PROCESS OF EFFECTIVE RISK MANAGEMENT AND MICROFINANCE BANK LENDING

PROCESS OF EFFECTIVE RISK MANAGEMENT AND MICROFINANCE BANK LENDING (A CASE STUDY OF GIANT STRIDE MICROFINANCE BANK)

CHAPTER TWO

LITERATURE REVIEW

Microfinance is the provision of a broad range of financial services such as savings, loans, payment services, money transfers, and insurance to poor and low-income persons, households and their microenterprises.

Meanwhile Microfinance services are provided by three types of institutions:

Formal institutions, such as microfinance banks, rural banks and deposit money banks;
Semi-formal institutions, such as non-government organizations and cooperatives; and
Informal sources such as Rotating Savings and Credit Associations (ROSCA), Accumulated Savings and Credit Associations (ASCA), daily savings collectors (also known as door-to-door ‘bankers’), money lenders and shopkeepers.

Institutional microfinance is defined to include microfinance services provided by both formal and semi-formal institutions. Microfinance institutions are defined as institutions whose major business is the provision of microfinance services. Microfinance banks are banks licensed and supervised by Central Bank of Nigeria (CBN) to deliver microfinance services.

Microfinance clients are typically self-employed, low-income entrepre-neurs in both urban and rural areas. Clients are often traders, street vendors, small farmers, service providers (hairdressers, cart pushers), artisans and small producers, such as black-smiths and seamstresses. Their activities provide income (often from more than one activity) for the individuals and their house-holds. Although they are often poor, they are generally not considered to be the “poorest of the poor”. These micro-entrepreneurs need a safe and secure place to keep their excess income; they require credit for business expansion or growth and require access to other financial services like insurance (usually provided through informal network of family and friends).

The concept of microfinance is not new. Savings and credit groups that have operated for centuries include the “susus” of Ghana, Ajo (Yoruba) ’ or ‘Akawo’ (Igbo) and Adashe (Hausa) in Nigeria. “Chit funds” in India, “tandas” in Mexico, “arisan” in Indonesia, “cheetu” in Sri Lanka, and “pasanaku” in Bolivia, as well as numerous savings clubs and burial societies found all over the world. Formal credit and savings institutions for the poor have also been around for decades, providing customers who were traditionally neglected by deposit money banks, a way to obtain financial services through cooperatives and development finance institutions. For many observers, microfinance, – a collection of banking practices built around providing small loans (typically without collateral) and accepting tiny savings deposits – is nothing short of a revolution or a paradigm shift[1]. One of the earlier and longer-lived micro credit organizations providing small loans to rural poor with no collateral was the Irish Loan Fund system, initiated in the early 1700s by the author and nationalist Jonathan Swift. Swift’s idea began slowly but by the 1840s had become a widespread institution of about 300 funds all over Ireland. Their principal purpose was making small loans with interest for short periods. At their peak they were making loans to 20% of all Irish households annually. In the 1800s, various types of larger and more formal savings and credit institutions began to emerge in Europe, organized primarily among the rural and urban poor. These institutions were popularly known as People’s Banks, Credit Unions, and Savings and Credit Co-operatives.

However, it should be noted that all form of lending (whether macro or micro) is associated with some risks. These risks must be well managed if the business of lending is to be a success.

WHAT IS RISK?

Risk can be defined as “the possibility of an undesirable outcome or the absence of a desired outcome disrupting your institution or project.” (Quoted from Microsave/ Shore-bank toolkit on Risk Management).

Some of the key words in the definition that needs to be assimilated are “Possibility”, “outcome”, “disrupting”. These words clearly explain that risk has a possibility of an event happening or not happening and producing an outcome which disrupts the project at large.

It is important to look at what kind of event we are talking about and what triggers the event especially when it can negatively impact the microfinance program. Below is the explanation of few more words that takes the reader to defining Risk Management.

WHAT IS A RISK EVENT?

Risk event can simply be defined as “the undesirable outcome”. A desired outcome not happening can also be the Risk Event. Examples of risk events are:

Loans falling delinquent
Capital becoming inadequate to run operations
Funders withdrawing their funding commitments
Not having liquid funds to meet maturing obligations
Fraud and Forgeries

In the above examples, you will note that they are all undesirable outcomes and therefore are risk events. How would we avoid these risk events from occurring? This is something we will learn in further sections in this chapter. But most importantly, to address the risk event, we need to address the risk driver.

WHAT IS A RISK DRIVER?

