 |
|
Financial and Risk Management | |
| Asset Liability Management (ALM) | The process of planning, monitoring and controlling asset and liability volumes, maturities, rates and yields. A primary goal of ALM is to minimize interest rate risk while still earning sufficient profits. ALM is more important and complex for institutions engaged in financial intermediation because interest rate risk tends to be higher for these institutions than for institutions engaged solely in credit or savings. Financial institutions manage interest rate risk by carefully maintaining a balance between different types and volumes of assets (in particular, loans) and liabilities (in particular, savings).
For example, time deposits tend to be interest rate sensitive. If a financial institution’s competitors raise the interest rates offered on time deposits, the institution will likely have to follow suit to ensure that time deposit holders will maintain their deposits in that institution. If the institution does not raise the interest rate offered on time deposits, it risks losing the deposit to higher paying competitors upon maturity. In order to increase the interest rate paid out, securing the continued source of funding, and still maintain the same level of profitability, the institution must also simultaneously charge a higher rate of interest on a similar volume of loans or other assets. This is at the core of managing interest rate risk: to maintain the interest rate spread, changes in interest rates for a given volume of assets must be matched in time with changes in interest rates for a similar volume of liabilities. This process of matching is a key component of asset liability management. |
| Deposit Insurance | Insurance to reimburse depositors for the loss of their deposits in the event that their financial institution fails. Deposit insurance is typically provided by government as an adjunct to regulation and supervision. It may also be required by regulation but provided by private insurers. Deposit insurance does carry a risk: by assuring that depositors will not lose their savings if a bank goes under, it can 1) undermine depositors’ motivation to oversee the institutions in which they deposit and 2) encourage managers to take on more risk than they otherwise would if the deposits were not insured.
(From Robert Peck Christen and Richard Rosenberg, “The Rush to Regulate: Legal Frameworks for Microfinance,” CGAP Occasional Paper No. 4, 2000, p.22) |
| Financial Intermediation | The process of mobilizing deposits and disbursing them as loans to clients or investing them in other types of financial instruments. Managing financial intermediation is significantly more demanding than managing credit alone. In particular, maintaining the quality of assets is more important in order to protect the value of deposits and managing liquidity, internal controls and assets vis-à-vis liabilities are more challenging. |
| Interest Rate Risk | The risk associated with changes in market interest rates that can harm a financial institution’s profitability. A financial institution exposes itself to interest rate risk when it mobilizes deposits at one interest rate and lends them out at another.
For example, an increase in market interest rates on deposits might force a financial institution to immediately increase the interest rate it pays on deposits in order to remain competitive and continue to attract deposits. At the same time, if the institution’s earning assets are concentrated in long-term, fixed-rate loans, it does not have the immediate option of increasing the interest rate it charges on these loans. Because the financial institution cannot increase its interest income from loans as fast as its cost of funds is rising, profitability will decrease and it could even face a shortfall in operating funds. Alternatively, if the market interest rate charged on loans drops, a financial institution could be squeezed since it cannot drop the rate it pays out on deposits below zero; in this case, it may be limited to covering costs with fee income. Institutions that have the capacity and regulatory approval to do so lend on a variable rate basis to reduce interest rate risk by adjusting loan rates as deposit rates change. |
| Interest Rate Spread | The difference between the rate the financial institution pays for deposits and the rate it charges for loans. In a financially sustainable institution, this spread is large enough to cover operating costs, the opportunity cost of holding liquid reserves that earn no or low interest, losses in the value of the institution’s assets due to inflation, the cost of provisions for loan and investment losses and capitalization |
| Internal Controls | Policies and procedures designed to minimize and monitor operational risks, in particular the risks of fraud and mismanagement. Because the unpredictable size and timing of cash deposits make financial institutions particularly vulnerable to fraud and errors, institutions that mobilize deposits must implement rigorous internal control policies and procedures. Essential controls include: board approval and monitoring of information; rotation and segregation of duties; dual control of safes and vaults; established limits on cash holdings and expenditures; signature requirements; cash management procedures; daily balancing of cash drawers with the general ledger; receipts for all transactions; restricted access to offices and assets; periodic physical inventory of assets and cash counts; internal operational reports that are timely, easy to understand and concise; accounting that complies with local accounting law and is consistent from one period to the next; sequential numbering of documents; an adequate audit trail; a secure management information system; and periodic reconciliation of the general ledger totals with bank statements or other subsidiary ledgers.
