Download - Mf Management5sept08
-
7/28/2019 Mf Management5sept08
1/34
5th September 2008
PRESENTATION DOCUMENT
Introduction to Risk ManagementBank of Lao - Session 4 of 4ASSET / LIABILITY MANAGEMENT
-
7/28/2019 Mf Management5sept08
2/34
- 1 -
What is risk management and why does it matter to us?
Capital Structure Overview
Capital Structure Overview
What is risk?
What is risk?
How do we manage risk?
How do we manage risk?
What does this mean for us?
What does this mean for us?
1
1
2
2
3
3
4
4
-
7/28/2019 Mf Management5sept08
3/34
- 2 -
1. Capital Structure Overview
1. Capital Structure Overview
3. How do we manage risk?
3. How do we manage risk?
4. What does this mean for
us?
4. What does this mean for
us?
2. What is risk?
2. What is r isk?
-
7/28/2019 Mf Management5sept08
4/34- 3 -
Capital is the basis of a financial institutionThere are three types of capital
Invested capital, Institutional capital (retained earnings and reserves), Debt capital
Capital serves a variety of purposes
A source of security and a buffer against risk and losses
A resource for expansion and growth
Capital must be, and remain, adequate to cover liabilities and losses (expected and
unexpected) Capital must grow in proportion to assets to serve more customers with loans and maintain
capital adequacy
Capital Structure
Overview
Capital Structure
Overview11
Capital to risk-weighed assets =
Invested capital + reserves + retained earnings
Risk-weighted assets
with 0% weight to cash, government securities and 100% weight to unsecured loans
Source: Ledgerwood
-
7/28/2019 Mf Management5sept08
5/34- 4 -
Liabilities Capital
Savings
Debt
Using its capital, a banking institut ion can borrow to acquire assets,
including loans to clients. The balance sheet shows how this is done. . .
Other peoples
money
Our money
Assets
Performing
assets
Other Assets
Capital Structure
Overview
Capital Structure
Overview11
Assets = Liabilities + Net worth
(Capital)
-
7/28/2019 Mf Management5sept08
6/34
- 5 -
The balance sheet shows how this is done
Capital Structure
Overview
Capital Structure
Overview11
Assets = Liabilities + Net worth
(Capital)
AssetsAssets
Cash and due from banksCash and due from banks
ExplanationExplanation
Cash on hand, call deposits, current accounts, etc
(usually paying little or no interest)
Cash on hand, call deposits, current accounts, etc
(usually paying little or no interest)
Short-term investments in
market instruments
Short-term investments in
market instruments Interest-bearing deposits in financial instruments
(usually for purposes of liquidity management)
Interest-bearing deposits in financial instruments
(usually for purposes of liquidity management)
Total loan portfolioTotal loan portfolio
Total outstanding balances of loans to clients,including loans past due but not written off
Total outstanding balances of loans to clients,
including loans past due but not written off
(Loan loss reserve)(Loan loss reserve) A negative asset account providing for estimated
future losses on problem loans not yet written off
A negative asset account providing for estimated
future losses on problem loans not yet written off
Other short-term assetsOther short-term assets Accounts receivable, accrued interest on loans etc Accounts receivable, accrued interest on loans etc
Long-term investmentsLong-term investments Investments or other long-term, illiquid assets that
usually earn returns
Investments or other long-term, illiquid assets thatusually earn returns
Net fixed assetsNet fixed assets Buildings, & equip, net of acc. depreciation and land Buildings, & equip, net of acc. depreciation and land
Source: Winship
-
7/28/2019 Mf Management5sept08
7/34
- 6 -
The balance sheet shows how this is done Assets = Liabilities + Net worth
(Capital)
LiabilitiesLiabilities
Savings accounts (compulsory)Savings accounts (compulsory)
ExplanationExplanation
Compulsory savings usually required as a condition
for loans
Compulsory savings usually required as a condition
for loans
Savings accounts (voluntary)Savings accounts (voluntary) Cash deposits from members or the general public Cash deposits from members or the general public
Time depositsTime deposits
Certificates of deposit held by members or the generalpublic
Certificates of deposit held by members or the general
public
Loans, commercial (often also
split by term)
Loans, commercial (often also
split by term) Loans to the institution at market rates from banks or
other financial institutions
Loans to the institution at market rates from banks or
other financial institutions
Loans, subsidizedLoans, subsidized Concessional loans from donors and others Concessional loans from donors and others
Other short -term liabil itiesOther short-term liabil ities Accounts payable, accrued interest to be paid on
loans and deposits, etc
Accounts payable, accrued interest to be paid onloans and deposits, etc
Other long-term liabil itiesOther long-term liabili ties Mortgages on property,etc. Mortgages on property,etc.
