MICROFINANCE RISK MANAGEMENT HANDBOOK

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M

ICROFINANCE

R

ISK

M

ANAGEMENT

H

ANDBOOK

Craig Churchill and Dan Coster

With Contributions from:

Victoria White, Terrence Ratigan, Nick Marudas, Emily Pickrell and Calvin Miller

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Table of Figures

Figure 1: Three-step Risk Management Process ...3

Figure 2: Categories of Microfinance Risks ...7

Figure 3: Organization of Microfinance Risks by Chapter...11

Figure 4: The Four Ms of Controlling Social Mission Risk...15

Figure 5: Market Research Tools...17

Figure 6: Monitoring Client Composition...18

Figure 7: Evolution of Capital Sources for a Microfinance Program ...21

Figure 8: Sustainability and Profitability Ratios...24

Figure 9: Types of Operational Risks ...34

Figure 10: Reducing Credit Risk through Product Design Features...37

Figure 11: The Five C’s of Client Screening ...38

Figure 12: Methods for Screening Client’s Character ...40

Figure 13: Alexandria Business Association: Delinquency Penalties ...44

Figure 14: Portfolio Quality Ratios...46

Figure 15: Examples of Microlending Fraud ...47

Figure 16: Controls in Handling Loan Repayments...53

Figure 17: Loan Collection Policies...57

Figure 18: Example of Currency Devaluation Impact ...66

Figure 19: Budget Comparison Report...70

Figure 20: The Parts of an MIS ...88

Figure 21: Chart of Accounts Structure...89

Figure 22: Criteria for Evaluating Loan Tracking Software...92

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M Risks M

Under pressure to expand her portfolio, Faith skipped important steps in the loan approval process such as visiting the applicants’ businesses. When the group did not show up on their first repayment day, Faith started looking for them, but to no avail. They were gone.

A cholera epidemic in the township resulted in a complete ban on public meetings. Without meetings, there were no repayments; and without repayments, portfolio quality plummeted.

Jose the loan officer had quite a scam going. He printed up a fake receipt book and went door-to-door collecting late payments. He kept telling his branch manager that he couldn’t find the people or that they were having difficulties because of illness in the family or business problems. In the meantime, he was using the cash to set himself up as a moneylender, charging twice the rates of his employer.

The NGO, Loans-R-Us, wasn’t willing to charge a high enough interest rate to cover costs, and yet it wasn’t improving efficiency enough to bring costs down. It was regularly losing money and eventually the donors got tired of subsidizing it. When the door was finally closed, 50 people were out of jobs and 10 communities no longer had access to the financial services that they depended on to help grow their businesses.

A gang had surreptitiously watched the repayment process for weeks and knew exactly when to intervene and grab the bag of money. The money and the thieves were gone before anyone realized what happened.

Management at the Micro Credit Trust (MCT) knew that many of its clients would have preferred individual loans, but believed that the group was such an efficient delivery mechanism that the organization didn’t do anything about it. Then People’s Bank appeared on the scene, offering individual loans at lower interest rates, without having to attend numerous meetings and training sessions. Before MCT could react, it had lost half of its clients to the competition.

People’s Bank grew much faster than it had projected. Before long, it had a stack of loan applications and not enough money to satisfy the demand. When delays started creeping into the disbursement process, word got around fast and borrowers stopped repaying.

Help Yourself was a new Microfinance Institution that was absolutely determined to become self-sufficient and independent of donors and international NGOs. Subsequently, it established a very strong Board of Directors comprised of influential people from the business and government community. The board fully controlled Help Yourself’s relatively weak executive staff and before long was forcing staff to give large loans to its friends and relatives, who assumed that the MFI was not serious about actually collecting loan repayments.

Under political pressure to help the poor, the government passed a usury law to cap interest rates at 25 percent. No financial institution in the country could cover their costs of issuing $50 or $100 loans at that rate, so rather than helping the poor, this misguided policy reduced the availability of institutional financial services to the very people it was trying to help.

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Introduction

ll microfinance institutions (MFIs) are vulnerable to risks like those described on the previous pages. While MFIs cannot eliminate their exposure to risks, through an effective risk management process, they can significantly reduce their vulnerability.

CARE’s Microfinance Risk Management Handbook provides guidance for managers of CARE affiliated microfinance programs to develop a risk management system. The

handbook describes institutional structures, management systems, and internal controls that should be in place in all microfinance programs. It outlines required and suggested policies and procedures for managing and governing MFIs in a way

that minimizes an organization’s vulnerability and maximizes the chances of fulfilling its potential.

The overriding objective of this handbook is to foster good management and accountability. This will encourage

cost-effectiveness, high portfolio quality, and minimal risk of loss or misuse of funds. The primary audience for this handbook is MFI managers and board members, who are responsible for maintaining the health of a microfinance institution. CARE SEAD Project Managers and their supervisors, internal and external auditors, as well as project evaluators should also find the handbook helpful.

What is Risk Management?

A risk is an exposure to the chance of loss. Risks are not inherently bad. Sometimes, it is necessary to take risks to accomplish worthy and meaningful goals. This is especially true in microfinance where loan officers take risks every day by lending money to people without credit histories, without business records and often without collateral. One has to take risks to operate a successful microfinance institution—but it is important to take calculated risks. Risk management, or the process of taking calculated risks, reduces the likelihood that a loss will occur and minimizes the scale of the loss should it occur. Risk management includes both the prevention of potential problems and the early detection of actual problems when they occur. As such, risk management is an ongoing three-step process: 1

A

This handbook is intended to foster good management and accountability

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Figure 1: Three-step Risk Management Process

1. Identify Vulnerabilities: Before managing risks, it is necessary to identify the organization’s vulnerability points, both current and future. An important aspect of assessing risk is to predict exposure in the short, medium and long term. To help MFIs identify their vulnerabilities, this document contains a risk assessment framework that addresses financial and institutional development issues.