Simply put, a Risk driver is the reason behind the risk event. If Risk Event is the symptom, risk driver is the cause for the symptom. For example, Loans have fallen delinquent because loan officers were negligent in their duties and thus not following up with the clients. So the real problem is the loan officer’s absence which in this case is called Risk Driver. If MFBs are able to handle the risk driver, they would reduce or mitigate the possibility of the occurrence of risk events.

WHY IS RISK MANAGEMENT NEEDED?

“Recent financial disasters in financial and non-financial firms and in governmental agencies point up the need for various forms of risk management. Financial misadventures are hardly a new phenomenon, but the rapidity with which economic entities can get into trouble is. Anyone who is aware of the leverage inherent in various interest rate derivatives knows he could have done this faster and even more ruinously had he set his mind to it. To their credit, most regulatory authorities appear to recognize that the core of the problem is not derivatives per se but inadequate risk management. Banks and similar financial institutions need to meet forthcoming regulatory requirements for risk measurement and capital.

BENEFITS OF EFFECTIVE RISK MANAGEMENT IN MICROFINANCE

Risk management faces difficulties in allocating resources. This is because resources spent on risk management could have been spent on more profitable activities. Ideal risk management minimizes spending and minimizes the negative effects of risks. Effective risk management framework enables managers of MFBs to proactively act to protect assets of the bank. Specifically, effective risk management framework assists MFBs in efficient management of resources, anticipation of risks and general process improvement. Effective risk management framework enables managers of MFBs to:

Adequately assess risks and take appropriate sets of actions. For instance effective liquid risk management strategy should be able to measure potential losses and prescribe actions that could be of benefit to the bank. Effective treasury management ensures efficient manage of funds. Earnings from invested funds are maximized while losses associated with liquidity risk are mitigated.
Outline systematic process for early identification of probable adverse incidences. This ensures that they are addressed before they escalate
Provides information on existing operations and potential consequences of probable occurrence of adverse events. Availability of such information can promote continuous enhancement of existing operations.

An effective risk management frame-work for microfinance banks should in a systematic manner be able to identify, measure, monitor and control or mitigate various forms of risks associated with field –based provision of numerous units of financial services to a large number of clients. For effectiveness, MFBs should devise structures and systems which incorporate the following steps:

Risk Identification. This involves identifying risks direct and indirectly, which the microfinance bank faces. As financial institutions with some measure of social mission, microfinance banks and institutions contend with a wide range of risks. It is the primary responsibility of top management to design effective structures and processes employed to continuously examine every unit of transactions or operations to identify risks and their nature. For example microfinance operators seeking to identify risks associated with small unit of operation, may ask and provide answer to a question as ‘what is the nature of risks inherent in the loan disbursement and collection methods currently adopted?’ If a new product or delivery method is introduced, risk assessment is required to be carried out. If a microfinance bank which adopts individual loan methodology decides to apply group loan approach, extensive risk assessment will be necessary. Risks may be identified after adverse event has occurred. This is not desirable. Effective risk management framework should be predictive and anticipate occurrence of adverse events.
Risk Measurement. It is useful that all conceivable risks are properly measured for the purpose of determining tolerance level for every identified risk. Regular measurement of risks associated with financial services delivery helps lending institutions to:
Determine the magnitude and possible severity of their impact
Set tolerance level. For instance, credit risk is a common and devastating risk in lending. A microfinance bank may want to set tolerance level for the proportion of its non-performing loan.
Risk Monitoring. An effective risk management framework should be able to track identified risks and possibilities of their occurrence and impact. Risk management structures and functionaries should have access to information relating to the performance of existing risk management strategies.
Risk management. Actions here consist of formulation of appropriate risk management or mitigation strategies as well as periodic evaluation of their effectiveness.

FEATURES OF EFFECTIVE RISKS MANAGEMENT IN MICROFINANCE

To be effective, risk management framework in microfinance must have the following features. It must be:

Anticipatory – the usefulness of a risk management strategy is its ability to effectively anticipate occurrence of adverse incidences with negative consequences on performances of the bank. Effective risk management frameworks must consist of elements which provide insight into risks inherent in units of operations and activities. Effective risk management system assists managers to anticipate and formulate response actions.
Comprehensive – An effective risk management framework must take into consideration all possible risks the bank faces. For a financial institution, the framework must identify all forms of risks ranging from financial to strategic risks. The framework must include all steps to be taken to anticipate, measure, and mitigate identified risks.
Flexibility – An effective risk management framework must be flexible enough to address unanticipated incidences arising from emerging internal and external situations. Microfinance banks operate in changing environments. Practice in the industry is constantly in a state of flux. New institutional practices and procedures throw up challenges and risks to be managed. The framework must be able to effectively respond to such developments.

