Enterprise-wide Risk Management in Microfinance Institutions: The ASA Experience

By Saleh Khan, Country Director , ASA International, Nigeria

This paper explores the typical risks that microfinance institutions (MFIs) face in their operations and outlines some of the steps that ASA, one of the world largest NGO MFI, takes to mitigate them. This discussion is from a practitioner’s perspective and is intended to provide examples of how a typical MFI might respond to risks that face them.

Microfinance Focus , July 18, 2010 : The Global Economic Crisis that has been prevailing over the last few years has seen the most resilient economies falter and the stalwarts of the financial industry come crashing down. The concepts of a ‘connected world’ and ‘global economy’ has never been more painfully obvious as country after country entered recession – dragged down by their exposures to each other and their economic inter-dependence.

Even though at first glance seemed that most emerging economies managed to remain insulated from this crisis, the impact of today’s global crisis on their economies are likely to be more complex, deeper, and more difficult to predict than in the past. It is expected that the medium and longer term effects of a worldwide recession are likely to be punishing for many poor people and the institutions that serve them (CGAP, 2009).

For the developing world, the knock-on effect from financial instability and uncertainty is having a compounding effect on their already existing problems. High fuel costs, soaring commodity prices coupled with fears of a prolonged global recession are worrying many analysts. In the long run, it is expected that foreign investments will likely reduce as the credit squeeze takes hold and foreign aid, which is important for a number of poorer countries, is likely to diminish as richer countries struggle to revive their domestic economies.

Developing countries could face increasing pressure to repay their debt as the international institutions and banks that have lent them money feel the need to shore up their own reserves. This pressure to service external debt obligations could see poorer countries make deeper cuts in basic social services which erode social safety nets and reduce the number of development projects undertaken. These cuts in development spending would certainly deteriorate the quality of lives of an already vulnerable population.

Civil society organizations and Microfinance Institutions are expected to bridge this development gap and assist the poorest. Microfinance Bank’s that target people at the lower end of the economic pyramid are also expected play a key role in revitalizing micro-SMEs and provide funding to stimulate business enterprises at the bottom of the socio-economic pyramid.

As formal financial institutions faltered and people lost confidence in them, the successes stories of microfinance received ever increasing attention. Microfinance has been presented as an effective and proven model for alleviating poverty. With the sector highlighted so widely, microfinance institutions (MFIs) are coming under increasing scrutiny for their reliability, resilience and maturity. As competition increases and the sector matures, MFIs are faced numerous risks – both operational and strategic in nature – that the institutions must mitigate in order to sustain in the long run.

This paper explores some of the key risks that MFIs face in their operations and outlines steps that ASA and ASA International takes to minimize them. This discussion is non-exhaustive, it does not encompass all possible risks that MFIs might face and neither is it a complete description of ASA’s risk management strategies. It is intended to provide examples of how a MFI might respond to risks that face them, and not be a prescriptive guideline.

Background

The practice of microfinance is not new and has probably been around for as long as currency itself has. Informal credit and savings services probably formed around social groups where the members got together to help one another as a community. Savings and credit groups that have operated for centuries include the “susus” of Ghana, “chit funds” in India, “tandas” in Mexico, “arisan” in Indonesia, “cheetu” in Sri Lanka, “tontines” in West Africa, and “pasanaku” in Bolivia.

According to Prameswaran & Raper (2003) one of the earliest microcredit organizations providing small loans to rural poor with no collateral was the Irish Loan Fund system, initiated in the early 1700s by the author and nationalist Jonathan Swift. Swift’s idea began slowly, but by the 1840s had become a widespread institution of about 300 funds all over Ireland. Their principal purpose was to provide small loans, at an interest, for short durations. At its peak, it is estimated that these institutions were giving loans to about 20% of all Irish households annually.

It was the integration of these traditional lending models into modern banking and financial framework (pioneered in the 1970s by Grameen Bank and ACCION International, amongst others) that lead to a “re-birth” of microfinance and introduced it as a viable mechanism for combating poverty. By formalizing and expanding upon these basic concepts, a new generation of microfinance institutions helped provide capital to small businesses and offered emancipation to a segment of population that have traditionally been marginalized.

