MICROFINANCE RISK MANAGEMENT HANDBOOK

Transcription

1 MICROFINANCE RISK MANAGEMENT HANDBOOK Craig Churchill and Dan Coster With Contributions from: Victoria White, Terrence Ratigan, Nick Marudas, Emily Pickrell and Calvin Miller 2001

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3 TABLE OF CONTENTS Table of Contents Table of Contents... i Risks...1 Introduction... 2 What is Risk Management?...2 Structure of the Handbook and How to Use It...4 Chapter 1: Risk Assessment Framework Institutional Risks Social Mission Commercial Mission Dependency Operational Risks Credit Fraud Security Financial Management Risks Asset and Liability Inefficiency System Integrity External Risks Regulatory Competition Demographic Physical Environment Macroeconomic Conclusion...10 Chapter 2: Institutional Risks and Controls Social Mission Risk Mission Statement Market Research Monitoring Client Composition and Measuring Impact Managing Growth Commercial Mission Risk Setting Interest Rates Designing the Capital Structure Planning for Profitability Managing for Superior Performance Monitoring for Commercial Mission Risk Dependency Risk Strategic Dependence Financial Dependence Operational Dependence...27 i

4 CARE MICROFINANCE HANDBOOK Cash Management CARE Core Costs: PN Institutional Culture Technical Assistance Dependency Risk Controls...30 Exit Strategy Independent Structure Recommended Readings...32 Chapter 3: Operational Risks and Controls Credit Risk Credit Risk Controls...35 Loan Product Design Client Screening Credit Committees Delinquency Management Credit Risk Monitoring Fraud Risk Types of Fraud Controls: Fraud Prevention...48 Excellent Portfolio Quality Simplicity and Transparency Human Resource Policies Client Education Credit Committees Handling Cash Collateral Controls Write-off and Rescheduling Policies Monitoring: Fraud Detection...55 Operational Audit Loan Collection Policies Client Sampling Customer Complaints Response to Fraud...59 Fraud Audit Damage Control Security Risk...60 Recommended Readings...62 Chapter 4: Financial Management Risks and Controls Asset and Liability Management Interest Rate Risk Foreign Exchange Risk Liquidity Risk Inefficiency Risk Inefficiency Controls...69 Budgeting Activity Based Costing Reengineering Inefficiency Monitoring...73 Efficiency and Productivity Ratios Monitoring Human Errors Systems Integrity Risks...75 Recommended Readings...76 ii

5 TABLE OF CONTENTS Chapter 5: External Risks Regulatory Risks Banking Regulations...78 Usury Laws Financial Intermediation Other Regulatory Risks...80 Directed Credit Contract Enforcement Labor Laws Regulatory Monitoring and Response Competition Risks Monitoring Competition Risks Competition Risk Responses Demographic Risks Physical Environment Risks Macroeconomic Risks...84 Recommended Readings...86 Chapter 6: Management Information Systems System Components: What Does an MIS Include? Accounting Systems...88 Chart of Accounts Cash vs. Accrual Accounting Fund Accounting General Software Design Consideration Portfolio Management Systems Linking Accounting and Portfolio Systems Financial Statement Presentation Voucher Preparation Frequency of Financial Statements Financial Statement Adjustments...94 Accounting Adjustments Adjusting for Inflation and Subsidies Constant Currency Reporting Key Issues in Report Design Reporting Framework Recommended Readings Annexes Annex 1: Checklist by Category of Risk Annex 2: Sample Chart of Accounts Inflation and Subsidy Adjustment Worksheet Annex 3: Inflation and Subsidy Adjustment Worksheet Annex 4: Sample Balance Sheet and Income Statement Bibliography iii

6 CARE MICROFINANCE HANDBOOK 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 Figure 23: Key Reports by Shareholder Category iv

7 INTRODUCTION Risks 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. 1

8 CARE MICROFINANCE HANDBOOK Introduction All 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. This handbook is intended to foster good management and accountability The overriding objective of this handbook is to foster good management and accountability. This will encourage costeffectiveness, 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 1 For a six-step version, see Campion (2000). 2

9 INTRODUCTION Figure 1: Three-step Risk Management Process Identify Current and Future Vulnerabilities Monitor Effectiveness of Controls Design and Implement Controls to Mitigate Risks 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. Risk management is ongoing because vulnerabilities change over time 3

10 CARE MICROFINANCE HANDBOOK 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 selfassessment tool. For example: 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. 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. 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. 4

11 INTRODUCTION 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. 5

12 CARE MICROFINANCE HANDBOOK Chapter 1: Risk Assessment Framework Most 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. 6

13 CHAPTER 1 Figure 2: Categories of Microfinance Risks Institutional Risks Social Mission Commercial Mission Dependency Operational Risks Credit Fraud Security Financial Management Risks Asset and Liability Inefficiency System Integrity External Risks Regulatory Competition Demographic Physical Environment Macroeconomic 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 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 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 7

14 CARE MICROFINANCE HANDBOOK 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) 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 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 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. 8

15 CHAPTER Financial Management Risks 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 shortterm 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 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 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. 9

16 CARE MICROFINANCE HANDBOOK 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 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 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 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 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' 10

17 CHAPTER 1 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. 11

18 CARE MICROFINANCE HANDBOOK 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: 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. 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. 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. 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. 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: 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), personality characteristics (outgoing, team player), and aptitudes (combination of hard and soft skills). Once you identify the ideal traits of a loan officer, then you can design your 12

19 CHAPTER 1 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. 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. 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: Benefits such as health insurance and vacation time An institutional mission where people feel that they can make a difference Workplace design that is comfortable and conducive to productivity An institutional culture that is unique so that employees feel like they are part of a special team Recognition of individual and group accomplishments Staff development and job enrichment opportunities 13

20 CARE MICROFINANCE HANDBOOK Chapter 2: Institutional Risks and Controls Institutional Risk Operational Risk Financial Management Risk External Risk Institutional 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. 14

21 CHAPTER 2 Figure 4: The Four Ms of Controlling Social Mission Risk Social Mission Provide Appropriate Financial Services To Large Volumes Of Low-Income Persons To Improve Their Welfare Mission Statement Controls and Monitoring Market Research Managing Growth Mission Statement Measuring Impact 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 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. 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. 15

22 CARE MICROFINANCE HANDBOOK Does your organization have a clear mission statement that balances the social and commercial objectives and identifies the target market? Do employees know the organization s mission statement and use it to help guide their actions? Does the composition of the board reflect the dual mission of microfinance? 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: Does your organization use appropriate screening mechanisms to ensure that it is serving the intended target market? Are the loan sizes appropriate to the needs of the clients? Lost customers are a valuable source of information about what is wrong with your products Do you offer a large enough range in loan sizes so that the best clients do not grow out of the program? 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? 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)? 16

23 CHAPTER 2 How do you conduct useful market research activities on a regular basis to keep in touch with the changing needs of your target market? How does your organization demonstrate a commitment to constant improvement? Tool 1. Questions on loan applications 2. Complaint and suggestions system 3. Customer satisfaction surveys Figure 5: Market Research Tools Explanation Collect information with each loan application from a) new clients regarding 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 Incorporate customer comment cards and/or a customer service desk Send a short questionnaire to a representative sample of clients, or to 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) 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. 17

24 CARE MICROFINANCE HANDBOOK Figure 6: Monitoring Client Composition Primary Indicators Average Outstanding Balance Average Loan Size (disbursed) Average Loan to 1 st Time Clients Percentage of Women Clients Secondary Indicators Monthly or Annual Household Income Household Assets Enterprise Asset Base 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. What indicators do you use to ensure that you are serving the intended target market? Is this information collected in a cost-effective manner? How does the board monitor the client composition? What information, if any, does your organization consistently collect regarding the impact of your services on clients? How often does senior management go to the field to talk with clients and staff? 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 they are ready. 18

25 CHAPTER 2 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. 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)) How has your retention rate changed over the past year and what are the primary reasons for that change? 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 shortterm 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. 19

26 CARE MICROFINANCE HANDBOOK Controls for commercial mission risk include: setting interest rates, designing the capital structure, planning for profitability, and managing for superior performance 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 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. Microfinance institutions need to reach certain economies of scale (roughly five to ten thousand clients) before they can become profitable. A start-up therefore needs capital to pay for operating deficits until it reaches break-even, perhaps in the form of investor equity, high risk debt, or grants. 20

27 CHAPTER 2 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 Transformation Grant Funds Concessionary Loans Commercial Loans with Guarantees Retained Earnings Investor Equity Commercial Loans and Customer Savings 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 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, 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. 21

28 CARE MICROFINANCE HANDBOOK 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 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 staff turnover has on customer loyalty. While this estimation will The retention of quality staff members is even more important than retaining clients 22

29 CHAPTER 2 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: A Thin Labor Market: Not being able to find enough affordable employees with the requisite skills The Peter Principle: Promoting people to their level of incompetence (good loan officers do not necessarily make good branch managers) 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: Develop a means of regularly identifying employee development and motivational needs Invest heavily in your employees by providing quality staff training and sending them on observation visits to MFIs in other countries Establish a family-like institutional culture in which the employee and the institution are fully committed to each other 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 Monitor employee turnover ratios Conduct exit interviews with departing staff members to determine the real reasons why they are leaving 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. 23

30 CARE MICROFINANCE HANDBOOK Figure 8: Sustainability and Profitability Ratios Operational Sustainability Financial Sustainability Interest Spread (Gross Financial Margin) Return on Assets Sustainability Operating income / (Operating expenses + provision for loan losses + financing costs) Operating income / (Operating expenses + provision for loan losses + adjustments for inflation and subsidies)* (Operating income financing costs) / Average performing assets Profitability Net income / Average assets Return on Equity Net income / Average equity *For more details about adjusting for inflation and subsidies, see Chapter 6. Is the interest rate set high enough to cover the MFI s full costs? Do you have a business plan to achieve self-sufficiency in a reasonable amount of time? Do you update the plan and use it regularly to make management decisions? What steps do you take to ensure that your employees are motivated and enthusiastic about their work? Is your human resource system effective and how do you know? Do you have job descriptions and annual performance appraisals for all employees, including senior management? 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? Do you monitor sustainability and profitability indicators, and if so are they trending in the right direction? Are you moving toward accessing commercial sources of capital and reducing reliance on subsidized funding sources? 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. 24

31 CHAPTER 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. Do you have an independent governing body? Does your organization have a plan to establish itself with an independent legal structure? 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? Does your organization have the capacity and commitment to develop its own business plan? Is CARE s role in the governance and management structure best described as supportive or dominating? 25

32 CARE MICROFINANCE HANDBOOK 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. Adapted from Campion and Frankiewicz (1999) 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 26

33 CHAPTER 2 against losses due to mismanagement or inefficiency and directly inhibit the MFI from achieving optimal levels of performance. What percentage of your operating expenses is covered by money received from or through CARE? Do you have an independent contract for financial resources from a donor or commercial lender? Is your organization reducing its dependence on donor/care subsidies by as much as estimated in the business plan? If not, why not? Is CARE the only entity that has raised investment capital and operational subsidies for your organization? Operational Dependence Operational dependence has both functional and cultural aspects. A functional dependence occurs when a routine task of the organization is performed or authorized by staff outside the MFI s management structure. For example, if the CARE finance department manages important treasury functions, a functional dependence exists. Functional dependence is normally easy to spot and efforts should be made to estimate the fair market value of any services provided by CARE to the MFI. But the MFI should have a plan to assume responsibility for all CARE functions within the shortest possible time, preferably from the start of operations. For MFIs that operate as projects of CARE the functional dependence can be assumed to be nearly complete as all authority for MFI activities is derived from CARE management. However, even in these cases the functional dependence can be reduced if the MFI develops the internal capacity to complete all tasks incumbent on any private business enterprise lacking only the legal authority to do so independently. Cash Management Cash management issues can arise in projects with CARE-owned MFIs, when the MFI financial management system is not separated from the CARE CO system. In these cases the CARE Financial Controller is likely to make cash management decisions regarding cash flows through the MFI, rather than allowing the MFI to manage its own cash. As a result, cash management decisions may be made in the best interests of the CARE CO, to the detriment of potential MFI revenues. Additionally, MFI managers become dependent on CARE financial managers to manage their cash. Regardless of structure or relationship with CARE, it is imperative that MFIs manage their own cash, as an internal treasury management capacity is essential for institutional survival. Does your organization have its own independent financial system? Do you make cash management decisions independently from CARE? CARE Overhead Core Costs CARE, as well as other development organizations, must cover its core operational costs. As a decentralized organization, it operates on the principle that every country office must be 27

34 CARE MICROFINANCE HANDBOOK able to pay for its own management structure from the country office revenues. A country office must keep central management costs to an efficient minimum and maintain a project portfolio that is large enough to cover these shared costs. Within CARE, project costs are generally shared among projects on a prorated basis. Effort must be made to ensure that the costs reflect fair fees in relation to the services provided to the project. This is especially important for MFIs since many of the overhead support activities typically done by CARE within a project are (and should be) directly handled by the MFI such as general management, financial management of day-to-day operations, etc. Even for projects that are not fully independent, their operations should be structured and managed as an MFI and not as a part of the CARE Country Office. 3 The Economic Development Unit advocates that the project constructs financial reports (balance sheet and income statement) to represent the financial position of the MFI apart from CARE and the project. Does the MFI have its own financial system? Are the financial and programmatic reporting expectations and procedures clear between the MFI and CARE? Are the CARE country office core costs reasonable? Is there a written and well-understood agreement between the MFI and the CARE country office on fees to be paid for support services provided by CARE? Institutional Culture Operational dependency may also manifest itself in the institutional culture of the MFI. The corporate culture of CARE as a relief and development NGO is necessarily different than the business-orientation of a successful microfinance institution. In many countries CARE staff are paid better than equivalent jobs in the government or even the private sector, largely to compensate for the insecurity of working for a grant-dependent, non-profit organization. CARE is not required to operate projects at a profit, but merely needs to negotiate sufficient donor support to pay for budgeted costs. Therefore, CARE employees do not necessarily have a personal stake in holding down operational costs and there is no universal measure of efficiency. By contrast, the survival of a business-oriented MFI depends on employees feeling a real sense of ownership over the activities and assets of the institution. In most cases, salaries and benefits have to be set below the norms established for CARE staff, consistent with the MFI s need for profitability and the promise of more stable, long-term employment. Success (and job security) or failure (and potential unemployment) is as clear as the MFI s profit and loss statement. 3 For specific financial guidelines on how to account for Country Office overhead costs, please refer to the CARE Financial Guideline Manual. 28

35 CHAPTER 2 Not surprisingly many employees of MFIs are tempted by the CARE culture. This tendency is particularly difficult to manage when the MFI is legally a project of CARE. It is very difficult to convince personnel who were hired by CARE that they should later become employees of a fledgling local organization. CARE country office regulations may stipulate salary and benefit structures that cannot be sustained by the MFI. SEAD program managers must have the flexibility to create an independent compensation schedule, staff incentives, and human resource manual based on the need for institutional profitability, the market realities of the local environment, and the dignity and performance of the individual employees. Institutional culture is also influenced by the image or brand name recognition of an institution. Some employees may find it easier to use CARE s name with clients and counterparts than work to establish the identity of a new microfinance institution. This can have a negative effect on repayment discipline, especially if CARE has distributed gratuitous relief during emergencies in communities served by the MFI. Do field staff members consider themselves employees of CARE or the MFI? If it is the former, what are the implications? What percentage of their time do loan officers spend in the field? If it is less than half of their time, does the association with CARE somehow make them think that they have administrative positions and should be sitting behind a desk rather than getting their shoes dirty? Technical Assistance A person learns to drive a car by being behind the steering wheel. S/he needs instruction on its operation and its controls prior to turning on the ignition. However, the process of training continues after the car is under the control of the new driver. Technical assistance (TA) is needed to mentor the driver through difficulties. Mentoring as a means of technical assistance can be much more difficult and challenging than actually driving. One of the challenges in the mentoring process is gradually decreasing the involvement of the mentor so as to reduce the potential for dependency. Technical assistance is normally focused on four primary aspects, which are: Tools: Having the things needed to operate, such as adequate staff, systems, procedures Training: Developing the skills of management and staff Coaching and mentoring: Using the ongoing operations as a setting for learning and dialogue (apprenticeship) Monitoring: Ensuring accountability through follow-up on clear expectations and joint analysis of the results Technical assistance plays a fundamental role during early operations. Effective TA results in a transfer of skills and systems, and builds local capacity so that the MFI can advance toward independence. The role of the technical assistance provider should decrease over time so that the institution becomes less vulnerable to dependency risk. Microfinance managers and directors should not assume, however, that once they learn how to run an MFI, they no longer need technical assistance. MFIs often reach capacity plateaus, or they encounter unforeseen and intractable difficulties. If they want to make the leap from 29

36 CARE MICROFINANCE HANDBOOK 10,000 to 20,000 clients, or introduce a new product, or use technology to create efficiencies, then they may benefit from external expertise. If client retention rates are plummeting or delinquency rates are rising, they may want to hire a consultant to get to the bottom of things. CARE may provide this external technical assistance, or it may come from other TA providers, either local or international. While CARE may take the lead role in training MFI staff at the start of the project, eventually the MFI must determine its own staff needs and develop its capacity to hire, train, and mentor its own staff. This implies the need for strong in-house training capacity that can replenish skills as staff move on and respond to a changing market environment. There is an important difference between using technical assistance and being dependent on it. To avoid dependency risk, MFIs should be the ones to determine the role of the TA providers. The TA contract should be for a specific time period and every effort should be made to transfer skills from the TA provider to local staff. Is your organization building its capacity to operate independent of ongoing technical assistance? Does your organization have the ability to identify its own needs and to contract appropriate technical expertise to address those needs on its own terms? Dependency Risk Controls Exit Strategy The risk of dependency is greatly increased in the absence of a clear vision of where one is going. If an external organization like CARE provides services to a microfinance institution, it should include an exit strategy to withdraw its support over a specified period of time. Without this strategy, the risk is for CARE to take its MFI partner(s) down a path of dependency, which is not healthy for partner organizations. Since CARE supports microfinance activities in a variety of different environments, there is not a general blueprint for organizational evolution. It may be appropriate to create a credit union in one country, a bank in another, and an NGO in a third. But there is one basic principal that should be followed to minimize the potential for dependency: local ownership. This does not have to mean ownership in an economic sense. At a minimum, ownership means that local personnel have the skills, resources and motivation to continue managing operations in CARE s absence. This principle does not mean that CARE must absolve itself of all ownership and links in order to complete the process of transfer. In many cases the best approach for CARE may be to remain involved as a board member, investor and/or possible lender to the MFI. It would be a serious mistake for CARE to transfer ownership and especially funds to an organization that is not equipped to manage its operations without oversight. The CARE donor project mentality often creates pressure to do exactly that as the project funding cycle winds down. This can be detrimental to the long-run health of the MFI. 30

37 CHAPTER 2 Does CARE have an exit strategy? Are there clear indications of local ownership such that microfinance service operations will likely continue in CARE s absence? Independent Structure A very critical first step toward the development of a self-sufficient microfinance institution is to separate the microfinance activities from the CARE structure as soon as possible, preferably from inception. To be classified as independent, a structure should have the following four elements: a separate financial system, a distinct governing body, human resource department, and an independent legal structure. Generally, no loans should be issued and no savings generated until the program or project has its own independent financial system. It is better to maintain accounting and loan ledgers by hand in an independent local structure than to use computerized systems in a project that is run by CARE. Identity and Institutional Culture MFIs that begin as CARE projects may struggle to establish an independent identity and distinct corporate culture. 1. Name: The MFI should choose a separate name as soon as possible and avoid the necessity of identifying itself as CARE 2. Office Space: The MFI should not share space with other CARE projects. 3. Recruitment: At startup the MFI may want to recruit some experienced CARE staff, but caution should be used in such cases as a large number of transfers from CARE projects may hinder efforts to establish a fresh, businessoriented corporate culture. 4. Orientation and Training: Newly hired staff should receive a thorough orientation designed to instill a sense of the vision, purpose and principles of the MFI, not CARE. 5. Quality of Leadership: MFI directors and managers must reinforce corporate values and lead by example. An independent MFI must have a designated or defined governing body. This may take the form of a board of directors, or the elected officials of a cooperative or association, or if the project is not yet a legal entity, an ad hoc advisory board that assumes oversight responsibilities and expects to evolve into a board of directors. If possible, CARE should be a part of this governing body at the beginning, but the local management should make operational decisions. A microfinance institution consists primarily of people: lots of loan officers and perhaps tellers, a handful of middle managers, some back office personnel, and senior management. For these people to have the appropriate skills and motivation, the MFI must have an independent human resource department that writes job descriptions, recruits and screens applicants, designs compensation systems, orients and trains new staff, provides ongoing training and staff development, coordinates a performance review process, and promulgates the institution s culture. It may not be possible or advisable for the local institution to form an official legal structure in the early stages, but it should at least articulate a general organizational development plan. The transfer of legal ownership is relatively easy if the other two pieces the MFI s financial systems and governing body are independent of CARE, and if checkpoints for eventual transfer of ownership are clearly outlined. Legality is less an issue in mitigating dependency risk than the mindset of employees, management, and directors. Consequently, if legally possible, employees should be hired by the MFI, not by CARE. 31

38 CARE MICROFINANCE HANDBOOK Recommended Readings Setting Interest Rates Castello, Carlos, Katherine Stearns and Robert Peck Christen (1991). Exposing Interest Rates: Their True Significance for Microentrepreneurs and Credit Programs. Discussion Paper No. 5. Somerville, MA: ACCION International. Website: Rosenberg, Richard (1996). Microcredit Interest Rates. CGAP Occasional Paper, No. 1. Washington, DC, USA: Consultative Group to Assist the Poorest. Website: Performance Ratios Bartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios I: Analyzing Profitability in Microcredit Programs. GEMINI Technical Note No. 7. Bethesda, MD: Development Alternatives, Inc. Website: Christen, Robert Peck (1997). Banking Services for the Poor: Managing for Financial Success. Somerville, MA: ACCION International. Website: Ledgerwood, Joanna (1999). M icrofinance Handbook: An Institutional and Financial Perspective. Washington DC: The World Bank. [email protected]. See pages: Ledgerwood, Joanna and Kerri Moloney (1996). Financial Management Training for Microfinance Organization: Accounting Study Guide. Toronto: Calmeadow. Website: Available from PACT Publications. SEEP Network and Calmeadow (1995). Financial Ratio Analysis of Micro-Finance Institutions. New York: PACT Publications. [email protected]. The MicroBanking Bulletin. A semi-annual publication. [email protected]. Governance and Management Campion, Anita and Cheryl Frankiewicz (1999). Guidelines for the Effective Governance of Microfinance Institutions. Occasional Paper No. 3. Washington DC: The MicroFinance Network. [email protected]. Available from PACT Publications. [email protected]. Rock, Rachel, Maria Otero and Sonia Saltzman (1998). Principles and Practices of Microfinance Governance. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: SEEP Network (1993). An Institutional Guide for Enterprise Development Organizations. New York: PACT Publications. [email protected]. Market Research Brand, Monica (1998). New Product Development for Microfinance: Evaluation and Preparation. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Brand, Monica (1999). New Product Development for Microfinance: Design, Testing and Launch. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Churchill, Craig F. and Sahra S.Halpern, (2001). Building Customer Loyalty: A Practical Guide for Microfinance Institutions. Technical Note No. 2. The MicroFinance Network: Washington DC. [email protected]. Available from PACT Publications. [email protected]. SEEP Network (2000). Learning from Clients: Assessment Tools for Microfinance Practitioners. USAID AIMS Project. Draft Manual. Website: 32