Internal controls should be supported by a culture that strongly discourages fraud and mismanagement; documented, clear and concise policies and procedures; job descriptions that clearly allocate responsibilities and accountabilities; transparent accounting practices and an adequate management information system that provides accurate and timely information; effective internal supervision, including routine audits and spot checks; and internal audit functions performed by a qualified individual(s) who reports directly to the board of directors. |
| Liquidity Management | The process of effectively balancing between two requirements: 1) satisfying all cash outflow requests and reserve requirements without having to sell assets at a loss or borrow at a high cost; and 2) holding enough assets in forms that earn sufficient interest to assure that operations are viable.
Financial institutions use tools such as cash flow forecasting and ratio analysis to project future liquidity needs and monitor current liquidity levels. They also arrange reliable options for obtaining liquid funds quickly when needed (a line of credit for example) and for safely investing excess liquid funds at reasonable rates of return. One ratio used to monitor liquidity levels is the liquidity adequacy ratio, which measures the ability of the financial institution’s liquid cash reserve to satisfy client savings withdrawal demands after meeting all immediate obligations. It is defined as: (Short term-assets – short-term liabilities) / Savings deposits Short-term assets are defined as total liquid assets with a maturity of less than 30 days. Short-term liabilities are defined as total short-term payables due in less than 30 days. Savings deposits are defined as total member deposits (all types). Under normal operating conditions (not considering seasonal demands), the liquidity adequacy ratio should be between 10% and 15% to meet operational liquidity demands without negatively impacting profitability. Whatever techniques are used, liquidity management policies and procedures should be clearly defined and documented. |
| Liquidity Reserve Requirements | Government regulations mandating the percentage of deposits that a financial institution must set aside as liquid reserves to be able to meet withdrawal demands. The reserve rate affects the viability of the institution in two ways. First, by improving the likelihood that depositors will be able to withdraw their funds when they want to, reserves protect the institution from the risk of a liquidity crisis and insolvency. Second, reserves often earn no or little interest, so if the reserve rate is high, the financial institution must compensate by obtaining a higher return when it invests the rest of its deposits. In some countries, non-bank deposit taking institutions are required to deposit their liquidity reserves in local banks or in a central finance facility. In these cases, the returns are determined by the reinvestment market, and are still likely to be lower than the returns on lending or long-term investments. |
| Liquidity Risk | The risk that a financial institution will not have enough liquid assets to meet the demand for cash outflows, including saving withdrawals, loan disbursements, and payment of operating expenses. A lack of liquidity can put a quick and final end to a financial institution’s efforts to mobilize deposits – and, in the worst case, can cause it to collapse or close. Deposit mobilization requires clients to trust that they will always be able to access their savings when they want or need them. A financial institution invests significant time and resources instilling this trust in clients, but a liquidity crisis can destroy it instantly. |
| Regulation | Government laws and rules that govern financial institutions. While credit-only institutions lend out capital belonging to other institutions (second-tier lenders), financial intermediaries, by definition, put the savings of individuals and institutions at risk, since they use them to finance their loan portfolios. For this reason, governments tend to focus their efforts on regulating financial intermediaries that mobilize deposits rather than on financial institutions that provide credit services only.
