The need for credit risk management in micro finance institutions
Micro finance institutions operate in the economy with the ultimate objective to serve the financially poor section of the society, by providing them with financial support and credit services (Luyirika, 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 bothered 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 and repay the loan amount. Many a times, to fulfil the object of generating regular cash flows in the institution, proper credit risk analysis is ignored. As such, the objective of maintaining the sustainability of the institutions is not given due attention and due to which, failure follows. According to (Nasir 2013), the micro finance institutions are struggling for their existence in India due to their lack of initiatives in managing the credit risks.
Challenges of the micro finance business
The recent case of Andhra Pradesh’s micro finance crisis demonstrates the ill-effects of overlending and illicit recovery practices followed by the micro finance institutions. The crisis was a result of many such institutes rushing to meet their sales target, resulting in over-lending to borrowers at exorbitant rates without due consideration to their repayment capacity. When the time came for the borrowers to repay their loans, they failed to do so, prompting their lenders to adopt aggressive recovery practices. Burdened by loss of crop (in many cases) and harassment faced from these micro finance institutions, many were driven to suicide (Kaur & Dey 2013). The micro finance boom in India soon turned into bust and a huge crisis ensued in the finance spectrum.
If the Andhra Pradesh 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 aggressive 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.
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 micro finance institutions has not been realized by many, except the large scale ones that can afford state-of-the-art risk management infrastructure. Many medium and small scale micro finance 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 they are extremely vulnerable to dishonourable debt. The problem spirals out of control when a large number of individuals or groups default on their loans, causing a huge dent on their financial returns (MicrofinanceGateway n.d.).
Importance of credit risk management system for micro finance institutions
Risk management, especially credit risk management, therefore deserves more attention than it is presently getting in micro finance. A robust risk management system would not only help micro finance institutions mitigate the credit risk but also help them devise solutions at the time of operational problems. The risk analysis aids the micro finance institutions to recognize, measure and evaluate those credit risks that may put a negative impact on the financial status of the institution. Following are few of the advantages offered by risk management tools (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 to credit risk assessment assists micro finance 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 the unexpected losses. The risk management tools and techniques can help in cultivating the culture of good risk management and helps in mitigating the losses with cost effective approach.
- Cost-effectiveness and profitability: Micro finance 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 business.
- Obtaining more funds: The micro finance institutions are funded either by the way of debt or with the savings that are deposited by the clients in their institutions. In order 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 these institutes and are required to be followed adequately to retain the strong financial position in the economy.
Given the highly volatile business environment and industry malpractices, there is a need for a revolutionary change in micro finance industry of India, especially medium and small scale ones. Most large scale institutes in India already have the risk management infrastructure in place due to their affordability quotient. But medium and small scale micro finance institutions 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.