39 CHAPTER 2 Waterfield, Charles and Ann Duval (1996). CARE Savings and Credit Sourcebook. Available from PACT Publications. [email protected]. Business Planning and Managing Growth Churchill, Craig F. (1997). Managing Growth: The Organizational Architecture of Microfinance Institutions. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Sheldon, Tony and Charles Waterfield (1998) Business Planning and Financial Modeling for Microfinance Institutions. Washington, DC, USA: Consultative Group to Assist the Poorest. Website: 33

40 CARE MICROFINANCE HANDBOOK Chapter 3: Operational Risks and Controls Institutional Risk Operational Risk Financial Management Risk External Risk Operational risks are the vulnerabilities confronting a microfinance institution in its daily operations that can ultimately result in the loss of its assets. At its core, an operational risk is the concern that an MFI will lose its money through bad loans, fraud and theft. This chapter describes controls and monitoring activities to reduce the three types of operational risks summarized in Figure 9. Figure 9: Types of Operational Risks Operational Risk Type of Loss Primary Perpetrator 1) Credit Risk Loss resulting from poor portfolio quality Clients 2) Fraud Risk Loss resulting from deceit MFI staff members 3) Security Risk Loss resulting from theft Non-MFI persons To reduce vulnerability to operational risks, microfinance institutions develop policies and procedures that form the core of the organization s internal control system. These controls usually include preventive and detective aspects. Preventive controls inhibit undesirable outcomes from happening. Examples of preventive controls include: Hiring trustworthy employees who can make good credit decisions Ensuring that loans are backed by appropriate collateral or collateral substitutes Segregating staff duties to prevent intentional wrongdoing Requiring authorization to prevent improper use of resources Maintaining proper record keeping procedures to deter improper transactions Installing sufficient security measures (i.e., locks, guards, safes) to protect cash and other assets 34

41 CHAPTER 3 Detective controls identify undesirable outcomes when they do happen. Examples of detective controls are: Reconciling bank statements with cash receipts Monitoring early warning signals for signs of pending portfolio quality problems Implementing delinquency management policies to prevent late payments from escalating into bad debts Monitoring staff performance to ensure policies and procedures are followed Visiting clients to ensure that their loan and saving account balances and transaction dates correspond with the MFI s records Arriving at the appropriate balance of preventive and detective controls involves judgment. Preventive controls avoid problems before they occur, but detective controls are generally easier to implement. For example, it is easier to do monthly bank reconciliation than to prevent employees from pocketing repayments. There are also important cost implications to consider. MFIs cannot eliminate losses due to operational risks. Some loans are bound to go bad and some staff members will undoubtedly succumb to temptation. Controls designed to minimize the losses from operational risks need to be carefully analyzed for their cost-effectiveness some controls may be more expensive than they are worth. 3.1 Credit Risk Credit risk, the most common and often the most serious vulnerability in a microfinance institution, is the deterioration in loan portfolio quality that results in loan losses and high delinquency management costs. Also known as default risk, credit risk relates to client failure to meet the terms of a loan contract. One microloan does not pose a significant credit risk because it is such a small percentage of the total portfolio. Since most microloans are unsecured, however, delinquency can quickly spread from a handful of loans to a significant portion of the portfolio. This contagious effect is exacerbated by the fact that microfinance portfolios often have a high concentration in certain business sectors. Consequently, a large number of clients may be exposed to the same external threat, like a crackdown on street vending or a livestock disease. These factors create volatility in microloan portfolio quality, heightening the importance of controlling credit risk Credit Risk Controls Credit risk management can be divided into the preventive steps lenders take before issuing a loan and the use of incentives and disincentives after loan disbursement to extract timely repayment. Prior to issuing a loan, a lender reduces credit risk through controls that reduce the potential for delinquency or loss, such as loan product design, rigorous client screening, and client orientation to expectations and procedures. Once a loan is issued, a lender s risk 35

42 CARE MICROFINANCE HANDBOOK management expands from controls that reduce the potential for loss to controls that reduce actual losses. As such, delinquency management procedures are key components of credit risk management. This section addresses four key credit risk controls: (1) loan product design, (2) client screening, (3) credit committees, and (4) delinquency management. Loan Product Design MFIs can mitigate a significant portion of default risk by designing loan products that meet client needs. Loan product features include the loan size, interest rate, repayment schedule, collateral requirements and any other special terms. Loan products should be designed to address the specific purpose for which the loan is intended. For example, a loan to purchase inventory for a neighborhood grocery store might have a different repayment schedule and use different collateral than a loan for a sewing machine. A loan for purchasing seeds and fertilizer to grow maize may have another structure, perhaps with repayment coming in a lump sum at harvest time. Loan products for non-business purposes, such as housing, emergency, education, and consumption smoothing, also require different design features. In designing loan products to minimize credit risk, consider the characteristics summarized in Figure 10. For new clients, MFIs commonly adopt conservative product design features, In Search of the Right Balance: The Costs of Credit Risk Controls and their Effect on Customer Satisfaction Microfinance institutions should strive to find the appropriate balance between managing credit (and fraud) risks, the costs and effectiveness of each control, and the attainment of customer satisfaction. For example, many MFIs require new clients to repay their loans in weekly installments. This is considered an important control for credit risk because smaller installment sizes are easier to repay and frequent repayments are easier to monitor. But how much more effective in controlling credit risk are weekly repayments than biweekly? Is it effective enough to endure the costs of having twice as many repayment transactions? Does the benefit of assumed lower loan losses justify the high costs (time and money) to clients in the form of travel and lost business? What effect does this control have on customer satisfaction and loyalty? MFIs should explore the same series of questions for all of their credit risk controls, such as forced savings, staggered disbursements, months of pre-loan training, etc. in an effort to significantly reduce the costs to both the client and the institution while hopefully improving the effectiveness of the controls. Often MFIs assume that certain controls are necessary to exact timely repayment, but they have not determined exactly how important they are, nor have they analyzed whether they are worth the cost. 36

43 CHAPTER 3 such as small loan amounts, short loan terms, and frequent repayment periods. This is particularly true if clients lack business records (i.e., they cannot provide evidence of their capacity to repay) and cannot offer collateral. Once the client establishes a track record with the lender, the MFI often increases the flexibility in loan terms to make the product more appropriate to client needs. This change reflects a balance between risk and control. New clients are categorized as high risk. Once they establish a credit history with the MFI, they can be considered a lower risk and the lender can reduce some of its controls. Eligibility Requirements Loan Amounts Loan Terms Repayment Frequencies Collateral Requirements Interest Rates and Fees Figure 10: Reducing Credit Risk through Product Design Features Many MFIs require that applicants meet certain criteria that are known to reduce credit risk. For microenterprise loans, for example, prospective borrowers are often expected to have been in business for at least six months to demonstrate that they have a commitment to their businesses and some experience. Other eligibility requirements include business documentation (i.e., bank statements, sales receipts) and a business plan. MFIs must ensure that the loan amount is within the client s capacity to repay. One of the most common product design flaws in microfinance is automatically increasing loan sizes. A second issue, though less common, is issuing multiple loans (where the client accesses loans from multiple sources) with an aggregate installment beyond client capacity to repay. One way to address the capacity issue is to extend the loan term to make installments smaller. This approach, however, has to be balanced with the fact that access to the next loan is a primary repayment incentive. If the prospect of a next loan is too far away, some clients may lose a key incentive to continue repaying this loan. Repayment frequency (i.e., weekly, monthly) allows the MFI to control credit risk. The more frequent the repayment, the more in-tune the institution is to its portfolio quality. The discipline of frequent repayments allows the MFI to more tightly control credit risk. However, repayment frequency must be balanced with transaction costs to the client and the institution, as well as the type of loan. Collateral is the primary mechanism lenders use to reduce credit risk. However, microfinance clients often do not have traditional collateral, such as property deeds. Instead, MFIs use non-traditional collateral (i.e., personal guarantees, household assets, forced savings) and collateral substitutes (i.e., peer group lending methods) to reduce credit risk. The price of the loan reflects a balance of various issues, including costs of delivery and risk level. In general, loans that are more costly and riskier require higher rates of interest. MFIs that price their products too low will not be able to cover their costs, and eventually will go out of business. If they price their products too high, however, they may have difficulty attracting sufficient lower-risk clients to maintain a healthy portfolio. The process of loosening these controls also rewards timely repayment. The MFI should inform clients from day one that their ability to access more accommodating services depends on their repayment history. If they repay on time, they can access preferred 37

44 CARE MICROFINANCE HANDBOOK product features such as larger loan sizes, lower interest rates, and less frequent repayment periods. Another positive benefit of reducing controls for low risk, repeat borrowers is that it helps to reduce client desertion. Desertion refers to clients who choose not to take a new loan after paying off an existing loan. Some of these clients may leave your organization because a competing MFI offers loan products better suited to their needs. MFIs that do not make appropriate accommodations for these clients find that they lose the borrowers they most need to keep. It is very important that an MFI conduct exit interviews with at least a portion of clients that do not apply for a new loan. The MFI needs to know if there is a growing trend of client desertion because of certain undesirable characteristics of MFI services or positive characteristics of competitor services, either of which may necessitate change in product design or service delivery. What characteristics of the product design are intended to control credit risk? Are those characteristics appropriate for different segments of the target market (i.e., new clients and repeat clients)? Are the features of the loan product reviewed regularly to determine if they should be modified? Are exit interviews conducted with clients who are leaving client groups or discontinuing to use the MFI services? Client Screening The first step in limiting credit risk involves screening clients to ensure that they have the willingness and ability to repay a loan. When analyzing client creditworthiness, microfinance institutions typically use the five Cs summarized in Figure 11. If any of these components is poorly analyzed, credit risk increases. To limit this risk, institutions develop policies and procedures to analyze each component. Figure 11: The Five C s of Client Screening (1) Character An indication of the applicant s willingness to repay and ability to run the enterprise (2) Capacity Whether the cash flow of the business (or household) can service loan repayments (3) Capital Assets and liabilities of the business and/or household (4) Collateral (5) Conditions Access to an asset that the applicant is willing to cede in case of non-payment, or a guarantee by a respected person to repay a loan in default A business plan that considers the level of competition and the market for the product or service, and the legal and economic environment These five components are relevant to all types of lending institutions. The weight assigned to each component will vary depending on the lending methodology (i.e. solidarity group, village banking or individual), the loan size, and whether it is a new or repeat customer. 38

45 CHAPTER 3 Not everyone who applies for a loan is a good credit risk. Regardless of the lending methodology, loan officers should be expected to make wise credit decisions. Unfortunately, in some MFIs, staff members act more like loan administrators than loan officers do. If all of the paperwork is in order and the applicants have fulfilled whatever savings and meeting requirements there might be, then they automatically receive a loan. This often results in poor portfolio quality. Loan officers and their immediate supervisors should consider the 5 Cs when making credit decisions and they should be held accountable for those decisions. Character: In microfinance, character is the single most important means of screening new applicants. By assessing a client s character, the lender gains important insight into the client s willingness to repay. Although the MFI does not want to put clients in a difficult situation, clients with good character will find a way of repaying their loans even if their businesses fail. The importance of character as the key trait to select new borrowers is heightened by the fact that many microenterprises do not have sufficient records to demonstrate their capacity to repay. Screening for character varies by the lending methodology. In group-lending programs, the group assumes responsibility for selecting members of strong motivation and character because members guarantee each other s loans. With individual lending, besides interviewing neighbors and opinion leaders in the community, loan officers also need to ensure that information provided by the applicant is internally consistent. This is often tested through a three-stage method whereby applicants provide information about themselves and their business in a loan application. Then the loan officer visits the household and/or business to, among other things, verify that the application information is correct. Finally, the loan officer checks other sources regarding the reliability of the Character Assessment at Bank Rakyat Indonesia s Microfinance Units At BRI s microfinance units, most loan rejections are based on character, not business assessment. Rejection occurs if the credit officer learns that the applicant is not respected in the community or has misrepresented himself in the application. Almost without exception, loan officers identified the neighbor s assessment of the applicant s character as the most important means of predicting a new applicant s future repayment behavior more important than the business assessment. Churchill (1999). information, such as a landlord regarding the size of rent and the length of residence, or a supplier regarding the frequency and size of inventory purchases. Figure 12 summarizes methods for character screening. 39

46 CARE MICROFINANCE HANDBOOK Figure 12: Methods for Screening Client s Character Check personal and community references to assess the applicant s reputation. Use peer groups in which clients select other group members who they believe are honest and reliable. Maintain a blacklist of past poor performers to avoid repeat lending to bad clients. Interview client to understand his or her motivation for borrowing money. Check credit history with suppliers, other credit organizations, or with credit bureau, if available. Campion (2000). Capacity: To assess an applicant s capacity to repay, loan officers conduct both business and household assessments. One challenge in determining the business capacity to repay is the fungibility of money: what the client says she will use the loan for and what she actually uses the loan for may be different. Because the lines between a microentrepreneur s business and household activities are often blurred, it is important for the loan officer to understand the flow of funds within and between the two. It is difficult to assess the repayment capacity of a low-income applicant. Loan Use Verification? Estimates of income and expenses may Another control to address the fungibility of money not be reliable, and applicants often do problem is for the loan officer to visit the business not have supporting financial records. after it has received the loan to verify how the loan was Experienced loan officers develop used. This method may not be recommended as a methods of improving the quality of these formal procedure because it can reduce the institution s estimates by determining the basis on efficiency and can be perceived as patronizing. Even which they are made and then testing so, it is appropriate for an MFI representative to make whether the assumptions are valid. spot visits to clients and inquire about the success of the business. However, wide variations may still exist between estimated and actual cash flow of a business, even if the applicant is not intentionally misleading the loan officer. To overcome these challenges, some MFIs assess a client s capacity to repay without taking into account the effect of the loan on the business. That means that the current net income of the business is a certain multiple of the proposed installment amount; in other words, the applicant estimates that the business is already generating enough revenue to repay the loan. MFIs also use small initial loan sizes and an ongoing process of collecting information to overcome the challenge of assessing the applicant s repayment capacity. Initial loan sizes tend to be smaller than the applicant requests because the loan officer does not have good information to assess repayment capacity. Clients are then asked to maintain basic business information on income and expenses so that loan officers can make credit decisions based on more reliable information and tailor subsequent loans to the cash flow of the business. 40

47 CHAPTER 3 With small loan sizes, it is appropriate that the applicant s character is the key screening element. As loan sizes increase, however, there needs to be a shift from soft information like character to harder information such as capacity. To make good credit decisions, therefore, it is important that loan officers collect information over time that will allow them to understand of the capacity of their clients businesses. Capital: Besides assessing the cash flow of the business to determine if it has the capacity to repay a loan, many MFIs collect information on the assets and liabilities of the business to construct a simple balance sheet. This allows the loan officer to determine if the business is solvent and how much capital the client has already invested in the business. With the smallest loans, this component is probably the least important, but its significance increases as loan sizes increase. In some cases, loan sizes are linked to the equity in the business. Some MFIs also conduct an asset inventory to reduce credit risk. Although they may not say so explicitly, loan officers convey the message that, if the client does not repay, the institution might seize these assets. This is known as implicit collateral. Collateral: One reason for the development of the microfinance industry is that traditional banks do not serve persons who cannot offer traditional collateral. Many microlending methodologies use peer groups, restrictive product terms and compulsory savings as collateral substitutes. Subsequent lending innovations provide microloans with nontraditional collateral, such as household assets and cosigners. Pawn lending and asset leasing are other methods of overcoming collateral constraints. Perhaps more important than the type of collateral is how it is used. In microfinance, collateral is primarily employed as an indication of the applicant s commitment. It is rarely used as a secondary repayment source because the outstanding balance is so small that it is not cost-effective to liquidate the collateral, much less legally register it if such a service is available. Only when clients are not acting in good faith do microlenders take a hard line Business and Household Assessments Loan officers visit applicants to observe the business in action, and assess how the applicant interacts with customers and the condition of business equipment. Since microentrepreneurs are unlikely to have the documentation required by traditional banks, microlenders collect information through observation. Rather than take information at face value, through this interview process the credit officer can probe when responses do not seem realistic or do not have internal consistency. The process of assessing applicants businesses, and in most cases their households as well, achieves five main purposes. First, the assessment determines if the applicant is creditworthy by collecting objective data regarding the business, the applicant s outstanding debts, and the household s cash flow. Second, it provides information to ensure the product is designed to the applicant s credit needs and capacity. Third, the assessment allows the credit officer to collect subjective information about the applicant s character to develop a gut feel if the applicant is trustworthy. Fourth, this process plays a role in educating the client about the lender s motives and mechanisms. Fifth, the assessment helps to forge a positive working relationship between client and loan officer. Churchill (1999). 41

48 CARE MICROFINANCE HANDBOOK stance and seize collateral. Consequently, MFIs tend to be less concerned about the ratio of the loan size to the value of collateral than how the clients would feel if the collateral was taken from them. As the loan size increases, however, this soft approach to collateral needs to change so those larger loans are indeed backed by appropriate security. Conditions: The fifth component, conditions, is often the hardest for loan officers to assess. Many MFIs adopt a microenterprise development approach to microfinance, which means that they are as concerned with improving the business as recovering their loan. As such, the process of assessing the level of competition, the size of the client s market, and potential external threats, can play an important role in helping the client to make smart business decisions and help the loan officer to make good credit decisions. Since loan officers do not usually have the expertise to analyze the conditions of all types of businesses, the primary means of controlling the credit risk posed by business conditions is to require that applicants be in business for a certain number of months (usually 6 to 12 months) before they are eligible for a loan. This requirement means that applicants will have sufficient experience to answer questions about market conditions. The existing business requirement also makes it easier to assess repayment capacity and business capital needs. What screening techniques does your organization use to minimize credit risk? How do those screening techniques vary by loan number and loan size? Are those techniques consistently applied in all branches? If it makes secured loans, does the program have appropriate policies and systems for dealing with collateral? Credit Committees Establishing a committee of persons to make decisions regarding loans is an essential control in reducing credit (and fraud) risk. If an individual has the power to decide who will receive loans, which loans will be written off or rescheduled, and the conditions of the loans, this power can easily be abused and covered up. While loan officers can serve on the credit committee, at least one other individual with greater authority should also be involved. For larger loans, a committee of three or more individuals is appropriate. A credit committee typically includes senior and middle managers, but it might also include community leaders, local bankers and even clients. The credit committee has the responsibility not only for approving loans, but also for monitoring their progress and, should borrowers have repayment problems, getting involved in delinquency management. This way the credit committee lives with the implications of its decisions. Additionally, MFIs should have written policies regarding loan approval authority. These policies should specify the loan amounts that can be approved with two signatures, loan amounts requiring additional signatures, and who has the authority to approve loans. This reduces risk of loans being inappropriately approved. Before recommending an application, loan officers have to have a high degree of confidence that the loan will be repaid With group lending methodologies, the group usually fulfills part of the credit committee s function. Since group members guarantee each other s loans, it is important that they be 42

49 CHAPTER 3 involved in the approval process. But MFIs should not abdicate all responsibility for loan approval to the group. Borrowers are unlikely to have the skills to make good credit decisions, and therefore the loan officer needs to be familiar with the businesses and should facilitate the discussion. Ultimately, the MFI s money is at risk, so loan officers and their immediate supervisors need to sign off on all credit decisions and feel comfortable that the money will be repaid. Loan officers should feel comfortable: a) rejecting entire groups if the members do not know and trust each other very well or if they do not appreciate the importance of joint responsibility; b) encouraging good group members to expel inappropriate members; and c) promoting smaller loan sizes that members are confident that they can repay. To act in this way, loan officers need the tools and the training to conduct business and character assessments, to facilitate group discussions, and to test the group s commitment. Are the loan approval policies strictly followed? Does the credit committee have sufficient experience to make good decisions? Is the credit committee involved in loan monitoring and delinquency management? Delinquency Management The first three types of credit risk control product design, client screening and credit committees are intended to prevent delinquency and eventual loan losses. However, it is unrealistic to plan on designing an ideal product and selecting ONLY the best clients in order to avoid loan delinquency. Some loans invariably become delinquent and loan losses will occur. To minimize such delinquency, CARE s Economic Development Unit recommends the following six delinquency management methods: 1) Institutional Culture: A critical delinquency management method involves cultivating an institutional culture that embraces zerotolerance of arrears and immediate follow up on all late payments. MFIs can also remind clients who have had recent delinquency problems that their repayment day is approaching. Creating a Culture of Repayment in Mozambique The loan officers in CARE s CRESCE program in Mozambique follow up with clients in the evening of the first day that a payment is missed. If the client refuses to pay, his/her photo is then placed in the window of the MFI office. These tactics, while strong, help build the reputation that the MFI is very serious about payments being made, and being made promptly. 2) Client Orientation: A logical first step toward developing a zero-tolerance institutional culture is to communicate this concept to each new client before she receives a loan. An orientation curriculum should be prepared along with graphics and teaching aids to simply and clearly describe the terms of services being offered, the expectations of each client, and procedures that will be followed in the case of arrears. 3) Staff Incentives: Creating staff involvement in discouraging delinquency, through a staff incentives system, can be effective. Financial incentives entail minimum portfolio quality criteria for incentive eligibility and should have a greater weight for portfolio quality than for portfolio quantity. In addition, staff should carry bad debt in their portfolio for a significant 43