2. Design and Implement Controls: Once an MFI has identified its vulnerability points, then it can design and implement controls to mitigate those risks. Because MFIs operate in different environments, and because CARE works with a diverse set of microfinance partners, the controls outlined in this handbook tend not to be specific or prescriptive. By understanding why a certain control should be in place, MFI managers and directors can tailor the control to their local environment. For example, taking collateral to control credit risk may be appropriate in some markets, whereas in other markets a group guarantee is a more appropriate control.

3. Monitor Effectiveness of Controls: Once the controls are in place, then the MFI needs to monitor their effectiveness. Monitoring tools consist primarily of

performance ratios that managers and directors need to track to ensure that risks are being managed.

This three-step risk management process is ongoing because vulnerabilities change over time. Risks also vary significantly depending on the institution’s stage of development. An MFI with 2,500 borrowers will experience different challenges

from an organization with 25,000 outstanding loans. As participants in a new industry, MFIs cannot afford to become complacent if they want to avoid being toppled by innovations, competition, and new regulations among other things. How often is “ongoing”? That will vary by country context, but at the very least the board should conduct an annual risk assessment update.

Identify Current and Future Vulnerabilities Design and Implement Controls to Mitigate Risks Monitor Effectiveness of Controls Risk management is ongoing because vulnerabilities change over time

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Besides analyzing the current state of the organization, risk management involves using a crystal ball to anticipate possible changes in the internal and external environment during the short-, medium- and long-term. Since no one can accurately predict the future, it is

recommended that you consider best, worst and average case scenarios for each of the three time periods. While it is probably excessive to prepare for the absolute worst-case scenario, risk management involves taking a conservative approach in preparing for potential outcomes. Managers and directors who only plan for best-case scenarios are deluding themselves and are setting their organization up for perpetual disappointments.

It is important to note that microfinance institutions cannot completely eliminate their exposure to risks. Any effort to do so would be prohibitively expensive, thus creating a vulnerability to another set of risks. Managing risk involves the search for the appropriate, though elusive, balance between the costs and effectiveness of controls, and the effects that they have on clients and staff.

Structure of the Handbook and How to Use It

The Handbook is divided into six chapters. The first chapter presents a framework for conceptualizing microfinance risks, and the next four chapters discuss the controls required to mitigate the four major categories of risks: institutional risks, operational risks,

financial management risks, and external risks. The final chapter describes the accounting and other systems required for effective risk management.

At the end of most sections is a set of questions that can be used as a control checklist. This checklist may be useful for managers and board members in conducting a self-assessment of whether sufficient controls are in place to mitigate various risks. External technical support agents, like CARE, can also use the checklist to conduct risk management assessments of their partners. These checklists are summarized and cross-referenced in the appendix by the individuals responsible for ensuring that the controls are in place. At the end of each chapter is a list of resources and recommended readings, which is also summarized in the bibliography that follows the annexes.

The handbook can be used as a mentoring-training guide, a reference manual and a self-assessment tool. For example:

ê The board of directors can use this handbook as a framework for conducting a risk assessment of the organization, which is one of its major responsibilities.

ê MFI managers can use the handbook to learn why various controls and systems are needed and apply the suggested guidelines to their local circumstances. There is not one way of doing things, so the handbook provides recommendations rather than hard and fast policies.

ê Supervisors and auditors could use the handbook as a checklist of procedures and systems that should be in place. Checklists have been inserted at the end of most sections to remind readers of key systems, controls and procedures.

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ê Project designers should use the handbook to describe expected controls and procedures that will exist by the end of a project.

This document is a work in progress. Just as microfinance is a constantly evolving arena, so will its subsequent risks, controls and monitoring mechanisms change over time. If you find that sections have become outdated, or new risks and controls have emerged, please bring this to the attention of CARE’s SEAD Unit so they can make necessary revisions.

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Chapter 1: Risk Assessment Framework

ost microfinance institutions are small and unprofitable, and they operate without systems that adequately reduce risk. Although the microfinance literature focuses on success stories, such as BancoSol in Bolivia or BRI’s microfinance units in Indonesia, these organizations are exceptional. For microfinance programs striving to fulfill their dual mission of sustainability and outreach to the poor, CARE suggests implementing the risk assessment framework that addresses two agendas:

1. Financial Health

2. Institutional Development

A standard risk assessment of a financial institution typically addresses the first issue only. In assessing the financial health of a bank or other financial institution, one would consider the organization’s asset and liability management, including credit risk, as well as operational risks such as fraud and inefficiency.

Microfinance risk assessment also needs to embrace an institutional development

perspective. As MFIs evolve from donor dependency to commercial independence, clear vision, reliable systems, effective governance and staff capacity become critical in their ability to manage risk.

This integrated risk assessment framework for MFIs, which analyzes institutional development and financial health issues, is organized into four categories of risk:

institutional, operational, financial, and external (see Figure 2). This framework provides

managers and directors of microfinance institutions with a step-by-step means of assessing their

organization’s current and potential vulnerabilities.

1.1 Institutional Risks

Microfinance success is defined as an independent organization providing financial services to large numbers of low-income persons over the long-term. An assessment of risks against this definition results in three categories of institutional risk: social mission, commercial mission, and dependency.

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Figure 2: Categories of Microfinance Risks

1.1.1 Social Mission

While all MFIs do not have the same mission statements, in general they have a dual mission: a social mission and a commercial mission. Their social mission is to provide valued financial services to large volumes of low-income persons that will enable them to improve their welfare. Microfinance institutions are vulnerable to social mission risk if they do not have a clearly defined target market and monitoring mechanisms to ensure that they are providing appropriate financial services to their intended clientele.

1.1.2 Commercial Mission

The commercial mission of MFIs is to provide financial services in a way that allows the organization to be an on-going concern; that is, to exist for the long-term as a self-sufficient organization. MFIs are exposed to commercial mission risk if they do not set interest rates high enough to cover costs and if they are not managed as a business.

The social and commercial missions sometimes conflict with each other. For example, offering larger loans might make it easier to become sustainable, but this could undermine the social mission to serve low-income and harder-to-reach people who traditionally demand smaller loans. The microfinance challenge is to balance the social and commercial missions to achieve them both.

