Microfinance Focus, July 9, 2011: According to a white paper ‘Weathering the Storm’, released by Centre for Financial Inclusion and sponsored by Calmeadow, Deutsche Bank, and Credit Suisse, failure by MFIs in either implementing or maintaining their selected microfinance methodology is identified as the most common issue that can cause or amplify an MFI crisis.

Methodological flaws such as improper client evaluation, inappropriate use of staff incentives, weak reporting systems, and overly large increases in loan amounts between lending cycles were found to be the leading causes of crisis in different microfinance markets.

Authored by Daniel Rozas, the paper examines seven microfinance institutions which have lived through crisis and offers valuable lessons by exploring the different kinds of risks these MFIs were exposed to, their turnaround factors and pre-crisis recommendations.

The paper highlights that the uncontrollable growth which has been viewed as a significant contributor to the crises faced by many MFIs in the past two years, was also a critical factor in many cases as MFIs weaken or abandon their internal controls, or undermine their methodological foundations (e.g. making larger loans than prudent).

State intervention, either in the form of undermining an MFI’s operations or its over-eager promotion can also trigger a crisis. It was the primary factor in the case of PADME (Benin), where the state effectively nationalized the institution, and an important supporting factor in two others – FuegoNord (Nigeria) and ShoreBank (US), where the state failed to provide sufficient regulation to temper runaway market enthusiasm that ended in a burst credit bubble.

Weakness in the financial structures of MFIs like currency mismatch, bad asset liability planning and excessive leverage, make them especially vulnerable to shifts in financial markets or downturns in the broader economy, the paper says.

However, good governance can prove to be the ultimate backstop for preventing and bouncing back from such crisis. Among the 10 cases studied, the most successful turnarounds (Caravela, Artemis, Belavoda) involved especially strong boards, while both FuegoNord and Loki – two of the three MFIs that ultimately failed – had major weaknesses on their boards.

The paper emphasizes the inclusion of monitoring of risk factors captured at the time of loan issuance, such as evaluation of borrowers’ repayment capacity and their outstanding debts. Most of the MFIs in the study’s sample ignored existing indebtedness levels when conducting borrower assessments.

The paper further lists out a series of measures for MFIs that encounter crisis. Maintaining sufficient liquidity should be the first in order of priority it says.  With sufficient liquidity to meet core operational costs for the immediate period (weeks, not months), the cash must be deployed to address the crisis itself.

It is also critical to maintain clients, staff and creditors’ confidence during times of crisis. MFIs need to make sure that the crisis doesn’t get communicated to clients and must continue with some reasonable level of loan disbursements. Staff needs to be convinced of management competence in dealing with crisis and must recognize that management cares about them in order to be more responsive.

Moreover, MFI needs to maintain trust with its creditors so that creditors will be more willing to take the difficult decisions that will ultimately protect their ability to recover as much of their funds as possible, the paper says.