There are two kinds of regulation: non-prudential and prudential. In non-prudential regulation, the financial sector authority (regulator) does not vouch for or assume responsibility for the soundness of the “regulated” institutions. Non-prudential regulatory techniques may include: registration and legal chartering of licensed entities; disclosure of ownership or control; reporting or publication of financial statements; norms for the content and presentation of such statements; accounting and audit standards; transparent disclosure of interest rates to consumers; external audits; submission of names of borrowers and status of their loans to a central credit information bureau; and interest rate limits. Enforcement of non-prudential regulations seldom involves regular supervision or on-site inspection. Prudential regulation is generally set out and enforced by the financial sector regulator; it defines detailed standards for financial structure, accounting policies, and other important dimensions of a financial institution’s business. Prudential regulations will include requirements for liquidity, capital adequacy, loan-loss provisioning and loan diversification, as well as limits on delinquency and non-earning assets. Compared to non-prudential regulations, enforcing prudential regulations requires more intensive reporting as well as on-site inspection that goes beyond the scope of normal financial statement audits. Because supervisory resources are often limited, enforcing prudential regulations for a multitude of small institutions can be problematic for regulators. (Christen and Rosenberg, p.9) |
| Risk Management | A systematic approach to identifying, measuring, monitoring and managing business risks in an institution. Effective risk management includes the following steps: 1) Identify, assess and prioritize risks; 2) Develop strategies to measure risk; 3) Design policies and procedures to mitigate risks based cost/benefit analyses of different measures; 4) Implement and assign responsibility for policies and procedures; 5) Test their effectiveness and evaluate the results; and 6) Revise policies and procedures as needed. The operational risks that financial institutions must manage include credit risk, liquidity risk, interest rate risk, reputation risk, transaction risk (the risk of financial loss due to negligence, mismanagement or errors), and fraud risk.
(Anita Campion, “Improving Internal Control: A Practical Guide for Microfinance Institutions,” MicroFinance Network with GTZ, 2000, pps. 2, 5, 8-10.) |
| Supervision | Systematic oversight of deposit-taking financial service providers to make sure that they comply with the regulations governing them, or to close them if they do not. Supervision plays a crucial role in protecting depositors from losses due to mismanagement or fraud. Typically, regulatory agencies have very limited resources yet are responsible for assuring the stability of the country’s financial system. As a result, policy makers must balance systemic risk and the costs of supervision to make the best use of scarce supervisory resources.
The cost of prudential supervision is high relative to the size of most microfinance institutions. This presents a challenge: how to effectively supervise the microfinance sector to protect the savings of small depositors without placing excessive cost burdens on either the regulator or the microfinance institutions. In many cases, policy makers prioritize the regulation of financial institutions that hold large volumes of deposits and/or accounts for large numbers of the population. (Christen and Rosenberg, p.1) |
Types of Savings Services | |
| Compulsory / Mandatory Savings | Savings payments that are required as part of loan terms or as a requirement for membership, usually in a credit union, cooperative, microfinance institution, village bank or savings group. Compulsory savings are often required in place of collateral. The amount, timing, and level of access to these deposits are determined by the policies of the institution rather than by the client. Compulsory savings policies vary: deposits may be required weekly or monthly, before the loan is disbursed, when the loan is disbursed, and/or each time a loan installment is paid. Clients may be allowed to withdraw at the end of the loan term; after a set number of weeks, months or years; or when they terminate their memberships. |
| Contractual / Programmed Savings | Savings in which the client commits to regularly depositing a fixed amount for a specified period of time to reach a pre-determined goal. After the maturity date, the client can withdraw the entire amount plus the interest earned. Early withdrawal is prohibited or penalized. Contractual products help depositors accumulate funds to meet specific expected needs, such as expenses associated with school, a festival, a new business, an equipment purchase, or a new house. They also help financial institutions better predict the volume and timing of deposits and withdrawals. |
| Current Accounts | Demand deposit accounts that allow the accountholder to transact using checks. Accountholders can also transact face-to-face in the branch and may be able to use ATMs or point of service devices. |