1.1.3 Dependency

Dependency risk is similar to commercial mission risk, but it is most pronounced for MFIs started and supported by international organizations such as CARE, particularly when the

Financial Management Risks

Asset and Liability Inefficiency System Integrity External Risks Regulatory Competition Demographic Physical Environment Macroeconomic Operational Risks Credit Fraud Security Institutional Risks Social Mission Commercial Mission Dependency

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microfinance activities are operated as a project rather than as an independent organization. These MFIs are vulnerable to dependency on support provided by the external organization. While this support may initially seem like an advantage, it can significantly undermine efforts to build an independent institution that will exist for the long-term.

1.2 Operational Risks

Operational risks are the vulnerabilities that an MFI faces in its daily operations, including portfolio quality (credit risk), fraud risk and theft (security risk).

1.2.1 Credit

As with any financial institution, the biggest risk in microfinance is lending money and not getting it back. Credit risk is a particular concern for MFIs because most microlending is unsecured (i.e., traditional collateral is not often used to secure microloans).

To determine an institution’s vulnerability to credit risk, one must review the policies and procedures at every stage in the lending process to determine whether they reduce

delinquencies and loan losses to an acceptable level. These policies and procedures include the loan eligibility criteria, the application review process and authorization levels, collateral or security requirements, as well as the “carrots and sticks” used to motivate staff and compel borrowers to repay. In addition to analyzing whether these policies and procedures are sound, it is also necessary to determine whether they are actually being implemented. The best policies in the world are meaningless if staff members are not properly trained to implement them or choose not to follow them.

1.2.2 Fraud

Any organization that handles large volumes of money is extremely vulnerable to fraud, a vulnerability that tends to increase in poor economic environments. Exposure to fraud is particularly acute where money changes hands. These vulnerabilities in a microfinance institution can be exacerbated if the organization has a weak information management system, if it does not have clearly defined policies and procedures, if it has high staff turnover, or if the MFI experiences rapid growth. The management of savings deposits, particularly voluntary savings, creates additional vulnerability in that a failure to detect fraud could lead to the loss of clients’ very limited cash assets and to the rapid deterioration of the institution’s reputation. In the detection of fraud, it is critical to identify and address the problem as quickly as possible to send a sharp message to staff before it gets out of hand.

1.2.3 Security

As with vulnerability to fraud, the fact that most MFIs handle money also exposes them to theft. This exposure is compounded by the fact the MFIs tend to operate in environments where crime is prevalent or where, because of poverty, temptation is high. For example, in high volume branches the amount of cash collected on a repayment day can easily exceed the average annual household income in that community.

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1.3 Financial Management Risks

1.3.1 Asset and Liability

The financial vulnerability of an MFI is summarized in asset and liability risks, which include interest rate, liquidity, and foreign exchange risks. Interest rate risk rises when the terms and interest rates of the MFI’s assets and liabilities are mismatched. For example, if the interest rate on short-term liabilities rises before an MFI can adjust its lending rate, the spread between interest earnings and interest payments will narrow, seriously affecting the MFI’s profit margin. MFIs operating in inflationary environments are particularly vulnerable to this type of risk. Liquidity risk involves the possibility of borrowing expensive short-term funds to finance immediate needs such as loan disbursement, bill payments, or debt repayment. MFIs are most vulnerable to foreign exchange risk if they have to repay loans in a foreign currency that they have converted to local currency and therefore are earning revenue in the local currency.

1.3.2 Inefficiency

Efficiency remains one of the greatest challenges for microfinance institutions. It reflects an organization’s ability to manage costs per unit of output, and thus is directly affected by both cost control and level of outreach. Inefficient microfinance institutions waste resources and ultimately provide clients with poor services and products, as the costs of these inefficiencies are ultimately passed on to clients through higher interest rates and higher client transaction costs.

1.3.3 System Integrity

Another aspect of financial management risk is the integrity of the information system, including the accounting and portfolio management systems. An assessment of this risk involves checking the quality of the information entering the system, verifying that the system is processing the information correctly, and ensuring that it produces useful reports in a timely manner.

1.4 External Risks

Although MFI managers and directors have less control over external risks, they should nonetheless assess the external risks to which they are exposed. A microfinance institution could have relatively strong management and staff, and adequate systems and controls, but still be prone to major problems stemming from the environment in which it operates. External risks are usually outside the control of the MFI, however it is important that these risks are perceived as challenges that the MFI should address, rather than excuses for poor performance.

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1.4.1 Regulatory

Policy makers, banking superintendents and other regulatory bodies are becoming

increasingly interested in, and concerned about, microfinance institutions. This concern is heightened when MFIs are involved in financial intermediation—taking savings from clients and then lending them out to other clients or institutions. Regulations that can create vulnerability in an MFI include restrictive labor laws, usury laws, contract enforcement policies, and political interference.

1.4.2 Competition

In some environments, microfinance is becoming increasingly competitive, with new players, such as banks and consumer credit companies, entering the market. Competition risks stems from not being sufficiently familiar with the services of others to position, price, and sell your services. Competition risk can be exacerbated if MFIs do not have access to information about applicants’ current and past credit performance with other institutions.

1.4.3 Demographic

Since most MFIs target disadvantaged individuals in low-income communities, microfinance managers need to be aware of how the characteristics of this target market increase the institution’s vulnerability. In assessing demographic risks, consider the trends and

consequences of illness and death (including HIV/AIDS), education levels, entrepreneurial experience, the mobility of the population, social cohesiveness of communities, past experience of credit programs, and local tolerance for corruption.

1.4.4 Physical Environment

Some areas are prone to natural calamities (floods, cyclones, or drought) that affect

households, enterprises, income streams and microfinance service delivery. In addition, the physical infrastructure—such as transportation, communications, and the availability of banks—in the MFI’s area of operations can substantially increase its vulnerability.

1.4.5 Macroeconomic

Microfinance institutions are especially vulnerable to changes in the macroeconomic environment such as devaluation and inflation. This risk has two facets: 1) how these conditions affect the MFI directly and 2) how they affect the MFI’s clients, their business operations, and their ability to repay their loans.

