For MFIs

In the context of Micro Finance Industries in India, Over indebtedness is widely seen to be symptomatic of deeper difficulties in the industry: an excess of lending capacity created by over-expansion and the arrival of new entrants, a lack of professionalism within MFIs, and an emphasis on growth and profit at the expense of prudence. It is also linked to the credit risk, which relates to the heavy exposure of MFIs to the lending business at a time of economic uncertainty and bank unpopularity.

The Indian response was dominated by the fall-out from the political controversies over the last two years, notably the anti-microfinance movement in Andhra Pradesh. This propelled political risk to second position in the list, the highest of any geographic grouping. The concern focused on the potential consequences of the controversy, the risk of loss of liquidity and funding as investors and banks shy away. Toughening regulation was also a high level preoccupation.

Corporate governance and management quality issues remain a high priority.

It is said that “the biggest risk to the microfinance industry currently is a reputational one. Many bad actors have been appropriately revealed, and now the burden of proof is on the microfinance industry to prove it is well governed and making a difference in people's lives”. Compared to other regions, concerns about over indebtedness and credit risk are lower down the ranking. India has imposed controls on multiple lending which are having an effect. Concern about the macro-economic situation is also low. In Bangladesh, home of microfinance, there were also concerns about the standing of the industry, though problems with staffing were high on the list. A senior director at one of the large MFIs said that the main risk facing the industry was “the inadequate availability of competent human capital to perform and lead its development”.

The Top TEN Critical Issues facing MFIs, in India in 2011-12 were :

  • Liquidity
  • Corporate Governance
  • Political Interference
  • Management Quality
  • Regulation
  • Client Management
  • Over indebtedness
  • Too little Funding
  • Credit Risk
  • Quality of Risk Management
Liquidity :

Liquidity risk relates to the ability of MFIs to finance the short-term cash needs of their business, and is a classic anticipatory risk: even financial institutions with a strong liquidity position worry that conditions could change for the worse overnight for political as well as economic reasons. Those at risk are particularly the smaller MFIs who may be less favoured by providers of liquidity, or who lack treasury skills to manage their liquidity needs. Some opine that there was not a shortage of liquidity but a glut, particularly where it encouraged MFIs to lend too liberally. However, most microfinance banks have a poor fund utilization ratio and plenty of cash for operations”.
Corporate Governance :

Corporate Governance and management are the two key factors which can differentiate stronger from weaker microfinance providers, and they are typically in short supply. Poor governance encourages Microfinance’s growing army of political and media critics at a time when the industry was already going through a difficult period. One of the other concerns was that the resulting reputational damage would deter investors and donors.
Political Interference :

This risk kept its high ranking from the last survey when it was driven largely by concern about events in Andhra Pradesh. The severity of this risk depends almost entirely on the country in question. In that political risk can take many forms. It often stems from the political pressures on a particular government and the type of people who borrow from MFIs. Even in countries where governments do not attack microfinance outright, they may create political risk by interfering with market mechanisms, setting interest rates, creating regulatory uncertainty and tilting the playing field. A third point is that some governments have a positive role to play in the microfinance industry, setting rules and creating the right environment. So, in some cases, interference can also be well-intentioned and constructive.
Management Quality :

“Quality of Leadership is the key differentiator among MFI.”
The Focus on the shortage of skilled personnel, which is increasingly a feature of the microfinance business as it expands, is that managers are good at delivering growth, but less good at “capacity building”, i.e. putting MFIs on a sustainable long term growth path.
With the expansion of the financial services and capital markets in emerging/developing economies, there is an increased demand for qualified management with escalating compensation which is more than MFIs can afford - so they will lose good trained staff if they cannot - a major risk as the pool of good local management and salespersons remains insufficient for a fast-growing industry. Plus, new constraints on financial literacy and client protection will put an additional stress on the staff skills.
Regulation :

This is a risk that varies greatly from one country to the next. 
Though Regulation in the MFI is generally getting better, concern persists about over-regulation of the microfinance industry as much as it does about the absence of good regulation. The perception by governments has begun to change globally, and there are more regulations restricting operators now, bringing microfinance closer to mainstream banking. Unfortunately, this has also meant that operational costs are increasing in order to meet the regulations and thus access to finance is limited. Another factor is that microfinance institutions suffer from a bad reputation and as microfinance becomes bigger and more complex, all these issues are likely to grow rather than recede, causing many respondents to see regulation as an advancing rather than receding risk.
Efforts are needed to inspire confidence so that MFIs can operate safely and show that they can compete with Banks.
Client Management :

