Being in business for about more than 30 years, microfinance institutions still have to face risks. There is a need to build strategies to mitigate risks. Some of the major reasons include:
- high dependency on the rural population on agriculture which itself is dependent on monsoon,
- lower income of people,
- fewer employment opportunities in the rural sector
Apart from these external risks general risks arise due to moral hazard and information asymmetry. Even though avoiding risk is not possible but its mitigation is possible. Therefore, microfinance institutions in India have started using innovative risk management strategies. This article will discuss various risks and strategies that are used by these institutions. Furthermore, some cases are highlighted which led to the downfall of the whole microfinance group in India.
Classification of risks in microfinance institutions
The types of risks faced by microfinance institutions are categorized into:
- market and
- credit risk.
Mismanagement by staff, failure of functioning of a process, frauds by staff and clients, insecurity in portfolio management are some reasons for operational risks.
Strategic risks arise due to poor leadership which lead to inefficient decision making. Furthermore, poor governance leads to the improper implementation of policies and inappropriate business strategies (Subburajan and Reuben, 2014).
The diversification of these institutions as commercial banks has also increased the risks. Some of the issues such as liquidity risk, volatility in the exchange rate, interest rate, cash movement are also major problems.
Consequently, credit risk in micro-financial institutions is due to their policy of having no collateral during the lending process. This led to a high rate of defaulters (MicroSave n.d.). Credit risk further consists of transaction risks (risk on individual loan) and portfolio risk (risk on the overall management of the portfolio).
Existing measures adopted by the microfinance institutions of India
Microfinance institutions being the game changer for the rural sector by uplifting them from existing poverty level are not free from risks. Risk management strategies are used to reduce the likelihood of the losses due to the risks explained above. General risk management strategies are in use and some examples from other microfinance institutions are:
Quantitative assessment coupled with incentives and penalties to mitigate credit risk
This involves default risk and delayed payments which come under individual loans. Similarly, another is portfolio risk which arises when clients deposit the money in unreliable or weak institutions that are in on the verge of solvency. In order to prevent credit risk, microfinance institution perform:
- quantitative assessment and screening of the customer,
- regular monitoring of activities of a client,
- offer an incentive to prevent delinquencies,
- also, the heavy amount of penalties is imposed in case of default and adoption of a limit on the amount of the loan.
In the case of agriculture loans, credit officers are trained for credit appraisal and management. It is now in practice that loan is preferably given to the individuals having a various source of incomes. Furthermore, institutions are also evaluating the debt capacity of the household (Fernando 2007).
Group lending is one of the innovative tools used to mitigate credit risk. The outstanding feature of group lending is that no collateral is required to lend loans but the group is responsible for the payback of the loan (EY 2014). Thus, peer pressure act as a collateral in this case. Several microfinance institutions in India are using Self Help Group and Joint Liability Group model in the rural sector.
An excellent example of these strategies is given by the Association of Social Advancements (ASA) a microfinance institution of Bangladesh which include building a strong credit culture, reporting of activities where credit is being used and strict organizational control.
Mitigation of operational risk by focusing on the recruitment process
Due to increase in diversification, geographical expansion (offices far from the head office, remote area offices) and positioning of officers from a long period in microfinance institutions in India, operational risks have increased over time. Microfinance institutions in India facing operational risk use various strategies to mitigate risks. Some of the most used strategies include:
- standardization of policies for staff (so that there is a less chance of fraud),
- effective internal control of any human error,
- recording of fraudulent staff,
- background verification of staff before recruiting.
Training of staff towards client-centric work not only improves efficiency but also leads to a loyal base of employees. Technology intervention has also proved to be helpful in reducing human error. Kenyan microfinance institutions K-Rep’s follows certain strategies which include incentives for its staff, strict monitoring, an arrangement of programs to speak against corrupt staff members etc. (Steinwand 2000).
Diversified portfolio to mitigate market risk
Many institutions are exposed to market risks, mainly interest rate risks which arise due to two major reasons. Firstly, due to the slow adjustment of institutions towards variable interest rate in the market. Secondly, liquidity risk due to an increase in term of loans. To reduce liquidity risk, microfinance institutions usually invest and have diversified portfolios, which attract investments for further lending (Fernando 2007).
Skilled and efficient board to tackle strategic risk
This arises due to a lack of management skills and poor governance. This form of risk becomes important for complex structured financial institutions. This management can make policies, handle and guide on strategic issues and can review the implemented actions. Foreign exchange risk is not considered in the study because the majority of Indian microfinance institutions are not using foreign funds for lending.
Despite the adoption of strategies to mitigate risk and the use of ethical practices to collect money, the microfinance industry is exposed to many risks and chances of fraud. Due to this crisis, institutions are losing their trustworthiness. Similarly, commercial banks are also refusing to disburse loans to microfinance institutions. This led to a negative borrowing trend in the industry which raised portfolio risk and made lending costly (Kaur & Dey 2013)
Need to learn from past and improve strategies accordingly
Functioning of microfinance in India has been commendable since it was started. However, due to various internal and external factors, risks and losses has led to negative growth and has reduced the trustworthiness. A risk is an essential part of every business and it is not possible to avoid them. So, risk management should be considered seriously and actions toward necessary measures should be taken on time. Identification, monitoring and controlling of risk-oriented steps should be done to minimize the losses. Microfinance institutions in India are present to serve the rural and poor population which should work on ethical lines. Also, microfinance institutions should keep in mind the lessons from cases of failure while devising strategies at the management level.
- Dirk Steinwand, 2000.A Risk Management Framework for Microfinance Institutions, Available at: http://www.ruralfinanceandinvestment.org/sites/default/files/1126266387218_A_risk_management_framework_for_MFIs.pdf.
- Sekar P. C. Subburajan, M. and Reuben, D., 2014. MICRO FINANCE INSTITUTIONS IN INDIA- AN EFFECTIVE RISK MANAGEMENT.INTERNATIONAL JOURNAL OF CURRENT RESEARCH. Available at: http://www.journalcra.com/sites/default/files/3979.pdf.
- EY, A., 2014.evolving-landscape-of-microfinance-institutions-in-india, Available at: http://www.ey.com/Publication/vwLUAssets/ey-evolving-landscape-of-microfinance-institutions-in-india/$FILE/ey-evolving-landscape-of-microfinance-institutions-in-india.pdf.
- Fernando, N.A., 2007. Managing Microfinance Risks: Some Observations and Suggestions, Available at: http://www.microfinancegateway.org/sites/default/files/mfg-en-paper-managing-microfinance-risks-some-observations-and-suggestions-jul-2008.pdf.
- Kaur, P. & Dey, S., 2013. Andhra Pradesh Microfinance Crisis and its Repercussions on Microfinancing Activities in India.Global Journal of Management and Business Studies. Available at: https://www.ripublication.com/gjmbs_spl/gjmbsv3n7_02.pdf.
- MicroSave,Risk Management, Available at: http://www.microsave.net/files/pdf/Risk_Management_Booklet.pdf.