| Demand / Sight Deposit | Fully liquid accounts in which the saver may deposit and withdraw any amount at any time with no advance commitment. The saver must maintain a minimum required balance. Demand deposit transactions (deposits, withdrawals, transfers/payments) may be made using passbooks, debit cards and ATMs and/or POS devices, and, in current accounts, checks. If clients overdraw their demand deposit accounts, financial institutions generally charge penalties and/or high levels of interest if they do not reject the payment outright. |
| Informal Savings | Savings held outside of a formal financial institution. Informal savings mechanisms include saving at home – in cash or kind, savings groups, rotating savings and credit associations (ROSCAs), accumulating credit and savings associations (ASCAs), through reciprocal savings and lending with neighbors or relatives, and with money guards (friends or relatives willing to hold a saver’s money for a period) or informal sector deposit collectors (people who charge a fee to hold a saver’s money for a determined period). Informal savings devices are often highly convenient but may be unreliable, insecure and/or illiquid. A financial institution should have a solid understanding of the local informal savings market before it attempts to develop savings services for poor people. |
| Passbook Accounts | Demand deposit accounts that use passbooks rather than checks, ATMs or point of service devices for transactions. |
| Savings / Regular Savings Accounts | Demand deposit accounts that use passbooks, magnetic stripe or smart cards, ATMs, POS devices or some combination of these for transactions. They do not allow accountholders to use checks. |
| Term / Time Deposit / Certificate / Fixed Deposit | A savings product in which a client makes a single deposit that cannot be withdrawn for a specified period of time. At the appointed time, the client withdraws the entire amount with interest. The financial institution offers a range of possible terms and usually pays a higher interest rate than on its demand deposit or contractual products. Because they tend to be larger than other types of deposits, have contracted withdrawal times, and involve fewer transactions, time deposits can provide a significant source of relatively low-cost funds that facilitate ALM. This is particularly true if an MFI can attract large and institutional depositors. |
Types of Savings Institutions | |
| Accumulating Savings and Credit Associations (ASCAs) | Informal savings groups that resemble ROSCAs but are slightly more complex. In an ASCA, all members regularly save the same fixed amount while some participants borrow from the group. Interest is usually charged on loans. ASCAs require bookkeeping because the members do not all transact in the same way. Some members borrow while others are savers only, and borrowers may borrow different amounts on different dates for different periods. If members pay interest on their loans, the return to savings has to be individually calculated and fairly shared among the group. |
| Credit Union / Savings & Credit Cooperative / Financial Cooperative | Not-for-profit member-owned financial institutions that are 1) governed by a board of directors comprised of members and 2) typically managed by paid staff who may or may not be assisted by volunteer committees of members. The board is elected by the members, each of whom has one vote. Credit unions and financial cooperatives are typically savings-based, i.e. they fund their loan portfolio with member deposits as opposed to external financing.
Credit unions and financial cooperatives must be registered; they may be regulated by a special cooperative law or by the formal financial sector regulations in a country. Standards set out in cooperative law may be somewhat easier to meet than those in the country’s banking law; for example, the capital adequacy requirements—if they exist—may be lower. At the same time, cooperatives may not be allowed to offer the same range of services as banks; they may not, for example, be allowed to offer current accounts. Where credit unions and financial cooperatives are regulated by the same entity as other financial institutions, they must comply with regulations issued either specifically for financial cooperatives or more generally for non-bank financial entities. |
| Rotating Savings and Credit Associations (ROSCAs) | Informal savings and credit groups in which each member deposits the same amount of money at the same regular interval; each time members deposit, they give the whole of the amount collected to one member. When there have been as many distributions as there are members, the ROSCA ends. Everyone has put in and taken out the same amount; for example, ten people each save $10 a week, and each week for ten weeks one person walks away with $100. |
| Savings / Self-Help Groups | Found everywhere, but especially in South Asia, savings groups provide their members with a mandatory illiquid savings service coupled with access to loans. Composed of about five to twenty members, each group meets monthly or weekly close to members’ homes. At each meeting all members save the same amount. The groups then lend these savings to members, store them in a lockbox, or deposit. |