Key Issues in Risk Management and SEEP MFRS Reporting Standards Workmddb.apec.org/documents/2011/GFPN/WKSP1/11_gfpn_wksp1... · 2012-11-24 · Key Issues in Risk Management and SEEP

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2011/GFPN/WKSP/016 Session 5

Key Issues in Risk Management and SEEP MFRS Reporting Standards Work

Submitted by: Opportunity International

Workshop on Microfinance Best Practices Ha Noi, Viet Nam

7-8 April 2011

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APEC Workshop on Microfinance Best PracticesHanoi, VietnamApril 7-8, 2011

Key Issues in Risk Management and SEEP MFRS Reporting Standards Work Lynn Exton‐Chief Risk OfficerOpportunity International

APEC Workshop on Microfinance Best Practices‐April 2011

Why Risk Management?

We are in the business of taking risksWe are in the business of taking risks

Managing risks is a dynamic process Managing risks is a dynamic process

Risk is the balance of likelihood and impactRisk is the balance of likelihood and impact

Identifying risks allows us to identify mitigating Identifying risks allows us to identify mitigating actionsactions

Active Risk Management can reduce potential losses Active Risk Management can reduce potential losses


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Who is responsible for Risk?

Central Bank

External Audit

Internal Audit

Risk Management

Management

Internal Compliance


Three Lines of Defence

BUSINESS LINESFIRST Line of Defence

RISK MANAGEMENTSECOND Line of Defence

INTERNAL AUDITTHIRD Line of Defence


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Roles and Responsibilities

Responsibility for Primary day‐to‐day management of riskBUSINESS LINE y g

Provide high‐level policies, limits and risk oversightRISK MANAGEMENT

Independent assessment of the design and effectiveness of internal controls over the risk to the business performance

INTERNAL AUDIT


Common Features of Sustainable MFIs


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Three Secrets for Healthy MFI/Client Relationships

The three principles underpin MFI that maintain healthy relationships with clients:healthy relationships with clients:

1. Choosing the right "partners" (sound underwriting) Assess capacity and willingness to pay

2. Deepening the relationship (providing savings) MFIs linked to clients around the lasting value of savings will have

stronger relationships than those who are in it only for the lending

i " '" d fi ( i i ff i li3. Putting "partners'" needs first (training staff in client service) A trained and motivated staff makes it all possible


MFI Failures: Lessons Learned *

CAUSES:1. Methodological flaws in credit process

• Applying unadapted, traditional consumer credit methods (e.g. credit scoring)

• Partial application of credit methods (caused by weak credit control)

• Disparately incentivizing credit growth over quality

2. Systematic fraud

• Mgmt level (insider loans & investments, contract embezzlement)

• Loan officer level (ghost clients, client collusion) – less financial impact; unethical

3. Uncontrolled growth

• Relaxed controls for sake of short term growth (branches, portfolio, etc)Relaxed controls for sake of short term growth (branches, portfolio, etc)

• Invariably compromises control and creates dependence on relatively unskilled staff

* Accion’s Center for Financial Inclusion “TAKING THE GOOD FROM THE BAD IN MICROFINANCE: LESSONS

LEARNED FROM FAILED EXPERIENCES IN LATIN AMERICA”,


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MFI Failures: Lessons Learned (2)

4. Loss of focus

– Pursuing products/strategies outside of the business’ core competencies, capital restraintsrestraints

– Entering business with an economic sector (s) and creation of products without careful due diligence and planning

5. Design flaws in the conception of the institution itself

– Setting up shop in countries with demographics which hinder sustainable enterprise (household incomes, informality)

– Failure to recognize that other market operators or financial entities fulfill microentrepreneur needs

6. Government intervention6. Government intervention

– State participation in microfinance creates preferential pricing; distorts market realities

– Excess gov’t funding creates disincentives for strong credit control, stewardship of resources (easy $$$)

– Other types of state interventions (eg interest rate caps) were not found to be primary causes of failure


Microfinance Financial Reporting Standards (MFRS)


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Microfinance Financial Reporting Standards (MFRS)

Challenge 1: The Credit Crunch Challenge 2: Duplicate Reporting

“The global recession exposed risks we haven’t been

managing.”

“For every new major donor/investor we get, we have to add an analyst to our staff.”

Challenge 3: New Products Challenge 4: Performance Evaluation

“We offer much more than credit, but our systems haven’t

kept up with our evolving business model.”

“We want current and potential funders to feel confident about

our operations.”


An industry‐wide solution to these four challenges

Microfinance Financial

The Credit Crunch

Better capital adequacy & liquidity info for decision-makers

Reporting Standards Initiative

(Builds upon 2005 SEEP

Duplicate Reporting

New Products

Standard set of required indicators for reporting to all stakeholders

(Builds upon 2005 SEEP Framework & FRAME Tool publications)Performance

Evaluation

New indicators to help MFIs better understand their clients


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Initiative Background

100+ organizations involved to improve MFI Financial Reporting Standards since 2005. Resulted in development of 18 key financial ratios and the FRAME Tool—a free

Initiative Background

of 18 key financial ratios and the FRAME Tool a free Excel workbook to track the ratios and help MFIs produce financial reports.