Today, there are a number of distinctive ‘models’ of microfinance operations that are being practiced around the world. This reflects the fact that microfinance methodologies have evolved differently under different environments and market conditions. Some countries tend to rely on one particular model or method, while others exhibit diversity in the models used.

The Asian Development Bank in one of their publications (2000) listed pre-dominant Asian models of microfinance operations and categorized them into four broad categories:

• Grameen Banking: perhaps the most widespread model in use today, characterized by the formation of small group organization and strict procedures;

• Self-help Groups (SHG): with larger and more autonomous groups and a mixture of social and financial intermediation;

• Regulated Financial Institutions: usually small and operating in favourable regulatory environments, such as Microfinance Banks, or Rural Banks; and

• Credit Cooperatives: some of which have made an effort to include the poor.

In a number of countries, including Bangladesh, the great majority of MFIs use one or another variant of the Grameen Bank model. Indeed in most countries, if not all, there are at least some MFIs who have adopted the Grameen model. This model, developed in Bangladesh, has thrived in a variety of physical, cultural, and institutional settings. It has, however, not remained static and neither has it been copied verbatim by MFIs, even within the same country context. In Bangladesh, some MFIs have modified it significantly to meet their own operating philosophies even though the core principles remained the same – providing small loans of short durations to poor people.

This diversity in creating new models is expected when one considers the diversity of the population even within various country contexts and realities on the ground, permitting competitive MFIs to segment the market and position themselves in empty slots. In microfinance operations no single model is a ‘one-size-fit-all’ solution, and over the years, ASA has been developing a set of procedures sufficiently differentiated from those of Grameen Bank to constitute a new and unique model.

ASA in Bangladesh

ASA is a non-governmental organization (NGO) from Bangladesh founded in 1978 by Mr. Md. Shafiqual Haque Choudhury, the current President of ASA. It has been working since inception with the overarching objective of reducing poverty in Bangladesh and has been exclusively focused on providing microcredit and microsaving services from 1992.

ASA’s operating model, called “ASA Cost–effective and Sustainable Microfinance Model” focuses on four key organizational norms:

1. provide a standardized loan product
2. provide basic voluntary deposit services
3. develop simple, effective and rigid procedures that allow cost-effective delivery of microcredit and limited deposit services, and
4. practice zero-tolerance on the late repayment of loan instalments

ASA is now recognized globally as one of the most cost-effective and fastest growing organizations of its kind, with years of experience in successfully providing high-quality microfinance services to millions of borrowers in Bangladesh. In 2002, the Asian Development Bank termed this as the “Ford Motor Model of Microfinance” for its resilience and effectiveness.

Some salient features of this model are:

• Reliance on a self-explanatory and clear cut written working manual
• Decentralization and delegation of authority to branch level officials
• On the job training approach (“each one teach one” policy)
• Simple and cost-effective branch structure without  dedicated accounts or finance officers
• Easy & close communication among officials as well as between officials & clients
• Strong monitoring and supervision from all levels
• Simple and transparent accounting and record-keeping using standardized formats
• Cost-effective / low-cost culture practiced from top to bottom
• No collateral for providing loans
• Loan disbursement within seven days of membership
• Savings (short and long term based) and Mini Life Insurance for clients
• No group financial guarantee for accessing loan

Towards the end of 2008, ASA in Bangladesh had an ongoing loan portfolio of USD 466 million, less than one percent (1%) of its portfolio was overdue, and had over 6 million borrowers, 3 300 branches and nearly 26 000 members of staff.

To promote this model and to help other institutions adopt it, ASA has been providing Technical Assistance (TA), since 1993, to NGO/MFIs of various countries as Microfinance advisors. ASA has already worked with MFIs in: Laos, Cambodia, Tajikistan, Jordan, Ethiopia, Myanmar, Afghanistan, Peru, Mauritius, Indonesia, Yemen, India, Pakistan, Sri Lanka, Nigeria and the Philippines.

