Operational 34 Are delinquency penalties and loan contracts enforced?Operational 34 Are staff members properly rewarded to maintain high standards of portfolio quality?Operational 34 Does the institution have an ongoing client education campaign?Operational 34 Are clients aware of their rights?Operational 34 What channels do clients have to voice complaints?Operational 34 Do at least two people meet all applicants and approve all applications?Operational 34 How do employees document their delinquency management steps?Operational 34 Does the MFI have standard procedures for delinquency follow up?Operational 34 Are these procedures followed?

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Annex 2: Sample Chart of AccountsAsset Accounts

1000 Cash and Equivalents1000 Cash in Vault1005 Petty Cash1010 Cash in Banks1011 Cash in Bank – Operating1012 Cash in Bank – Lending1013 Cash in Bank – Savings1050 Reserves in Central Bank1100 Short-term Investments

1200 Loan Portfolio1210 Portfolio/Type A1220 Portfolio/Type B1240 Restructured loans

1300 Reserves for possible losses1310 Loan loss reserve1320 Interest loss reserve (for

accrual systems only)

1400 Interest and fees receivable1410 Interest receivable,

current loans1420 Interest receivable,

non-performing loans1440 Interest receivable,

rescheduled loans1450 Commissions receivable1459 Other loan fees receivable

1500 Receivables1510 Accounts receivable1520 Travel advances1525 Other advances to employees1530 Other receivables

1600 Long-term Investments1610 Investment A1612 Investment B

1700 Property and Equipment1710 Buildings1711 Depreciation, buildings1720 Land1730 Equipment1731 Depreciation, equipment1740 Vehicles1741 Depreciation, vehicles1750 Leasehold improvements1751 Depreciation, leasehold

improvements

1800 Other Assets1810 Prepaid expenses

Liability Accounts2000 Payables2010 Trade accounts payable2012 Accounts payable, members2014 Accounts payable, employees

2100 Interest Payable2110 Interest payable, loans2120 Interest payable, passbook savings2130 Interest payable, time deposits2150 Interest payable, other

2200 Client Deposits2210 Collateral savings2220 Voluntary savings2230 Time deposits

2300 Loans Payable — Short-term2320 Loans payable, Bank 12322 Loans payable, Bank 22330 Loans payable, other2350 Lease payable

2400 Loans Payable — Long-term2420 Loans payable, Bank 12422 Loans payable, Bank 22430 Loans payable, other2450 Lease payable

2500 Accrued Expenses2510 Accrued salary2520 Accrued payroll taxes2530 Accrued benefits, insurance2540 Accrued benefits, leave2550 Accrued federal taxes2590 Other accrued expenses

2600 Deferred Revenue — Program2610 Deferred interest2620 Deferred commissions2622 Deferred loan service fees

2700 Deferred Revenue — Grants2710 Deferred revenue — Grant 12712 Deferred revenue — Grant 2


110

Equity AccountsIncorporated institution3000 Shareholders’ Capital3010 (Paid-in Common Stock)

Capital3020 Common stock at par value3030 Donated capital, current year3040 Donated capital, previous years

3100 Gain (Loss) from Currency Adjustments3200 Retained earnings, current year3300 Retained earnings, previous years.

Nongovernmental organization3000 Fund balance3010 Unrestricted fund balance3020 Fund balance, credit program3030 Fund balance, noncredit program

3100 Gain (loss) from current adjustments3200 Surplus/(deficit) of income over expenditure

Income Accounts4000 Interest Income4010 Interest income, performing loans4020 Interest income,

non-performing loans4040 Interest income, rescheduled

loans

4100 Other Loan Income4120 Income from commissions4122 Income from loan service fees4124 Income from closing costs4130 Penalty income4140 Income from other loan fees

4200 Fee Income (non-credit)4210 Classroom fees4220 Income from other fees

4300 Bank and Investment Income4310 Bank interest4320 Investment income

4400 Income from Grants4410 Restricted / Government4420 Restricted / Private4430 Unrestricted / Government4440 Unrestricted / Private4450 Individuals' Contributions

4500 Other Income 4510 Miscellaneous income

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111

Expense Accounts5000 Financing Expenses5010 Interest on loans5014 Bank commissions and fees5020 Interest on client savings5030 Other financing costs

5100 Loss Provisions5110 Loan loss provisions5120 Interest loss provisions

5200 Personnel Expenses5210 Salary — Officers5212 Salary — Others5214 Honoraria5220 Payroll tax expense5230 Health insurance5232 Other insurance5240 Vacation5242 Sick leave5250 Other benefits

5300 Office Expenses5310 Office supplies5312 Telephone/Fax5314 Postage and delivery5316 Printing5320 Professional fees5322 Auditing / Accounting fees5324 Legal fees5330 Other office expenses5332 Insurance

5400 Occupancy Expenses5410 Rent

5420 Utilities5430 Maintenance and Cleaning

5500 Travel Costs5510 Airfare5514 Public ground transportation5516 Vehicle operating expenses5520 Lodging costs5530 Meals and incidentals5540 Transport of goods5542 Storage5550 Miscellaneous travel costs

5600 Equipment5610 Equipment rental5620 Equipment maintenance5630 Equipment depreciation5640 Vehicle depreciation5650 Leasehold amortization

5700 Program Expenses5710 Instructional materials and supplies5730 Books and publications5740 Technical assistance

5800 Miscellaneous Expenses5810 Continuing education5820 Entertainment

5900 Non-operating income and expenses5910 Gain/(Loss) on sale of investments5920 Gain/(Loss) on sale of asset5930 Federal taxes paid5940 Other taxes paid5990 Other


112

Annex 3: Inflation and Subsidy Adjustment Worksheet

You get the inflation adjustment expense by multiplying the organization’s equity by the inflation rate—ineffect this is the amount of equity that the MFI lost to inflation. You generate an inflation adjustmentincome by multiplying the value of fixed assets by inflation. The Net Inflation Adjustment is the differencebetween the two.

