The Crucial Role of Proactive Risk Management in Microfinance Institutions

Proactive risk management is essential to the long-term sustainability of microfinance institutions (MFIs), but many microfinance stakeholders are unaware of the various components of a comprehensive risk management regimen. It is important for the board of directors and managing directors who play the most active role in the MFI’s oversight, and lay down guidelines for implementing the core principles of effective risk management into the MFI’s culture and operations.

Risk is an integral part of financial services. Finance institutions should neither avoid risk (thus limiting their scope and impact) nor ignore risk (at their folly). Like all financial institutions, microfinance institutions (MFIs) face risks that they must manage efficiently and effectively to be successful. If the MFI does not manage its risks well, it will likely fail to meet its social and financial objectives. When poorly managed risks begin to result in financial losses, donors, investors, lenders, borrowers and savers tend to lose confidence in the organization and funds begin to dry up. When funds dry up, an MFI is not able to meet its social objective of providing services to the poor and quickly goes out of business.

As MFIs play an increasingly important role in local financial economies and compete for customers and resources, the rewards of good performance and costs of poor performance are rising. Those MFIs that manage risk effectively – creating a systematic approach that applies across product lines and activities and considers the aggregate impact or probability of risks – are less likely to be surprised by unexpected losses (down-side risk) and more likely to build market credibility and capitalize on new opportunities (up-side risk).

The core of risk management is making educated decisions about how much risk to tolerate, how to mitigate those that cannot be tolerated, and how to manage the real risks that are part of the business. For MFIs that evaluate their performance on both financial and social objectives, those decisions can be more challenging than for an institution driven solely by profit. A risk management framework allows senior managers and directors to make conscious decisions about risk, to identify the most cost-effective approaches to manage those risks, and to cultivate an internal culture that rewards good risk management without discouraging risk-taking.

For example, highly successful MFIs, such as BRAC in Bangladesh, the Alexandria Business Association (ABA) in Egypt, and BancoSol in Bolivia, perform well because they have internal early warning systems and management responses that prevent small problems from exploding into large ones. But even among top performers, the focus is often on credit risk, and less on equally important risks such as funds management and liquidity.

Major Risks to Microfinance Institutions
Many risks are common to all financial institutions. From banks to unregulated MFIs, these include credit risk, liquidity risk, market or pricing risk, operational risk, compliance and legal risk, and strategic risk. Most risks can be grouped into three general categories: financial risks, operational risks and strategic risks, as shown below:

Financial Risks 

Credit Risk 
Transaction risk 
Portfolio risk 
Liquidity Risk 
Market Risk 
Interest rate risk 
Foreign exchange Risk 
Investment portfolio risk 

Operational Risks 

Transaction Risk
Human resources Risk 
Information & technology risk 
Fraud (Integrity) Risk 
Legal & Compliance Risk 

Strategic Risks 

Governance Risk
Ineffective oversight 
Poor governance structure 
Reputation Risk 
External Business Risks
Event Risk