The risk in poor Client Management is defined as “the risk that microfinance providers will lose business by failing to understand or communicate with their clients, or by failing to develop appropriate products”. It is reflected in the view that recent market crises stemmed, at least in part, from precisely that risk.
The biggest risks to the microfinance industry are related to inadequate attention to the wants and needs of the client. This has contributed to pushing inappropriate products, often resulting in over indebtedness and a product mismatch. Further, this has resulted in a lack of client protection through acts of commission (such as aggressive/abusive sales and collections practices) or omission (such as lack of transparency in pricing and absence of recourse mechanisms). The resulting risks to the industry take the form of credit risk and reputation risks. Many microfinance institutions seem to have too little understanding of the true repayment capacity of clients – experts say – and some others – "many microfinance providers are living an illusion that they are close to their clients when in reality they have no clue who their customer is. Otherwise why would we have an over indebtedness problem and multiple cross borrowings?" But the real challenge is ensuring that the wealth of information on clients held by loan or field officers, feeds back into product development by the institution. If done effectively, this could be a serious competitive advantage to the microfinance provider.
Part of developing appropriate products for clients entails treating clients with respect and dignity. The bad treatment that some companies are giving clients has generated resentment towards the industry, and thus, increased the probability of clients viewing lenders as loan sharks and not as a source of social benefit.
Over indebtedness :

Although the exact scale of over indebtedness is not precisely known, the perception is strong that growing numbers of microfinance users are in danger of borrowing beyond their capacity to repay. For the majority of our respondents, this trend is causing financial as well as reputational damage to the industry at a time when it is already facing criticism about its effectiveness. Over indebtedness can often be traced to multiple lending (or more, accurately, multiple borrowing) when customers take out several loans from different lenders for a variety of motives: to increase available cash, to pay off existing loans, or simply to take advantage of competition among lenders.The growth in multiple lending was blamed by many respondents on the lack of credit reference bureaux and accurate data on people's borrowing commitments. But responses also reflected the view that MFIs have become less diligent about checking out the financial position of potential borrowers, simply because they want the business. But while overindebtedness has received a high score, the size of the problem is hard to judge. However, if overindebtedness is a smaller problem than many think, there is clearly a wide perception gap, even among practitioners and close analysts of the industry. Judging by the results, the prevailing view is that overindebtedness is big and possibly growing. This contains risks of its own, notably that the industry may be suffering unnecessary reputation damage.
Too little Funding :

After a period of abundant funding, microfinance is beginning to feel the pinch. The fall-out from the financial crisis, plus the controversies surrounding the business have reduced the flow of funds to the sector, and created anxieties On the donor side, aid budgets are being cut back. Private investors are having greater difficulty raising funds, and the commercial banks have become more tight-fisted with their loans, all of which makes life more difficult for MFIs, particularly those at the smaller end of the scale. 
On the donor side, aid budgets are being cut back. Private investors are having greater difficulty raising funds, and the commercial banks have become more tight-fisted with their loans, all of which makes life more difficult for MFIs, particularly those at the smaller end of the scale.A concern facing investors is whether microfinance can sustain its attractive returns given the risk of mounting loan losses and tighter political constraints on its activities.  
A particular worry in this regard is India where the Andhra Pradesh affair has led to much tougher regulation, including caps on interest rates. Despite the best efforts of the MFIs and the central regulator, banks have not yet fully resumed funding to MFIs. Foreign investors have also shied away from the sector owing to the inherent political risks and devoid of sources of funding, smaller MFIs may be forced to shut up shop. Funding also creates an opportunity for banks to move in “offering the full range of financial services, and a 'ladder' for clients to graduate to 'grown-up' banking rather than remaining in the ghetto of microfinance”. 
Credit Risk :

For the first time in three years, credit risk does not occupy the top position in the MFI ranking. But this is only partly good news because the focus in this area has narrowed to concern about over indebtedness, which has emerged as the most serious risk facing the industry. The majority feel that it results from management failings of various kinds: poor response to competitive pressure, weak internal controls, poor credit assessment, badly structured incentive schemes, and poor procedures for dealing with arrears and defaults. There is a tendency by borrowers to misunderstand terms and conditions associated with loans, and to miscalculate their ability to repay them. It is felt that few people really take advantage of their loans, i.e. by managing their affairs so as to be able to repay them. They do not hesitate to take out a further loan at another MFI and so on. Ultimately, this ends up in a vicious circle. Poor borrowers, in some countries, leave their communities and break the relationship with the microfinance institute, and as a result their loan becomes overdue forever. However, analysts feel that such risks are low. Small businesses are more concerned about paying their debts, to maintain access to credit that will grow. This augurs well for MFI Credit Assessment. 
Quality of Risk Management :

It is widely felt that there is a low level of risk awareness in many MFIs, particularly the smaller, less sophisticated ones. But where such awareness existed, there were often inadequate risk management skills - and even a view that risk management itself was costly and unnecessary. This is seen to be an area of management weakness. Although controls are in place at most institutions, it is important that these are considered to be beneficial management tools to improve the performance of the institution. Often, however, textbooks and other devices exist, but are not understood by the staff”.
While many believed that poor risk management is caused by inadequate resources and training, some argued that the problem lay deeper, in a lack of conviction among MFI boards and management about its value. The challenge is more action about these risks: how to improve information systems, human resources, governance, and finances to prevent and then deal with such risks.