Importance of credit risk in microfinance institutions
Microfinance institutions operate in the Indian economy with the ultimate objective to serve the financially poor section of the society. This is done by providing them with financial support and credit services (Lyuirika, 2010). However, their objective of financial stability and their long term viability can’t be overlooked. Very often, the task of managing both the purposes becomes a bother grindstone for such Micro Finance Institutions. The reason behind the same lies in the fact that the unprivileged section, to whom the loans are provided, lacks a stable income to provide the collateral to the loan amount. Many times, to fulfil the objective of generating regular cash flows in the institution, proper credit risk analysis is totally ignored.
As such, the objective of maintaining the sustainability of the institutions is not given due attention. This leads to the failure of such schemes. According to Nasir (2013), microfinance institutions are struggling for their existence in India due to their lack of initiatives in managing the credit risks.
Lesson from the microfinance crisis in Andhra Pradesh
The recent case of Andhra Pradesh’s microfinance crisis demonstrates the ill-effects of overlending and illicit recovery practices followed by the microfinance institutions. The crisis was a result of many such institutions rushing to meet their sales target. This results in over-lending to borrowers at exorbitant rates without due consideration of their repayment capacity. When the time came for the borrowers to repay their loans, they failed to do so. So these microfinance institutions start adopting harmful recovery practices. Burdened by loss of crop (in many cases) and harassment faced by these institutions, many were driven to suicide (Kaur & Dey 2013). The microfinance boom in India soon turned into a bust and a huge crisis ensued in the finance spectrum.
If the microfinance credit crisis has taught us anything, is that it is extremely important for banks to:
- Check the credit worthiness of the borrower (although not base their decisions on the credit worthiness alone).
- Offer loans to borrowers at reasonable rates of interest so that repayment of loan does not seem out of reach.
- Refrain from employing unethical and harmful recovery tactics that may lead to unintended consequences like death of the borrower.
- Employ better risk management mechanisms within the bank that will check the credit worthiness, anticipate the likelihood of loan default and make the management of loans more efficient.
Adoption of risk management only by large scale financial institutions
Risk management has undoubtedly emerged as one of the most important tools for mitigation of anticipated risks or failures for a financial institution. However, its importance in microfinance has not been realized by many. Only some large scale institutions can afford state of the art risk management infrastructure. Many medium and small scale institutions still find themselves with no systems to fend them. They rely on traditional forms of analysis like subjective judgment or do not do any analysis at all. In such cases, microfinance institutions are extremely vulnerable to bad debts. The problem spirals out of control when a large number of individuals or groups default on their loans, causing a huge dent in their financial returns (MicrofinanceGateway n.d.).
Importance of credit risk management system for microfinance institutions
Risk management, especially credit risk management, therefore deserves more attention than it is presently getting in microfinance. A robust risk management system would not only help microfinance institutions mitigate the credit risk but also help them devise solutions at the time of operational problems. The risk analysis aids these institutions to recognize, measure and evaluate those credit risks which have a negative impact on the financial status of the institution. Following are a few of the advantages offered by risk management to microfinance institutions (MicrofinanceGateway n.d.):
To keep up with the scope and level of expansion of business
Institutions are growing bigger in size and reach. In order to stay ahead of dynamism in the market, they need to upgrade their internal management systems and risk management. It helps them manage credit and liquidity risks, market risks, pricing and operational risks, etc. Only the proper analysis of credit risk can help the bank to avoid facing the failures of financial losses.
Making calculated decisions
Prior credit risk assessment assists these institutions in making educated and calculated decisions about the risks that cannot be tolerated. The important steps in this regard are also decided in advance in order to evade unexpected losses. The risk management tools and techniques can help in cultivating a culture of good risk management. This will also help in mitigating the losses with a cost-effective approach.
Cost-effectiveness and profitability
Microfinance institutions, particularly in India, are struggling to stay afloat financially by looking for cost-effective solutions. Risk management methods can ensure that their capital and cash are managed better with minimal risk to the business.
Obtaining more funds
There are mainly two major sources of funds for these institutions.
- Through debt from other institutions.
- From savings that are deposited by the clients in their institutions.
To maintain a position in the economy and to obtain more funds by the way of debt, strong financial performance becomes a due necessity. In such cases, the application of credit risk mitigation strategies or techniques become the obligation of the microfinance institutes and are required to be followed adequately to retain a strong financial position in the economy.
In this day and age, given the highly volatile business environment and industry malpractices, there is a need for a revolutionary change in the microfinance industry of India, especially medium and small scale ones. Most large scale microfinance institutes in India already have the risk management infrastructure in place due to their affordability quotient. But medium and small scale microfinance institutes still operate on traditional banking terms, which may prove detrimental to their business growth.
- Kaur, P. & Dey, S., 2013. Andhra Pradesh Microfinance Crisis and its Repercussions on Microfinancing Activities in India. Global Journal of Management and Business Studies., 3(7), pp.695–702.
- LUYIRIKA, M.N., 2010. THE ROLE OF MICROFINANCE IN THE SOCIO-ECONOMIC DEVELOPMENT OF WOMEN IN A COMMUNITY: A CASE STUDY OF MPIGI TOWN COUNCIL IN UGANDA. UNIVERSITY OF SOUTH AFRICA.
- MicrofinanceGateway, Risk Management. Microfinance Gateway.
- Nasir, S., 2013. Microfinance in India: Contemporary Issues and Challenges. Middle-East Journal of Scientific Research, 15(2), pp.191–199. Available at: https://idosi.org/mejsr/mejsr15(2)13/4.pdf.