1.5 Conclusion

The management and board of a microfinance institution should consider each of the risks identified in this chapter as vulnerability points. It is their responsibility to assess the institution’s level of exposure, prioritize areas of greatest vulnerability, and to ensure that proper controls are in place to minimize the MFI’s exposure. The next four chapters'

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address the controls and monitoring tools required to manage each of these four categories of risk.

Figure 3: Organization of Microfinance Risks by Chapter

Chapter 2 Institutional Risks Social Mission Commercial Mission Dependency

Chapter 3 Operational Risks Credit Fraud Security

Chapter 4 Financial Management Risks Asset and Liability Inefficiency System Integrity Chapter 5 External Risks Regulatory

Competition Demographic

Physical Environment Macroeconomic

Chapter 6 then presents the accounting and portfolio management systems required creating an effective risk monitoring system. The fact that it comes at the end of this document should not lessen its importance. The implicit basis for effective risk management is

transparency. If an MFI does not have accurate and timely information that it can analyze through a variety of different lenses, then it cannot manage its risks. Chapter 6 provides guidance in how to enhance transparency through information systems.

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The Ultimate Risk Management Controls: Good Governance and Quality Human Resources

This handbook contains a host of controls to mitigate the specific risks to which a microfinance institution is exposed. There are two overarching controls, however, that deserve special mention because they cut across numerous risks and serve as critical building blocks on which many of the other controls are based.

Good Governance: The board of directors plays a critical control function in a microfinance

institution. One of the board’s key responsibilities is to analyze risks and ensure that the MFI is implementing

appropriate controls to minimize its vulnerability. This handbook is a valuable tool for directors to

comprehensively review possible risks and to pinpoint the areas of greatest vulnerability. Unfortunately, the microfinance industry is not particularly well known for its effective

governance, which presents its own set of risks. In the search for effective governance, consider the following guidelines:

ê The board should be comprised of a group of external directors, with diverse skills and perspectives that are needed to govern the MFI. The composition should balance the dual mission of microfinance, with some directors more concerned with the social mission and others focused primarily on the commercial mission.

ê It is critical that board members dedicate sufficient time to fulfill their functions. It is not appropriate to appoint directors solely for their “political” value; while it might seem nice to have the names of famous people in the annual report, if they do not actually attend board meetings and play a meaningful role, then they are not providing good governance.

ê There needs to be a clear separation of roles and responsibilities between the board and management. The board oversees the work of senior managers and holds them accountable, which includes setting performance targets and taking disciplinary action if necessary.

ê The board should meet often enough to keep a close eye on the organization. During periods of change, this may mean weekly meetings. In mature, stable MFIs, quarterly meetings might suffice, especially if there is an executive committee of the board that is in more frequent contact with management.

ê Boards should be regularly rejuvenated so that new ideas and fresh energy are injected into the organization. This can be accomplished through term limits and/or a performance appraisal system that encourages inactive and ineffective directors to step down.

Trained and Motivated Personnel: The other “building block” control is the MFI’s

employees. As a service industry, the delivery of microfinance products is just as important as the products themselves. An MFI can dramatically reduce its vulnerability to most risks if it has well-trained and motivated employees. This is accomplished through a three-pronged strategy: ê Hiring: The first step is finding the right people. In hiring field staff, you are probably not

going to find people with microfinance expertise, so instead you should look for certain

values (honesty, commitment to the target market, a willingness to get their shoes dirty),

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screening techniques accordingly. When you find a few of the ideal people, then figure out where they came from to see if there are more of them out there. Sometimes certain schools, religious groups or social organizations are excellent sources of new employees.

ê Training: Once you have hired the right people, the next step is to train them well. Training often focuses on the nuts and bolts of doing a job—such as what forms do you fill out for what purposes—but to serve as an effective control, training should impart much more than just technical skills. New staff orientation is the ideal time to indoctrinate your employees, to bathe them in the institution’s culture, to cultivate their commitment to the organization, its mission and its clients, and to teach and practice the social skills needed to perform their jobs, such as group mediation and facilitation, adult education, customer service, and time

management. Training should not end once the loan officer hits the streets. To retain quality people, and to ensure that they grow and develop as the organization evolves, it is necessary to provide regular in-service training as well. In the search for increased efficiency, MFIs are constantly looking for ways to streamline operations and cut corners; they should resist any temptation to short-change the training of new or existing employees.

ê Rewarding : It is difficult to keep employees motivated and enthusiastic about their work. MFIs should view their best employees the same way they view their best customers: once you have them, do every thing possible to keep them. An MFI that wants to retain staff needs to position itself as the employer of choice. This involves providing a competitive compensation package, but it is much more than just wages. Salaries are already the biggest line item in most MFI budgets—so it is necessary to find creative ways of rewarding and motivating staff. Other factors that influence an employee’s satisfaction, and therefore their willingness to remain with the employer, include:

ê Benefits such as health insurance and vacation time

ê An institutional mission where people feel that they can make a difference ê Workplace design that is comfortable and conducive to productivity

ê An institutional culture that is unique so that employees feel like they are part of a special team

ê Recognition of individual and group accomplishments ê Staff development and job enrichment opportunities

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Chapter 2: Institutional Risks and

Controls

nstitutional risks come in two types. The first type involves the institution’s mission, which has two aspects of its own: the social and commercial. Microfinance is a powerful development strategy because it has the potential to be a long-term means for fighting poverty and inequity. One of the greatest challenges in designing and running microfinance operation is to balance the dual mission so that your MFI: a) provides appropriate financial services to large volumes of low-income persons to improve their welfare (social mission); and b) provides those services in a financially viable manner

(commercial mission). Too heavy a focus on one or the other, and microfinance will not live up to its potential.

The second institutional risk is the dependency of a microfinance program on international support organizations such as CARE. MFIs that rely on strategic, financial, and operational support from international organizations are at risk because the longer those links continue, the harder it is to break them—yet no one should be under the illusion that those links can continue indefinitely. Microfinance programs that were created as CARE projects, rather than separate institutions, are particularly vulnerable to dependency risk.

2.1 Social Mission Risk

The social mission of microfinance institutions is to 1) provide appropriate financial services 2) to large volumes 3) of low-income persons 4) to improve their welfare. These four

elements are highlighted in the left-hand column in Figure 4. The right-hand column lists the controls and monitoring tools that MFIs need to mitigate social mission risk.