ASA’s[1] Approach to Microfinance Risk Management

All financial intermediation carries an element of risk to it and the one of the key challenges that financial institutions face is to identify and hedge them. These risks vary in nature and severity for different institutions even when they operate within the same business environment. Each Microfinance Institution is, therefore, faced with its own unique set of strategic & operational risk which must be identified and managed in order for it to sustain operations. Traditionally, microfinance institutions (MFIs) tend to grow organically and mature their operational policies as they grow. Perhaps, this is more applicable to NGO MFIs than Microfinance Banks, but in general, MFIs are less structured in their growth than their formal banking counterparts.

From the time they start operations, most MFIs are aware of and try to mitigate their financial risks. These are the most obvious to spot and MFIs develop mechanisms to minimize their credit and liquidity risks. But as their operation grows in size and their loan portfolios diversify, a number of different types of risks begin to manifest themselves beyond the obvious financial ones.

Risk management, in the context of a microfinance institution, is defined as “the process of controlling the likelihood and potential severity of an adverse event: it is about systematically identifying, measuring, limiting, and monitoring risks faced by an institution” (Fernando, 2008, p 21).

In one of its publications, Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ, 2000) identified three major categories of risks facing microfinance operations; (as outlined in Figure 1 above):

Financial Risks

MFIs are usually well aware of Financial Risks that are inherent in the business environment that they are operating in and modify their lending methodologies in order to minimize these risks. They focus heavily on minimizing risks due to late or non-payment of loan obligations – credit risks. Credit Risks include both risks due to individual loans characteristics (transaction risk) and the risks inherent in the composition of the overall loan portfolio (portfolio risk).

Managing Credit Risk is an integral part of ASA’s operating methodology, and ways to reduce these risks can be found in almost every aspect of operations. Some of the mechanisms that have found to be most effective are:

• Relationship building: ASA puts a lot of emphasis on building and maintaining a cordial relationship between itself and clients. Loan Officers visit clients every week to collect instalments and spend time with them to understand their needs and issues. Regular visits are also made to the client’s place of business to monitor the health of their business and to further strengthen the relationships. ASA’s experience over the years have shown that in collateral free lending situations, one of the key factors that influence timely repayment is the relationship between the clients and the institution.

• Engaging in group lending: although ASA provides loans to individuals, the clients still have to form peer groups of 8 – 10 members each and are responsible for selecting and nominating members to receive loans. The group members are ultimately responsible for ensuring the repayments of loans by individuals in that group – this is usually done through peer based discussions and negotiations. Non-performance of a single member affects the credit standing of the others in the group, thus creating a social pressure towards the non-performing member to make timely repayments. This also ensures that groups nominate only those they think are capable of timely repaying, this providing an effective initial screening mechanism.

• 100% borrower verification: loan officers are responsible for visiting and verifying each and every client’s place of business, and residence, to ensure that the client has provided accurate information and have the capacity to borrow and pay back the loan. Inquiries are made to neighbours and peers regarding their standing in society and the performance of their business enterprise. These mechanisms help in preventing ‘ghost’ or fake loans and ensure that the clients are not over-leveraged.

• Product standardization: loan products are standardized across the organization ensuring that the loan portfolio is made up of homogeneous products which are easy to manage and monitor.

• Regular reports: regular portfolio performance reports are sent to the head office via regional offices. These management summary reports are designed to provide ‘at a glance’ information where key progress indicators are tracked. Exceptions are easily identified and corrective measures are suggested where required.

In addition, the ASA methodology promotes a strong ‘credit culture’ within the organization where staff are encouraged to prevent, disclose and respond to problems arising in individual loans rapidly so as to limit potential credit losses.

Liquidity risks arise when a MFI cannot meet its cash obligations in a timely and cost-efficient manner. MFIs must be able to anticipate the volume of loans to be disbursed, its client’s savings withdrawal demands (in countries where regulation allows a MFI to mobilize deposits from its clients, as ASA in Bangladesh does) and operational fund requirement and be able to match these against available funds.