50 CARE MICROFINANCE HANDBOOK period of time (at least six months) to ensure that they are held accountable for making credit decisions. Non-financial incentives include branch and loan officer competitions and special recognition for top performers. 4) Delinquency Penalties: Clients should be penalized for late payment. This could include delinquency fees pegged to the number of days late and limiting access to repeat loans based on repayment performance. An example of these types of penalties from the Alexandria Business Association in Egypt is summarized in Figure 13. Figure 13: Alexandria Business Association: Delinquency Penalties Number of Days (cumulative) 3+ days late (first loan) A repeat loan is refused < 5 days late (repeat loan) No consequences Sanction 6 to 9 days late (repeat loan) A penalty of one month interest and the next loan amount may be kept constant 10+ days late (repeat loan) A 2 nd penalty of one month interest and further loans will likely be refused 5) Enforcing Contracts: An MFI will quickly lose control of portfolio quality if it fails to enforce its contracts. MFIs should not have any policies in their contracts that they are not prepared to enforce. While certain accommodations can be made for borrowers who are willing but unable to repay, any uncooperative behavior from delinquent clients should quickly escalate to the most severe penalties that the MFI could enforce, including the use of the local judicial system if appropriate. Clients should be oriented to penalties and delinquency procedures before receiving their first loans, so they know exactly what to expect if their loans become delinquent. The Carrot Approach: Repayment Incentives The stick of delinquency management needs to be balanced with the carrot of repayment incentives. The primary incentive microlenders use is to reward clients in good standing with access to subsequent loans, which often means larger loans. Preferred services for repeat clients may also include lower interest rates, faster loan approval, and access to parallel credit products such as seasonal loans. The most tangible incentive is interest reimbursement. For example, the BRI units offer a prompt payment incentive for clients who pay on time for six consecutive months, which amounts to one quarter of the interest payment during that period. In effect, the units charge the delinquency fee up front, and then reimburse clients who repay on time. 6) Loan Rescheduling: Given the vulnerability of the target market, it is common for borrowers to be willing but unable to repay. After carefully determining that this is indeed the case (i.e., concluding that clients are not cleverly pulling on one s heartstrings), it may be appropriate to reschedule a limited number of loans. Only done under extreme circumstances, this may involve extending the loan term and/or reducing the installment size. MFIs must be transparent about their rescheduling policies and they must report their portfolios 44

51 CHAPTER 3 accordingly. Portfolio quality indicators and provisioning requirements should clearly distinguish between regular and rescheduled loans. Does the program have a culture that is intolerant of delinquency? Is there a formal orientation of clients and staff to expectations, policies and procedures? Are loan officers well trained in effective delinquency management strategies? Are delinquency penalties and loan contracts enforced? Are staff members properly rewarded to maintain high standards of portfolio quality? Does the MFI have an appropriate and transparent rescheduling policy? Agriculture Lending Most successful MFIs serve primarily traders people who have a stall in a market place or a small grocery shop attached to their house. This is because there is a good fit between their businesses needs and the standard microcredit product (i.e., small amounts that gradually increase over time, short loan terms, frequent repayments). Some MFIs have also figured out how to modify this product to meet the working capital needs of manufacturers. Few MFIs, however, have successfully adapted a microloan product to manage the credit risks associated with lending to small farmers. While this is certainly an important market in many regions, it is recommended that extreme caution be taken by MFIs trying to lend for agricultural purposes. Some tips include: Carefully monitor the percentage of agriculture loans in the portfolio (not more than 10 to 20 percent) Diversify away from single crop lending Avoid relying on balloon payments at the end of the term Consider the entire household s cash flow when making a credit decision, not just the farm income Credit Risk Monitoring To monitor portfolio quality, CARE s EDU recommends, at a minimum, that an MFI monitor portfolio quality ratios on a monthly basis. These include Portfolio at Risk, Loan Loss Ratio and Reserve Ratio. Additionally, an MFI should be aware of the number and value of loans that have been rescheduled and should maintain an aging of delinquency report. The recommended ratios are listed in Figure

52 CARE MICROFINANCE HANDBOOK Figure 14: Portfolio Quality Ratios Portfolio at Risk: this ratio should be used as the primarily indicator for monitoring portfolio quality. Value of outstanding balances of all loans in arrears Value of loans outstanding Loan Loss Ratio: indicates the extent of unrecoverable loans over the last period. Amount written off Average loans outstanding Reserve Ratio: indicates adequacy of reserves in relation to portfolio. Loan loss reserve Value of loans outstanding Loan Rescheduling Ratio: indicates the extent of loans that have been rescheduled in the last period. Amount of loans rescheduled Average loans outstanding Because of the small loan sizes, microfinance portfolios are not typically exposed to the same concentration of risk as traditional banks, where individual loans should not represent a significant portion of the portfolio. However, MFIs need to monitor their loan portfolio composition and quality by region, business sector, loan cycle number and loan size to reduce the institutions' vulnerability to external threats that may affect a large portion of their clients. For example, if 25 percent of the portfolio goes to coffee farmers and the price of coffee beans drops, a quarter of the portfolio will likely be at risk. 3.2 Fraud Risk All microfinance institutions will at some point experience fraud perpetrated by staff members, perhaps in cahoots with clients. Wherever there is money, there is an opportunity for fraud. MFIs should not assume that they could eliminate fraud. However, through proper controls they can reduce their vulnerability to fraud. This section first summarizes common types of fraud, and then discusses controls for preventing and detecting fraud Types of Fraud Preparing a complete list of possible fraudulent acts is not possible. However, it is useful to categorize fraudulent activities by the lending process in which they can occur: 1) loan disbursement, 2) repayment, 3) collateral procedures, and 4) Closure activities. 46

53 CHAPTER 3 Figure 15: Examples of Microlending Fraud Disbursement Repayment Collateral Closure Loan officer issues loans to ghost clients. Cashier makes loan to himself. Loan officer charges clients an unofficial fee to apply for a loan. Loan officer collects payment, issues receipt, but does not deposit. Agents collecting loan payments do not deposit them in a timely manner. Loan officer charges unofficial delinquency fees. Loan officer collects collateral but does not deposit it in storage area. The storekeeper appropriates the collateral and conceals it by making false entries in the warehouse records. Forced savings refunds do not find their way back to the clients, and borrowers forget to ask for them. Loan officer collects payments on loans that have been officially written off. Microfinance fraud certainly is not limited to the organization s lending activities. In fact, an MFI may be even more vulnerable to fraud associated with savings because it is harder to detect. Fraud can also occur in managing the business operations of the branch, such as misuse of petty cash, false claims for travel reimbursement and kickbacks from procurement contracts. Internal control policies and procedures are designed to cost-effectively reduce the risk of fraud committed by an employee on his own, but they are generally not cost-effective in reducing risk stemming from collusion among employees or from management override. The latter occurs when a high level employee uses his/her authority to incite a lower level employee to violate control policies or procedures, enabling the high level employee to commit fraud. An example is a finance manager ordering the cashier to give him the key to the safe for some reason. Risk of fraud stemming from collusion among employees or from management override is usually reduced through soft controls, instead of formal control policies and procedures. Examples of soft controls include senior management emphasizing and demonstrating ethical conduct and high levels of control consciousness, an environment of open communication, and swift action against anyone committing fraud. It is important to note most fraud is detected by employees of the operation where the fraud is committed, and not by auditors. Therefore, MFIs should create a work environment that provides incentives for employees to report suspected fraud to the appropriate level of management. MFIs should also establish formal policies and procedures on how and to who to report Coworkers, not auditors, detect most instances of fraud suspected fraud. There are a number of red flags that make MFIs more vulnerable to fraud, such as: 4 4 Adapted from Valenzuela (1998). 47

54 CARE MICROFINANCE HANDBOOK An MFI with poor portfolio quality will have difficulty distinguishing between bad loans and fraudulent loans because of the large number of loans in arrears. A weak information system exposes the institution to fraud. If an MFI cannot detect delinquency at the loan officer level then it could have significant problems with fraud. A change in the information system is a time of particular vulnerability. To protect against fraud when an MFI introduces a new MIS, it is common practice to run the old and the new system in parallel until both have been audited. Weak internal control procedures create an environment in which fraud can be prevalent. Many MFIs do not have an internal audit function and their external auditors do not visit branches, much less confirm client balances. In these MFIs, fraud is likely to be rampant. MFIs are vulnerable when they have high employee turnover or when staff members are on leave. When a MFI fires an employee or an employee resigns, the organization is also vulnerable to that person collecting money from his former clients. If the organization offers multiple loan products, or if its products are not standardized, staff and clients have an opportunity to negotiate mutually beneficial arrangements. If loan officers handle cash and clients do not understand the importance of demanding an official receipt, the MFI is vulnerable to wide scale, petty fraud. When an institution experiences rapid growth, it is difficult to cultivate the depth of integrity that is required among staff. Has your organization experienced fraud? If so, what conditions made your organization vulnerable to fraud? What have you done to try to reduce your vulnerability? Controls: Fraud Prevention The CARE EDU suggests the following eight categories of MFI operations controls to reduce operational performance that can lead to fraud: 1. excellent portfolio quality; 2. simplicity and transparency; 3. human resource policies, 4. client education, 5. credit committees, 6. handling cash, 7. handling collateral, and 8. write-off and rescheduling policies. 48

55 CHAPTER 3 Flexibility: The Double-edged Sword One of the criticisms of microfinance is that the loan products are so rigid that they do not meet the needs of the target market. This rigidity results in high client desertion and reduces the impact that microfinance could have. In an ideal world, microfinance products could be flexible and customized to individuals needs. But there are some challenges involved in accomplishing the ideal: Efficiency: One of the reasons why microloan products tend to be rigid is to increase the efficiency of delivering these services. With very small loans, it will not be cost effective to customize them to each person s needs. Staff Skills: Many MFIs hire relatively inexpensive labor that can handle routine or rote tasks without too much difficulty, but may not have the skills to deliver flexible financial services. MIS: The information systems in many MFIs have difficulty coping with straightforward microloan products. Flexible loan products exacerbate the MIS challenge. Fraud Risk: As an MFI increases the complexity of its financial services, it greatly increases its vulnerability to fraud risk. How should MFIs deal with this double-edged sword? There is no easy answer, but by being aware of the importance of flexibility and the challenges of being flexible, an MFI can try to forge a middle ground. Excellent Portfolio Quality If very few loans are in arrears, the chances that the MFI is experiencing fraud in its lending activities are significantly reduced. The handful of delinquent loans can be easily checked to determine if they are fraudulent. But when large volumes of loans are in arrears, and delinquency management systems get overloaded, then fraudulent loans may go undetected for long periods of time, which will breed more fraudulent loans. Which branch has the worst portfolio at risk? Could this branch be experiencing fraud? Simplicity and Transparency If an MFI s products and delivery systems are simple and straightforward, it will go a long way toward preventing fraud. As an organization becomes more complicated and diversifies its services, there is a much greater likelihood that fraud will proliferate. Fraud is a particular concern in MFIs where loan officers have significant discretionary authority, such as determining loan sizes, accepting collateral, and setting interest rates. In this way, an MFI has to balance being responsive and customizing its services to client needs with the concern that this will expose the organization to fraud. A particular area of vulnerability is the discretion that field staff may have regarding the imposition of delinquency fees. MFIs often charge a delinquency fee for late payment, yet waive the fee if clients have a good reason for being late. Consequently, it is difficult to 49

56 CARE MICROFINANCE HANDBOOK monitor whether fees are being paid and pocketed, or whether they are regularly being waived, in which case they are not serving their purpose. To reduce exposure to fraud, MFIs should either make the fees mandatory regardless of the reason, or find another way for penalizing late payers like creating a repayment incentive for those who pay on time. Are loan officers allowed any discretion, such as lowering interest rates, requesting loan size exemptions or waiving delinquency fees? If so, how do you control for fraud in these circumstances? Human Resource Policies An MFI s human resource policies include hiring, training, compensating, and terminating staff members. All four activities serve as potential controls for preventing misappropriation of assets. Hiring: Microfinance institutions should identify sources of prospective staff members with high moral integrity, such as certain schools or religious communities, and actively recruit new staff members from these sources. In addition, MFIs should use staff screening mechanisms, like personality tests and employee references, to ensure that they are hiring upstanding citizens. They should also consider conducting background checks. Training: A critical aspect of bringing on new recruits is to indoctrinate them into the institution s culture. This is the ideal opportunity to promote the organization s core values of honesty and integrity, and demonstrate the zero-tolerance policy by making examples of fallen employees who succumbed to temptation and suffered the consequences. Compensation: Employees should have a strong incentive to perform their job in a responsible and competent manner. Employees who do not feel sufficiently compensated will be much less likely to carry out their responsibilities with the needed thoroughness and attention to detail. Likewise, they are much more vulnerable to committing fraud, especially in economies where sums that they handle daily represent months or even years of salary. A competitive salary is a strong preventive control in deterring sloppy or fraudulent employee behavior. Rotating Staff? Termination: Employees awareness of potential negative consequences for inadequate job performance can also be a preventive control, especially for employee fraudulent activity. There should be a clear message that staff members will be immediately terminated, lose their valuable source of income and benefits, and be taken to court (if possible) if they perpetrate fraud. Swift and permanent action in response to even the least consequential fraudulent activity sends a clear message to employees that the MFI does not tolerate fraud of any type. PULSE, a CARE microlending program in Zambia, attempts to ostracize former employees by placing their picture in the office window. Some MFIs regularly rotate staff members between branches as a means of controlling fraud risk. Staff rotation makes it possible for different employees to interact with each client, which should discourage collusion and expose any fraud that has taken place. While this may be an effective way of controlling and detecting fraud, it is not recommended because it undermines the relationship between a loan officer and the client. One of the reasons why clients repay their loans is to avoid disappointing their loan officer. Loan officers should have a close rapport with their clients to encourage them to keep coming back and to discourage them from not paying their loans. 50

57 CHAPTER 3 Are your hiring procedures designed to attract individuals who are honest and well motivated? Are new employees oriented to the MFI culture of honesty and zero-tolerance? Are staff compensation levels reasonable and competitive? Is there an immediate termination policy for staff fraud or dishonesty? Every loan must be approved by at least two persons who have both met the applicant Client Education Informing clients of their rights and responsibilities in the loan process is another strong preventive control. Because target clients tend to be illiterate and/or under-educated, they are more vulnerable to being defrauded by loan officers, and to not catching errors in the loan process. This is especially problematic because the loan officer-client relationship is key to the ultimate success of an MFI. Thus, an essential control for preventing errors and potential fraud is to actively educate clients of their rights and responsibilities, including: Demanding an official, pre-numbered receipt whenever money or collateral changes hands. Only giving or receiving money from a designated MFI employee if possible, this should always be the cashier. Knowing the appropriate channels to voice complaints and concerns. Well-publicized campaigns to this effect will not only educate clients, but also make employees think twice about taking advantage of their customers. In group-lending programs, it can be reinforcing to have clients provide peer orientations around these issues to new clients entering the program. Does the institution have an ongoing client education campaign? Are clients aware of their rights? What channels do clients have to voice complaints? Credit Committees Credit committees not only play an important role in reducing credit risk, but also are an essential element of an operational integrity and fraud prevention strategy. Every loan must be approved by at least two persons. With small loans, the signatures typically come from the loan officer and the branch manager. The branch manager must take this responsibility very seriously. When reviewing applications, the branch manager ensures that they comply with MFI policy and do not contain unreasonable information, such as monthly income levels that are unrealistic for a particular type of business. To reduce the chances that loan officers are creating ghost borrowers, the branch manager should meet all applicants, preferably before they receive the loan. Loan approval authority levels also reduce MFI exposure to fraud. The authority levels might look like this: all loans below $500 require two signatures (loan officer and branch manager); loans between $500 and $2,000 require three signatures (previous two plus an 51

58 CARE MICROFINANCE HANDBOOK external chair of the credit committee); and loans above $2,000 require five signatures (the previous three plus the operations manager from the head office and a member of the board of directors). Therefore, if the branch manager and loan officer collude to defraud the company, they would only be able to steal $500 at a time. Any person who places his/her signature on an application must realize the significance of that action. Too often, signing applications, vouchers or other documentation is not taken seriously. Sometimes senior people do not even look at what they are signing because they have to approve so many items. This behavior obviously defeats the purpose. If an organization suffers from this blind signing, it needs to revisit its authority levels. If five signatures provide greater protection from fraud than two, then why does the MFI not require five signatures for all loans? A fraud prevention and detection strategy needs to balance the costs of minimizing fraud with the need to reduce vulnerability. The more people involved in the application review process, the more expensive it is to issue loans. Since the smallest loans generate only a tiny amount of revenue, the organization would probably lose money issuing them if five people, including several with higher wage levels, had to review the applications. To reduce approval costs, some organizations set variable authority levels for branch managers depending on their level of seniority and their portfolio quality. The other factor determining approval authority is quality of customer service. The more people involved in the review process, the longer it takes to turn around loan applications. For MFIs to provide prompt service, they need to cut out unnecessary approval layers. Do at least two people meet all applicants and approve all applications? Does the loan approval authority structure balance efficiency, customer service and fraud control? Do managers avoid and actively discourage blind signing? Handling Cash MFIs face the greatest risk of misappropriation when money changes hands, such as when the loan is disbursed, repayments are made, and deposits are placed in a savings account. Here is a list of 12 basic controls recommended to reduce risk of misappropriation for MFIs that disburse loans directly to clients. If the disbursement is made by a bank or into the client s account, certain modifications are required. 1. Use standardized, pre-printed, pre-numbered loan agreement forms, reviewed and approved by local legal counsel. 2. Prepare loan agreements in quadruplicate, maintaining one copy at the branch, giving one to the borrower, and sending two to the accounting department. 3. Loan agreements should include borrower name and identification number, unique loan reference number, loan amount, interest rate, payment schedule, description of collateral (if applicable), definition of late payment, and penalty for late payment. 4. Access to blank loan agreements should be restricted and carefully safeguarded. 52

59 CHAPTER 3 5. Accounting determines whether the agreement is properly completed. If so, Accounting prepares and approves a disbursement voucher, and gives it to the cashier along with a copy of the loan agreement. 6. Before disbursing funds, the cashier matches the loan amount on the agreement with the amount on the disbursement voucher and determines whether the loan agreement contains necessary signatures. 7. The cashier prepares, in duplicate, an official pre-numbered disbursement receipt, containing date, amount, and payee name and signature. 8. The cashier retains one copy of the disbursement receipt and gives the other to the payee. 9. In disbursing funds directly to the borrower, the cashier checks for evidence that the person accepting funds is the borrower named in the loan agreement by inspecting a picture ID and/or comparing the person s signature to borrower s signature on the loan agreement. 10. If compensating controls are not in place to reduce the risk of a cashier keeping loan disbursements and making loan payments himself, then an accountant should compare payee signatures on loan disbursement receipts to signatures of borrowers on loan agreements. 11. If the cashier disburses loan funds to an agent who then gives funds to borrowers, such disbursements are recorded as advances to agents. The advances are liquidated when agents present disbursement receipts containing correct loan amounts and borrower signatures to the accounting department. 12. Accountants must not have access to funds, and cashiers must not have access to changing accounting records. Figure 16 provides a list of seven recommended controls for reducing the risk of irregularities or fraud in the repayment process. Figure 16: Controls in Handling Loan Repayments 1. Agents collecting loan payments prepare repayment receipts, in triplicate, containing date, amount, and agent s and payer s signatures. 2. Agents retain two copies and give the other to payers. 3. Agents deposit funds to designated accounts in a timely manner. MFIs should have a policy on where to deposit funds and on the definition of timely. 4. Agents request a deposit slip containing date, amount, and signature of person accepting funds for every deposit made. 5. Agents submit to the accounting department a copy of receipts documenting borrower payments and deposit slips documenting deposits. 6. Accounting staff match amount of deposit slip with amount of borrower receipt and record interest and principal based on loan agreement and payment amount on borrower s receipt. 7. Accounting staff reconciles amount of cash deposited per bank records with cash received per the accounting records on a monthly basis. 53

60 CARE MICROFINANCE HANDBOOK Organizations that offer voluntary savings services are particularly vulnerable to fraud. This is partly because of the high volume of transactions, and also because the deposit amounts and frequencies are unpredictable. With loan repayments, the organization knows how much and when they are expected, so if the amounts or dates are different than expected, they can be investigated. Savings accounts do not have a similar early warning signal. Yet it is absolutely critical to reduce the potential for savings fraud because it could undermine customer confidence in the banking institution. To control for savings fraud, clients must have savings records (i.e., passbooks) that they keep in safe places. The MFI should have a signature card and a copy of the client s identification. The signature on the deposit/withdrawal slip needs to match that on the client s savings book and the organization s account record. A tighter review of larger withdrawals is also recommended. Are loan officers allowed to collect repayments when in the field? Does the MFI have appropriate polices for handling cash in its loan disbursement and collection procedures? Are these policies followed? What systems are in place to minimize the potential for fraud with savings accounts? Collateral Controls If an MFI secures its loans with collateral, it is vulnerable to potential irregularities or fraud in the collection, storage and return of collateral. The assigned staff person may collect collateral but not deposit it in the designated storage area, or collect the wrong type of collateral, or neglect to collect it at all. Risk associated with collateral can be mitigated through the following steps: MFIs must have policies and procedures on when to require collateral, whether to assume custody of collateral versus allowing borrower to maintain custody, where to deposit and store collateral, and how to value collateral. If the borrower maintains collateral, the loan agent periodically inspects the collateral for impairment. The loan agreement includes a detailed description of the collateral and serial or other identifying number of the property, and requires that collateral must not be sold without prior notice to the loan officer. Procedures must be clearly stated for returning collateral to the borrower upon full repayment of the loan. Procedures should be recommended to improve the chances that liquidation of collateral is at the best available price, and that proceeds from liquidation are deposited intact into the bank. Do you have adequate policies and procedures on collateral control? Are these policies followed? Write-off and Rescheduling Policies Another area of risk is loan write-off or rescheduling. While MFIs usually have stringent requirements and carefully followed policies for receiving loans, they tend to be more lax in following up delinquent loans and ensuring that procedures are carefully followed. Loan 54

61 CHAPTER 3 write-off and rescheduling should follow similar procedures: the credit committee should make all decisions and multiple signatures should be required for a write off or rescheduling to be authorized. In the write-off process there are two primary fraud vulnerabilities. First, the MFI needs to make sure that it is not writing off a fraudulent loan. To control for this risk, each person involved in the process of recovering the loan needs to document the steps that they took. This documentation, in a delinquency management log, provides evidence that proper steps were taken by several people, and this was indeed a bad loan not a fraudulent one. Second, once a loan has been written off, the MFI is still vulnerable to the unauthorized collection of the outstanding balance by its employees. This risk is often controlled by handing over bad debts to a workout department or an external debt collector whose collection activities may reveal unauthorized efforts. Does your institution have clear write-off and rescheduling policies that are consistent with a fraud prevention strategy? Are those policies followed? How do employees document their delinquency management steps? Everyone involved in the delinquency management need to document the steps that they took to recover the loan Monitoring: Fraud Detection The best prevention strategies in the world are not going to eliminate fraud. This is partly because the policies may be ignored or flaunted; and partly because, in an effort to balance the costs of the controls with the potential exposure, the organization is still going to have areas of vulnerability. Whenever fraud occurs within an organization, it reflects poorly on the whole MFI and everyone who works there. Fraud detection is therefore the implicit responsibility of all staff members, from the chairman of the board and executive director down to the cleaners and drivers. Once an organization reaches a certain scale (around 100 employees), it can justify having a person or department dedicated to the function of fraud detection. This responsibility is tasked to an internal auditor or internal audit department, which should report directly to the board of directors (or the audit committee of the board). Fraud detection is the responsibility of all staff members, from the chairman of the board down to the cleaners and drivers Fraud detection involves the following four elements: 1) operational audit; 2) loan collection policies; 3) client sampling; and 4) customer complaints. Operational Audit After creating appropriate controls, the first step in fraud detection is to ensure that those controls are implemented. Microfinance managers at all levels of the organization must make sure that persons working under them follow institutional policies. In addition, MFIs 55