I

Financial Management Risk External Risk Operational Risk Institutional Risk

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Figure 4: The Four Ms of Controlling Social Mission Risk

Social Mission Controls and Monitoring

Provide Appropriate Financial Services Market Research

To Large Volumes Managing Growth

Of Low-Income Persons Mission Statement

To Improve Their Welfare Measuring Impact

2.1.1 Mission Statement

The process of controlling social mission risk begins by identifying the target market. In its mission statement, the governing body of the MFI has to clearly articulate whom the

institution wants to serve and why it wants to serve them. The mission statement should also indicate that the organization intends to serve this market for the long term as an independent and self-sufficient institution. This mission statement then serves as a guiding light for managers and employees as they apply it in their daily activities.

In developing the mission statement, it is important to strike a balance between the social and commercial mission. If the organization narrowly defines the target market, then it may have difficulty achieving sufficient scale and efficiencies to fulfill its commercial mission. For example, if the MFI only wants to serve refugees or people with HIV/AIDS, then the potential market for its services may not be large enough to create a sustainable institution, or it may be too

expensive to identify and deliver services to a market that is geographically disparate, or the risks of serving a narrowly defined target group may be too high.

The composition of the board of directors can contribute significantly toward ensuring that the institution has a good balance, both in its mission statement and how it goes about fulfilling its mission. It is difficult to find individuals who embody the dual mission of microfinance, so boards are often constructed to be balanced, with roughly half of the directors personifying a social bias and the other half with a commercial bent. This may create some tense board meetings, but it tends to produce appropriate microfinance policy.

Commercial Banks and Social Mission

Do all microfinance institutions have to have a social mission? Many commercial banks, including CARE’s partner in Zimbabwe, are beginning to serve the microenterprise market without a strong sense of social mission. Banks may be motivated to serve low-income persons because they have been pushed down market by increasing competition at the upper end, or because they see microenterprises as a profitable niche market, or for public relations reasons—but they are rarely concerned about alleviating poverty. It remains to be seen whether microfinance players who only have a commercial mission will be successful. It is logical though that an organization that deeply cares about its clients

and serves them on a commercial basis will be more

successful over the long term than an MFI that is purely profit-driven.

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ê Does your organization have a clear mission statement that balances the social and commercial objectives and

identifies the target market?

ê Do employees know the organization’s mission statement and use it to help guide their actions? ê Does the composition of the board reflect the dual mission of microfinance?

2.1.2 Market Research

Once the organization identifies its target market, the next step is to understand the needs of those persons to ensure that it provides them with appropriate services. If the mission is to serve the poor, an MFI must determine what services the poor want and need. Microfinance institutions should have the capacity to conduct quality market research. This will allow them to learn about the needs, opportunities, constraints and aspirations of their intended clients. Market research is not a once-off activity. The needs of an institution’s target market will evolve over time. The MFI needs to keep in touch with those changing needs and to respond accordingly. Microfinance institutions should have an ongoing commitment to

improvement.

Figure 5 provides a summary of the tools used by microfinance institutions to gather information from current, former, and prospective clients to determine whether they are providing appropriate financial services, and to solicit suggestions regarding how to continuously improve those services.

Each MFI has to decide which of these tools are appropriate given their scale and stage of development. It is unlikely that all nine will be needed at once, but it is helpful to rely on three or four market research methods to ensure that you are getting consistent and reliable results. Of the nine, exit interviews are probably the most important. Lost

customers are a valuable source of information about what

is wrong with your products and services, and sometimes by demonstrating an interest in their opinions you can even attract those clients back.

One of the main purposes of conducting market research is to collect sufficient information to tailor an MFI’s products and services to the requirements of the target market. To determine if the financial products and delivery systems are designed appropriately, consider the following questions:

ê Does your organization use appropriate screening mechanisms to ensure that it is serving the intended target

market?

ê Are the loan sizes appropriate to the needs of the clients?

ê Do you offer a large enough range in loan sizes so that the best clients do not grow out of the program? ê Do the requirements for accessing a loan (i.e., collateral, meetings, business plan, forced savings) address the

institution’s need to control credit risk (see next chapter) without being excessively demanding on clients?

ê Is it convenient for the target market to access services, in terms of the amount of time required, location of services

(i.e., branch locations), and the timing of those services (i.e., office hours)?

Lost customers are a valuable source of information about what is wrong with your products

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ê How do you conduct useful market research activities on a regular basis to keep in touch with the changing needs of

your target market?

ê How does your organization demonstrate a commitment to constant improvement?

Figure 5: Market Research Tools

Tool Explanation

1. Questions on loan

applications Collect information with each loan application from a) new clientsregarding their expectations and their experiences with competitors’ products; and from b) old clients about whether their expectations were met and how the organization can improve

2. Complaint and suggestions

system Incorporate customer comment cards and/or a customer servicedesk 3. Customer satisfaction

surveys Send a short questionnaire to a representative sample of clients, orto all clients who recently purchased a service along with a thank you note from the loan officer

4. Individual interviews Hire a market research consultant to conduct interviews with a sample of current, former and prospective customers

5. Focus groups Gather a small group of clients for an informal discussion on how the institution can improve its services

6. Client advisory committee Form a committee of client representatives at the branch level to give regular feedback on products and services

7. Mystery shopping Employ “mystery shoppers” to pose as customers and to evaluate your organization’s customer service

8. Exit interviews Determine why clients are not continuing to access your services by interviewing or surveying former clients

9. Staff feedback loop Develop a system by which field staff actively solicit complaints and suggestions; they should regularly (often daily) document the feedback they receive, both positive and negative, and then this information is centrally collated and analyzed

Adapted from Churchill and Halpern (2001).

2.1.3 Monitoring Client Composition and Measuring Impact

Management and the board should have some way of determining whether the organization is serving the market that it is intended to serve and whether its services are having the desired effect.

