In our previous posts on risks faced by microfinance institutions we covered
Risks for MFIs do not end with just credit and operational risk, the third category of risk which we will now discuss in this post is the market risk faced by Microfinance Companies .
Market risks are risks of financial nature, which occur due to fluctuations in the financial market or due to mismatch in assets and liabilities of an organization. As the MFIs become bigger in size and complex in terms of their asset and liability composition market risks become more pertinent. The assets and liabilities composition of MFIs, expose them to various kinds of market volatilities. As a result changes in market conditions, through external to MFIs, impact them either favorably or unfavorably and are therefore risks. For MFIs there are three most important market risks.
a. Liquidity risk
b. Interest rate risk and
c. Foreign exchange risk: Foreign exchange risk arises due to fluctuation in exchange rate of currency in which the MFI has borrowed funds, against local currency: they can be mitigated (“hedged”) by accessing financial products offered by banks. Foreign exchange risk is not relevant from Indian micro-finance perspective as Indian MFIs are generally not dependent on foreign sources of funds.
a. Liquidity Risk
The financial position at any point in time of any organization is reflected by its Balance Sheet, which shows the position of Assets and Liabilities. Assets are the resources owned by the organization through which it generates its revenues. These are application of funds and reflect where all the funds available with the MFI are deployed. Funds could be lying in the form of cash, fixed assets or be invested in portfolio, fixed deposits or other securities. Liabilities on the other hand are sources of fund; these are the obligations of organization, which need to be fulfilled according to the contract. Borrowings, savings raised, other payables are all examples of liabilities as they are the obligations on the organization.
An organization meets its committed payments or fulfills its obligations through the assets it has. In order to use the assets to meet obligations they should be available to the organization in liquid form that is cash. From the example of assets such as cash, fixed deposits, loan portfolio or other receivables and fixed assets we see that not all assets can be used, immediately to fulfill obligations. It is well known that to repay a loan from a bank an organization cannot send fixed deposit certificate or a fixed asset means its ability to be turned into cash. A fixed deposit for 3 years cannot be turned into cash before three years and hence is not a liquid asset but an investment. An investment which is maturing in next one month is liquid as it will be turned into cash in one month’s time. Asset liability management is therefore, a process through which an organization has to match maturing of its assets (that is when they can be turned into cash) with maturing of its liabilities (that when they are falling due for poor payments). If an organization does not have sufficient assets maturing to fulfill its liabilities falling due then there is a risk that the organization may not be able to honor its committed obligation and this risk is called Liquidity Risk.
Assets, maturing within one year period are termed as Current Assets, while liabilities which are falling due within one year period are called Current Liabilities. Liquidity management is therefore, basically managing current assets and currents liabilities. If an organization’s current liabilities are more than current assets than such an organization has an immediate liquidity risk.
Liquidity risk in financial institutions is considered to be one of the most sensitive issues and a risk of high priority. As liquidity problem can result in a financial institution failing to honor its obligations it can result in loss of reputation, loss of credibility among lenders and depositors and has the potential to snow ball into a big crisis. If an MFI is not able to pay back savings of depositors when they come for withdrawal because they don’t have enough cash then it can immediately give wrong signal in the market. Rumors may spread that either MFI does not have intention to pay back savings or is financially bankrupt. Spread of this news with other depositors can result in panic situation who may also come for withdrawal and this could lead to a situation called run on savings, where everyone wants to withdrawal their savings compounding the entire problem. Similarly, defaulting on repayments to be made by the MFI to its lenders can result in loss of confidence of not only of current lender but also other lenders, which can make borrowings very difficult in the future. Credit rating of the MFI can also fall down which can create further problems in its fund raising.
As we now understand the downside of the lack of liquidity: should we suggest that MFIs remain highly liquid (that is having sufficient cash) at all the times to meet any contingency The answer to the question is No. One must understand that liquidity comes at a cost and if the assets are held in cash the MFI may not be able to earn any fee or interest. Idle assets should be avoided. An organization maintaining high liquidity will be losing on the returns from the asset it could have invested the money in. For an MFI it is generally the loan portfolio. If an MFI keeps high amount of cash it loses out on the interest it could have earned had that amount been invested in portfolio. The loss does not end there; the MFIs generally have this cash either from the borrowed funds or from the clients deposits and both sources of funds have cost attached to them. MFI has to pay interest on its borrowing as well as deposits irrespective of the fact that they are deployed in loans or not .Any cash laying idle means that MFI is losing on income from that cash while it has to pay charges on it in the form of interest. Hence idle cash results in losses. It is the responsibility of MFI to deploy its cash as efficiently as possible so that it (Cash) does not sit idle. So we see that while high liquidity brings the profitability and sustainability of an MFI down; insufficient liquidity results in the risk of defaulting on obligations. All financial institutions including MFIs have to juggle their assets and liabilities to strike the right balance. This balancing, to strike the right mix of not having too much idle funds while at the same time having enough funds to meet all obligations, is called liquidity management or asset liability management (ALM). The MFIs need efficient cash planning and management systems within the organization to make required funds available to all branches for their operations. Any excess fund lying anywhere in the system has to be timely transferred to a place where it is required.