62 CARE MICROFINANCE HANDBOOK Audit Committee of the Board Some MFIs assign specific board members to an audit committee to oversee internal and external audits. The audit committee reviews internal and external audit reports and, based on these findings, assesses the integrity of the financial statements and adequacy of internal controls. The audit committee reviews the procedures, reports and recommendations that are generated by the internal audit department and ensures that management takes corrective actions. In addition, the audit committee reviews the external audit and regulatory reports to assess the MFI s overall control environment, and reports its findings and observations to the full board of directors. Campion (2000). should consider conducting regular operational audits to confirm that policies are being followed. When policies are not followed, it is usually for one of three reasons: 1) the employee was involved in some sort of fraudulent activity; 2) the employee did not know about the policy or didn t understand it; or 3) the employee believed that the policy was unreasonable. So while an operational audit might detect fraud, it will also identify staff training needs as well as certain policies that may need to be reevaluated. The internal auditor should report to the board of directors An operational audit is a review of all operational activities, procedures and processes, including human resources, procurement, finance, information systems and any other operational areas. Internal auditors usually perform operational audits, as they will have more experience with the general operations of an organization, and will be better prepared to analyze the structure of operations critically. If an external audit firm is used, management should be very careful, prior to engaging the firm, to gauge what level of experience and understanding the external firm has with the organization, microfinance in general, and operational auditing. For organizations that are large enough to hire an internal auditor, it is important that this person or department report to the board of directors, not to management. Without sufficient independence from management, internal auditors cannot conduct an objective review of the MFI s entire operations. By reporting directly to the board, it ensures the board s involvement in the internal audit process and it gives credibility and legitimacy to internal auditors as they conduct their reviews. Loan Collection Policies While loan collection policies are primarily seen as a response to credit risk, they also have a very important role in fraud detection. By involving several different persons in the collection process, MFIs not only escalate the pressure on the client, but also help to identify instances of fraud. If the loan officer is the only person who ever interacts with a delinquent borrower, he could easily be pocketing repayments. Figure 17 provides an example of loan collection policies designed to detect such a situation. 56

63 CHAPTER 3 Figure 17: Loan Collection Policies Senior management establishes written policies on past due loans that includes when to take collection efforts and what efforts to take. (make efforts or take actions not take efforts) Those assigned to collect loans should not have access to changing the accounting records. The loan officer who issued the loan should conduct the first delinquency visit. If that proves unsuccessful, a different agent (usually the branch manager) should perform the next collection visit. If that visit is unsuccessful, ideally another, more senior person should make the third visit. This sends the message to the client that the institution s concern is escalating. It also plays an important control function since subsequent personnel can make sure that a collection agent was not pocketing some or all of a past due payment. Client Sampling A main aspect of fraud detection is to visit clients to ensure that client and the MFI records are in agreement. Given the large volumes of customers, internal auditors use selective sampling of borrowers to identify clients for balance confirmation so that the visits are biased toward loans that are more likely to be fraudulent. For example, an internal auditor may select all clients with more than three payments in arrears, 50% of clients with more than 2 payments in arrears, and 25% with 1 payment in arrears, as well as a number of clients who are up-to-date. If the MFI reschedules loans, the internal auditor should also visit a high percentage of those clients as well. While this sampling technique primarily selects customers who are in arrears, it is important to also include clients whose loans are current. The internal auditor may find major discrepancies between information in the client s file and the reality in the field, which could expose the organization to credit or fraud risk. Loan officers also might be receiving kickbacks on loans that do not show up in a delinquency report. Selective sampling is not possible with voluntary savings accounts because there isn t a warning sign that some accounts are more vulnerable to fraud than others. Consequently, the sample of depositors will probably be larger than the sample of borrowers. Prior to visiting the specific clients, the internal auditor reviews their files to ensure that the documentation conforms to the organization s policies and procedures. When visiting borrowers for example, the internal auditor compares the disbursement and repayment information in the MFI s records with the client s records, including current balances, and the amount and date of each transaction, and the collateral that was pledged. It is also important to compare the information in the file with the actual business, including address, type of business, purpose of the loan, assets, etc. If there was false documentation, then either Internal auditors spend the vast majority of their time in the field the client took advantage of the loan officer, or they collaborated to give a loan to someone who was not worthy. While these visits are primarily for internal audit purposes, they can fulfill other important functions such as delinquency management, gathering information on customer satisfaction 57

64 CARE MICROFINANCE HANDBOOK and market trends, and identifying staff training needs. An internal auditor may not be the most popular person in an MFI, but he can play one of the most critical functions if his job is well designed, if he has the skills to fulfill multiple roles, and if he spends the majority of his time in the field. Customer Complaints Because the customers of MFIs tend to be poor and uneducated, they are particularly susceptible to being victims of fraud. But these people are not stupid, and they often realize that someone is trying to take advantage of them. The problem is that they may not feel empowered to do anything about it. Even if they want to do something, they may not know how since their primary contact with an MFI may be the person who is causing the problem. Another important method for detecting fraud, and for improving customer service, is to establish a complaint and suggestion system that creates a communication channel through which clients can voice their opinions. If it is easy for clients to complain, and if their complaints can by-pass the local branch office, then they will be more likely to report questionable conduct of loan officers and other field staff. It is then important that this conduct is investigated by MFI management to address issues and determine if there is fraud. Does senior management consistently monitor portfolio quality? Does the MFI have standard procedures for delinquency follow up? Are these procedures followed? Does your organization regularly sample clients to confirm savings and loan balances? Does a reliable firm audit the MFI annually? Does the MFI have an internal audit function? 58

65 CHAPTER 3 Risk Management and Scale As mentioned in the Introduction, risk management is an ongoing process. Vulnerabilities change over time partly because the institution matures and grows. Many of the controls for operational risks described in this chapter may be relevant for large MFIs, but are not as applicable to small organizations or start-ups. In designing a risk management strategy, it is necessary to determine what is appropriate for the scale of your operations. For credit risk, for example, a new organization with small loans will rely more on character in the loan assessment process, but when the loan size increases a collateral based approach is more appropriate. In a new MFI, the credit committee may just consist of the loan officer and her supervisor, but for larger loans the organization should formalize the review process. One of the major methods for controlling fraud is through the corporate culture, yet this too changes as the MFI grows. In a small organization, the managing director sets an example and personifies the core values of honesty and transparency. This value-driven approach to internal control must evolve into formal policies and procedures. Managers will assume the auditing function initially, and then once the organization achieves a certain scale, it can justify hiring an internal auditor. Methods for managing security risk depend on the volume of money that passes through the branch on a daily basis and on the local environment. Even in the safest locations, greater precautions should be taken as the number and size of the transactions increases. For new MFIs, it is important to adopt a risk management approach to their operations. While this approach will probably rely on informal control methods to start, by adopting a risk management mindset from the beginning it will make it easier to implement more formal systems as the organization grows. Are internal audits conducted regularly? What is the process by which your organization confirms client savings and loan balances? Do you have a system for collecting, analyzing and following up with customer complaints? Response to Fraud If fraud is suspected, in most cases the MFI should conduct a fraud audit and then implement damage control proceedings. Fraud Audit A fraud audit, sometimes called a forensic audit, has the specific aim of determining whether irregularities have occurred and, if so, their magnitude. A fraud audit generally consists of an extension of ordinary audit procedures, as proposed by the auditors and, in some instances, agreed to by the client. The decision to conduct a fraud audit involves considerable judgment. Two important factors in this decision are the potential magnitude of the fraud and the extent of evidence of a fraud. Frauds involving potentially very large amounts of cash with scant evidence are more likely to require a fraud audit than frauds involving small amounts with considerable evidence. Fraud audits should be conducted by auditors with specialized training in forensic auditing. Contrary to common belief, most auditors do not have the training to conduct an effective fraud audit. 59

66 CARE MICROFINANCE HANDBOOK Damage Control If fraud is identified, the MFI needs to move into a damage control mode. For this to happen quickly, organizations should consider developing contingency plans that can be dusted off and put into action when the need arises. This contingency plan should include the following elements: What action will the MFI take against the perpetrator (i.e., termination, legal proceedings, efforts to recoup losses)? What approach will the organization take with clients who were victimized? How can the MFI diminish the negative effects of fraud on its reputation, or even turn this public relations nightmare into a coup? What changes to the internal control policies need to be made to prevent this from occurring again? Some MFIs require new employees to pay a security deposit, which they will lose if they are involved with fraud. 5 This serves both as a deterrent to fraud as well as a means of reducing the MFI s vulnerability to losses. Fraud and Group Lending MFIs that use a group lending approach may experience instances when group members defraud each other. This occurs most frequently when a group representative is responsible for submitting the repayments for the entire group, and then chooses to hold on to them for a while. Some programs control this risk by having all group members make their own repayments, but this adds transaction costs to the clients, especially if the deposit location is not nearby. Alternatively, group members can be educated to ask to see the official receipt when the representative returns. Do you have a contingency plan in place so that you can quickly mitigate the damage caused by fraud when it occurs? If so, what does the plan consist of? 3.3 Security Risk The third form of operational risk is the exposure of an MFI to theft. Some MFIs never have difficulty with security risk, whereas others are extremely vulnerable. This risk has two basic elements: 1) Safety of Cash: Any MFI that disburses and receives money directly is vulnerable to theft. They need to ensure that cash is protected from theft during office hours, after office hours and in transit. 2) Safety of Office Assets: Although thieves usually prefer cash, it is not the only asset that is vulnerable. MFIs need to ensure that they are protecting their computers, fax machines, photocopiers, and even office equipment like desks and chairs, from theft. 5 Employees may also lose their security deposit if they leave the organization within a specified period of time, often 12 to 24 months. If employees leave earlier, their security deposit is used to pay for their training. 60

67 CHAPTER 3 The most effective control to safeguard cash is not to handle it. Many microfinance programs conduct all their financial transactions (disbursements, repayments, and savings) through local banks. This control dramatically reduces the threat of theft, but it also limits the MFI s ability to provide valuable services to its customers. They are constrained by the location of banks, their hours of operation, and their willingness to process large volumes of small transactions. For MFIs that do handle cash, they should consult with local security experts and banking officials regarding controls for reducing vulnerability to theft. Appropriate responses may vary significantly from branch to branch. Some of the security measures to consider include safes, vaults, window bars, door locks, teller shields, interior and exterior lighting, security guards (armed or unarmed), and security alarms and cameras. MFIs also reduce their exposure through liquidity policies that stipulate the maximum amount of cash that can be kept in the branch over night. Liquidity policies require an effective system for transporting money to a central depository and then delivering sufficient cash to each branch in the morning. In addition to the systems designed to protect cash, MFIs should also have a fixed asset register that lists all the organization s assets, description, date and price of purchase, and serial number (if applicable). When the internal auditor visits the branch, he should compare the equipment in the branch with the asset register to ensure that equipment has not been taken (temporarily or permanently). Has your organization contracted an expert to analyze your security needs on a branch-by-branch basis? What are your organization s major vulnerabilities to theft, and how are you addressing them? 61

68 CARE MICROFINANCE HANDBOOK Recommended Readings Lending Methodologies Berenbach, Shari and Diego Guzman (1992). The Solidarity Group Experience Worldwide. Monograph No. 7. Washington DC: ACCION International. Website: Churchill, Craig F. (1999). Client-Focused Lending: The Art of Individual Microlending. Toronto: Calmeadow. Website: Available from PACT Publications. SEEP Network (1996). Village Banking: The State of the Practice. New York: United Nations Development Fund for Women. Website: Yaron, Jacob, McDonald Benjamin, and Gerda Piprek (1997). Rural Finance Issues, Design and Best Practices. Washington DC: The World Bank. Product Development Brand, Monica (1998). New Product Development for Microfinance: Evaluation and Preparation. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Brand, Monica (1999). New Product Development for Microfinance: Design, Testing and Launch. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Internal Control Campion, Anita (2000). Improving Internal Control: A Practical Guide for Microfinance Institutions. Technical Note No. 1. Washington DC: MicroFinance Network. [email protected]. Available from PACT Publications. [email protected]. 62

69 CHAPTER 3 Chapter 4: Financial Management Risks and Controls Institutional Risk Operational Risk Financial Management Risk External Risk The risks associated with financial management represent a third area of vulnerability for microfinance institutions. Distinct from institutional and operational risks, financial management risks are inherent in the range of strategies and procedures used by microfinance managers to optimize financial performance. Key risk areas that emerge from these strategies include: 1) Asset and Liability Management Risks 2) Inefficiency Risks 3) System Vulnerability Risks This chapter will define each of these key risk areas and provide guidance on how to adequately monitor and control these risks. 4.1 Asset and Liability Management In the banking world, asset/liability management (ALM) refers to the management of the spread, or the positive difference between the interest rate on earning assets and the cost of funds. Successful management of this spread requires control over: a) interest rate risk, b) foreign exchange gap, c) liquidity, and d) credit risk. Credit risk is normally the most important of risk categories for MFIs and was addressed in Chapter 3; the other three are presented in this chapter. 63

70 CARE MICROFINANCE HANDBOOK A microfinance institution is only vulnerable to these three risks if it has one of the following characteristics: It borrows money from commercial sources to fund its portfolio; It funds its portfolio from client savings; It operates in a high inflation environment; or It has liabilities denominated in a foreign currency. If none of these characteristics apply to your organization, and you do not expect that they will in the near future, you can skip ahead to Section 4.2. These components of asset and liability management need to be considered carefully. In formal financial institutions, a management committee normally carries out ALM, as it involves both operations and treasury activities. Because most MFIs do not have this kind of management depth, however, the executive director and financial manager will most likely carry out ALM within an MFI, with perhaps some support from a board member who has expertise in this area Interest Rate Risk Interest rate risk arises when assets and liabilities are mismatched, in terms of interest rates and terms. Interest rate risk is particularly problematic for MFIs operating in high inflationary environments. If inflation rises, the interest rate on loans may not be sufficient to offset the effects of inflation. An MFI s ability to adjust interest rates on its loans is determined by the degree to which short-term liabilities are used to fund longer-term assets within the portfolio. If the rates on short-term liabilities rise before an MFI can adjust its lending rates, the spread between interest earnings and interest payments will narrow, seriously affecting the MFI s profit margin. MFIs should monitor interest rate risk by (1) assessing the amount of funds at risk for a given shift in interest rates, and (2) evaluating the timing of the cash flow changes given a particular interest rate shift. All types of assets and liabilities do not respond to a change in interest rates in the same manner. Some are more sensitive to interest rate changes than others, a characteristic known as interest rate sensitivity. For example, small scale savings accounts tend not to be very interest rate sensitive, as low income clients typically maintain savings accounts more for reasons of liquidity and safety, than for rate of return. For this reason, if the interest rate falls, such clients will not necessarily withdraw their savings. On the other hand, bank certificates of deposit are usually highly interest rate sensitive. Certificates of deposit, or other time deposits, are usually purchased by investors who are concerned with the rate of return on their investment, and will thus be more likely to withdraw their savings in the event of a decrease in interest rates. In other words, such investments tend to be more interest rate sensitive than small-scale savings accounts. This type of interest rate sensitivity analysis is important for microfinance institutions that mobilize funds from a variety of sources. 64

71 CHAPTER 3 For MFIs that serve primarily low-income clients, interest rate sensitivity may be less important than responding to the timing of any cash flow shifts. Determining the gap between rate-sensitive assets and rate-sensitive liabilities, or gap analysis, provides a mechanism for identifying the timing of cash flow shifts. Rate-sensitive assets or liabilities are those that can be priced either upward or downward over the next few months. A useful indicator for monitoring interest rate risk is the net interest margin, commonly called the spread. This ratio calculates the income remaining to the institution after interest is paid on all liabilities, and compares the result with either the total assets or the performing assets of the institution. Net Interest Margin: (Interest Revenue-Interest Expense) / Average Total Assets A variation of this ratio is (interest revenue financial expenses) / average assets, where financial expenses include interest expense, inflation adjustment, exchange rate depreciation expense, and a subsidized cost of funds adjustment. (See Chapter 6, Adjusting for Inflation and Subsidies, for guidance on how to calculate imputed costs.) This second ratio may be more useful than the first for MFIs with large equity bases (capitalized by donor funds) or subsidized loans. It is particularly useful to compare this ratio to the operating expense ratio total operating expenses / average total assets to assess whether the interest rate margin is sufficient to cover operating costs. (See Inefficiency Risks below for further discussion on the operating expense ratio.) Is the MFI susceptible to interest rate risk? For those MFIs operating in highly inflationary environments, is gap analysis conducted regularly? What is your net interest margin? Foreign Exchange Risk Foreign exchange risk occurs when an MFI holds cash or other investments (assets) or debt (liabilities) in foreign currency. The devaluation or revaluation of these assets or liabilities has the same effect as interest rates in exposing MFIs to potential gain or loss. If the local currency has devalued against the foreign currency used, the MFI will have to make up the difference. This difference constitutes an additional interest rate that must be generated by the institution through its operating income. 6 Likewise, if the local currency revalues against the foreign currency used, the MFI stands to profit from a potential gain. MFIs primarily need to be concerned about foreign exchange risk when they assume liabilities denominated in a foreign currency and convert these funds into assets denominated in a local currency. For example, many MFIs fund their local currency loan portfolios with dollar denominated loans from donors or commercial sources. When the assets are converted back to dollars, the MFI faces the effects of foreign exchange risk. Assume an MFI receives $100,000 as a loan from a commercial bank, and converts these funds into South African Rand (R) at R6 to the dollar to on-lend to clients. When the liability comes due, the MFI will have to convert the Rand assets back into dollars. If the 6 Christen (1997), p

72 CARE MICROFINANCE HANDBOOK Guarantee Funds In Egypt, CARE uses a guarantee fund to minimize foreign exchange risk. In this example, CARE places a Certificate of Deposit in U.S. dollars in a bank in Egypt. The bank makes a loan to CARE s microfinance partner in the local currency, thus eliminating foreign exchange risk for the microfinance institution and for CARE. Rand has devalued against the dollar so that the rate is now R7 to the dollar, the MFI could be susceptible to foreign exchange losses. Figure 18 highlights the impact of this risk on an institution s bottom line by comparing a stable currency situation with a devalued currency. Assuming the MFI does not adjust its interest rates in time to accommodate currency devaluation, the MFI will incur a loss when repaying the $100,000 liability. In general, MFIs that are not operating in a multiple currency environment should avoid taking on foreign denominated debt to avoid this kind of foreign exchange risk. However, if the economy is dollar denominated and clients conduct transactions in dollars, it may be appropriate for an MFI to offer loans in dollars, and thus to fund these dollar assets with dollar liabilities. Unless the MFI can match foreign liabilities with foreign assets of equivalent duration and maturity, the MFI should seek to avoid funding the portfolio or lending in foreign currency. Figure 18: Example of Currency Devaluation Impact Amount lent: $100,000 at 20% USD Scenario 1 - SAR Scenario 2 - SAR (no devaluation) (devaluation) Amount lent 100, , ,000 Exchange rate at due date - R6/USD R7/USD Amount due 120, , ,000 Principal 100, , ,000 Interest 20, , ,000 Actual cost of funds* 20, , ,000 Client revenue** 420, ,000 Operating costs*** 240, ,000 Net difference 180, ,000 Profit / (Loss) 60,000 (60,000) * Includes interest expense, revaluation of principal, and revaluation of interest expense ** Assume interest rate of 70% *** Assume operating cost ratio of 40% For MFIs with foreign currency exposure, appropriate control mechanisms should be established. If the devaluation is relatively constant and foreseeable, options include: 1. Add the expected devaluation rate to the nominal local interest rate in any loans offered. An MFI in Latin America, for example, charges 3.5 percent per month on loans in US dollars and 4.0 percent a month on local currency loans. 2. Include a provision for devaluation expense on the balance sheet and income statement. 3. Index the interest rate on local currency loans to foreign currency, so that if the local currency devalues, the value of the loan in the foreign currency must still be repaid. 66

73 CHAPTER 3 (Note that this passes on the risk of depreciation loss to the client, which may ultimately lead to increased credit risk). In cases where devaluation occurs suddenly due to shocks to the local financial system, MFIs that have not appropriately matched their exposure could face bankruptcy. A key monitoring ratio for institutions facing currency exposure is the currency gap risk ratio. This ratio helps identify a high exposure if the MFI has borrowed funds denominated in foreign currency that it lends out in local currency. For MFIs that hold assets or liabilities in foreign currency, are appropriate control mechanisms in place to mitigate foreign exchange risk? Currency Gap Risk: (Assets in Specified Currency - Liabilities in Specified Currency) / Performing Assets Liquidity Risk 7 Liquidity refers to an MFI s ability to meet its immediate demands for cash, such as loan disbursements, bill payments and debt repayment. Liquidity risk arises when an MFI is unable to cover a liquidity shortfall. Due to the unique nature of microlending, a temporary lack of access to adequate loan capital can be serious. In microlending, a primary reason why borrowers repay their loans is to receive subsequent loans. If the institution cannot meet disbursement requests, repayment rates could plummet, as borrowers no longer perceive this incentive to repay. While some MFIs can access short-term funds to cover these liquidity shortfalls, these funds are usually expensive and not A temporary lack of loan capital can result in a dramatic spike in portfolio quality problems always reliable. Given these circumstances, microfinance managers should generally err on the side of conservative liquidity management. Effective liquidity management requires MFIs to achieve a balance between maintaining sufficient liquidity for sudden cash demands and earning revenue through longer-term investments. While liquidity management and cash flow management are often used interchangeably, liquidity management includes the management not only of cash, but also of short-term assets and liabilities. A key control for mitigating liquidity risks is cash flow management. Cash flow management refers to the timing of cash flows to ensure that cash inflow is equal to or greater than cash outflow. Due to the cyclical nature of credit demand in many countries (particularly high around holidays, for example) and the propensity for young MFIs to expand quickly in their early years, an MFI can experience peak loan demand in spurts. To control for these high demand periods, finance managers need to establish a sound cash flow management program. This program should ensure that: 7 This section adapted from Ledgerwood (1999), p