The two most common indicators used to monitor client composition are average loan size and the percent of women clients. It is also useful to track average loan size specifically for first time borrowers, because while the average loan size for all clients often rises as the MFI matures the loans to first-time borrowers should remain fairly steady. If this value is

rising—certainly if it is rising faster than inflation—then the MFI may be migrating away from its original target market.

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Figure 6: Monitoring Client Composition

Primary Indicators Secondary Indicators

Average Outstanding Balance Monthly or Annual Household Income Average Loan Size (disbursed) Household Assets

Average Loan to 1st_{Time Clients} _{Enterprise Asset Base}

Percentage of Women Clients

In the process of choosing appropriate indicators, such as from the list in Figure 6, it is important to consider the balance between the social and commercial missions. Some data, such as household income and enterprise asset base, may be easily available because loan officers need that information to conduct the credit analysis. If loan officers are expected to collect information that is not essential to make sound credit decisions, however, they may have difficulty being efficient and carrying large enough case loads to create a sustainable institution.

ê What indicators do you use to ensure that you are serving the intended target market? ê Is this information collected in a cost-effective manner?

ê How does the board monitor the client composition?

ê What information, if any, does your organization consistently collect regarding the impact of your services on

clients?

ê How often does senior management go to the field to talk with clients and staff?

2.1.4 Managing Growth

While many MFIs are interested in serving large volumes of people, in their efforts to do so, they commonly encounter three types of problems:

1) Capacity Constraints: Some MFIs operate in markets with a large pent up demand for microfinance. To respond to the demand, an organization may grow very quickly, only to realize that it does not have the capacity or the systems to satisfy the demand. These MFIs often experience bottlenecks in the disbursement process and risk losing credibility in the market place. Before expanding, MFIs need to ensure that they have the systems to cope with the projected volume of applications. If the demand exceeds expectations, and it is not possible to expand capacity, then the MFI needs to find a way of tempering demand,

perhaps by raising interest rates, lengthening the pre-loan process, or limiting the number of applications a loan officer can submit each month.

2) Premature Expansion: Other organizations operating in similar environments expand before they have fine-tuned their lending methodology, only to find out after it is too late that they have large volumes of poor quality loans on the streets. MFIs must ensure that their loan product is well designed and that the lending methodology is working before they step on the gas and expand. It is also important that they resist pressure from donors and others to grow before

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3) Reaching a Plateau: The opposite growth problem is also prevalent: some MFIs hit a growth plateau where they get stuck. No matter how hard they try, they cannot seem to push their expansion to the next level even though they have not

saturated the market. Some get stuck at the 2500 to 3000 active client mark. Others get stuck at the 5000 to 6000 mark. In some cases, these organizations need to improve their marketing efforts. A closer examination, however, will often indicate that the organization has a client retention problem, which will suggest that the product is not designed appropriately for the market.

To monitor for this third risk, MFIs should track their client retention rates on a monthly basis. For the length of the period, annual is most commonly used, even for short-term loans, because a 12-month period neutralizes the affect of seasonal fluctuations. There is no industry benchmark that would be particularly useful with this indicator. It is more important for the institution to monitor its retention rate trend. As

with other performance indicators, it is useful to disaggregate the retention rate by type of product, loan cycle and branch to determine if desertion is a bigger problem in certain segments of the institution’s client base.

ê How has your retention rate changed over the past year and what are the primary reasons for that change? ê Does your organization currently have excess capacity, which suggests that you should be poised for growth, or do

you need to build capacity before continuing to expand?

2.2 Commercial Mission Risk

Although intended to serve the poor, microfinance is a business operation that must run on business principles. This means that a microfinance institution should make decisions based upon sound business rules, not on charitable sentiment. If an institution’s managers and board members do not share a business-like perspective, the MFI will be extremely vulnerable to commercial mission risk.

It seems counter-intuitive that an organization dedicated to helping the poor needs to charge high interest rates and strive for profitability. The commercial approach makes sense, however, if you adopt a long-term view. Many of CARE’s development initiatives are short-term projects with a specific end date. Microfinance, on the other hand, has the unique ability to provide developmental services on an ongoing basis if it is designed and implemented properly. With microfinance activities, it is critical to adopt a long-term perspective because clients do not just want loans for the next three to five years. They want—and deserve—a safe place to save their money and a convenient place to borrow funds indefinitely. The only way to provide them with this extremely valuable service over time, and generate its important development benefits, is by fulfilling the commercial mission of microfinance.

Retention Rate:

(# of Loans Made during the Period – Number of First Time Borrowers)

/

(Active Clients (beginning of period) + # of Loans Made – Active Clients (end of period))

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Controls for commercial mission risk include: setting interest rates, designing the capital structure, planning for profitability, and managing for superior performance.

2.2.1 Setting Interest Rates

In determining their interest rates, MFIs, like all financial institutions, need to cover four sets of “expenses”:

a) Operating expenses

b) Cost of capital (including adjustments for inflation and subsidies) c) Loan losses

d) Intended surplus (for retained earnings and/or dividends to shareholders) If, for example, operating costs amount to 20 percent of average outstanding portfolio, the cost of capital is 10 percent, and loan losses are 2 percent, then the MFI has to charge an effective interest rate of 32 percent just to break even. In fact, it should charge a slightly higher rate so that it can generate a small surplus (perhaps 5 to 15 percent) that can be used to replace old equipment, open new branches, develop new technologies, etc.

Many mature MFIs are not charging interest rates that are high enough to cover these four costs, and therefore they have to be subsidized. In fact, many MFIs do not have a clear understanding of each of these costs. In effect, they are passing their subsidy on to their clients in the form of an interest rate that is lower than the cost of providing the loan. While it is nice to give poor people a break, that is not the purpose of microfinance and it is not sustainable. Microfinance programs need to charge appropriate interest rates that cover the full costs of providing the services.2

2.2.2 Designing the Capital Structure

The social mission drives some MFIs to provide appropriate financial services to large volumes of low-income persons. To provide a large number of loans, even very small loans, it requires a large amount of capital for the loan portfolio, as well as ongoing investments into the MFI such as upgrading the information system. This raises the question, where do MFIs get the funds they need to build an institution and fuel the growing demand for microcredit?