(iv) Clarity of responsibilities – To be effective, the risk management framework must clearly identify risk management responsibilities for key organs such as the Board of Directors (BOD), Executive Management Committee (EMC) and Asset and Liability Committee (ALCO).

RISK MANAGEMENT FEEDBACK LOOP

Risk management process is a continuous one; therefore, interventions and steps in risk management are dynamic. It consists of cyclical flow of information from the field operations level to the senior management staff at the head office and back to the field after appropriate refinement necessitated by experience. The cyclical process is referred to as Risk Management Feedback Loop. The risk management feedback loop consists of a continuous flow of identification and assessment of assumed risks; development or refinement of strategies to assess and control risks; implementation of risk control strategies; test and evaluation of effectiveness and revision of strategies where found inadequate.

The Risk Management Feedback Loop enables top management to be constantly in touch with operations in the field especially as they relate to managing risks. The frequency with which this process is carried and the level of involvement by top management reflects the priority accorded to the assumed risks. Risks as portfolio loss, liquidity and financial risk could be monitored quite frequently, such as weekly at branch level and daily at institutional level by reviewing periodic reports as incidences of these losses have direct impact on the bank’s sustainability. Significant risks should attract attention of key officers and organs of management and governance such as the Asset and Liability Committee (ALCO) and Board of Directors (BoD). Sets of actions in the Risk Management Feedback Loop are:

Risk Management Feedback Loop

Identification, assessment and prioritization of risks

The first set of actions in risk management for a microfinance bank consists of identification and assessment of risk. To identify risks in all operations and transactions, the bank should carry extensive review all its operations and transactions. For instance lending activities such as loan application appraisal, disbursement and loan collection procedures should be examined for risks. There may also be a need to review savings procedures and portfolio management process as well as funding diversification. For instance disproportionately high portfolio for a particular loan product as farming loan could carry significant risk. The identification process may throw up several risks in various operations and procedures of the microfinance bank.

Once major risks are identified, the next step is to assess first the probability of the risk. For example if loan losses due to portfolio concentration (in farming) is identified, management will assess the probability of occurrence of such an incidence; probably due to drought or policy change that may constrain the capacity of the farmers to meet repayment obligations as at when due. Next is the assessment of the potential severity of the assumed risks. Various methods may be adopted to assess probability and severity of identified risks. One approach is the risk management chart or matrix. Risk managers use risk management matrix to assign ratings to various risks and prioritize areas which require attention and improvement. For each identified risk the matrix risk assigns a rating of the following factors outlined in Table 1: Risks Management Matrix below.

Table 1: Risks Management Matrix

Risk/Activity	Factors for assessment
*Farming Loan Product*	*Quantity of risks*	*Quality of existing risk mgmt*	*Aggregate risk profile*	*Direction/ Trend*	*Risk manager*
Borrower recruitment (and training)	Low	Acceptable	Low	Stable
Credit procedures	Moderate	Acceptable	Moderate	Stable
Approval and disbursement	Acceptable	Moderate	Low	Stable
Loan utilization monitoring	Low	Moderate	Low	Stable
Credit policy and Underwriting	High	Moderate	High	Decreasing

Source: Adapted from the risk management matrix used by South Shore Bank and the HPMS White Paper, June, 1996.

The application of the matrix is simple. The quantity or severity of the identified risk could be rated based on the potential severity and probability of occurrence (low, moderate or high). Ratings as ‘weak’, ‘acceptable’ or ‘strong’ could be assigned to assessment of the bank’s existing risk management strategy, and how management currently identifies, measures and monitors identified risk. The aggregate risk profile for that risk, combining the first two measures could be ‘high’ ‘moderate’ or ‘low’. The direction of identified risk could be ‘Stable’, ‘Increasing’ or ‘Decreasing’. The matrix also identifies who is responsible for assessment of identified risks.

For effectiveness, the matrix should be reviewed periodically (at least once in a quarter). It assists the management to assess the most important risks which calls for urgent attention. The risk management committee may recommend sets of interventions based on the outcome of the risk assessment using the risk management matrix. The ‘risks inspection unit’ may be required to expand its scope of activity to certain areas or operations based on the weaknesses identified by the matrix.

