Risk Management for African Microfinance Institutions

More than 30 years ago, microfinance began with the simple idea of lending small amounts of money to groups of low-income entrepreneurs, the majority of them women. As the industry and its clients have matured, microfinance institutions (MFIs) have offered a broader array of products and sought new sources of capital. Women’s World Banking (WWB) works with its global network of MFIs as they mature, helping them reach sustainability and, in some cases, transform into regulated institutions.

Microfinance has the capacity to reach millions of people, predominantly women, who have not previously had access to financial services. According to a 2007 World Bank report, more than 400 million Africans live below the poverty line – equalling half of the continent’s population. This, combined with the importance of the informal economic sector, makes it a good environment for microfinance.

Historically, donors and governments have been the main providers of resources to the microfinance sector in Africa. Today, however, microfinance players have access to diversified sources of funding including private equity, commercial borrowing, savings mobilisation and capital markets.

Effective Risk Management in the Microfinance Sector

While it is hard to make generalisations about Africa’s microfinance sector because of its regional and institutional diversity, there is clear evidence that the continent is following the global trend of increased transformation of MFIs into regulated financial institutions (this includes non-governmental organisations (NGOs) transforming into regulated entities, as well as MFIs choosing to become regulated institutions at inception). As MFIs increasingly choose to become regulated institutions, regulators often mandate their risk management strategies.

When an institution becomes regulated, it is generally required to dedicate more focus to portfolio classification and management, loan loss provisioning, asset and liability matching, and information technology systems. Effective risk management strategies are also essential for MFIs in order to attract capital, protect against losses, and gain the confidence of customers, donors, investors and rating agencies. As with many MFIs globally, African institutions are drawing on best practices from the corporate world to develop effective risk management strategies.

A recent report by WWB and the Africa Microfinance Action Forum (AMAF), ‘Diagnostic to Action: Microfinance in Africa’, surveyed the achievements, challenges and growth trends in the African microfinance sector in order to inform strategic decisions with regard to scaling up microfinance on the continent. One finding of the report is that few African MFIs have risk management units in place. Drawing on another WWB publication, ‘Tool for Developing a Financial Risk Management Policy’, we present the following comments and recommendations with regard to financial risk management for African MFIs.

An institution should perform a 360⁰ enterprise risk assessment that includes assessing operational risks and credit risk policies, particularly asset liability management (ALM) and liquidity risk management, which are often neglected by MFIs. Traditionally, MFIs have focused solely on credit risk and did not have systems in place to address more complex financial risks. The key to managing these risks is to ensure that an institution’s assets and liabilities are well aligned and, where gaps exist, mitigating strategies minimise the exposure.

Risk management in Africa presents unique challenges. According to a 2007 Microfinance Information eXchange (MIX) publication, African MFIs reported higher percentages of portfolios at risk, as well as lower percentages of risk coverage and higher percentages of non-earning liquid assets. A good risk management programme will help MFIs facing these realities develop a customised plan to identify such trends and address them.

For example, operating costs are typically higher for MFIs in Africa than elsewhere. Throughout Africa, weak infrastructure (communications and roads), low population density, predominantly rural markets and high labour costs all contribute to high operating expenses. However, despite the high cost environment, African MFIs do not pass on these costs to clients. One reason for this is the large number of savings and loan co-operatives, which are member-based and intend to operate profitably but not to maximise profits.

Another reason is that some MFIs refrain from keeping rates high for prolonged periods. In this context, a financial risk management programme will demonstrate the link between profitability and sustainability and encourage MFI managers to price products appropriately. It will also help them develop an appropriate product mix.

Several regions are facing problems of over-indebtedness at the client level, resulting in an increase in write-offs and loan loss reserves. In the case of one MFI in east Africa, the branch manager succeeded in bringing the portfolios at risk of more than 30 days down from 15% to about 4%. However, she still had a lengthy list of borrowers delinquent more than 90 days and had little hope of recovery. In most of these cases, the borrowers were delinquent on several loans from other lenders. In an effort to decrease these write-offs, and in keeping with the institution’s risk management goals, she joined other branch managers in the area to minimise overlap in borrowing.

Corporate Governance and Management

Another challenge in the African context is governance. The ultimate accountability for financial risk management rests with the board of directors. When an MFI is non-regulated, and especially if a few key individuals manage it, the importance of the board’s role in supervising financial risk management is even more critical. The board plays a crucial role in setting financial policies and risk tolerance, while management is charged with ensuring the implementation of these policies at the operating level.

Management must also ensure that individuals with the right capabilities are hired, carefully drawing lines of responsibilities between them. They must also guarantee that the magnitude of risks is adequately addressed. It should build the board’s confidence in its capacity to implement these policies. Strong, open communication allows managers to identify and address the MFI’s risks.

Finally, when the MFI is managed by a small number of key managers, the existence of ‘key person risk’ makes proper segregation of duties an imperative. A survey by the Centre for the Study of Financial Innovation (CSFI) found that two of the major risks to the African microfinance market are corporate governance and management. A good financial risk management policy incorporates articulation of governance roles and responsibilities.

Risk Management Education is Key

More than five years ago, when Women’s World Banking (WWB) began working with MFIs to improve their risk management capabilities, few of the organisations were regulated and most did not have formal risk management policies. As part of its work with MFIs, WWB has developed a workshop and electronic course for understanding financial risk management. The workshop teaches groups of MFI managers to focus on asset and liability management and measuring liquidity risk, and to think holistically about product development.

In 2005, in partnership with Citi, WWB began to host the first of these risk management workshops. The first African workshop was offered in 2007, in Kampala, Uganda, to help east African MFIs develop clear financial risk management strategies and systems in order to protect and sustain profitability, and gain increased access to capital to fuel institutional growth and client outreach.

In December 2008, an additional programme will be offered in South Africa, a ‘training of trainers’ in financial risk management that will enable instructors to then offer classes more broadly throughout Africa. WWB has also developed a financial risk management toolkit which contains five modules covering:

1. Risk management generally.
2. Roles and responsibilities.
3. A balance-sheet based template for creating a risk management policy.
4. Training on preparing asset liability tables.
5. Liquidity and cash management policy.

The toolkit includes Excel models for MFIs to replicate or adopt.

Looking ahead, the WWB/AMAF ‘Diagnostic to Action’ report stresses the importance of developing managerial skill for the continued growth of microfinance in Africa: “The importance of getting the basics right cannot be understated. It is of ultimate importance in mastering the challenges of delivering financial services in a high-operating cost environment like Africa. There are still many institutions that do not grow because they are unfamiliar with or unable to adopt good practices that could ensure institutional health and opportunities for growth. Senior MFI and bank managers need both the vision and the managerial capacity to find a business model that can create efficiencies in the particular context, plan for its execution, know the risks, chart a path that overcomes the major challenges, and stay the course.”

There is reason for optimism in the African MFI sector – its astounding growth, institutional diversity and product diversity, as well as innovation in developing regional solutions to counteract high operating costs. With solid financial risk management policies in place, African MFIs will continue to contribute toward poverty alleviation in their countries of operation.