To minimize liquidity risk, all ASA Branches prepare a ‘Daily Fund Plan’ that anticipates the cash inflow and outflow for that branch on the next day. It takes into account the cash inflow from loan and savings instalment collections (that takes place in the morning) and matches it against the cash outflow from loan disbursements (that takes places in the afternoon) plus operational expenses. Any surplus funds are deposited with a correspondent bank at the end of the day and any anticipated shortfall is covered by withdrawing funds from the bank early in the day. Branches are not allowed to hold cash overnight to reduce risks of theft or misappropriation.

The branches also prepare a monthly fund plan that outlines the number of loans it anticipates to give out the next month, the amount of savings withdrawals expected and projected operating expense. This ensures that the finance department can anticipate funding needs of individual branches and identify branches with potential cash surplus or shortfall. Surplus funds are routed to the central treasury account and funds are sent to branches that have a shortfall, any idle funds are invested in short term deposits. Quarterly fund plans are also prepared to allow the Treasury Unit anticipate medium term funding needs and allows ASA to plan its borrowings from external sources.

Market Risks are environmental in nature and encompass risks that might arise from financial losses due to changes in market interest rates (interest risk), or due to inadequate protection from fluctuations in currencies (foreign exchange risk), or due to long term asset and liability management (investment portfolio risk).

Although foreign exchange risks, are more applicable to ASA’s international operations rather than its domestic operations (in Bangladesh) the other risks in this category remain valid for ASA Bangladesh. Domestically ASA is not exposed to Foreign Exchange Risks since it has no external borrowings tagged in US Dollars or any other currencies. ASA borrows from commercial banks in Bangladesh for its operating funds and relies heavily on retained earnings for its loan portfolio growth. ASA engages in short term borrowings, often utilizing established lines of credit, to manage its interest rate risks and its longer term investment portfolio risks.

To manage its global operations, ASA International has established a Treasury Unit that studies market condition in the countries it operates in. Interest rates are established for each country after studying the prevailing market lending and borrowing rates. These rates are monitored on a continuous basis by a team of experts and changes are made to mitigate any interest rate risks.

ASA International prefers to borrow from local sources to meet its loan portfolio growth, thus avoiding the need to hedge foreign currency exposure. An example is ASA International India that, in 2009, raised an equivalent of USD 15 million in Indian Rupees from debt fund providers in India. Working with local debt providers in each of its operating countries ASA International minimizes its foreign currency exposure.

Operational Risks

Operational risk arises from the possibility of human or system related errors during the delivery of products or services. It is the potential that inadequate information systems, operational problems, insufficient human resources, inadequate staff skills, or breaches of integrity (fraud) will result in unexpected financial losses. Managing these risks require a combination of an effective internal control framework, appropriate information technology systems, employee integrity, and streamlined operating processes.

The most obvious source of operational risk lies in the client-loan officer interactions where financial transactions take place (transaction risks). When traditional banks transact, the staff carrying it out is usually a trained professional and there are multiple levels of cross-checking put into place. Since loan officers in MFIs usually handle far more numerous short-term loans of very tiny amounts, this same degree of cross-checking is not cost effective; this increases the opportunities for both error and fraud (fraud risk).

To minimize transaction and fraud risks, some of the measures utilized by ASA are:

• Use of a “Daily Collection Board”: the money due to be collected on any given day (both loan instalments and savings collection) is posted against the names of each loan officer on a large board placed in the branch. This enhances transparency, sets daily collection targets for the loan officers and helps prevent the scope for misappropriation.

• Collections in group meetings: all savings and loan instalments are collected in group meetings in full view of all group members. This ensures that the clients witness all financial transactions and helps prevent misappropriation as well as increase client confidence in the organization.

• Rotation of loan accounts: every six months, the client accounts looked after by one loan officer is transferred to another within the same branch. This ensures transparency and accuracy in record keeping, performs an ad hoc six monthly audit, and helps in detecting fraud or errors.