Inflation Adjustment Previous Year’s Equity $0,000,000 Inflation Rate x infl%

1. Inflation Adjustment Expense $ 00,000

Previous Year’s Fixed Assets $000,000 Inflation Rate x infl%

2. Inflation Adjustment Income $ 00,000

3. Net Inflation Adjustment line 1 – line 2

IMF, International Financial Statistics, line 64x

Effects: Enter as a separate capital account, offsetschange in profit

IMF, International Financial Statistics, line 64x

Effects: Increases Fixed Assets, Total Assets

Effects: Usually increases Total Interest Expense, anddecreases Net Operating Profits (Note: If fixed assetsexceed equity, interest expense will decrease, profitswill increase.)

The cost of funds adjustment is used for organizations that have below market (i.e., subsidized) liabilities.To calculate the adjustment, take the average balance of liabilities and multiply it by a shadow price cost offunds—The MicroBanking Bulletin uses the Deposit Rate. This shows roughly what the organization shouldhave paid as a cost of funds. Subtract from that the actual cost of funds, and the difference is theadjustment. Additional adjustments should be made for cash and in-kind subsidies.

Subsidy AdjustmentCost of Funds Adjustment

4. Balance of Liability, year-end 1999 $0,000,0005. Balance of Liability, year-end 2000 $0,000,0006. Average Balance of Liability (line 4 + 5)/2 Shadow Price (Deposit Rate) x deposit% “Market” Cost of Funds $000,000 Less Actual Interest Paid -$000,000

Cost of Funds Adjustment $000,000

Cash Donations Adjustment $000,000

In-kind Subsidy Adjustment $000,000

IMF, International Financial Statistics, line 601

Effect : Increases Total Interest Expense, decreases NetOperating Profits. Appears on the Balance Sheet as aseparate capital account to offset change in profits.No change in Total Capital.

Effect : Reduces Net Operating Profit, increases NetNon-Operating Profits

Effect : Increases Total Administrative Expensesreduces Net Operating Profits.

Source: The MicroBanking Bulletin

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Annex 4: Sample Balance Sheet and Income StatementBalance SheetOrganization: As of:ASSETS

1 Cash2 Interest-bearing Deposits

Loans Outstanding3 Loans Outstanding: Current4 Loans Outstanding: Non-Performing5 Loans Outstanding: Rescheduled6 Total Loans Outstanding 3 + 4 + 57 (Loan Loss Reserve)8 Net Loans Outstanding 6 – 79 Accounts Receivable10 Other Current Assets11 TOTAL CURRENT ASSETS 1 + 2 + 8 + 9 + 10

12 Long-term investments13 Property and Equipment14 (Accumulated Depreciation)15 Net Property and Equipment 13 – 1416 TOTAL LONG-TERM ASSETS 12 + 15

17 TOTAL ASSETS 11 + 16

LIABILITIES AND CAPITALLIABILITIES

18 Short-term Debt19 Client Savings: Passbook20 Client Savings: Time deposits21 Deferred Revenue22 Payables23 TOTAL CURRENT LIABILITIES 18 + 19 + 20 + 21 + 22

26 Long-term Debt27 Other Long-term Liabilities28 TOTAL LONG-TERM LIABILITIES 26 + 2729 TOTAL LIABILITIES 23 + 28

CAPITAL30 Grant Capital31 Shareholder Capital/Paid In Capital32 Excess (Deficit) of Income over Expenses (prior years)33 Excess (Deficit) of Income over Expenses (current year)34 TOTAL CAPITAL 30 + 31 + 32 + 33

35 TOTAL LIABILITIES AND CAPITAL 29 + 34


114

Income StatementOrganization: Period: Cumulative for Year

FINANCIAL INCOME1 Interest Income on Loan Portfolio

2 Loan Fees and Service Charges

3 Penalties on Loans

4 Total Loan Income 1 + 2 + 3

5 Income from Investments6 Income from Other Financial Services

7 Total Other Financial Income 5 + 6

8 Total Financial Income 4 + 7

FINANCIAL COSTS OF LENDING FUNDS9 Interest on Borrowed Funds10 Interest Paid on Deposits

11 Total Financial Costs 9 + 10

12 GROSS FINANCIAL MARGIN 8 - 11

13 Provision for Loan Losses

14 NET FINANCIAL MARGIN 12 - 13

OPERATING EXPENSES15 Salaries and Benefits

16 Office Supplies17 Communication18 Rent & Utilities19 Fuel, Travel Costs and Vehicle Maintenance

20 Depreciation21 Training22 Other Costs and Services23 Bank Fee

24 Total Operating Expenses Sum 15…23

25 NET INCOME FROM OPERATIONS 14 - 24

NON FINANCIAL INCOME26 Operating Grant Income27 Non-financial Services Income

28 Total Non-financial Income 26 + 27

29 EXCESS (DEFICIT) OF INCOME OVER EXPENSES 25 + 28

ANNEXES

115

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Sheldon, Tony and Charles Waterfield (1998) Business Planning and Financial Modeling for MicrofinanceInstitutions. Washington, DC, USA: Consultative Group to Assist the Poorest. Website:www.cgap.org.

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Yaron, Jacob, McDonald Benjamin, and Gerda Piprek (1997). Rural Finance Issues, Design and Best Practices.Washington DC: The World Bank. Email: [email protected].

Documents

MICROFINANCE RISK MANAGEMENT HANDBOOKmfi-resources.org/.../Risk_Management_Handbook.pdf · 2014. 10. 3. · ll microfinance institutions (MFIs) are vulnerable to risks like those