Initial capital often comes in the form of grants from donors. Donor grants are an excellent source of capital for new programs, but are not a long-term solution. Donor capital is finite and fickle. Concessionary loans are a related source of capital that also have their time and place, but again are not a reliable source for the long-term.

Retained earnings are another common source of capital. For MFIs that are generating a surplus of income over expenses, they can plow their “profits” back into their loan

portfolios (or make other necessary investments). This requires being able to generate a

2_{It is unrealistic to expect new MFIs to charge an interest rate that is high enough to cover its costs.}

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surplus in the first place, and it is unlikely that MFIs will produce such a large surplus to completely fund their growth.

Commercial loans are available to some microfinance programs. These are usually available to unprofitable programs only with some form of external guarantee, such as a donor-supported loan guarantee fund. Once MFIs become sustainable, they may be able to access commercial loans using their portfolio or other assets as collateral. As non-profit organizations, however, MFIs cannot typically get commercial loans at very favorable rates or in large enough amounts to fund their growth. Consequently, many microfinance NGOs are considering establishing regulated financial institutions.

Figure 7: Evolution of Capital Sources for a Microfinance Program

The transformation into a regulated financial institution creates opportunities for an MFI to access two other sources of capital. First, it may allow them to attract equity from

shareholders, which more favorably leverages commercial loans. Second, as a regulated financial institution, the MFI may be able to accept savings for financial intermediation. Many MFIs accept savings from their clients, but unless they are regulated financial institutions, they should not be using that pool of funds for lending.

Figure 7 depicts a common evolution of an MFI’s source of funds, starting with grants and eventually weaning away from donor-supported funding sources. To monitor its

effectiveness in controlling commercial mission risk (i.e., achieving financial self-sufficiency), MFIs should properly account for and recognize subsidies in their financial statements. Chapter 6 provides guidance on making appropriate subsidy adjustments.

It is important to note that, while transformation opens up opportunities for MFIs to access additional and perhaps more stable sources of capital,

CARE does not expect all of its partners to create regulated financial institutions. It is not an appropriate solution in all-regulatory environments or for all institutions that provide microfinance services.

2.2.3 Planning for Profitability

It takes a considerable amount of planning to produce a profitable microfinance institution and mitigate

commercial mission risk. The first step in the planning process is a strategic plan that outlines where the organization is going over the next three to five years,

Grant Funds Concessionary Loans Commercial Loans with Guarantees Retained Earnings Investor Equity Commercial Loans and Customer Savings Transformation

Creating Ownership: Planning from the Bottom Up

Since most targets and ratios highlighted in the business plan need to be achieved by the field staff, it is essential that they are involved in the process of identifying what they think are realistic and

achievable goals. Branch managers and their teams will feel more motivated to achieve targets if they are involved in setting them.

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and why. Typically the board is actively involved in the strategic planning process. Then management creates a business plan that answers the question: how will the organization accomplish its strategic plan? While the business plan may cover the same length of time as the strategic plan, it will be much more detailed in Year 1 than it will be for subsequent years.

The Year 1 details then serve as the foundation for the annual budget. The business plan also produces a monthly or quarterly work plan that management reviews regularly and updates and adjusts accordingly. This ensures that the business plan is not just a nice report that collects dust on the shelf, but rather a working document that guides and propels the organization forward. As time passes, the initial projections should be updated with actual numbers to help managers adjust their plans and budgets accordingly.

The business plan should include a detailed projection model that predicts when the organization will achieve self-sufficiency and under what circumstances. These projections are not only important to help set targets, but they can also be used to explain to all

employees that the organization can afford to cover its costs, but to do so it needs to fulfill certain assumptions. For example, the projection model can help identify how many borrowers, what size portfolio, what average loan size and term, etc. that organization will need to achieve self-sufficiency. This process can also help determine how many loans need to be processed per week and how many clients each credit officer needs to maintain. With this information in hand, MFI management should take a careful look at its systems,

documentation requirements, the paper trail and approval processes, and aspects of its lending methodology to determine how to streamline things to make self-sufficiency a reality.

2.2.4 Managing for Superior Performance

To reduce the institution’s vulnerability to commercial mission risk, management needs to drive the organization to achieve superior levels of performance. Managing for superior performance allows an MFI to get the most out of its employees. This is critical in achieving both the social and the commercial mission. If the MFI has highly productive and efficient staff members, the institution will be able to generate more revenue for a fixed set of expenses, while maintaining small average loan sizes. Once the organization is profitable— revenue is greater than expenses—then any additional improvements in productivity and efficiency can allow it to lower its interest rates.

The process of managing for superior performance involves collectively setting

performance targets at all levels within the organization, monitoring the achievement of targets, and rewarding accomplishments. You can only manage well if you have a system to measure the effectiveness of what is being managed.

To fulfill the institution’s commercial mission, the retention of quality staff members is even more important than retaining clients. Try to calculate the costs of losing good people, which includes hiring and training replacements, higher loan losses and lower productivity of green employees, and the negative impact

The retention of quality staff members is even more important than retaining

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rely heavily on educated guesses, it will probably show that an MFI cannot afford to lose its best employees. And if employees leave to work for another MFI, you are in effect

subsidizing the competition.

Managing for superior performance also involves mitigating the effects of certain human resource risks, such as:

ê A Thin Labor Market: Not being able to find enough affordable employees with the requisite skills

ê The Peter Principle: Promoting people to their level of incompetence (good loan officers do not necessarily make good branch managers)

ê Which Comes First? If the MFI is not financially secure and stable, it may have difficulty attracting the quality of staff that it needs, but if it cannot attract the right people, it will have difficulty achieving self-sufficiency

To determine whether your human resource policies and systems are effective, consider the following controls:

ê Develop a means of regularly identifying employee development and motivational needs ê Invest heavily in your employees by providing quality staff training and sending them on

observation visits to MFIs in other countries

ê Establish a family-like institutional culture in which the employee and the institution are fully committed to each other

ê Create internal communication channels such as a two-way performance review process, regular employee satisfaction surveys, and an employee advisory committee to advise the human resource department

ê Monitor employee turnover ratios

ê Conduct exit interviews with departing staff members to determine the real reasons why they are leaving

2.2.5 Monitoring for Commercial Mission Risk

To monitor whether an MFI is sustainable and generating a surplus, CARE recommends that organizations monitor the sustainability and profitability ratios summarized in Figure 8. Efficiency and productivity indicators are also important; these are addressed in Chapter 4.