Capital Structure
Overview
Capital Structure
Overview11
Source: Winship
-
7/28/2019 Mf Management5sept08
8/34
- 7 -
The balance sheet shows how this is done
Assets =
CapitalCapital
Paid-in equity from shareholders
(if any)
Paid-in equity from shareholders
(if any)
ExplanationExplanation
Equity contribution of owners Equity contribution of owners
Donated equityDonated equity Equity received through cash donations from sources
that do not receive stock
Equity received through cash donations from sources
that do not receive stock
Retained earnings (losses)Retained earnings (losses) Accumulated earnings - not including cash donations Accumulated earnings - not including cash donations
Other capital accountsOther capital accounts Any special reserves/other capital accounts, plus any
non-financial operations retained earnings
Any special reserves/other capital accounts, plus any
non-financial operations retained earnings
Capital Structure
Overview
Capital Structure
Overview11
Source: Winship
Liabilities + Net worth
(Capital)
-
7/28/2019 Mf Management5sept08
9/34
- 8 -
The return comes from performing assets
Capital Structure
Overview
Capital Structure
Overview11
Fixed CostFixed Cost
Net ProfitNet Profit
RevenueRevenue TaxTax
Operating
Cost
Operating
Cost
Net Fin.
Revenue
Net Fin.
Revenue-
-
Variable
Cost
Variable
Cost
Cost of
Funds
Cost of
Funds
Interest &
Fee Income
Interest &
Fee Income
-
+
RevenueRevenue
Total
Assets
Total
Assets
PerformingAssets
Performing
Assets
Other
Assets
Other
Assets
+
Net Profit
Net Worth
Net Profit
Net Worth
Return on
Equity
Total Assets
Net Worth
Total Assets
Net WorthNet Profit
Total Assets
Net Profit
Total Assets=
Leverage
(Equity
Multiplier)
Return on
Assets
Revenue
Total Assets
Revenue
Total Assets
Net Profit
Revenue
Net Profit
Revenue
Profit
Margin
Asset
Turnover
-
7/28/2019 Mf Management5sept08
10/34
- 9 -
Assets = Liabilities + Capital
Assets = Liabilities + Capital
Leverag
e
A bank uses leverage to maximise return on capital whilecontrolling risk
Leverag
e
Revenue Cost Net ProfitRevenue Cost Net Profit
-
7/28/2019 Mf Management5sept08
11/34
- 1 0 -
1. Capital Structure Overview1. Capital Structure Overview
2. What is risk?2. What is risk?
3. How do we manage risk?3. How do we manage risk?
4. What does this mean for us?
For partner MFIs?
4. What does this mean for us?
For partner MFIs?
-
7/28/2019 Mf Management5sept08
12/34
- 1 1 -
What can a properly functioning financial institution do?
A properly functioning financial institution can
issue new loans at a reasonable price
pay salaries, electricity bills, rent, etc.
repay loans taken from other institutions (donors, banks)
return depositors money on request
expect to continue functioning in the future
RiskRisk22
Liquid
meeting everyday
financial
obligations
Liquid
meeting everyday
financial
obligations
Stable: likely
to remain liquid
in the future
Stable: likely
to remain liquid
in the future
RiskRisk
What could stop an institution from doing this?