Design Operational Policies and Procedures to Mitigate Risk

As noted earlier there are a number of factors in the practice which heighten risks in microfinance operations, hence microfinance banks and institutions must manage risks. Given the direct relationship between risk and return, an attempt to completely avoid risks would result in loss of business (i.e. low or no returns). Consequently, they contend with various risks and make choices of methodologies, operational design and control procedures to ensure the following:

That the risks do not exceed acceptable levels and threaten the bank’s existence. That Credit risk for instance is brought under reasonable level through adoption of appropriate lending methodology which promotes credit discipline amongst other benefits. That detailed procedures on client enlistment, pre-loan training (if applicable), disbursement, and collection procedures all hedge against loan delinquency.
That when a loss occurs the bank has sufficient capital and capacity to absorb or address the loss. Examples of such risk hedging or control mechanisms include:
- Procedures and manuals – These are basic procedures which are designed in such a manner that minimize risks. Example, checks and balances in loan authorization and disbursement. Microfinance banks should design or adopt operational procedures which have the capacity to mitigate risks associated with the lending methodology used.
- Application of technology over manual processing – This is to reduce human error and enhance speed of data analysis and processing. Efficient Management Information System ensures timeliness, accuracy and correctness of reports and returns.

Implementation of Operations & Assignment of Responsibilities

Implementation phase of the risk management loop involves systematic integration of the policies, procedures and control measures into the main-stream operations of the microfinance bank. The process of integration includes assignment of responsibilities to mainstream operations staff. It defines who will be the major implementation agent(s) of the policies and procedures. For instance, operations staff will provide insights into the possible operational implications of new procedure. What for example, will be the implications for the clients and their possible reactions? Will the new risk management procedures be too stifling and inconvenient to the clients to the extent of precipitating mass exit? Discussions should be held with frontline staff. And in some cases it may be necessary to carry out client surveys or interviews to understand clients’ reactions to a new operational procedure or internal control measure.

BASIC GUIDELINES FOR IMPLEMENTING RISK MANAGEMENT

For effectiveness, risk management strategies should be fully integrated into all levels of operations of microfinance banks. To aid systematic integration of risk management policies and procedures, MFBs should adopt the following guidelines outlined below.

Lead the risk management process from the top – It is the responsibility of the top management especially the MD/CEO to set the tone in risk management. The commitment of top management will ensure adequate allocation of resources – human and financial, to the risk management effort. With commitment of the leadership, the right questions are asked and the lower level will be committed to implementation of policies and strategies which mitigate risks.
Incorporate risk management into process and systems design – It is common among microfinance institutions to incorporate risk management strategies into their operational procedures. For instance, credit risk is mitigated with appropriate client screening procedures. Loan utilization monitoring is another element of operational procedures which seek to provide early warning of repayment delinquency.
Keep it simple and easy to understand – The risk management tool in an MFB should be a working document for all levels of staff. Management should therefore seek to make risk management procedures as simple as possible. It should be easy to understand by staff. There should be no ambiguity over intention of components of the risk policy. Complicated tools could overstretch operations staff or could lead to resistance to their application.
Involve all levels of staff: Management should strive to ensure that all levels of staff are committed to risk management. It is agreed that certain units such as audit unit, play key roles in risk management, however, the task of anticipation, identification and management of risks should not be left to those units alone. Involvement should begin with the process of formulation of the risk management framework of the bank.
Align risk management goals with the goals of individuals – Risk management objectives should be sufficiently aligned with the expectations of staff of the microfinance bank to stimulate commitment and involvement. For instance, incentives for loan officers may be tied to the quality of loan assets. For staff with information management and reporting, incentives could be based on quality of reports and reporting.
Address the most important risks first – There may be the temptation to take on all risks. This approach could yield little results. The recommended approach is conscious prioritization of risks. This can be achieved with the help of a risk management matrix as discussed above. The approach is to identify risks that could result in severe consequences for the microfinance bank and focus on their mitigation. Liquidity risk for instance could not only negatively impact on revenue, but also on the reputation of the microfinance bank. Management should be able to measure the impact of risks even for those risks which appear remote.
Assign responsibilities and set monitoring schedule – All levels of key risk management functions should be assigned to staff for the purpose of constant assessment and monitoring. At the branch level, functions of monitoring should be done on a daily basis. Performance within the set standard must be monitored. Staff members should be assigned to production of timely reports. Those who review reports must ensure that prompt feedback is provided for policy review in a timely manner.
Design informative management reporting to board – A good reporting system is vital to risk management. At every level, reports for review must contain information useful for decision making. Operations managers should be provided with detailed information while the board should be provided with summarized information with emphasis on performance ratios and trends. The board should require correct and accurate reports providing adequate insights into the performance of the microfinance bank as well as highlighting potential threats to the bank. Without information reporting, the board cannot perform its prime function of protecting the assets of all stakeholders (investors, depositors, creditors and staff).
Develop effective mechanisms to evaluate internal controls – Internal control is a vital part of the risk management strategy of an MFB. The scope of audit functions ranges from few periodic spot checks to comprehensive review of operations. To enhance internal control systems, adequate steps should be taken to continuously evaluate their effectiveness. Reports of audit exercises provide insight into the effectiveness of existing risk management systems. Audit exercise should take the field-based nature of microfinance operations into account. No audit exercise is complete without visits to credit individuals and groups for reconciliation of primary records with the microfinance bank’s records.
Manage risk continuously using a risk management feedback loop – Risk management should be a continuous process. In its entirety risk management should not be a single event. Using the feedback loop, management should be able to address emerging risk from arising changes that are internal and external in nature. New products and services require new or modified procedures which may expose the bank to new risks. Changes in the operating environment could bring about new risks to manage. The risk management process should therefore be continuous to address emerging risks.