74 CARE MICROFINANCE HANDBOOK Liquidity needs are planned on the basis of worst-case scenarios to limit the potential for liquidity crises Policies are set for minimum and maximum cash levels Cash needs are forecast (see budgeting section below) Cash budgets are continuously updated Surplus funds are invested or disbursed as loans Cash is available for savings withdrawals and loans MFIs with strong track records often manage liquidity by establishing a line of credit with a local bank. If there is a spike in demand, they can draw down on their line of credit to meet disbursements. This allows the organization to only incur financial expenses when the funds are used. Besides the cash flow projections, the liquidity indicator most appropriate for an institution depends on the institutional type. If the institution mobilizes voluntary savings, for example, it will need to ensure adequate liquidity to meet client withdrawal requests and debt service payments, using an indicator such as the quick ratio. The quick ratio numerator should exclude any liquid assets that are restricted by donors for certain uses, as they will not be able to meet savings withdrawal needs. MFIs can further monitor their overall cash flow by using the liquidity ratio. The liquidity ratio helps institutions determine if there is enough cash available for disbursements and also whether there is too much idle cash. It should always be greater than 1. Cash inflows and outflows should be projected on a monthly basis and should include only actual cash items. Depreciation, provisions for loan losses or subsidy and inflation adjustments do not affect cash flow. Finally, MFIs should monitor the allocation between cash and other income generating assets on a regular basis. The idle funds ratio measures the ratio between funds that are not earning any revenue (cash and near cash) and income generating funds. Near cash refers to deposits that earn a very low rate of return, with a maturity of three months or less. For liquidity purposes, a certain amount of idle funds is necessary. However, too great an amount will depress the MFI s overall return on assets. The appropriate amount will depend on a number of factors, including the institution s Quick Ratio: Liquid Assets / Current Liabilities Liquidity Ratio: (Cash + Expected Cash Inflows In The Period) / Anticipated Cash Outflows In The Period Idle Funds Ratio: (Cash + Near Cash) / Total Outstanding Portfolio level of maturity, other short term investment opportunities, and whether or not the institution is a regulated financial intermediary and therefore subject to reserve requirements. Does your organization follow a cash flow management program, i.e. cash needs forecasting, budgeting, etc.? Do you monitor its liquidity risk through consistent monitoring of key ratios: quick, liquidity, idle funds? 68

75 CHAPTER Inefficiency Risk The first great challenge in microfinance was to minimize the credit risk associated with providing unsecured loans. Many MFIs have largely succeeded in overcoming this obstacle and have now set their sights on the next major challenge: improving efficiency. It involves 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 passed on to clients through higher interest rates and transaction costs. MFIs can improve efficiency in three ways: (1) increase the number of clients to achieve greater economies of scale, (2) streamline systems to improve productivity, and (3) cut costs. The first two goals are closely related; both seek to increase the number of clients, or units of output, the MFI serves by having staff work harder or, preferably, smarter. In microfinance organizations that are not managed in a business-like manner, employees often have excess capacity. And yet, as is human nature, they find ways of filling their days so they end up being very busy doing things that are not particularly important. A close analysis of time allocation and time management will often reveal waste. The third goal addresses the cost side of the equation. Administrative costs, including salaries and other operating expenses, represent the greatest component of the cost structure of an MFI. Reducing the delivery costs associated with providing financial services improves operating efficiency. If these costs can be reduced, the savings can be passed on to clients through more competitively priced products, ultimately improving customer satisfaction Inefficiency Controls Improving efficiency is the next major challenge for the microfinance industry Budgeting The budget represents the master plan of all expenses that it will take for the MFI to maintain its operations and all sources of capital used to meet expenses. The budget should be sufficiently detailed to isolate the cost structure of each element of its operations (branch office, support unit, senior management, etc.). In a multi-branch MFI, treating branches as profit centers, which includes providing them with decision-making authority to manage their own efficiency, is a key building block toward improving efficiency for the entire organization. Decentralizing day-to-day decision making to branch managers and unit heads is an effective way to increase efficiency and to spread the responsibility throughout the MFI for managing costs. 69

76 CARE MICROFINANCE HANDBOOK Figure 19: Budget Comparison Report 123 Microfinance Institution Summary Actual-to-Budget Income Statement For the Period Jan 1 to Dec Actual 2000 Budget % Budget INCOME Interest income on loans 300, , % Loan Fees and Service Charges 32,000 35, % Late fees on loans 12,000 10, % Total credit income 407, , % Income from investments and other 8,909 5, % Income from other financial services 0 0 Total other income 4,380 5, % Total Financial Income 412, , % FINANCIAL COSTS Interest on debt 58,000 52, % Interest on deposits 1,900 3, % Total Financial Costs 63,000 55, % GROSS FINANCIAL MARGIN 349, , % Provision for Loan Losses 31,200 30, % NET FINANCIAL MARGIN 317, , % EXPENSES Salaries and benefits 162, , % Administrative expenses 120, , % Depreciation 3,000 3, % Other % Total Operating Expenses 285, , % NET FINANCIAL SERVICES OPERATING MARGIN 32,640 66, % GRANT INCOME 18,700 25, % Total grant income for Financial Services 20,000 25, % NET INCOME FOR SERVICES 52,640 91, % EXCESS OF INCOME OVER EXPENSES 54,140 81, % Subsequently, the budget needs to be developed, understood and owned by a wide range of senior staff in the MFI. Senior managers need to be oriented to think, plan and operate routinely from a budget perspective to enable the MFI to become commercially minded and efficient. Toward this end, it is essential for senior managers to participate in reviewing actual expenses and revenues compared to the budget to develop a working understanding of the cost structure of the operations and to be held accountable for achieving the targets set forth on their own budget worksheets. 70

77 CHAPTER 3 A budget comparison report (see Figure 19) compares the actual income and expense to the budgeted amount for the time period (usually either monthly or year-to-date). A third column indicates the variance or the percentage of the actual to the budgeted amount. The primary purpose of this report is to allow the board and staff to monitor performance relative to the approved budget. Managers need to carefully monitor income and expenses relative to budget on a monthly basis. Major discrepancies may call for mid-year adjustments or even urgent revisions to the annual operating plan. Since the budgeting process generally follows the chart of accounts, so does this report format. Activity Based Costing As MFIs mature, they often introduce new financial products to meet the evolving needs of their target market. When they do so, they should seriously consider establishing an activity based costing (ABC) system that allocates both the direct and indirect related costs to a specific revenue generating activity. Information about the allocation of expenses gives a more accurate picture of how costs and revenues relate to each other. ABC provides information to understand the relative costs to deliver different products and to identify which products generate the highest profit and which are relatively wasteful. This information is invaluable in pricing products and developing risk management strategies. For example, an MFI may decide to employ a loss-leader pricing strategy that intentionally under-prices one product that will attract customers, who will then hopefully purchase other, more profitable products. Conducting ABC To measure activity-based costs, one allocates administrative expenses based on the amount of time spent on an activity in a representative month. This information, collected from staff members at all levels within the organization, is gathered either through employee interviews or through time sheet documentation. The next step is to multiply each person s time ratios by their direct and indirect costs. When the calculations are completed, all administrative costs that appear on the income and expense statement must be allocated. Adapted from Gheen et al (1999). Even an MFI that only offers one product can benefit from an ABC analysis if the activity is defined more narrowly. Instead of comparing the costs between two or more products, you can analyze the costs of different aspects of one product. For example, you may want to determine the costs that go into marketing, screening, disbursing and repaying the loan to see if there are ways to streamline the delivery and repayment process. Or you may want to compare the costs of serving new clients vs. repeat borrowers, measure the additional costs required to manage delinquent loans, or compare the costs of delivering the same service from different branches. Activity based costing is also an appropriate means of analyzing product pilots. For example, an MFI may want to test the effectiveness of three sets of controls designed to manage credit risk. In this case, effectiveness involves comparing the costs of the controls with the resulting portfolio quality. 71

78 CARE MICROFINANCE HANDBOOK Reengineering 8 Most MFIs have systems and procedures that may have made sense at one stage in the organization s development. As the MFI grew and diversified, those practices continued because that s what we ve always done, without a thoughtful and holistic analysis of what makes sense today, in the current market environment, given the MFI s current and projected structure. Consequently, the MFI has inefficiencies eroding its bottom line that need to be cleaned up. The process for cleaning up inefficiencies is called reengineering, or redesigning business processes through streamlining, consolidating, reorganizing roles and responsibilities, and automating. Reengineering varies widely in scope and form. It can involve the entire organization or select units, though it works best when approached holistically. Reengineering can focus on a specific business process (such as customer service or new product development) or the institution s entire operations. The depth and breadth depends on the extent of the problem and management s willingness to undertake meaningful, and often painful, change. In designing a reengineering process, it is useful to establish phases because it allows an MFI to test its modified processes and benefit from lessons learned before implementing the changes institution-wide. One of the major areas of focus of reengineering is on employee optimization: organizing tasks and allocating them among different staff levels to maximize productivity (see box). The greatest challenge to successful reengineering is the lack of strong leadership to manage organizational resistance to change. This resistance often results when the organizational culture and support systems are not aligned with the new work model, undermining employee trust and their commitment to change. Initial resistance also stems from residual Reengineering at Mibanco In anticipation of increased competition, ACCION International guided its Peruvian affiliate, Mibanco, through a reengineering process so it would be prepared to stave off competitive threats. An important focus of the reengineering was at the branch level, where an analysis of the daily activities of loan officers indicated that they were spending 2/3 of their time in their office, (participating in credit committees, underwriting, and processing loan applications) rather than in the field generating new loans. Part of this misallocation of time resulted from the homogenized way that applications were analyzed, including the structure and timing of the credit committee. To address this issue, reengineering established criteria, based on loan size, loan officer experience, and delinquency track record, to delegate more authority to senior credit officers with low-risk loans. This reduced the number of loans that required committee approval. Some administrative functions were pushed down to less expensive administrators. These changes resulted in a better utilization of loan officers, increasing their time in the field by 65 percent. Adapted from Brand (2000) 8 Adapted from Brand (2000). 72

79 CHAPTER 3 sentiments of previous change efforts, as well as the misperception that reengineering means job loss. The success of reengineering is tied to how it is undertaken. The most critical factor is senior management s ability to lead the effort, articulate the desired outcomes, and explain the rationale for change. When employees understand the rationale and the road map for reengineering, they can help facilitate, rather than resist, change. Soliciting employee participation in assessing the problem and generating solutions is critical for staff to take ownership of the new business model. Internally generated ideas are usually complemented with external best practices to establish benchmarks and goals. Reengineering often begins with a brainstorming session to identify desired improvements before documenting as-is business practices. For this reason, reengineering almost always involves outside consultants, who bring the expertise, creativity, and objectivity, to help improve ingrained processes and cultures. Finally, a successful reengineering effort leaves in place a culture of continuous improvement that seeks to regularly enhance the business so that organization does not have to undergo a drastic and perhaps painful reengineering process again. Does your organization develop an annual budget? Is the annual budget used and updated regularly? Do you actively compare the budgeted to actual numbers and identify cost over-runs? (For MFIs that offer multiple products) Do you do activity-based costing? Have you analyzed your systems and procedures to identify and eliminate inefficiencies? Inefficiency Monitoring Efficiency and Productivity Ratios Besides institutionalizing mechanisms for controlling costs, MFIs should monitor key efficiency ratios. To analyze its level of efficiency, an MFI should compare its current performance to two other data sets: 1) the organization s past performance (trend analysis) and 2) similar organizations identified as industry leaders (industry benchmarks). The following efficiency indicators represent recommended monitoring tools for inefficiency risk. 9 Operating Expense Ratio: The operating expense Operating Expense Ratio: ratio gives a general overview of how efficiently the Total Operating Expenses MFI uses assets. The numerator, total operating / expenses, includes administrative expenses, loan loss Average Total Assets provisions and financial costs. An alternative ratio for MFIs, particularly those that only offer lending services, is total operating expenses to average loan portfolio. 9 For current benchmarks refer to The MicroBanking Bulletin, a semi-annual journal that includes performance ratios based on data from more than 100 leading MFIs from around the world. 73

80 CARE MICROFINANCE HANDBOOK Administrative Expense Ratio: The administrative expense ratio provides a good idea of relative efficiency when comparing MFIs because non-productive guarantee funds and year-end Administrative Expense Ratio: spikes can cloud comparisons between operating Total Administrative Expense expense ratios. / Average Loan Portfolio Salary Expense Ratio: Salary expenses, which include direct salaries and staff benefits, tend to represent the largest expense in MFIs, averaging 60 percent of total administrative expenses. Salary Expense Ratio: Salary Expenses / Average Loan Portfolio Bank Efficiency Ratio: This ratio analyzes the extent to which total income (net interest and other income before loan loss provision) is consumed by expenses. This helps MFIs to focus not just on how expenses affect efficiency, but also the impact of revenue. This ratio shows how many dollars are earned for each dollar spent. The majority of US financial institutions have efficiency ratios at or below 55 percent. 10 Average Cost Per Client or Per Loan: The average cost per client or per loan is particularly useful as it identifies transactions costs on a per unit basis. Unlike the other indicators, which are relative to portfolio or assets, this indicator helps to show poverty lenders MFIs with really small loans whether their inefficiency is due to high costs or small loan sizes. Number of Clients (or Loans) per Loan Officer (or Field Staff, or Total Staff): This basic productivity indicator has numerous variations on the same theme: how many units can employees manage? Number of Field Staff (or Loan Officers) as a Percentage of Total Staff: This ratio enables the MFI to ensure that it is focusing its resource on its core business, delivering financial services, without a large back office or overhead. No one indicator independently captures all of the aspects of efficiency that need to be monitored, so it is important to review a set of efficiency and productivity ratios. Since the denominator for most of the efficiency ratios is either total portfolio or total assets, one way to improve efficiency Bank Efficiency Ratio: Total Expenses (before taxes) / Net Interest Income (before provisions) + Other Income Cost per Client: Total Administrative Expenses / Average Number of Clients Do not artificially increase average loan size to improve your efficiency might be to increase the average loan size. While the loan size tends to increase naturally over time as the client base consists of more repeat clients, an artificial increase in loan size is not recommended because it leads to two other risks that were discussed above. Assuming 10 Brand and Gerschick (2000). 74

81 CHAPTER 3 that the MFI is offering an appropriate product for its target market, an artificial increase in loan size can overburden them and result in credit risk. Another means of raising average loan sizes is by providing larger loans to a different segment of the market, which could result in mission risk. Monitoring Human Errors One of the greatest contributors to inefficiency is simple human error. Errors due to haste, carelessness, and poor training occur throughout the paper trail. Even minor mistakes like transposing a receipt number are expensive to resolve. The extra time that employees take to make sure they are doing things correctly is usually an enormous investment in efficiency. MFIs should keep an error log to track the mistakes that occur and the estimated costs that it took to resolve them. The error log becomes the basis for ongoing training, staff discipline, as well as possible reengineering targets. Does the MFI actively monitor its operating efficiency through key ratio analysis? Does your organization maintain an error log that allows it to identify and rectify common mistakes? 4.3 Systems Integrity Risks The financial health of an institution is primarily monitored through key financial statements and management reports. The reliability of both source data and the information contained in these financial statements and management reports is critical to this process. Without assurances that these key reports are accurate, an MFI is flying in the dark. External audits provide definitive assessments of the reliability of financial reports and systems in an MFI. MFIs should typically have a financial audit conducted on an annual basis. This audit involves a review of all financial statements, including the balance sheet, income statement, and cash flow statements to check the accuracy and reliability of accounting records, in order to safeguard company assets. This type of audit, if done to fulfill regulations or requirements, must be done by an external audit firm. The financial audit reviews historical data, and does not make projections about future financial information. Is the MFI audited annually by a reliable audit firm? 75

82 CARE MICROFINANCE HANDBOOK Recommended Readings Efficiency, Activity Based Costing and Reengineering Brand, Monica and Julie Gerschick (2000). Maximizing Efficiency: The Path to Enhanced Outreach and Sustainability. Monograph No. 12. Somerville, MA: ACCION International. Website: Asset and Liability Management Bartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios II: Analyzing for Quality and Soundness in Microcredit Programs. GEMINI Technical Note No. 8. Bethesda, MD: Development Alternatives, Inc. Website: Christen, Robert Peck (1997). Banking Services for the Poor: Managing for Financial Success. Somerville, MA: ACCION International. Website: Ledgerwood, Joanna (1996). Financial Management Training for Microfinance Organization: Finance Study Guide. Toronto: Calmeadow. Website: Available from PACT Publications. Ledgerwood, Joanna (1999). Microfinance Handbook: An Institutional and Financial Perspective. Washington DC: The World Bank. External Audits CGAP (1999). External Audits of Microfinance Institutions: A Handbook. Technical Tool Series No. 3. Washington DC: CGAP. Website: Available from PACT Publications. 76

83 CHAPTER 6 Chapter 5: External Risks Institutional Risk Operational Risk Financial Management Risk External Risk External risks are considerably different than the other sets of risks to which a microfinance institution is exposed because the organization has less control over them. Therefore, instead of highlighting monitoring and controls, as has been done with the other risks, for external risks it is necessary to discuss how to monitor and respond. The five sets of external risks addressed in this chapter are: Regulatory Competition Demographic Macroeconomic Natural Environment A note of caution must be attached to a discussion of external risks. It is fairly common for MFIs that are not doing particularly well to point to external causes for their plight, such as the following excuses for poor portfolio quality: These clients have never borrowed money before The clients are used to handouts Our clients are so poor that it is hard for them to repay their loans The economy is so bad that it is hurting their businesses Statements like these indicate a need to better understand microfinance. The purpose of microfinance is to serve poor people who do not have experience with credit and who live in difficult conditions. The rationale behind the design of a microloan product is to overcome these challenges. If a microloan product is not working, unless there has been a significant and recent change in the local conditions, the problem probably lies with the product or its delivery, not the market. These external risks represent challenges that management and the board need to identify and respond to, but they are not excuses for poor performance. External risks represent challenges to overcome, but they are not excuses for poor performance 77

84 CARE MICROFINANCE HANDBOOK It is also worth noting that, while you may be operating under difficult conditions, there is probably another MFI out there that has succeeded in overcoming the same challenges. The lesson from their experiences: challenges can be addressed and overcome. 5.1 Regulatory Risks Various governmental bodies may have some influence over the activities of microfinance institutions. The regulatory risks discussed in this section are summarized in the following table: Banking Regulations Usury Laws Financial Intermediation Other Regulatory Risks Directed Credit Contract Enforcement Labor Laws Banking Regulations In the last twenty years, MFIs have developed new technologies such as group lending methodologies and streamlined delivery systems to provide financial services to excluded populations. These developments were possible because MFIs had considerable freedom to innovate and experiment beyond the purview of most regulatory bodies. Now that microfinance institutions are growing in scale and number, regulators and policymakers are becoming increasingly interested in them. This attention has the potential to be constructive. Appropriately designed regulations can create an enabling environment within which microfinance can blossom. However, the opposite reaction is also a possibility. Microfinance is different from traditional banking in many ways. Policymakers who do not appreciate the unique characteristics of microfinance are likely to impose inappropriate regulations that could stifle the industry. Within this context, there are two areas of banking regulation to which microfinance institutions are particularly vulnerable: usury laws and regulations regarding financial intermediation. Usury Laws Many jurisdictions have usury laws that limit the interest rate that financial institutions can charge on loans. These laws tend to put a ceiling on interest rates that is lower than MFIs need to charge in order to cover their costs. Microfinance institutions need to charge interest rates high enough that low-income communities can have access to financial services for the long term. Donor subsidies are not sufficient to meet the global demand for financial services and they are a fickle source on which MFIs cannot rely. The only long-term solution is to generate enough income from 78

85 CHAPTER 6 your loan portfolio to cover administrative and financial costs. To do so, most MFIs charge real annual effective interest rates that range from 20 to 60 percent. This wide range depends on many factors including the local labor market, loan sizes, and the institution s size. These rates are typically higher than most usury ceilings. Financial Intermediation Regulators are primarily responsible for two things: 1) to preserve the integrity of the financial system and 2) to protect the savings of depositors. In general, the microfinance industry believes that as long as MFIs do not mobilize voluntary savings from the public, they should not be regulated as a banking institution. If the MFI goes bankrupt, it will only lose the money of donors and investors, neither of whom regulators are obligated to protect. A gray area emerges when an MFI requires compulsory savings as a part of its lending methodology. In this case, as long as it is not intermediating or on-lending those funds, then the MFI generally should not fall under the authority of bank regulators. But as a microfinance institution matures, clients may demand access to voluntary savings products. In addition, the institution may encounter funding constraints, in which case it might use the deposits that it has mobilized as loan capital. If these conditions occur and the MFI goes bankrupt, then it could lose the savings of depositors. If it is a large institution, its poor health could even undermine the integrity of the financial system. Regulators should be concerned when MFIs start entering the territory of financial intermediation. Many common banking regulations for financial intermediaries are not applicable to microfinance institutions. For example, security and documentation requirements, portfolio examination methods, and performance standards are completely different for commercial banks than would be appropriate for microfinance institutions. MFIs that rush to become regulated so that they EDPYME in Peru In an effort to build the capacity of microfinance NGOs, and to make them eligible to borrow from the government s line of credit, the Peruvian banking superintendency created a new category of financial institution called an EDPYME. For a small minimum capital requirement, it is possible to create a regulated financial institution that only provides credit. Once an EDPYME demonstrates that it is well managed, it can request permission to offer other services like passbook savings. CARE s partner, EDYFICAR, became one of the first EDPYME in Peru. can offer savings services may find banking regulations force them to adopt new policies that are prohibitive to serving their intended market. Are there usury laws in the country preventing the MFI from charging cost recovery rates? Is the MFI intermediating savings? Is it legally permitted to do so? Is the regulatory environment appropriate / accommodating? 79