• Periodic review of passbooks: all client passbooks are checked at least once every quarter by the respective branch manager to ensure that the transaction details noted in the client’s passbook tallies up with the figures in branch documents. This helps identify fraudulent or erroneous transactions. Random checks are also done by head office staff and field managers when they visit clients.

• Disbursements are made from branch offices: clients come to the Branch Office where loans are disbursed in presence of all loan officers and branch manager; all of who sign the loan application form indicating that they have verified disbursement of the sum approved on the application form. This helps avoid misappropriation by ensuring that the entire loan amount is handed over to the clients, not a part of it.

• Peer-group cross checking: peer based cross-checking is a continuous process within ASA and exists at all levels of operations. Loan officers cross check each other’s books of records weekly and branch managers cross-audit each other’s branches monthly. This helps in rapidly identifying irregularities in branches.

• Cashbook duty rotated: since ASA branches do not employ dedicated accountants or cashiers, one of the loan officers perform the duty of a cashier and maintains the branch cashbook. This duty is rotated on a regular basis to ensure that no single person keeps custody of the cashbook for a long period of time and helps identify errors or fraud.

• Check books are kept with a non-signatory: each branch office maintains its own bank account which has at least two signatories – typically the branch manager and a loan officer (on a rotational basis). Bank check books are kept under lock and key in custody of a loan officer who is not a signatory to the account. This helps prevent fraudulent check issue and misappropriations.

• Internal and external audits: internal audits are carried out on branches at random intervals whilst external audit is done annually.

• Computerized record-keeping: the ASA Microfinance Management System (AMMS) is a home-grown Microfinance Management Information System (MF MIS) that was tailor made to cater to ASA’s lending methodology. This MIS keeps track of a branch’s lending performance and has separate modules for loan administration, accounts and human resources management. AMMS is currently being implemented in Bangladesh and a number of other countries by ASA International.

To minimize Legal and Compliance risks, ASA International’s in-house legal team works closely with local legal advisors in all its operating countries to ensure that it meets all statutory and legal requirements.

Strategic Risks

Strategic risks arise when a MFI has inadequate governance structure in place (governance risk) or if its market reputation suffers due to mismanaged operations or client interactions (reputation risk) or due to external market factors (external business risks and even risks).

All ASA International entities are governed by experienced staff members who are deputed from ASA Bangladesh to these institutions. Most have over 10 years working experience with ASA in Bangladesh and are therefore well acquainted with both ASA’s philosophies and its core principles. As entities mature, their Board of Directors is expanded to include individuals who have specialized knowledge of a market and are aligned with the mission of ASA International.

Every single ASA and ASA International staff members are made aware of ASA’s core philosophy of focusing on its clients first. This, coupled with ASA’s strategy of fostering close ties with its clients, minimizes reputation risks. To minimized external risks or event risks, ASA International’s Business Development Unit keeps track of major macroeconomic, legal, regulatory and fiscal policy trends that have the potential to affect operations for each operating country. Regular reports are prepared for senior managers and corrective actions are taken as required.

Recommendations

The intrinsic and environmental risks that microfinance institutions (MFI) face are unique to it. While broad categories of risks might remain the same, the urgency and possible adverse impact of these risks are different for individual MFIs. There is no ‘comprehensive risk management’ strategy that is applicable for all MFIs and risk minimization processes that work for one MFI (however large and successful be) might not work for another.

Each microfinance institution must, therefore, mitigate risk on its own terms, considering its own variables. According to GTZ (2000), classic risk management takes a four step process:

1. Identifying and assessing risks in terms of their severity (either frequency or consequences);
2. Measure risks and evaluating your risk tolerance or risk appetite;
3. Monitor the identified risks on a regular basis and identify any new ones; and
4. Manage these risks through close oversight and performance evaluations

In carrying out these steps, an effective ‘feedback loop’ must be developed – one that reports information effectively and timely back to decision makers so that they may act upon this.