b. Interest Rate Risk
Interest rate risk arises due to the fluctuations in the interest rates at which the MFI has borrowed from financial institutions. Such as banks can change their interest rates (at which they lend to MFIs) based on their own change in internal policies/strategies or due to changes in marco-economic conditions. Changes in rate may mean increase or decrease in the cost of fund for the MFI which directly affects its margins. If the bank interest rates drop it may result in extra income for the MFI while exactly opposite may happen if the interest rates go up. It is this uncertainly, which brings in the element of risk for the MFI and is called interest rate risk.
One may argue that an MFI may also revise its own interest rate to match the bank interest rates to manage the risk. However, in practical terms revising interest rates frequently is not possible for the MFIs because of various operational reasons such as:
1. Increasing interest upward in an issue of controls and is not easy even though MFIs put a clause that interest rate can be changed from time to time. Therefore, normally once an interest is indicated in a loan it is not varied till the end of the agreed terms. In case of investments the issuer may not.
2. Floating rate loans and investments are not popular in the country.
3. With simple MIS that MFIs generally have, revising interest rate means managing different sets of data, which becomes source of confusion and is very cumbersome.
4. MFIs generally have printed cards, formats for its loans, it involves cost to change these formation to a new interest policy
5. Staff training is also an issue; staffs are used to working with a certain policy and generally get completely accustomed to it. A new loan system requires the staff to learn new installment size etc. which against is time consuming and difficult.
6. It is also difficult to retrain the clients on new polices, new installment systems particularly when the clients may be used to a particular kind of repayments schedules.
Even if an MFI could change its own interest rate, it will not be possible to do that for the running loans. This is also knows as the reprising risk. If an MFI has a taken a loan on which the bank has put a clause that it can reprise (change the interest rate) the loan every six months and the MFI has invested these borrowed funds in one-year fixed rate loans to its clients, the MFI cannot change the interest rate before one year, although bank can changes its rate in every six months, which can result in losses.
MFIs have to be very cautions while they sign loan agreements with banks or other financial institutions. It is important to read such clause, be aware of them and their implications. Generally, it is better to have funds, which have long reprising terms or are of fixed rates even if they come at a slightly higher rate, as this will not expose the MFI to risk of interest rate fluctuation. Specialized financial institutions take calculated risks reading the market situation and expecting the market trend and try to take advantage of it. If the long-term fixed interest rate investments are funded through short-term floating rate funds, then if the interest rates in the market fall it results in profit for the organization. For example if an organization gives a loan for 18% for two year and the rate is fixed for two year. The organisation has given this loan from funds, which it has borrowed at 12% floating rate, which will be reprised every 3 months. If the overall interest rates in the market fall then the cost of funds for the MFI will fall down from 12% while its own interest rate will remain fixed at 18% thereby increasing the organization’s profit.
Interest rate risk for financial institutions with a large portfolio will be subject to greater complications. In the case of such institutions, a change in interest rate not only affect immediate profitability but can also change the value of the underlying assets and liabilities because of the change in the present value of the future cash flows. However, for MFIs interest rate risk is mainly related to the immediate pressures on the margin and adapting to new market conditions.
It is important that while raising funds such clause on reprising are carefully considered and compared between sources of funds. A s MFIs are not specialized in handling such kind of market risks it is often better to go for fixed interest borrowing even if they cone at a slightly higher rate. If there is a certainly about borrowings even if they come at a slightly higher rate. If there is a certainty about borrowing rates MFIs can have strategic such as higher scale of operations, cutting operational expenses or setting its own interest rates to factor in higher cost of funds. But if the rates are fluctuating then it can be difficult fro the MFIs to manage it.
We discussed three types of marker risks: liquidity risk, interest rates risk and foreign exchange risk. One can now appreciate the varied kind of risks that MFis are exposed to and which are all of very different nature be it credit risk, operational risk or market risk. This again underscores the need for strong risk management system with in MFIs.