86 CARE MICROFINANCE HANDBOOK Other Regulatory Risks Directed Credit Directed credit risk is when local policy makers will legislate or otherwise pressure an MFI to lend to certain individuals for political reasons. Successful microfinance institutions, which tend to have strong community support and significant outreach, may be attractive vehicles for policy makers who see the potential to use MFIs for political purposes, sometimes under the guise of regulations. Few things could undermine a microfinance institution faster than political pressure to provide credit or other services to particular communities or individuals. It is imperative that MFIs retain their independence regarding where they operate and to whom they lend. MFIs are especially vulnerable during an election period when incumbent politicians may try to use them inappropriately. Contract Enforcement Contract enforcement risk is the possibility that the MFI will not have the legal means of enforcing its loan contracts in the local legal system. For microfinance institutions to be successful lenders, they must enforce their credit contracts. When borrowers default on their loans, the MFI goes through several stages of delinquency management to recover its money whereby retribution typically escalates. The MFI hopes that it can rely on the legal system to support its efforts. If the MFI cannot legally enforce contracts by seizing collateral or taking defaulters to court, then it is deprived of important options in its delinquency management strategy. Labor Laws Labor law risk is the concern that labor regulations will prevent MFIs from containing salary costs or dismissing employees, even if it is warranted for cost reasons or for internal control purposes. Salaries represent the single largest budget item for most MFIs. The sustainability of the organization often depends on its ability to hire inexpensive staff; credit methodologies are often designed to be implemented by a moderately skilled staff. In environments where labor regulations inappropriately inflate salary costs, MFIs will have significant difficulty achieving self-sufficiency. MFIs also need to be able to take appropriate actions with staff members who do not perform appropriately, particularly when fraud is involved. If the institution cannot dismiss staff members who have committed fraud and is unable to seek appropriate retribution, the MFI will not be able to operate optimally. Is there political pressure to lend to certain target groups? Are contracts easily enforceable? Do labor laws constrain the organization? An MFI needs to enforce its loan contracts to have sufficient teeth to maintain portfolio quality If unionized, are the union stewards familiar with the MFI s projection model (i.e., have they been shown the implications of different salary increases on the institution s sustainability)? 80

87 CHAPTER Regulatory Monitoring and Response Regulatory risks are considered external risks because microfinance institutions, particularly small to moderately sized ones, tend to have little influence over the regulatory environment. Individual MFIs tend to only exert authority in the policy arena if they have very influential board members who are big players in the local political scene. However, an industry association or network of MFIs can often have an active and even influential voice in shaping public policy. It is also effective to work through a local body that can represent the national microfinance industry. A downside of this active industry role is the potential to be distracted from the MFI s operational activities. Therefore a careful assessment of the potential regulatory risks will determine the appropriate involvement at the industry level. To remain in good standing with regulators, it is advisable to conduct a regular compliance audit to review conformity with external requirements, policies and procedures, and financial or otherwise relevant legislation. Compliance audits can be done by internal or external auditors, and require a lower audit skill level than operational audit, as compliance auditing requires less need for exercising professional judgment. 5.2 Competition Risks In some environments, microfinance is becoming increasingly competitive, with new players, such as banks and consumer credit companies, entering the market. The three main sources of competition risk are: Lack of knowledge of whether a competitor is providing a similar service to a similar market Lack of familiarity with a competitor s services to adequately position, price and sell one s own services Lack of sufficient information about clients current and past credit performance with other institutions Without this information, an MFI can experience client desertion and a loss of market share, which can hamper an MFI s ability to expand Monitoring Competition Risks If an organization has high retention rates, then it is probably protecting itself from competition risks today. But the market can change very quickly if a new competitor arrives on the scene with a more attractive product. To monitor your organization s vulnerability to competition risks, it is imperative that you keep a close watch on other service providers and prospective providers, including banks, consumer credit companies, and suppliers. To monitor for competition risk, it is necessary for an MFI to collect information about its competitors. It should ensure that it has current and accurate information about the products and services of other institutions in the market. A mystery shopper approach can 81

88 CARE MICROFINANCE HANDBOOK be used to collect product and service details from other MFIs. Some of the other methods of measuring customer satisfaction can also be used to learn about the service provided by the competition, such as exit interviews and focus groups. One of the easiest ways of monitoring the competition is through questions on loan applications. Some MFIs routinely ask with each loan if the applicant has ever borrowed from formal or informal sources, including friends, neighbors, moneylenders, suppliers, banks and other MFIs. If applicants answer affirmatively, they are asked follow up questions to understand the nature of the other products and the clients analysis of the strengths and weaknesses of each Competition Risk Responses With feedback from clients and other sources about competitors in hand, the MFI should use that information to reduce its vulnerability to competition risks. The type of information it receives will determine the appropriate response, which might include: Refining its credit products: Longer and/or shorter terms, different loan sizes, lower interest rates or fee arrangements, various forms of security Incentives for retention: Provide repeat clients with preferred services, such as fast loan approval, lower interest rates Offering new products: Introduce new credit and savings products that are designed to meet a wider range of household needs besides just self-employment Improving access: Change office locations, add satellite offices, extend hours of operation Improving service: Train staff on customer oriented service delivery techniques Another response to market risks is a credit bureau, a mechanism for sharing information between MFIs regarding credit histories and current Market Share: level of indebtedness. This industry database could be a Number of Outstanding Loans (or function for the local network. If this database exists, Clients) of the MFI then it would also be possible to produce another / indicator to monitor market risks: market share. Total Number of Outstanding Loans (or Clients) in the Industry Do you track client retention rates? How do you collect information about your competition? Do you routinely collect customer satisfaction information and use that to modify your products and services? Do you have access to an industry-wide bad debtors list or credit bureau? 5.3 Demographic Risks Providing financial services to low-income persons in disadvantaged communities is not easy. If it were easy, then banks would have done it long ago. It is risky to serve this market 82

89 CHAPTER 6 because the market itself is risky. The products and services need to be designed to minimize the vulnerability of both the client and the institution. Best practices in microfinance methodologies tend to be adopted in one region based on what was successful in another. When conducting a risk assessment, consider whether the organization is sufficiently addressing local characteristics that might generate special challenges. Several factors should be considered: Education level of clients: If clients lack literacy and numeric skills, they may be greater credit risks and are probably more vulnerable to fraud. Special systems and controls should be used in serving illiterate borrowers. Entrepreneurial attitude and aptitude: Some societies have a strong tradition of informal markets, such as in West Africa; others, like post-communist countries, do not have this expertise. Client training may form a larger component of the service delivery in regions that have less entrepreneurial expertise. Social cohesion: Character assessments and peer pressure are important aspects of most microlending methodologies, yet the ability to exert pressure or collect good character information varies significantly from one region to the next, even in the same country. In cohesive communities, where everyone knows each other s business, it is easier to analyze an applicant s character and to use the borrower s standing in the community to exert repayment pressure, even with an individual lending methodology. It is much more challenging to serve transient populations in communities where people do not know or trust each other very well, and where there is a higher likelihood that a borrower will disappear. Societal attitudes towards fraud: The level of tolerance in the political and business culture for corruption and lack of transparency must be factored in when determining appropriate controls for reducing risk. Prevalence of crime: In low-income communities, particularly in urban areas, the prevalence of crime can create a significant challenge for MFIs. The security and controls required to reduce this vulnerability can be quite expensive. Past experiences with NGOs and credit providers: Different countries have different attitudes and expectations regarding non-governmental organizations. If the MFI is perceived as an extension of an international aid agency, this might create the perception that loans are gift money, and appropriate training is needed to dissuade clients of this notion. This notion would be reinforced if the market had previous experiences with credit facilities that were not operated on a commercial basis. Occurrences of illness and death: In some regions, a major cause of credit risk is associated with the poor health of clients or their family members. This is especially true in HIV/AIDs prevalent countries. To address this issue, some organizations allow repayment slides, in effect rescheduling loans due to illness if the client has a note from a health care professional. Other organizations are entering partnerships with insurance companies to either provide clients with health care coverage, or to pay for outstanding balances in cases of illness and death, or both. 83

90 CARE MICROFINANCE HANDBOOK The demographic risks can also extend to an organization s employees. One of the implications of working in an area with minimal levels of education is that recruitment and training of MFI staff can be particularly challenging. This has an impact on both the operating costs (staff may be expensive in relation to their productivity) and also on the design of management, information and control systems. This situation creates another balancing act: on the one hand, the MFI wants to be more responsive to its clients by offering more customized products and services; on the other hand, if the organization offers a diverse set of services, the more difficult it will be for field staff to implement and the greater the exposure to fraud and credit risk. 5.4 Physical Environment Risks The physical environment of low-income communities exacerbates the risks involved in delivering financial services. The local conditions raise two different sets of issues that need to be considered in a risk assessment: Infrastructure challenges: The infrastructure in which the MFI operates significantly impacts the organization s ability to maintain efficient operations with tight controls. Key factors include the availability of electricity, telephone, transportation systems and banking facilities. Perhaps the best control to overcome these challenges is to operate in a limited number of areas that are near each other. It is extremely difficult to manage risk if you operate in numerous distant regions with poor communication. Natural disaster risks: Some areas are prone to natural calamities (floods, cyclones, or drought) that affect households, enterprises, income streams and microfinance service delivery. Countries that experience repeated natural disasters will require specific risk management strategies, such as requiring business diversification, accessing disaster insurance, creating disaster relief funds, encouraging savings, and developing appropriate rescheduling policies. It is interesting to note that the mitigation strategy for infrastructure challenges could be exactly the opposite of the strategy for natural disaster risks. While poor infrastructure may encourage an MFI to cluster operations in a small geographic area, this increases the vulnerability to localized natural disasters. Besides the affect that disasters might have on an MFI s clients, it is also important to protect against the affects that they might have on the institution itself. An MFI should consider its own insurance needs, for flood or fire, as well as appropriate protection of its information system and records. 5.5 Macroeconomic Risks 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 84

91 CHAPTER 6 operations, and their ability to repay their loans. The poor tend to be more vulnerable to economic fluctuations than other segments of the population. Microfinance institutions protect themselves from these challenges by keeping loan terms short, by pegging interest rates to a relevant index, and/or by lending in foreign currency (and hence passing on the risk to the clients). 85

92 CARE MICROFINANCE HANDBOOK Recommended Readings Regulation and Supervision Berenbach, Shari and Craig Churchill (1997). Regulation and Supervision of Microfinance Institutions: Experience from Latin America, Asia and Africa. Occasional Paper No. 1. Washington DC: MicroFinance Network. Available from PACT Publications. Rock, Rachel, Maria Otero and Sonia Saltzman (1997). From Margin to Mainstream: The Regulation and Supervision of Microfinance. Monograph No. 11. Somerville, MA: ACCION International. Website: Rosenberg, Richard and Robert Peck Christen (2000). The Rush to Regulate: Legal Frameworks for Microfinance. Occasional Paper No. 4. Washington DC: CGAP. Website: Van Gruening, Hennie, Joselito Gallardo and Bikki Randhawa (1998). A Framework for Regulating Microfinance Institutions. Working Paper 206. Washington DC: The World Bank. [email protected]. Competition Churchill, Craig F. ed. (1998). Moving Microfinance Forward: Ownership, Competition and Control of Microfinance Institutions. Washington DC: MicroFinance Network. [email protected]. Available from PACT Publications. Rhyne, Elizabeth and Robert Peck Christen (1999). Microfinance Enters the Marketplace. Monograph. Washington DC: USAID. Website: Challenging Environments Brown, Warren and Geetha Nagarajan (2000). Disaster Loan Funds for Microfinance Institutions: A Look at Emerging Experience. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Doyle, Karen (1998). Microfinance in the Wake of Conflict: Challenges and Opportunities. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Nagarajan, Geetha (1998). Microfinance in the Wake of Natural Disasters: Challenges and Opportunities. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: 86

93 CHAPTER 6 Chapter 6: Management Information Systems To properly control risks, an MFI needs a strong information system. As discussed in the introduction, risk management is a dynamic three-step cycle in which MFIs identify their risks, design and implement controls to mitigate these risks, and establish systems to monitor them. These monitoring systems are then used to help identify additional risks, setting in motion a dynamic process. Management information systems (MIS) lie at the heart of this dynamic, serving as the primary link between these three elements. Whether computerized or manual, an effective MIS provides critical information for risk identification, acts as a mechanism for systematizing business processes and controls, and offers a tool for monitoring organizational performance and pinpointing future risk areas. As such, MIS is the foundation for effective risk management. This chapter provides guidance on the following three key issues relating to management information systems: 1. System Components: This section introduces the primary components of an MIS, the accounting and portfolio management systems, as well as related subjects such as the chart of accounts, cash vs. accrual accounting, fund accounting, and criteria for evaluating loan-tracking software. 2. Financial Statement Presentation: The second section focuses on financial statements, providing advice on vouchers, frequency of financial statement preparation, and the key adjustments needed to accurately present the financial position of an MFI. 3. Report Preparation: The chapter concludes by outlining important considerations in report preparation, including the key issues in report design and recommendations for a reporting framework. 6.1 System Components: What Does an MIS Include? A management information system is the processes and actions involved in capturing raw data, processing the data into usable information, and disseminating the information to users. 11 As such, MIS includes all the systems used for generating the information that guides management in its decisions and actions. Good information is essential for an MFI to perform efficiently and effectively. MIS must be accurate and easy to use. By 11 Waterfield and Ramsing (1998) p

94 CARE MICROFINANCE HANDBOOK transforming data, or unprocessed facts, into information through a systematic process, management information systems provide tools for identifying, controlling and monitoring key risks within an organization. The better the information, the better the MFI can manage its risks. A microfinance institution typically has two main systems: the accounting system, centered on the chart of accounts and general ledger, and the portfolio tracking system, covering the performance of accounts for each financial product offered by the institution. These two systems may or may not be linked depending on the human and financial resources available to maintain them. In addition, an MFI may also have a client database that permits detailed impact analysis, as well as a separate human resource module for payroll. These latter two systems are not dealt with in this handbook. Figure 20: The Parts of an MIS Data Input Accounting data Input Loan and savings data Policies and procedures Chart of accounts Accounting system Portfolio system Methodology Information Choice of indicators Financial Statements Management reports Choice of indicators Adapted from Waterfield and Ramsing (1998) Accounting Systems The foundation of any financial management system is accounting. Transactions and accounting ledgers are part of a larger, complex system for controlling funds and reporting on their sources and uses. Although standard accounting and auditing procedures vary from country to country, there are basic principles and concepts that determine the underlying logic of accounting information systems. These include: the structure of the chart of accounts, cash vs. accrual accounting, fund accounting, and general design considerations. 88

95 CHAPTER 6 Chart of Accounts To track the flow of funds in an organization, accountants need a chart (or list) of accounts, which is a structure for posting transactions to different accounts and ledgers. The core of an institution s accounting system is its general ledger. The skeleton of the general ledger is, in turn, the chart of accounts. The design of the chart of accounts reflects a number of fundamental decisions by the institution. The structure and level of detail determine the type of information that management can access and analyze. If the chart of accounts captures information at too general a level, it will not provide information precise enough to generate sophisticated indicators needed to adequately track performance. On the other hand, attempting to track too much detail generally means creating too many accounts, resulting in information that is so desegregated that management cannot identify and interpret the trends. MFIs should design their chart of accounts to meet the needs of management, providing information with a degree of detail that is meaningful for managers at all levels. While the degree of detail will differ among MFIs, CARE s Small Economic Activity Development (SEAD) Unit recommends the account structure presented in Figure 21 as a starting point. Figure 21: Chart of Accounts Structure ABCC-DD-EE-FF, where ABCC = Account A = Type of account (asset, liability) B = Group (cash, portfolio receivable) CC = Individual accounts DD = Program EE = Branch FF = Funder Waterfield and Ramsing (1998). The first four digits of each account designate the account number: ABCC. A: The first digit normally refers to the type of account (with 1 indicating assets, 2 liabilities, 3 equity, 4 income and 5 expense). B: The second digit loosely identifies a group with common characteristics, such as cash, interest and fees receivable, or fixed assets. General ledger accounts typically progress from assets and liabilities that are most liquid (such as cash-account 1100) to those that are least liquid (such as fixed assets-account 1700). CC: The next two digits indicate specific accounts in the group, such as petty cash or checking account, two accounts in the cash group. When possible, related accounts should have related numbers: for example, if the interest income on rescheduled loans is account 4040, the loan portfolio for rescheduled loans could be Additional digits can also be added to track by branch office, by program, and by funder, using extended account numbers, such as: DD-EE-FF (see section on Fund Accounting below). 89

96 CARE MICROFINANCE HANDBOOK While each MFI s chart of accounts should reflect its own operations, structure, and information needs, the CARE SEAD Unit recommends the sample chart of accounts presented in Annex 1 as a guide for CARE affiliates. In some cases, however, regulatory bodies will require institutions under their jurisdiction to use a specific chart of accounts. Cash vs. Accrual Accounting Accounting systems can be cash-based (accounting for income and expenses when cash changes hands), accrual-based (accounting for income and expenses when they are incurred), or modified cash systems (in which most accounting is cash-based, but selected accounts are accrual-based). The CARE SEAD Unit encourages all CARE affiliated MFIs to accrue important expenses, such as personnel benefits and interest payable on loans that may require only annual interest payments. (See section on Accounting Adjustments for more discussion.) Fund Accounting Donors often require detailed reporting by microfinance institutions on the use of funds they provide. For this reason, CARE encourages its affiliated MFIs to use fund accounting in their operations. Creating a chart of accounts with masking techniques that include or exclude accounts designated by certain digits in the account number provides extra power in recording and reporting information and greatly eases reporting on donor funds. This setup permits synthesis of the accounts from the perspective of financial management, while maintaining the ability to report to each funding source the use of its particular funds. For multi-purpose organizations, such as programs that provide financial and business development services, the chart of accounts must allow for the proper segregation of the various activities. These organizations should clearly separate income and expenses from financial services (savings and credit) from non-financial services. General Software Design Consideration In selecting and evaluating accounting software packages, MFIs should ensure the following: Separate Systems: CARE and MFIs As a non-profit, CARE uses a non-profit flow-of-funds accounting system. This system is not appropriate for MFIs because it only accounts for the sources and uses of funds. A business operation needs a balance sheet and income statements. For CARE to develop self-sustaining Savings & Credit programs, it must root the systems in the business world. This means that microfinance operations must have a separate accounting system that complies with basic business principles. Separate income and expenses for microfinance activities from nonmicrofinance activities A system that requires a single input of data to generate various financial reports; Software that incorporates rigorous accounting standards (for example, does not accept entries that do not balance; supports accrual accounting); 90

97 CHAPTER 6 A flexible chart of accounts structure that allows the organization to track income and expenses by program, branch, funding source, etc.; A flexible report writer that allows the organization to generate reports by program, branch, funding source, etc.; The capacity to maintain and report on historical and budgetary, as well as current, financial information a user friendly design that includes clear menu lay-outs, good documentation, and the capacity to support networked operations, if relevant; Reasonably priced local support, either by phone or in person; Relatively modest hard-disk utilization requirements Portfolio Management Systems The second component of an MIS is the portfolio management system, used for tracking credit and, if applicable, savings products. While well-established accounting practices are reflected in general ledger software, the variety of lending methodologies, repayment schedules, pricing policies, and delivery mechanisms used among MFIs has resulted in a number of portfolio management systems, with varying approaches to the way information is tracked, the kinds of reports that are generated, and the kinds of features that are included. Because there are no universal standards for loan tracking systems, and because the information tracked and reported is relatively complex, this section will not attempt to identify specific requirements for portfolio management systems. Instead, Figure 22 provides MFIs with a framework for assessing portfolio management software, which will allow them to compare a wide range of systems to their specific needs. 91

98 CARE MICROFINANCE HANDBOOK Ease of use Documentation Tutorials Error handling Help screens Interface Figure 22: Criteria for Evaluating Loan Tracking Software Hardware/software issues Programming language Data storage format Network support Operating system Access speed Features Languages Setup options Methodology issues Loan product definition Multiple loan products Principal repayment methods Monitoring methods Fund accounting of portfolio Data disaggregation Interest calculations Fee calculations Savings Branch office management and consolidation Linkages between accounting and portfolio Support Customization available Training Cost issues Reports Existing reports Ease of creating new reports Print preview Printers supported Width of reports Security Passwords and levels of administration Data entry and modification Backup procedures Audit trails Source: Waterfield and Sheldon (1997) in Ledgerwood (1999) Linking Accounting and Portfolio Systems 12 Many people expect computerized portfolio and accounting systems to be seamlessly linked so that all transactions entered in the portfolio system are automatically reflected in the accounting system. While such a link is ideal, it is expensive and requires maintenance. Small institutions are probably better off not linking client accounts and the general ledger by computer. A non-linked system provides another level of internal control, offers more user flexibility and less computer dependence, and is less expensive because it does not demand additional programming or software support. For programs that are not linked, daily reconciliation of the portfolio system with the accounting system is critical. Transaction reports from the two systems should be printed and reconciled on a daily basis, For non-linked to permit the timely resolution of any irregularities. Even for systems, daily institutions that have linked systems, periodic (at least reconciliation is monthly) reconciliation is important to ensure that proper critical information is being recorded in both. 12 This section is drawn from Waterfield and Ramsing (1998). 92

99 CHAPTER Financial Statement Presentation To analyze the financial performance of an MFI properly, independent financial statements (i.e., income statements and balance sheets see Annex 3 for sample format) should be prepared on a consistent basis and in accordance with generally accepted accounting principles. While a number of Independent financial CARE s microfinance projects have relied on CARE s fund statements should be accounting to generate financial information for them, prepared on a CARE s SEAD Unit strongly encourages all microfinance consistent basis, programs, regardless of where they are in their progression regardless of the MFI s from project to independent financial institution, to produce stage of development and analyze independent financial statements on a regular basis. Due to the unique structure of many MFIs, a number of adjustments may be necessary to accurately reflect the institution s financial position. This section highlights key issues associated with financial statement preparation, including voucher preparation, frequency of financial statement preparation, accounting adjustments, and adjustments for inflation and subsidies Voucher Preparation 13 Each time a transaction occurs, documentation must be maintained through the preparation of vouchers to ensure a proper paper trail. While each MFI has its own specific procedures for voucher preparation, in general, vouchers should be supported by invoices and check stubs or cash requests and should include the following: Number and nature of voucher Name of department Date prepared Account name and number and amount of money Source and description of transaction Authorized signature Attachment of original bills and cash requests Frequency of Financial Statements Effective financial management requires frequent review of financial performance. The CARE SEAD Unit encourages MFIs to produce profit and loss statements for the whole institution on a monthly basis. It may also be useful to generate a partial income statement MFIs should produce for each cost center, such as the branches, even though some monthly profit and loss program costs, such as head office overhead, are not statements incorporated at this level. In addition, CARE encourages MFIs to produce a balance sheet at least annually, depending on the size of their operations. 13 This section is drawn from Ledgerwood and Moloney (1996). 93