Benefits for All Stakeholders

MFIs

• Better information for decision making• Streamlined reporting to stakeholders• Greater investor confidence leading to more funding

• Deeper understanding of MFI financial health & performance

Better Standards

Investors &Funders

Vendors

p g p• Increased transparency • Easier comparability between MFIs

• Better data transfer through XBRL, other systems• Centralized place to get updates/changes• Decreased costs to provide services (rating, MIS, auditing, etc.)

Support Orgs

• Higher quality, more readily‐available data• Cheaper, simpler information sharing

Regulators

Central Banks &

Regulators

• Reduced risk for microfinance clients• Reduced labor from accurate self‐reporting• Alignment between national and international best practices


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MFRS: Objectives

• Understand the fundamental changes in the new gratios, the rational for their selection

• Appreciate the sector changes and challenges for reporting institutions

• Provide input into the exposure draft

• Evolve in the direction of sector MFI performance l ianalysis


Microfinance Institutions Have Matured

o Beginnings in the NGO sectoro Beginnings in the NGO sectoro Investors exceed donors in ongoing growth –

globally, investors are still bullisho Commercialization and professionalization continue

as more institutions are regulatedo The questions, language and criteria for evaluation

have changed!g


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An Overview of What’s New in the MFRS : (1)


An Overview of What’s New in the MFRS (2)


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An Overview of What’s New in the MFRS (3) :Asset/Liability Management (ALM) Tables

Liquidity Risk Measures liquidity based on maturity Liquidity Risk (Maturity tables)

Measures liquidity based on maturity dates of MFI assets and liabilities in order to identify funding gaps

Interest Rate Risk (Re-pricing Risks)

Monitors the mismatches created when MFI assets and liabilities reach term and interest rates are repriced

Foreign Currency Risk

Monitors the effect of exchange rate changes on hard currency assets and Risk changes on hard currency assets and liabilities and the MFI’s ability to meet those liabilities as they become due

Liquidity Risk per Currency

Monitors the liquidity needed to meet obligations in various currencies


Next Steps

WHAT WHEN

“Pocket G ide” p blished No 2010“Pocket Guide” published Nov 2010

Publish final standards as revised FRAMEWORK

1H 2011

Awareness/education for ‘update’• Training courses for associations• Update related practitioner tools

2H 2011• Update related practitioner tools


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Questions?


Appendices

1. Banana Skins Report 2011- “Losing Its Fairy Dust”

2. MFI’s FX Exposures

3. “5 countries where Microfinance works”


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Banana Skins 2011

“Losing its fairy dust”


Background to Banana Skins Report

• 2011 update published by the Centre for the Study of Financial Innovation, sponsored by Citi and CGAP

• Identifies the main risks and challenges facing the MF industry

• Also illustrates how risk perceptions have evolved through the course of the financial crisis


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Top 10 Risks‐2011(2009 position in brackets)

10 highest ranking risks in 2011 (in parenthesis 2009 rank) included:

1. Credit (1)2. Reputation (17)3. Competition (9)4. Corporate governance (7)5. Political interference (13 )6. Inappropriate regulation (13)

( )7. Management quality (4)8. Staffing (14)9. Mission drift (19)10.Unrealistic expectations (18)


Fastest rising risks‐2011(2009 position in brackets)

1. Competition (3)

2. Credit risk (1)

3. Reputation (11)

4. Political interference (7)

5. Mission Drift (13)

6. Strategy (‐)

7. Staffing (20)

8. Unrealistic expectations (17)

9 fi bili (9)9. Profitability (9)

10. Inappropriate regulation (22)


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The Big Movers‐UP

UP:• Reputation the good name of microfinance increasingly• Reputation‐the good name of microfinance increasingly

under attack

• Competition‐undermining business and ethical standards

• Corporate governance‐showing weakness under stress

• Political interference‐backlash against MFI lending practices

• Inappropriate regulation‐failing to provide a healthy environment


The Big Movers‐Down

DOWN:•Macro economy ebbing concerns about the global•Macro-economy-ebbing concerns about the global crisis

•Liquidity-cash shortages easing

•Too little funding-investors returning to the market

•Foreign exchange-”currency wars not a major concern

•Interest rates- lower and less volatile


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Key Messages

• Global feedback confirmed that the immediate risks posed by the global economic crisis have receded

BUT• Larger concerns about the future direction of the industry have

emerged

• Internal issues in Africa (corporate governance, management, staffing, control systems) remain the highest risks within the region

• Overall level of preparedness of MFI to handle the risks was viewed as middling. There are concerns about MFI’s ability to manage risk successfully in the volatile environment, particularly in the areas of credit and reputation.


Going forward

• Widespread agreement that the microfinance industry now stands at the threshold of big long termnow stands at the threshold of big long term decisions which needed to be firmly addressed to ensure survival.