RISK MANAGEMENT ORGANS AND RESPONSIBILITIES

In its study manual for microfinance bank 2014, the Nigerian chartered institute of bankers postulated the following as risk management organs and responsibilities. “The overall responsibility for effective risk management is that of key officers and organs such as the Board of Directors and top management as well as the Asset and Liability Committee (ALCO).

Board of Directors – Risk management is a key function of the Board of Directors. Effective risk management enables the board to perform its other prime functions of guiding the institution in fulfilling its corporate mission and protection of the bank’s assets such as loan assets. The Board of Directors is the ultimate risk management organ and could be actively involved in risk management functions through its standing committee such as the Risk Management Committee or Board Credit Committee. Specifically, the Board (through the ALCO and or the Executive Management Committee) is expected to:
Ensure that all significant risks of the bank have been identified. It should require the management to identify the entire range of risks in the MFB’s operations.
Ensure that appropriate strategies are in place to manage identified risk. The board should approve the strategies before they are implemented.
Demand and review relevant reports from management, and the internal and external auditors to determine if existing risk management strategies are effective. Where weaknesses are detected, the board directs the management to make necessary adjustments.
Ratify risk management policies and guidelines formulated by the management. It holds the management responsible for effective implementation of approved risk management strategies.
Ascertain on continuous basis if significant risks are identified, measured, monitored and adequately managed.
Top Management – The MD/CEO is responsible for the overall risk management system of the microfinance bank. He/she is accountable to the board for the development and effective implementation of risk management strategies. He supervises the development and review of the bank’s risk management matrix.
Risk managers and Asset and Liability Committee (ALCO) – Some managers may have risk management functions incorporated into their duties. Some may address credit risks, while another manages liquidity risks. A key risk management organ is the Asset and Liability Committee (ALCO). Ideally, membership of the Asset and Liability Committee should cut across key departments and units. These include Operations, Credit, Risk and Treasury. ALCO must amongst other functions set policies and guidelines for:
Risk identification,
Risk assessment/measurement,
Monitoring and management.

The ALCO periodically reviews risks faced by the bank. It establishes risk tolerance limits for the bank. For effectiveness, ALCO is expected to periodically determine the bank’s current and future position on each of the identified risks. Where the tolerance level is exceeded, ALCO is expected to recommend corrective interventions to the management and board. For example if tolerance level for portfolio at risks is 2% and actual performance is 5.2%, ALCO is expected to highlight the level of under-performance and make specific recommendations for improved results.”

CHAPTER THREE

RESEARCH METHODOLOGY

INTRODUCTION

This chapter deals with the following procedure and methodologies for achieving the aims of the research work under the following teachings.

Research Design
Population of the Study
Samples and Sampling Techniques
Research Instrument
Validation of Instrument
Reliability of Instrument
Method of Data Collection
Method of Data Analysis.

RESEARCH DESIGN

This study is a descriptive research because it investigates the phenomenon as it exist therefore, the research made use of a descriptive research design.

POPULATION OF THE STUDY

Since the study is base on the investigation into the process of effective risk management and microfinance bank lending. It comprises the staff of Giant Stride Microfinance Bank.

SAMPLE AND SAMPLING TECHNIQUE

Obviously, not every member of the population was considered because of time and financial constraint.

INSTRUMENT FOR DATA COLLECTION

The instrument that was used to collect this information is a questionnaire

VALIDATION OF INSTRUMENT

A copy of the research instrument was submitted to the supervisor for moderation and corrections where necessary.

RELIABILITY OF INSTRUMENT

The reliability of the respondents was tested by administering the questionnaire twice.

METHOD OF DATA COLLECTION

The researcher administered the questionnaire personally by giving the staff of Giant Stride Microfinance bank. Then the administered questionnaire was collected from the respondents the same day after when they have answered the questions.

METHOD OF DATA ANALYSIS

For the purpose of this study, the data required for testing of the hypotheses was analysed using the chi-square.

This test enabled the researcher to determine the variability between the actual outcomes from the expected outcome.