MFIs also need to be aware that risk management is a continuous process and should be treated so, not as a ‘one-off’ exercise that is carried out annually or bi-annually. The risk management processes should have its own champions within the organization and senior management needs to be an active part of this process. Indeed the entire risk management process should be led by senior management with feedback and recommendations coming to them from all levels of the organization – it is important to listen to the experiences and voices from the fields in order to understand ground realities.

They also have to be more comprehensive in their risk identification and assessment process, looking beyond the obvious ones and identifying potential risks. This process should also include looking at clients. Helping clients learn how to minimize their own risks and build resilient to economic shocks (such as saving regularly to build up working capital) helps strengthen the operations of a MFI in the long run.

Conclusion

Microfinance Institutions (MFIs) have come a long way from their modest beginnings and some have matured to world class institutions that rival their formal financial cousins. With poverty remaining a major issue in the 21^st century, MFIs are set to proliferate and grow into even larger institutions. Unless these MFIs embrace some of the mechanisms adopted by formal financial institutions, especially in terms of managing their business risks, most might not sustain in the longer run.

Over the last decade or so, enterprise-wide risk assessment and risk management has emerged as an important exercise for MFIs and most have been utilizing it in one form or other. They might not apply formal terminologies to these processes or even recognize that such strategies they have put in place, but all MFIs have some risk management strategy inherently built into their lending methodology. Risk management now needs to emerge as a separate business activity – one that is systemic and integrated into the core business process of the organization. It should become as important an exercise as fund planning or budgeting.

In creating their own risk management strategies, MFIs should learn from what others are doing in similar business environments and learn from past mistakes made in the industry. They need to recognize, however, that strategies are unique to each institution and to simply copy what successful ones are doing might not bring the same results.

Microfinance practitioners need to be aware of the importance of risk management and the entire process should be led by the caretakers of these institutions – the Board of Directors.

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[1] In the context of this paper, ASA and ASA International are often used interchangeably when discussing risk management strategies. The primary reason being ASA International replicates the ASA’s Methodology of Microfinance Operations in all countries that it operates it, and some risks are more relevant to ASA International’s operations than ASA’s in Bangladesh.

References

Asian Development Bank (ADB) (2000). The Role of Central Banks in Microfinance in Asia and the Pacific: Overview. Manila: Asian Development Bank (ADB).

Churchill, Craig, and Cheryl Frankiewicz (2006). Making Microfinance Work: Managing for Improved Performance. Geneva: International Labour Office (ILO).

Consultative Group to Assist the Poor (CGAP) (2009). The Global Financial Crisis and Its Impact on Microfinance. Focus Note No. 52. Washington, DC: CGAP

Fernando, Nimal A. (2002). ASA – The Ford Motor Model of Microfinance. Published in the quarterly newsletter of the Focal Point for Microfinance, June 2002, Volume 3 Number 2. Manila: Asian Development Bank (ADB).

Fernando, Nimal A. (2008). Managing Microfinance Risks: Some Observations and Suggestions. Manila: Asian Development Bank (ADB).

Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ) (2000). A Risk Management Framework for Microfinance Institutions. Frankfurt: GTZ.

Parameswaran, Siddhart & Raper, Nicholas (2003). Microfinance: Financial Services for the Poor. Paper presented to the Institute of Actuaries of Australia, 2003 Biennial Convention. Australia.

Author’s Note

This paper represents the views of the author alone and does not necessarily reflect the opinions or positions of either ASA International or any other organization he may be associated with.

This paper was first presented in its draft form to the “4^th Annual Microfinance Conference” organized by the Central Bank of Nigeria (CBN) in January 2010 at Abuja, Nigeria.

About the Author

Saleh Khan

“Saleh Khan is the Country Director of Nigeria for ASA International where he is responsible for overseeing microfinance lending operations in Nigeria, as well as Ghana. Before taking up this post, he was a Junior Investment Director in Catalyst Microfinance Investor’s (CMI) Bangladesh Office, where he was responsible for strategizing the fund’s investments in Asian and African MFIs and monitoring their performances.

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