A large number of clients do not make loan repayments as expected
Lenders to the institutions do not extend a new loan as expected
A large number of depositors unexpectedly withdraw their deposits
-
7/28/2019 Mf Management5sept08
13/34
- 1 2 -
Risks can be divided into number of categories
Asset RiskAsset Risk
Operating Risk
Operating Risk
Liquidity RiskLiquidity Risk
Interest Rate RiskInterest Rate Risk
Foreign Exchange Risk Foreign Exchange Risk
Other RisksOther Risks
-
7/28/2019 Mf Management5sept08
14/34
- 1 3 -
Asset Risk is the risk that assets which are expected to generate areturn wil l not the problem of delinquent or non performing loans
Risk
Delinquent loans affect
cash flows
revenue
expenses
profitability
Increased asset risk from
loans concentrated in geographies and markets
no collateral
Risk22
Source: Winship
-
7/28/2019 Mf Management5sept08
15/34
- 1 4 -
Delinquent loans increase costs significantly
RiskRisk22
Guy takes a 3,000loan, 46 months,monthly repaymentof 75
11 Guy repays for 14
months only22
DefaultDefault
Princip
al
3,000
912
2,088
450
138
312
Expected Actual Loss
3,450 1,050 2,400
Interest
What to do? How do we
recover loss? New loans.33
Revenue from one 3,000 loan = 450
Cost of one 3,000 loan = 270
Contribution of one 3,000 loan = 180
Need 14 successful new
loans to recover loss fromGuys loan
Need 14 successful new
loans to recover loss fromGuys loan
Earn 180
per loan
Source: Ledgerwood
2,400 loss2,400 loss
-
7/28/2019 Mf Management5sept08
16/34
- 1 5 -
Operating Risk arises from unforeseen expenses
Fraud
Clients
Staff
Few checks
Errors
Manual systems
Changing systems
RiskRisk22
-
7/28/2019 Mf Management5sept08
17/34
- 1 6 -
Liquidity Risk is the potential for an institution to be unable to meetobligations to pay, or do so only at high cost
Risk
Failure has a high cost: borrowing costs, lost customers, embarrassment, potentialto undermine depositor confidence
However, the institution must ensure there are not excess idle funds (subject toopportunity cost)
Risk22
Cash Flows in Period
Start In Out End
Managed
Start In Out End
High Outgoings
Start In Out End
Low Incomings
-
7/28/2019 Mf Management5sept08
18/34
- 1 7 -
Interest Rate Risk exists because assets and l iabili ties may notmatch in rate or term
RiskRisk22
Foreign Exchange Risk exists when liabilit ies and assets are indifferent currencies, subject to changing ratesSource: Winship
300
700
1,000
Assets Liabilities Capi tal20 10
100 70
Revenue Finance
Cost
Operating
Cost
Net
income
At 10%At 10%
35
50
-5
Revenue Finance
Cost
Operating
Cost
Net
income
At 5%At 5% 20
-
7/28/2019 Mf Management5sept08
19/34
- 1 8 -
Example of interest sensitivity
Balance sheet:
Prior period
interest rate
New period interest
rate
10% 5%
Interest earned: New interest earned:
Loans outstanding 1,000,000 100,000 50,000 Gross Income falls by 50,000
Debt 700,000 70,000 35,000 Financial costs fall by 35,000
Equity 300,000 n/a n/a
-
7/28/2019 Mf Management5sept08
20/34
- 1 9 -
Other forms of risk also exists
Donor risk
Regulatory risk
Government views on informal financial institutions may change e.g. (after an election)
Central Bank
External Risks
E.g. conflict
RiskRisk22
Ri k
Ri k2
2
-
7/28/2019 Mf Management5sept08
21/34
- 2 0 -
Risk affects the institutions ability to preserve, and generate areturn, on its capital
RiskRisk22
Net Profit
Net Worth
Net Profit
Net WorthTotal Assets
Net Worth
Total Assets
Net WorthNet Profit
Total Assets
Net Profit
Total Assets
Fixed CostFixed Cost
=
Revenue
Total Assets
Revenue
Total Assets
Net Profit
Revenue
Net Profit
Revenue
RevenueRevenue
Net ProfitNet Profit
RevenueRevenue
Total
Assets
Total
Assets
TaxTax
Operating
Cost
Operating
Cost
Net Fin.
Revenue
Net Fin.
Revenue
Performing
Assets
Performing
Assets
Other
Assets
Other
Assets
-
-
Variable
Cost
Variable
Cost
Cost of
Funds
Cost of
Funds
Interest &
Fee Income
Interest &
Fee Income
-
+
+Return on
Equity
Leverage
(Equity
Multiplier)