100 CARE MICROFINANCE HANDBOOK Financial Statement Adjustments To analyze the financial performance of your MFI, your financial statements must be consistent with generally accepted accounting principles. To do this, it may be necessary to adjust the balance sheet and income statement to reflect the institution s actual financial performance. There are two types of adjustments required: accounting adjustments, which are necessary to adhere to proper accounting standards; and inflation and subsidy adjustments, which restate financial results to reflect more accurately the full financial position of the MFI. Accounting Adjustments Loan losses Depreciation of fixed assets Accrued interest Accrued expense Inflation and Subsidy Adjustments Inflation Operating cost subsidies In-kind subsidies Concessionary funding Donated equity Accounting Adjustments Accounting for Loan Losses MFIs need to maintain very high portfolio quality to ensure long-term financial viability. Loan delinquency increases costs both through direct losses (assuming the loan is not repaid, and the loss is passed directly through the income statement as a bad debt), higher administrative costs (as staff divert time and resources to chasing clients), and reduced net interest margins (by lowering the institution s interest income and increasing their cost of funds). To reflect the financial performance of an MFI accurately, it is necessary to determine how much of the portfolio is generating revenue and how much is likely to be unrecoverable. This is done by examining the quality of the loan portfolio, creating a loan loss reserve, and periodically writing off loans. A loan loss reserve (LLR) is the balance sheet reserve account against which bad assets, or portions thereof, are written-off. In most countries, the LLR account appears as a negative or contra asset on the balance sheet and is netted against loans for financial reporting purposes. (Some MFIs maintain the account in the liabilities section of the balance sheet without netting, a standard that tends to overstate total assets.) The reserve is normally created and maintained through a charge to provision expense on the profit and loss (P&L) statement. The reserve for loan losses is synonymous with the allowance for possible loan losses and the reserve for bad debts. An MFI s loan portfolio should be adjusted on a monthly basis to reflect estimates of possible loan losses. If an MFI does not maintain a loan loss reserve account, its balance sheet will be overstated, and financial statements will be significantly impacted by any writeoff. Conversely, when an LLR account is maintained, the accountant adjusts the balance sheet by subtracting the real loss both from the loan loss reserve and from the loan portfolio 94

101 CHAPTER 6 account. As the LLR account is a contra asset account, this double entry has no net effect on the total asset figure. In addition, if the loan has been appropriately reserved against, the write-off will have no impact on net income. Provisioning Policies: The most accurate measure of portfolio risk is derived from an asset classification process, which provides a basis for determining an adequate level of loan loss reserves. Because each MFI has its own history of defaults, classification categories will vary. Normally, financial institutions estimate the amount of expected bad debt they expense to the loan loss reserve based on the number of days the loan is past due and the institution s prior experience. Categories are established and a level of required reserves, expressed as a percentage of the total unpaid outstanding balance of a classified loan, is assigned to each classification category. The following provisioning schedule adapted from CGAP s policy framework provides an example: Days Late Provisioned Amount 1 30 days 10% of unpaid balance days 25% of unpaid balance days 50% of unpaid balance > 180 days 100% of unpaid balance Loan terms also influence an institution s provisioning policy. A product with daily repayments will have a different provisioning schedule from a loan with monthly repayments. In determining an adequate reserve, MFIs should also consider such factors as reasonableness of credit policies and procedures, prior loss experience, loan growth, the quality and depth of management in the lending area, loan collection and recovery practice, and general trends in the economy. As an alternative to the classification procedure, an MFI could expense 0.25 percent of the current portfolio at the end of each month and credit this to the loan loss reserve. Institutions that do not have any provision for loan losses should open the reserve with a one-time deduction of five percent of the current portfolio to establish the reserve. Adjustment for Substandard or Doubtful Loans: The percentage of a loan that must be covered by the reserve is typically a function of the number of days the loan is past due. A loan with an installment over 15 days past due, for example, should have 10 percent of its value on reserve in the LLR account, according to the provisioning schedule detailed above. If the amount in the LLR account is insufficient to cover this value, the account needs to be topped up by expensing an amount necessary to achieve this value. This addition to the LLR is charged as provision expense on the P&L and results in reducing the net loan figure. Adjustments for Loan Losses: Once a loan is classified as a loss, it should be written off the MFI s balance sheet. In other words, the total value of the loan should be reduced from the loan amount and the amount of the reserve. Such assets are considered non-bankable, but not necessarily non-recoverable; they may still warrant strong collection efforts. 95

102 CARE MICROFINANCE HANDBOOK Write-Offs An MFI should not write off loans unless they were carefully determined as losses. There is often a tendency to write off loans as a means of improving the status of its loan portfolio. While this may reduce the value of the loans in the doubtful category, it shrinks the balance sheet and does not present an accurate picture of the health of the loan portfolio. The decision on when to write off a loan should be based on a sound policy established and agreed to by the board members of an MFI. Normally, the write-off policy is determined by local accounting custom and requires the institution to fulfill legal obligations regarding formal attempts to collect overdue loans. For MFIs involved in financial intermediation (and thus under jurisdiction of the bank superintendent), they will need to enter into a dialogue with regulators about provisioning requirements. The application of traditional provisioning criteria may result in insufficient provisioning as microfinance loans are typically short term, and can be become nonrecoverable within a short period of time. Traditional provisioning may not require the MFI to write off delinquent loans until they are over a year past due. On the other hand, the traditional reserve requirements for unsecured loans may require the MFI to provision too conservatively, so it is important to get regulators to recognize the value of peer pressure and other forms of non-traditional collateral. Accounting for Depreciation of Fixed Assets Depreciation is an annual expense that is determined by estimating the useful life of each asset. When a fixed asset, such as property and equipment, is purchased, there is a limited time that it will be useful. (Land theoretically does not lose value over time and therefore it is not depreciated.) Many countries set standards for depreciation for different classes of assets. Depreciation expense is the accounting term used to allocate and charge the cost of this usefulness to the accounting periods that benefit from the use of the asset. Like the loan loss provision, depreciation is a non-cash expense and does not affect the cash flow of the MFI. To make the adjustment, when a fixed asset is first purchased, it is recorded on the balance sheet at the current value or price. When a depreciation expense (debit) is recorded on the income statement, it is offset by a negative asset (credit) on the balance sheet, called accumulated depreciation. This offsets the gross property and equipment, reducing the net fixed assets. Accumulated depreciation represents a decrease in the value to property and equipment that is used up during each accounting period. There are two primary methods of recording depreciation: the straight-line method and the declining balance method. The straight-line method allocates an equal share of the asset s total depreciation to each accounting period. This is calculated by taking the cost of the asset and dividing it by the estimated number of accounting periods in the asset s useful life. The declining balance method refers to depreciating a fixed percentage of the cost of the asset each year. The percentage value is calculated on the remaining un-depreciated cost at the beginning of each year. 96

103 CHAPTER 6 For example, assume an MFI has purchased a $2,000 computer, which according to the country s depreciation standards, is assumed to have a useful life of three years and has an estimated value of $500 at the end of three years. Under the straight-line method, its depreciation per year is calculated as follows: Cost salvage value 2, = $500 depreciation per year Service life in years 3 Under the declining balance method, if the computer were depreciated on a declining balance at 33.3 percent a year, the first year s depreciation would be $ ($2,000 x 33.3%). In the second year, the depreciation amount would be applied to the remaining amount, $ One third of $ is $444.40, which would be the depreciation expense for the 2 nd year. This continues until the asset is either fully depreciated or sold. Accounting for Accrued Interest Revenue 14 Revenue that has been earned but not yet received in cash is called accrued revenue. For an MFI, accrued interest income represents the most common example (other examples of income receivables include consulting earnings that are paid at the completion of the assignment or speaking fees that are paid months after the speaking engagement). Recording interest that has not yet been received is referred to as accruing interest revenue. Assuming that interest will be received at a later date, accrued interest is recorded as revenue and as an asset under accrued interest or interest receivable. While an MFI s treatment of accrued interest revenue will vary, the CARE SEAD Unit encourages its affiliates to adhere to the following guidelines: If an MFI does not accrue interest revenue at all and makes loans that have relatively infrequent interest payments (such as quarterly or bi-annually), it should accrue interest revenue at the time financial statements are produced. MFIs that have weekly or biweekly payments need not accrue interest revenue, as it is more conservative not to and may not be material enough to consider. If an MFI has accrued interest on loans that have little chance of being repaid, the amount of accrued interest on delinquent loans should be deducted on the balance sheet by crediting the asset where it An MFI should not was recorded initially (outstanding loan portfolio or interest accrue interest on receivable) and reversed on the income statement by delinquent loans decreasing interest revenue (debit). The best practice for an MFI is not to accrue interest at all on delinquent loans. Some sophisticated accounting software can automatically accrue interest; if such a system is not available, MFIs should generally avoid accruing interest. In a stable, limited growth institution, where payments are made frequently, the differences between cash and accrual accounting are not significant. 14 This section drawn from Ledgerwood (1999), p

104 CARE MICROFINANCE HANDBOOK Interest revenue is accrued by determining how much interest revenue has been earned but not yet become due (the number of days since the last interest payment times the daily interest rate times the balance outstanding, assuming declining balance calculation) and recording this amount as revenue (credit) and debiting the asset account accrued interest. Accounting for Accrued Interest Expense Likewise, financial statements may need to be adjusted to reflect expenses that have been accrued but not yet paid. Examples of accrued expenses include financing costs on borrowed funds, annual audit fees, and salaries. CARE s SEAD Unit recommends that MFIs accrue significant expenses, assuming their accounting system has the capacity. Financing costs can represent such an expense. At year-end, MFIs may owe interest on borrowed funds for the period from the last interest payment to the day the period ends. If the interest expense is not accrued, the MFI s financing costs at the end of the year will be understated, its profitability overstated, and its liabilities understated. To accrue interest expense, the amount of interest owed as of the date the balance sheet is debited on the income statement as a financing cost and credited as a liability on the balance sheet in the accrued interest expense account. Adjusting for Inflation and Subsidies Adjustments for both subsidies and inflation should be made to determine the true financial viability of the MFI. While these adjustments may not be required by official accounting policies, the CARE SEAD Unit encourages MFIs to perform these adjustments because they create a clear picture of the MFI s ability to maintain the real value of its capital. These adjustments also facilitate a benchmarking comparison with other MFIs that have made similar adjustments on their financial statements. There are many ways of approximating the effects of inflation on MFI equity and the effect subsidies have on overall financial performance. The method suggested here reflects a simplified version of inflation-based accounting used by The MicroBanking Bulletin. (See Annex 2 for the adjustment worksheet.) Inflation Even though inflation is not usually reflected in audited financial statements, MFIs should treat it as a real cost that can eat away at the value of their equity. Most of an MFI s assets are financial assets (loan portfolio being the largest), which are hit hardest when inflation erodes the value of money. (The value of fixed assets, on the other hand, such as equipment and land, is assumed to increase with inflation.) As such, the value of an institution s financial assets decreases with inflation, while its operating and financial costs increase. Over time an MFI s costs increase and its financial assets, on which it earns revenue, decrease in real terms. Adjustments for inflation result in changes to both the balance sheet and the income statement. These include the following: Revaluation of Assets: Because fixed assets do not devalue with inflation, their nominal value is increased to the extent of annual inflation. The initial value, net of depreciation, is multiplied by the inflation rate. The result is income that could be received as a result of inflation, if the assets were to be sold. This revaluation adjustment is registered as 98

105 CHAPTER 6 operating income on the income statement and as an increase in the value of the fixed asset account on the balance sheet. Calculation of the cost of inflation on the real value of equity: The cost of inflation on equity is reflected by multiplying the prior period s closing capital balance by the current year s inflation rate. This result is then reflected as an operating expense on the income statement and as an increase in the value of the capital account, called accumulated inflation, on the balance sheet. Subsidies There are four types of subsidies typically received by MFIs: Funds donated to cover operational costs Donations in-kind Concessionary loans Donated equity MFIs should adjust their financial statements to address each of these subsidies. Unlike traditional financial intermediaries that fund their loans with voluntary savings and debt, many MFIs fund their loan portfolios with donated equity or concessionary loans. Many also receive in-kind subsidies, such as free office space and equipment. Mature MFIs typically replace the donated equity with market rate debt and find alternative office space and equipment. To prepare for these eventualities, an MFI should know the status of its own financial viability, independent of any current subsidies. This will permit more meaningful financial analysis and allow comparison with other institutions. Adjustments for subsidies result in a change in the net income on the income statement equal to the value of the subsidies; they do not ultimately affect the balance sheet. Donations for Operating Expenses: Donated funds for operations should be reported below the net income line, resulting in a reduction in operating revenue, and therefore, a reduction in the amount transferred to the balance sheet as current year net surplus. An offsetting credit entry is made to the balance sheet in the accumulated capital subsidies account. (Note: Only the amount spent in the year is recorded on the income statement; any amount still to be used in subsequent years remains as a liability on the balance sheet, referred to as deferred revenue.) Donations In-kind: In-kind donations such as free office space, volunteer staff, or employees paid by others should be recorded as an expense on the income statement and offset in the equity account on the balance sheet in the accumulated capital subsidies line. Concessionary Loans: Concessionary loans are loans received by the MFI with lower than market rates of interest. To determine the appropriate market rate to apply, MFIs should choose the form of funding that would most likely replace these subsidized funds. These would include: Local prime rate for commercial loans 90-day certificate of deposit rate Interbank lending rate Average deposit rate at commercial banks Inflation rate plus 3 to 5 percentage points per year 99

106 CARE MICROFINANCE HANDBOOK (Note: The MicroBanking Bulletin uses the deposit rate for each country as a proxy for the market rate.) Adjustments are made to both the balance sheet and the income statement. The amount of the subsidy is entered as an increase in equity (credit) under the accumulated capital subsidies account and as an increase in financial costs (debit). Donated equity: Funds donated for loan capital are often treated as equity, in which case they are adjusted for inflation. For MFIs that treat donations for loan capital as income, a subsidy adjustment is made using a market rate for commercial debt or equity (see Ledgerwood (1999) p. 197 for more information) Constant Currency Some MFIs may want to restate their financial statements in constant currency terms. Constant currency means that, on a year-by-year basis, financial statements continually reflect the current value of the local currency relative to inflation, permitting year-to-year comparisons of the real growth or decline in key accounts. To convert prior year data, amounts are either multiplied by one plus the annual rate of inflation for each year or divided by the consumer price index for each year (see Christen (1997) pp for more details). 6.3 Reporting Having reviewed the key components of an MIS and key issues related to financial statement preparation, this chapter concludes with guidance on report preparation. Reports are the primary means for getting information (the key output of the management information system) to those who need it to perform their jobs and make decisions. This section will examine two elements of reporting: report design and reporting frameworks Key Issues in Report Design 15 The way a report is designed will determine how useful the information is to management. If information does not reach staff in a useful form, the MIS loses its value. This section identifies key issues to think about when designing reports. Content: Reports should generally focus on one issue and present all information pertinent to that issue. (An exception would be a summary operational report.) Categorization and Level of Detail: Present information at different levels of aggregation and provide comparison information from different branches/units of the institution. Frequency and timeliness: Reports need to be carefully designed around the timing of information needs in the institution. 15 This section adapted from Waterfield and Ramsing (1998), pp

107 CHAPTER 6 Identifying information: All reports should have: standard headers and footers with important identifying information, unique titles, unique report numbers; and should display the date and time of printing, and the timeframe the information covers. Trend analysis: Important reports should include trend information. Period covered: Reports should be generated to cover different time periods. Usability: Ensure report users can easily read and use reports. Graph analysis: Generate key graphs, such as portfolio in arrears and actual and projected activity, on a regular basis and display in common areas. Rules for Designing Good Reports Use standard letter-size paper whenever possible. Present all information pertinent to an issue in a single report rather than spread over several reports. Present information at the appropriate level of aggregation for the user. Include identifying headers and footers in every report and explanatory legends at the end. Study how reports are used and continually improve them. Waterfield and Ramsing (1998), p Reporting Framework While the number and mix of reports will depend on an institution s size, level of operations, and range of financial products, this section identifies a minimum reporting framework for all CARE affiliated MFIs. Each MFI has key stakeholders, each of whom will require information on a timely basis and in a useful form. Each of these stakeholders and their corresponding information requirements need to be identified up-front and continually reassessed. Figure 23 identifies six key shareholder categories and 38 reports from seven categories: A) savings reports, B) loan activity reports, C) portfolio quality reports, D) income statement reports, E) balance sheet reports, F) cash flow reports, and G) summary operational reports. For sample reports, see Section of the CGAP MIS Handbook (Waterfield and Ramsing (1998)). 101

108 CARE MICROFINANCE HANDBOOK Figure 23: Key Reports by Shareholder Category Shareholder Category Key Reports Clients Field Staff Branch & Regional Managers Senior Managers Board Donors and Shareholders A. Savings Reports A1. Savings Account Activity X X A2. Teller Savings Report X A3. Active Savings Accounts by Branch and Product X A4. Dormant Savings Accounts by Branch and Product X A5. Upcoming Maturing Time Deposits X A6. Savings Concentration Report X X B. Loan Activity Reports B1. Loan Repayment Schedule X X B2. Loan Account Activity X X B3. Comprehensive Client Status X X B4. Group Membership Report X B5. Teller Loan Report X B6. Active Loans by Loan Officer X B7. Pending Clients by Loan Officer X X B8. Daily Payments Report X B9. Portfolio Concentration Report X C. Portfolio Quality Reports C1. Detailed Aging of Portfolio at Risk by Branch X C2. Delinquent Loans by Loan Officer X X C3. Delinquent Loans by Branch and Product X X C4. Summary of Portfolio at Risk by Loan Officer X X C5. Summary of Portfolio at Risk by Branch and Product X X C6. Detailed Delinquent Loan History by Branch X C7. Loan Write-off and Recuperation Report X X C8. Aging of Loans and Calculation of Reserves X X C9. Staff Incentive Report X X D. Income Statement Reports D1. Summary Income Statement X D2. Detailed Income Statement X D3. Income Statement by Branch and Region X D4. Income Statement by Program X D5. Summary Actual-to-Budget Income Statement X D6. Detailed Actual-to-Budget Income Statement X X D7. Adjusted Income Statement X X E. Balance Sheet Reports E1. Summary Balance Sheet X X E2. Detailed Balance Sheet X E3. Program Format Balance Sheet X F. Cash Flow Reports F1. Cash Flow Review X X F2. Projected Cash Flow X F3. Gap Report X G. Summary Operational Reports G1. Summary Operations Report X X X Drawn from Waterfield and Ramsing (1998), pp

109 CHAPTER 6 Recommended Readings CGAP (2001). Disclosure Guidelines for Financial Reporting by Microfinance Institutions. Washington DC: Consultative Group to Assist the Poorest. Website: Christen, Robert Peck (1997). Banking Services for the Poor: Managing for Financial Success. Somerville, MA: ACCION International. Website: Ledgerwood, Joanna (1999). Microfinance Handbook: An Institutional and Financial Perspective. Washington DC: The World Bank. [email protected]. Ledgerwood, Joanna and Kerri Moloney (1996). Financial Management Training for Microfinance Organization: Accounting Study Guide. Toronto: Calmeadow. Website: Available from PACT Publications. [email protected]. Mainhart, Andrew (1999). Management Information Systems for Microfinance: An Evaluation Framework. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Waterfield, Charles and Nick Ramsing (1998). Handbook for Management Information Systems for Microfinance Institutions, CGAP Technical Tool Series No. 1. Website: 103

110 CARE MICROFINANCE HANDBOOK ANNEXES 104

111 ANNEXES Annex 1: Risk Management Checklist by Category of Risk Risk Page Number Question Executive Director Institution 14 How does your organization demonstrate a commitment to constant improvement? Institution 14 How often does senior management go to the field to talk with clients and staff? Institution 14 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? Institution 14 Do you have a business plan to achieve self-sufficiency in a reasonable amount of time? Institution 14 Do you update the plan and use it regularly to make management decisions? Institution 14 Do you monitor sustainability and profitability indicators, and if so are they trending in the right direction? Institution 14 Do you have an independent governing body? Institution 14 Do you share with clients of other CARE programs? If so, is the strategy driven by the business plan of the MFI and contribute to long-term sustainability or do projections show a continuing need to cross-subsidize this population? Institution 14 Is your organization building the capacity to operate independent of ongoing technical assistance? Institution 14 Does the MFI have the ability to identify its own needs and to contract appropriate technical expertise to address those needs on its own terms? Operational 34 Does a reliable firm audit the MFI annually? Financial Management 63 Is the MFI audited annually by a reliable audit firm? External 77 Are there usury laws in the country preventing the MFI from charging cost recovery rates? External 77 Is the MFI intermediating savings? External 77 Is it legally permitted to do so? External 77 Is the regulatory environment appropriate / accommodating? External 77 Is there political pressure to lend to certain target groups? External 77 Are contracts easily enforceable? External 77 Do labor laws constrain the organization? External 77 Do you track client retention rates? External 77 How do you collect information about your competition? External 77 Does your organization routinely collect customer satisfaction information and use that to modify your products and services? External 77 Does it have access to an industry-wide bad debtors list or credit bureau? Executive Director and Board Institution 14 Does your organization have a clear mission statement that balances the social and commercial objectives and identifies the target market? Institution 14 Does the composition of the board reflect the dual mission of microfinance? Institution 14 How does the board monitor the client composition? Institution 14 Does your organization have a plan to establish itself with an independent legal structure? Institution 14 Does your organization have the capacity and commitment to develop its own business plan? Institution 14 Is CARE s role in the governance and management structure best described as supportive or dominating, or some other adjective? Institution 14 What percentage of your operating expenses is covered by money received from or through CARE? Institution 14 Does CARE have an exit strategy? Institution 14 Are there clear indications of local ownership such that microfinance service operations will likely continue in CARE s absence? Finance Manager Institution 14 Is the interest rate set high enough to cover the MFI s full costs? 105