• Lessons from the financial crisis must be built upon, particularly in the areas of Developing stronger management and

governance skills Improving MF credit and risk management Customer focus, rather than product or growth

focus


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MFI’s FX Exposures

“Risky Business”


Background

• 2011 inaugural study on MFI risk exposure to FX published by the MFX Solutions and sponsored by FMOSolutions and sponsored by FMO

• This is the first empirical study to measure the volume, extent, and nature of MFIs’ foreign exchange risk.

Key conclusion:

“The level, prevalence, and complexity of MFI foreign exchange risk are greater than presumed Microfinance foreign exchangeare greater than presumed. Microfinance foreign exchange practices are risky business, with MFIs exposed to currency risk on both sides of the balance sheet, leading to significant gains or losses depending on currency movements.”


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Key Recommendations to Make MFIs More Resilient in the Future

Microfinance Industry

1. Develop microfinance industry‐wide guidelines on prudent foreign exchange risk exposure limits.

2. Provide tailored microfinance hedging products to crossborder lenders to hedge foreign currency risk.

3. Provide additional training and education in asset‐liability management and overall financial risk management for MFIs.


Microfinance Institutions

Key Recommendations to Make MFIs More Resilient in the Future – cont’d

1. MFIs should maintain foreign exchange risk exposure at a prudent level.

2. MFIs should not pass on foreign currency risk to micro‐borrowers who are not earning revenues in that foreign currency.

3. Track and monitor foreign exchange risk at the MFI level.

4. Improve transparency: MFIs should report the extent and impact of foreign risk exposure in annual audited financial statement.


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Microfinance Lenders

Key Recommendations to Make MFIs More Resilient in the Future – cont’d

Microfinance lenders should lend to MFIs in local currency and not directly or indirectly cause MFIs to pass on currency risk to micro-borrowers.

Regulators National regulators should establish required prudent MFI foreign exchange risk exposure limits.

AuditorsAuditors should disclose MFI foreign exchange risk exposure levels and practices.


Key Metrics to measure FX exposure

1. Net Open Position as a Percentage of EquitySixty-five percent of MFIs exceed the recommended 10% foreign exchange net open y p g g pposition as a percentage of equity.

2. Assets to Liabilities RatioOnly 21% of MFIs achieve a prudent A-L ratio per foreign currency within the recommended range.

3. MFI Foreign Exchange Gains and LossesThe average foreign exchange gain or loss was about one-third of MFI net income.The average foreign exchange gain or loss was about one third of MFI net income.

4. The Myth of Mitigation: Foreign Currency On-lendingMFI’s pass along FX risk to clients with over two-thirds (69%) of MFI’s total disclosed foreign currency assets comprising foreign currency loans to MFI client borrowers.


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A Few Caveats

While the data presented provides an overall picture of the industry, it likely d t t th bl f lunderstates the problem for several reasons:

1. Not all MFIs reported whether or not they carried foreign currencies on their balance sheet.

2. Other MFIs reported foreign currency total assets and total liabilities levels only without disclosing underlying foreign exchange holdings details.

3. Still others did not break down assets and liabilities by currency.

4. On the other hand, some mismatch data may represent strongly pegged

currencies where the risk is minimal.


Macroeconomic volatility is a fact of life…..

Recommended Best Practice Foreign Exchange Risk Exposure GuidelinesGuidelines

Report foreign exchange gains and losses on the income statement

Provide a foreign exchange mismatch table per currency with breakdown of all affected asset and liability line items

Perform a foreign exchange risk sensitivity analysis

Disclose relevant information on any foreign currency holdings in all relevant asset and liability financial statement notes

Disclose all on‐ and off‐balance sheet foreign exchange contracts and hedging mechanisms


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Where to find full report:

“Risky Business

An Empirical Analysis of Foreign Exchange Risk Exposure inAn Empirical Analysis of Foreign Exchange Risk Exposure in Microfinance”

January 2011

Author: Julie Abrams, Microfinance Analytics

Contributors: Jerome Prieur, MFX Solutions

http://www.mfxsolutions.com/


“5 countries where Microfinance works” *

• Tiny Bolivia got many things right. • Cambodia and Mongolia followed Bolivia’sCambodia and Mongolia followed Bolivia s

example.• Indonesia showed what a state- owned bank can

do. • The Philippines took an eclectic approach


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Lessons to Learn: The need for good policies and supportive policymakers

Savings needs to accompany credit, both to be truly beneficial to clients and to prevent aggressive growth by lenders

These countries created specialized regulatory frameworks that were These countries created specialized regulatory frameworks that were empowering to institutions wishing to serve the low end of the market.

They made sure that requirements to ensure safety and solvency were a good fit for institutions working with the tiny transactions of the poor.

All the countries encouraged microfinance to develop as a commercial business, but not one where unbridled profit- seeking was the norm.

They did this by placing the driving force into the hands of owners with social commitment alongside their requirements for financial returns.

* Elisabeth Rhyne is managing director of the Center for Financial Inclusion at ACCION.


Documents

Key Issues in Risk Management and SEEP MFRS Reporting Standards Workmddb.apec.org/documents/2011/GFPN/WKSP1/11_gfpn_wksp1... · 2012-11-24 · Key Issues in Risk Management and SEEP