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Figure 8: Sustainability and Profitability Ratios Sustainability

Operational Sustainability Operating income / (Operating expenses + provision for loan losses + financing costs)

Financial Sustainability Operating income / (Operating expenses + provision for loan losses + adjustments for inflation and subsidies)*

Interest Spread (Gross

Financial Margin) (Operating income – financing costs) / Average performing assets

Profitability

Return on Assets Net income / Average assets Return on Equity Net income / Average equity

*For more details about adjusting for inflation and subsidies, see Chapter 6.

ê Is the interest rate set high enough to cover the MFI’s full costs?

ê Do you have a business plan to achieve self-sufficiency in a reasonable amount of time? ê Do you update the plan and use it regularly to make management decisions?

ê What steps do you take to ensure that your employees are motivated and enthusiastic about their work? ê Is your human resource system effective and how do you know?

ê Do you have job descriptions and annual performance appraisals for all employees, including senior management? ê Does your organization set challenging, yet achievable, performance targets for all layers of the organization, and

does it monitor and reward achievement of these targets?

ê Do you monitor sustainability and profitability indicators, and if so are they trending in the right direction? ê Are you moving toward accessing commercial sources of capital and reducing reliance on subsidized funding

sources?

ê Do you properly account for subsidies and in-kind donations?

2.3 Dependency Risk

The objective of CARE SEAD program managers is to create independent, sustainable microfinance institutions. But how does an institution define independence? CARE is a robust international organization, yet there is continual concern over potential dependence on one or two major donors. The dependency risk is greatest for any MFI that begins life as a project of CARE, but the risk also exists for MFIs that are legally independent of CARE. The risk of dependency can be evaluated at three levels: 1) strategic planning, 2) financial resource mobilization, and 3) operational management. For any given MFI the dependency risk may be focused in one or more of these areas, but a truly independent organization must be the master of all three.

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2.3.1 Strategic Dependence

CARE is a multi-sectoral relief and development agency, not a specialized microfinance organization. The decision to pursue microfinance in a given country is based on a Long-Range Strategic Plan (LRSP) that matches CARE’s many comparative and competitive advantages within the development context of the host country. Microfinance is never the only activity for a CARE country office (CO). CARE program managers often view

microfinance as a component of a larger development strategy. There are certain advantages to this approach at an analytical level, but there are also several risks that MFI and CARE managers must keep in mind.

First, country office program managers may view the MFI strategy as subordinate to the short and medium-term objectives of other programs in the CARE portfolio. For example, an MFI could be pushed into extending credit to farmers in rural areas to meet the needs of participants in a CARE development project even though rural loans could undermine the long-term financial and institutional sustainability of the MFI.

Second, there may be a timing mismatch between CARE’s “long range” strategic planning process and the time it takes for an MFI to achieve financial sustainability. Changes in country office and regional management during and between LRSP periods can add insecurity and inconsistency to the business planning cycle of an MFI that depends on CARE for financial or technical support.

Finally, when CARE is the actual or effectively the owner of the MFI, local managers and board members can be marginalized by the dominant position of CARE within the governance structure. Board members with little personal stake in the MFI and even less experience in microfinance may be easily persuaded to defer to CARE for strategic and operational decisions.

ê Do you have an independent governing body?

ê Does your organization have a plan to establish itself with an independent legal structure?

ê Do you share clients with other CARE programs? If so, is the strategy driven by the business plan of the MFI

and does it contribute to long-term sustainability or do projections show a continuing need to cross-subsidize this population?

ê Does your organization have the capacity and commitment to develop its own business plan?

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2.3.2 Financial Dependence

A CARE country office has a distinctly different strategy for mobilizing financial resources than an independent microfinance institution. The two strategies can find themselves in conflict. This conflict may be hidden by a high degree of apparent consent between CARE and the MFI, yet financial dependence, however agreeable to the MFI, will ultimately undermine the long-term objective of self-sustainability.

CARE generates the bulk of its financial resources by developing project proposals and winning grants from institutional donors. Larger, more complex projects typically win bigger grants and pay for a greater percentage of core costs for the CARE country office. But microfinance projects have the opposite tendency. As a successful MFI grows in scale and profitability, the need for donor subsidies diminishes towards zero. CARE may receive grant funding to continue a technical partnership, but the contribution to core costs quickly becomes negligible. While CARE does not encourage dependency simply to secure grant funding, the lost donor income will have an impact on the viability of the country office. At a minimum it can be said that there is no business incentive for a CARE country office to push a young MFI towards independence.

The MFI may also be reluctant to see a reduction in CARE’s grant funding. Ideally an independent microfinance institution will acquire its financial resources through retained earnings, equity investments, or taking on commercial debt. Yet CARE’s ability to raise money may discourage MFI managers from aggressively pursuing a more sustainable

financial management strategy. At worst, CARE financial support may be seen as insurance Responsibilities of an Independent Board of Directors

The board’s responsibilities consist of five categories of activities:

Legal obligations: The board ensures that the MFI fulfills its legal obligations and protects it

from unnecessary liability and legal action.

Strategic direction: The board ensures that the institution’s mission is well defined, reviewed

periodically, and respected over time. The board works to enhance the image of the institution and ensures that an appropriate planning process takes place.

Fiduciary: The board serves as the institution’s steward. It should ensure that the institution has

adequate resources to implement agreed-on plans. The board guarantees the long-term viability of the institution.

Oversight: The board governs, not manages. It appoints and oversees the managing director.

The board monitors operations and business performance. The board evaluates the institution’s performance in relation to other MFIs. The board assesses and responds to internal and external risks,

and protects the institution in times of crisis.

Self-assessment and renewal: The board should regularly assess its own performance. Board

renewal is one of the most important outcomes of the self-assessment process.