112 CARE MICROFINANCE HANDBOOK Risk Page Number Question Institution 14 Are you moving toward accessing commercial sources of capital and reducing reliance on subsidized funding sources? Institution 14 Do you properly account for subsidies and in-kind donations? Institution 14 Do you have an independent contract for financial resources from a donor or commercial lender? Institution 14 Is your organization reducing its dependence on donor/care subsidies by as much as estimated in the business plan? If not, why not? Institution 14 Is CARE the only entity that has raised investment capital and operational subsidies for your organization? Institution 14 Does your organization have its own financial system? Institution 14 Do you make cash management decisions independently from CARE? Institution 14 Are PN85 costs removed from the cost structure of the MFI? Institution 14 Does the CARE country office have a means of recovering applicable PN85 charges without directly charging the MFI? Institution 14 Is there an agreement between the MFI and the CARE country office on fees to be paid for services provided by CARE? Financial Management 63 Is the MFI susceptible to interest rate risk? Financial 63 For those MFIs operating in highly inflationary environments, is gap analysis conducted Management regularly? Financial Management 63 What is your net interest margin? Financial 63 For MFIs that hold assets or liabilities in foreign currency, are appropriate control Management mechanisms in place to mitigate foreign exchange risk? Financial 63 Does your organization follow a cash flow management program (i.e., cash needs forecasting, Management budgeting, etc.)? Financial 63 Do you monitor its liquidity risk through consistent monitoring of key ratios: quick, liquidity, Management idle funds? Human Resources Manager Institution 14 What steps do you take to ensure that your employees are motivated and enthusiastic about their work? Institution 14 Is your human resource system effective and how does the organization know? Institution 14 Do you have job descriptions and annual performance appraisals for all employees, including senior management? Institution 14 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? Operational 34 Are loan officers from the community in which they work? Operational 34 Are your hiring procedures designed to attract individuals who are honest and well motivated? Operational 34 Are new employees oriented to the MFI culture of honesty and zero-tolerance? Operational 34 Are staff compensation levels reasonable and competitive? Operational 34 Is there an immediate termination policy for staff fraud or dishonesty? Operations Manager Institution 14 Does your organization use appropriate screening mechanisms to ensure that it is serving the intended target market? Institution 14 Are the loan sizes appropriate to the needs of the clients? Institution 14 Do you offer a large enough range in loan sizes so that the best clients do not grow out of the program? Do the requirements for accessing a loan (i.e., collateral, meetings, business plan, forced Institution 14 savings) address the institution s need to control credit risk (see next chapter) without being excessively demanding on clients? Institution 14 How do you conduct useful market research activities on a regular basis to keep in touch with the changing needs of your target market? Institution 14 What indicators do you use to ensure that you are serving the intended target market? Institution 14 Is this information collected in a cost-effective manner? Institution 14 What information, if any, does your organization consistently collect regarding the impact of your services on clients? Institution 14 How has your retention rate changed over the past year and what are the primary reasons for that change? 106

113 ANNEXES Risk Page Number Question Institution 14 Do field staff consider themselves employees of CARE or the MFI; if it is the former, what are the implications? Institution 14 Is your interest rate so high that it hurts your clients? How do you know that they can afford the rates that you are charging? Operational 34 What are the characteristics of the product design that are intended to control credit risk? Operational 34 Are those characteristics appropriate for different segments of the target market (i.e., new clients and repeat clients)? Operational 34 Are the features of the of the loan product reviewed regularly to determine if they should be modified? Operational 34 Are exit interviews conducted with clients who are leaving client groups or discontinuing to use the MFI services? Operational 34 If it makes secured loans, does the program have appropriate policies and systems for dealing with collateral? Operational 34 Does the credit committee have sufficient experience to make wise decisions? Operational 34 Is the credit committee involved in loan monitoring and delinquency management? Operational 34 Does the program have a culture that is intolerant of delinquency? Operational 34 Does the MFI have an appropriate and transparent rescheduling policy? Operational 34 Which branch has the worst portfolio at risk? Operational 34 Could this branch be experiencing fraud? Operational 34 Are loan officers allowed any discretion, such as lowering interest rates, requesting loan size exemptions or waiving delinquency fees? If so, how do you control for fraud in these circumstances? Operational 34 Does the loan approval authority structure balance efficiency, customer service and fraud control? Operational 34 Do managers avoid and actively discourage blind signing? Operational 34 Does the Operations Manager, or other senior manager, consistently monitor portfolio quality? Operational 34 Do you have a system for collecting, analyzing and following up with customer complaints? Operational 34 Do you have a contingency plan in place so that you can quickly mitigate the damage caused by fraud when it occurs? If so, what does the plan consist of? Operational 34 Has your organization contracted an expert to analyze your security needs on a branch-bybranch basis? Financial Management 63 Does your organization develop an annual budget? Financial Management 63 Is the annual budget used and updated regularly? Financial Management 63 Do you actively compare the budgeted to actual numbers and identify cost over-runs? Financial Management 63 (For MFIs that offer multiple products) Do you do activity-based costing? Financial Management 63 Have you analyzed your systems and procedures to identify and eliminate inefficiencies? Financial Management 63 Does the MFI actively monitor its operating efficiency through key ratio analysis? Financial 63 Does your organization maintain an error log that allows it to identify and rectify common Management mistakes? Operations Manager and Internal Auditor Operational 34 Has your organization experienced fraud? If so, what conditions made your organization vulnerable to fraud? Operational 34 What have you done to try to reduce your vulnerability? Operational 34 Does your institution have clear write-off and rescheduling policies that are consistent with a fraud prevention strategy? Operational 34 Are those policies followed? Internal Auditor Operational 34 Does the MFI have appropriate polices for handling cash in its loan disbursement and collection procedures? Operational 34 Are these policies followed? Operational 34 Do you have adequate policies and procedures on collateral control? 107

114 CARE MICROFINANCE HANDBOOK Risk Page Number Question Operational 34 Are these policies followed? Operational 34 Does your organization regularly sample clients to confirm savings and loan balances? Operational 34 Does the MFI have an internal audit function? Operational 34 Are internal audits conducted regularly? Operational 34 What is the process by which your organization confirms client savings and loan balances? Operational 34 What are your organization s major vulnerabilities to theft, and how are you addressing them? Field Staff Institution 14 Do employees know the organization s mission statement and use it to help guide their actions? Institution 14 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)? Institution 14 What percentage of their time do loan officers spend in the field? If it is less than half of their time, does the association with CARE somehow make them think that they have administrative positions and should be sitting behind a desk rather than getting their shoes dirty? Operational 34 What screening techniques does your organization use to minimize credit risk? Operational 34 How do those screening techniques vary by loan number and loan size? Operational 34 Are those techniques consistently applied in all branches? Operational 34 Are the loan approval policies strictly followed? Operational 34 Is there a formal orientation of clients and staff to expectations, policies and procedures? Operational 34 Are loan officers well trained in effective delinquency management strategies? Operational 34 Are delinquency penalties and loan contracts enforced? Operational 34 Are staff members properly rewarded to maintain high standards of portfolio quality? Operational 34 Does the institution have an ongoing client education campaign? Operational 34 Are clients aware of their rights? Operational 34 What channels do clients have to voice complaints? Operational 34 Do at least two people meet all applicants and approve all applications? Operational 34 How do employees document their delinquency management steps? Operational 34 Does the MFI have standard procedures for delinquency follow up? Operational 34 Are these procedures followed? 108

115 ANNEXES Annex 2: Sample Chart of Accounts 1000 Cash and Equivalents 1000 Cash in Vault 1005 Petty Cash 1010 Cash in Banks 1011 Cash in Bank Operating 1012 Cash in Bank Lending 1013 Cash in Bank Savings 1050 Reserves in Central Bank 1100 Short-term Investments Asset Accounts 1500 Receivables 1510 Accounts receivable 1520 Travel advances 1525 Other advances to employees 1530 Other receivables 1600 Long-term Investments 1610 Investment A 1612 Investment B 1200 Loan Portfolio 1210 Portfolio/Type A 1220 Portfolio/Type B 1240 Restructured loans 1300 Reserves for possible losses 1310 Loan loss reserve 1320 Interest loss reserve (for accrual systems only) 1400 Interest and fees receivable 1410 Interest receivable, current loans 1420 Interest receivable, non-performing loans 1440 Interest receivable, rescheduled loans 1450 Commissions receivable 1459 Other loan fees receivable 2000 Payables 2010 Trade accounts payable 2012 Accounts payable, members 2014 Accounts payable, employees 2100 Interest Payable 2110 Interest payable, loans 2120 Interest payable, passbook savings 2130 Interest payable, time deposits 2150 Interest payable, other 2200 Client Deposits 2210 Collateral savings 2220 Voluntary savings 2230 Time deposits 2300 Loans Payable Short-term 2320 Loans payable, Bank Loans payable, Bank Loans payable, other 2350 Lease payable Liability Accounts 1700 Property and Equipment 1710 Buildings 1711 Depreciation, buildings 1720 Land 1730 Equipment 1731 Depreciation, equipment 1740 Vehicles 1741 Depreciation, vehicles 1750 Leasehold improvements 1751 Depreciation, leasehold improvements 1800 Other Assets 1810 Prepaid expenses 2400 Loans Payable Long-term 2420 Loans payable, Bank Loans payable, Bank Loans payable, other 2450 Lease payable 2500 Accrued Expenses 2510 Accrued salary 2520 Accrued payroll taxes 2530 Accrued benefits, insurance 2540 Accrued benefits, leave 2550 Accrued federal taxes 2590 Other accrued expenses 2600 Deferred Revenue Program 2610 Deferred interest 2620 Deferred commissions 2622 Deferred loan service fees 2700 Deferred Revenue Grants 2710 Deferred revenue Grant Deferred revenue Grant 2 109

116 CARE MICROFINANCE HANDBOOK Incorporated institution 3000 Shareholders Capital 3010 (Paid-in Common Stock) Capital 3020 Common stock at par value 3030 Donated capital, current year 3040 Donated capital, previous years 3100 Gain (Loss) from Currency Adjustments 3200 Retained earnings, current year 3300 Retained earnings, previous years Interest Income 4010 Interest income, performing loans 4020 Interest income, non-performing loans 4040 Interest income, rescheduled loans 4100 Other Loan Income 4120 Income from commissions 4122 Income from loan service fees 4124 Income from closing costs 4130 Penalty income 4140 Income from other loan fees Equity Accounts Nongovernmental organization 3000 Fund balance 3010 Unrestricted fund balance 3020 Fund balance, credit program 3030 Fund balance, noncredit program Income Accounts 3100 Gain (loss) from current adjustments 3200 Surplus/(deficit) of income over expenditure 4200 Fee Income (non-credit) 4210 Classroom fees 4220 Income from other fees 4300 Bank and Investment Income 4310 Bank interest 4320 Investment income 4400 Income from Grants 4410 Restricted / Government 4420 Restricted / Private 4430 Unrestricted / Government 4440 Unrestricted / Private 4450 Individuals' Contributions 4500 Other Income 4510 Miscellaneous income 110

117 ANNEXES 5000 Financing Expenses 5010 Interest on loans 5014 Bank commissions and fees 5020 Interest on client savings 5030 Other financing costs 5100 Loss Provisions 5110 Loan loss provisions 5120 Interest loss provisions 5200 Personnel Expenses 5210 Salary Officers 5212 Salary Others 5214 Honoraria 5220 Payroll tax expense 5230 Health insurance 5232 Other insurance 5240 Vacation 5242 Sick leave 5250 Other benefits 5300 Office Expenses 5310 Office supplies 5312 Telephone/Fax 5314 Postage and delivery 5316 Printing 5320 Professional fees 5322 Auditing / Accounting fees 5324 Legal fees 5330 Other office expenses 5332 Insurance 5400 Occupancy Expenses 5410 Rent Expense Accounts 5420 Utilities 5430 Maintenance and Cleaning 5500 Travel Costs 5510 Airfare 5514 Public ground transportation 5516 Vehicle operating expenses 5520 Lodging costs 5530 Meals and incidentals 5540 Transport of goods 5542 Storage 5550 Miscellaneous travel costs 5600 Equipment 5610 Equipment rental 5620 Equipment maintenance 5630 Equipment depreciation 5640 Vehicle depreciation 5650 Leasehold amortization 5700 Program Expenses 5710 Instructional materials and supplies 5730 Books and publications 5740 Technical assistance 5800 Miscellaneous Expenses 5810 Continuing education 5820 Entertainment 5900 Non-operating income and expenses 5910 Gain/(Loss) on sale of investments 5920 Gain/(Loss) on sale of asset 5930 Federal taxes paid 5940 Other taxes paid 5990 Other 111

118 CARE MICROFINANCE HANDBOOK Annex 3: Inflation and Subsidy Adjustment Worksheet You get the inflation adjustment expense by multiplying the organization s equity by the inflation rate in effect this is the amount of equity that the MFI lost to inflation. You generate an inflation adjustment income by multiplying the value of fixed assets by inflation. The Net Inflation Adjustment is the difference between the two. Inflation Adjustment Previous Year s Equity $0,000,000 Inflation Rate x infl% 1. Inflation Adjustment Expense $ 00,000 Previous Year s Fixed Assets $000,000 Inflation Rate x infl% 2. Inflation Adjustment Income $ 00, Net Inflation Adjustment line 1 line 2 IMF, International Financial Statistics, line 64x Effects: Enter as a separate capital account, offsets change in profit IMF, International Financial Statistics, line 64x Effects: Increases Fixed Assets, Total Assets Effects: Usually increases Total Interest Expense, and decreases Net Operating Profits (Note: If fixed assets exceed equity, interest expense will decrease, profits will increase.) The cost of funds adjustment is used for organizations that have below market (i.e., subsidized) liabilities. To calculate the adjustment, take the average balance of liabilities and multiply it by a shadow price cost of funds The MicroBanking Bulletin uses the Deposit Rate. This shows roughly what the organization should have paid as a cost of funds. Subtract from that the actual cost of funds, and the difference is the adjustment. Additional adjustments should be made for cash and in-kind subsidies. Subsidy Adjustment Cost of Funds Adjustment 4. Balance of Liability, year-end 1999 $0,000, Balance of Liability, year-end 2000 $0,000, Average Balance of Liability (line 4 + 5)/2 Shadow Price (Deposit Rate) x deposit% Market Cost of Funds $000,000 Less Actual Interest Paid -$000,000 Cost of Funds Adjustment $000,000 Cash Donations Adjustment $000,000 In-kind Subsidy Adjustment $000,000 IMF, International Financial Statistics, line 601 Effect: Increases Total Interest Expense, decreases Net Operating Profits. Appears on the Balance Sheet as a separate capital account to offset change in profits. No change in Total Capital. Effect: Reduces Net Operating Profit, increases Net Non-Operating Profits Effect: Increases Total Administrative Expenses reduces Net Operating Profits. Source: The MicroBanking Bulletin 112

119 ANNEXES Annex 4: Sample Balance Sheet and Income Statement Balance Sheet Organization: As of: ASSETS 1 Cash 2 Interest-bearing Deposits Loans Outstanding 3 Loans Outstanding: Current 4 Loans Outstanding: Non-Performing 5 Loans Outstanding: Rescheduled 6 Total Loans Outstanding (Loan Loss Reserve) 8 Net Loans Outstanding Accounts Receivable 10 Other Current Assets 11 TOTAL CURRENT ASSETS Long-term investments 13 Property and Equipment 14 (Accumulated Depreciation) 15 Net Property and Equipment TOTAL LONG-TERM ASSETS TOTAL ASSETS LIABILITIES AND CAPITAL LIABILITIES 18 Short-term Debt 19 Client Savings: Passbook 20 Client Savings: Time deposits 21 Deferred Revenue 22 Payables 23 TOTAL CURRENT LIABILITIES Long-term Debt 27 Other Long-term Liabilities 28 TOTAL LONG-TERM LIABILITIES TOTAL LIABILITIES CAPITAL 30 Grant Capital 31 Shareholder Capital/Paid In Capital 32 Excess (Deficit) of Income over Expenses (prior years) 33 Excess (Deficit) of Income over Expenses (current year) 34 TOTAL CAPITAL TOTAL LIABILITIES AND CAPITAL

120 CARE MICROFINANCE HANDBOOK Income Statement Organization: Period: Cumulative for Year FINANCIAL INCOME 1 Interest Income on Loan Portfolio 2 Loan Fees and Service Charges 3 Penalties on Loans 4 Total Loan Income Income from Investments 6 Income from Other Financial Services 7 Total Other Financial Income Total Financial Income FINANCIAL COSTS OF LENDING FUNDS 9 Interest on Borrowed Funds 10 Interest Paid on Deposits 11 Total Financial Costs GROSS FINANCIAL MARGIN Provision for Loan Losses 14 NET FINANCIAL MARGIN OPERATING EXPENSES 15 Salaries and Benefits 16 Office Supplies 17 Communication 18 Rent & Utilities 19 Fuel, Travel Costs and Vehicle Maintenance 20 Depreciation 21 Training 22 Other Costs and Services 23 Bank Fee 24 Total Operating Expenses Sum NET INCOME FROM OPERATIONS NON FINANCIAL INCOME 26 Operating Grant Income 27 Non-financial Services Income 28 Total Non-financial Income EXCESS (DEFICIT) OF INCOME OVER EXPENSES

121 ANNEXES Bibliography Bartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios I: Analyzing Profitability in Microcredit Programs. GEMINI Technical Note No. 7. Bethesda, MD: Development Alternatives, Inc. Website: Bartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios II: Analyzing for Quality and Soundness in Microcredit Programs. GEMINI Technical Note No. 8. Bethesda, MD: Development Alternatives, Inc. Website: Berenbach, Shari and Craig Churchill (1997). Regulation and Supervision of Microfinance Institutions: Experience from Latin America, Asia and Africa. Occasional Paper No. 1. Washington DC: MicroFinance Network. Available from PACT Publications. Berenbach, Shari and Diego Guzman (1992). The Solidarity Group Experience Worldwide. Monograph No. 7. Washington DC: ACCION International. Website: Brand, Monica (1998). New Product Development for Microfinance: Evaluation and Preparation. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Brand, Monica (1999). New Product Development for Microfinance: Design, Testing and Launch. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Brand, Monica and Julie Gerschick (2000). Maximizing Efficiency: The Path to Enhanced Outreach and Sustainability. Monograph No. 12. Somerville, MA: ACCION International. Website: Brown, Warren and Geetha Nagarajan (2000). Disaster Loan Funds for Microfinance Institutions: A Look at Emerging Experience. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Campion, Anita (2000). Improving Internal Control: A Practical Guide for Microfinance Institutions. Technical Note No. 1. Washington DC: MicroFinance Network. [email protected]. Available from PACT Publications. [email protected]. Campion, Anita and Cheryl Frankiewicz (1999). Guidelines for the Effective Governance of Microfinance Institutions. Occasional Paper No. 3. Washington DC: The MicroFinance Network. [email protected]. Available from PACT Publications. [email protected]. Castello, Carlos, Katherine Stearns and Robert Peck Christen (1991). Exposing Interest Rates: Their True Significance for Microentrepreneurs and Credit Programs. Discussion Paper No. 5. Somerville, MA: ACCION International. Website: CGAP (1999). External Audits of Microfinance Institutions: A Handbook. Technical Tool Series No. 3. Washington DC: CGAP. Website: Available from PACT Publications. CGAP (2001). Disclosure Guidelines for Financial Reporting by Microfinance Institutions. Washington DC: Consultative Group to Assist the Poorest. Website: Christen, Robert Peck (1997). Banking Services for the Poor: Managing for Financial Success. Somerville, MA: ACCION International. Website: Churchill, Craig F. (1997). Managing Growth: The Organizational Architecture of Microfinance Institutions. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Churchill, Craig F. (1999). Client-Focused Lending: The Art of Individual Microlending. Toronto: Calmeadow. Website: Available from PACT Publications. [email protected]. 115

122 CARE MICROFINANCE HANDBOOK Churchill, Craig F. and Sahra S.Halpern, (2001). Building Customer Loyalty: A Practical Guide for Microfinance Institutions. Technical Note No. 2. The MicroFinance Network: Washington DC. [email protected]. Available from PACT Publications. [email protected]. Churchill, Craig F. ed. (1998). Moving Microfinance Forward: Ownership, Competition and Control of Microfinance Institutions. Washington DC: MicroFinance Network. [email protected]. Available from PACT Publications. [email protected]. Doyle, Karen (1998). Microfinance in the Wake of Conflict: Challenges and Opportunities. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Gheen, William E., Diego Jaramillo and Nathalie Pazmino (1999). Measuring Unit Loan Costs, in The MicroBanking Bulletin, July 1999, Issue No. 3. Website: Available from PACT Publications. [email protected]. Ledgerwood, Joanna (1996). Financial Management Training for Microfinance Organization: Finance Study Guide. Toronto: Calmeadow. Website: Available from PACT Publications. [email protected]. Ledgerwood, Joanna (1999). Microfinance Handbook: An Institutional and Financial Perspective. Washington DC: The World Bank. [email protected]. Ledgerwood, Joanna and Kerri Moloney (1996). Financial Management Training for Microfinance Organization: Accounting Study Guide. Toronto: Calmeadow. Website: Available from PACT Publications. [email protected]. Mainhart, Andrew (1999). Management Information Systems for Microfinance: An Evaluation Framework. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Nagarajan, Geetha (1998). Microfinance in the Wake of Natural Disasters: Challenges and Opportunities. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Rhyne, Elizabeth and Robert Peck Christen (1999). Microfinance Enters the Marketplace. Monograph. Washington DC: USAID. Website: Rock, Rachel, Maria Otero and Sonia Saltzman (1997). From Margin to Mainstream: The Regulation and Supervision of Microfinance. Monograph No. 11. Somerville, MA: ACCION International. Website: Rock, Rachel, Maria Otero and Sonia Saltzman (1998). Principles and Practices of Microfinance Governance. USAID s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website: Rosenberg, Richard (1996). Microcredit Interest Rates. CGAP Occasional Paper, No. 1. Washington, DC, USA: Consultative Group to Assist the Poorest. Website: Rosenberg, Richard and Robert Peck Christen (2000). The Rush to Regulate: Legal Frameworks for Microfinance. Occasional Paper No. 4. Washington DC: CGAP. Website: SEEP Network (1996). Village Banking: The State of the Practice. New York: United Nations Development Fund for Women. Website: SEEP Network (2000). Learning from Clients: Assessment Tools for Microfinance Practitioners. USAID AIMS Project. Draft Manual. Website: SEEP Network and Calmeadow (1995). Financial Ratio Analysis of Micro-Finance Institutions. New York: PACT Publications. [email protected]. SEEP Network (1993). An Institutional Guide for Enterprise Development Organizations. New York: PACT Publications. [email protected]. 116

123 ANNEXES Sheldon, Tony and Charles Waterfield (1998) Business Planning and Financial Modeling for Microfinance Institutions. Washington, DC, USA: Consultative Group to Assist the Poorest. Website: The MicroBanking Bulletin. A semi-annual publication. [email protected]. Website: Valenzuela, Liza (1998). Overview on Microfinance Fraud, in Craig Churchill, ed., Moving Microfinance Forward: Ownership, Competition and Control of Microfinance Institutions. Washington DC: MicroFinance Network. [email protected]. Available from PACT Publications. [email protected]. Van Gruening, Hennie, Joselito Gallardo and Bikki Randhawa (1998). A Framework for Regulating Microfinance Institutions. Working Paper 206. Washington DC: The World Bank. [email protected]. Waterfield, Charles and Ann Duval (1996). CARE Savings and Credit Sourcebook. Available from PACT Publications. [email protected]. Waterfield, Charles and Nick Ramsing (1998). Handbook for Management Information Systems for Microfinance Institutions, CGAP Technical Tool Series No. 1. Website: Yaron, Jacob, McDonald Benjamin, and Gerda Piprek (1997). Rural Finance Issues, Design and Best Practices. Washington DC: The World Bank. [email protected]. 117