Return on
Assets
Profit
Margin
Asset
Turnover
-
7/28/2019 Mf Management5sept08
22/34
- 2 1 -
1. Capital Structure Overview1. Capital Structure Overview
2. What is r isk?2. What is risk?
3. How do we manage risk?3. How do we manage risk?
4. What does this mean for us?4. What does this mean for us?
-
7/28/2019 Mf Management5sept08
23/34
- 2 2 -
Risks should be addressed systematically and routinely
PlanPlanPlan ahead on basis of
identified assumptions
Plan ahead on basis of
identified assumptions
MonitorMonitorCarefully track relevant
risk factors
Carefully track relevant
risk factorsAdjustAdjust
Change MFI to meet
risk profiles it faces
Change MFI to meet
risk profiles it faces
QuantifyQuantifyConsider possible
effect of changing
factors
Consider possible
effect of changing
factors
Source: Winship
Managing Risk
Managing Risk3
3
-
7/28/2019 Mf Management5sept08
24/34
- 2 3 -
Asset and Liability Management ensures the required spreadbetween interest income received and interest expenses paid
Managing Risk
Formal banks often have an assets and liabilities committee (ALCO)
sets policies and guidelines to establish the risk tolerance of the organisation
involves operations management and treasury managers
meets frequently to review the current positions against target risk profile and forecastexpected future positions
If the organisation is currently, or expected to be, outside risk limits the ALCO decides how to
correct Potentially change balance sheet structure
Potentially change policies (less common)
Managing Risk33
Source: Ledgerwood
-
7/28/2019 Mf Management5sept08
25/34
- 2 4 -
An acceptable risk profile can be defined and monitored usingindicators
Risk ProfileRisk Profile MeasureMeasure Goal
Source: WCCU PEARLS
Goal
Protection of assetsProtection of assets
Provisions to cover PAR360
Provisions to cover PAR30 - 360
Provisions to cover PAR360
Provisions to cover PAR30 - 360
Financial structureFinancial structure Net loans / total assets
Liquid investments / total assets
Net loans / total assets
Liquid investments / total assets
Asset qualityAsset quality
PAR30 / total loans
Non earning assets / total assets
PAR30 / total loans
Non earning assets / total assets
Return and costsReturn and costs ROE
Operating expenses / average assets
ROE
Operating expenses / average assets
LiquidityLiquidity Liquid reserves / withdrawable savings Liquid reserves / withdrawable savings
100%
35%
100%
35%
60% - 80%
Max 20%
60% - 80%
Max 20%
Inflation
< 10%
Min 10% Min 10%
EXAMPLE
EXAMPLE
GrowthGrowth Institutional capital growth Institutional capital growth
-
7/28/2019 Mf Management5sept08
26/34
- 2 5 -
Managing Asset Risk requires an intense focus on delinquency
Managing geographic and occupational concentration in portfolio
Managing delinquency
Recovering non performing loans where profitable
Managing RiskManaging Risk33
-
7/28/2019 Mf Management5sept08
27/34
- 2 6 -
Operating Risk management is linked to the improvement agenda
New MIS
Internal audit
Management oversight
Managing RiskManaging Risk33
-
7/28/2019 Mf Management5sept08
28/34
- 2 7 -
Liquidity management addresses liquidity risk
The institution must always remain liquid, with
Liquidity management policies and systems are used to minimise the cost of maintaining
adequate liquidity
Policy decisions are taken on using stored liquidity or purchased funds
A robust system for accurately forecasting cash needs at all branches / districts is required
Managing RiskManaging Risk33
Liquidity ratio =
Cash + expected cash inf lows in the period
Anticipated cash outflows in the period> 1
Source: Francis
-
7/28/2019 Mf Management5sept08
29/34
- 2 8 -
and involves cash management
Managing RiskManaging Risk33
EXAMPLE CASH MANAGEMENT MODEL
Actual
February
Beginning cash 50
Loan repayments due 600Current repayment rate 80%
Expected loan repayments 480
Savings deposits 15
Other income 21
Total incoming 516
Expected loan disbursements 300
Expected payments fixed 50
Expected payments variable 30
Savings withdrawal -
Total outgoing 380Net change in cash 136
Transfers from (to) investments/borrowings (130)
Ending cash 56
Minimum cash buffer 50
Beginning investments (debt) 200
Transfers from (to) operations 130
Ending investments (debt) 330
March
56
40085%
340
14
16
370
400
50
35100
585
(215)
210
51
50
330
(210)
120
EXAMPLE
EXAMPLEBudget
April
51
37580%
300
18
17
335
275
50
3220
377
(42)
45
54
50
120
(45)
75
May
54
60090%
540
15
20
575
300
50
3010
390
185
(180)
59
50
75
180
255
June
59
40090%
360
15
18
393
305
50
285
388
5
-
64
50
255
-
255
Managing Risk
Managing Risk3
3
-
7/28/2019 Mf Management5sept08
30/34
- 2 9 -
Managing Interest Rate Risk requires careful matching of the ratesand terms of assets and their funding liabilit ies
g g
Interest rate risk becomes important when an institution takes on rate sensitive liabilities, e.g.
commercial debt and voluntary savings
Generally, the institution wants to have terms of assets and their funding liabilities match
Gap analysis is central to managing interest rate risk
g g
Gap ratio =
Assets repricing or maturing Liabilities repricing or maturing
Total assets
Source: Winship, Ledgerwood
M i Ri k
M i Ri k3
3
-
7/28/2019 Mf Management5sept08
31/34
- 3 0 -
Other forms of risk are also important to manage
Donor risk
Regulatory risk
Managing RiskManaging Risk33
-
7/28/2019 Mf Management5sept08
32/34
- 3 1 -
1. Capital Structure Overview1. Capital Structure Overview
2. What is risk?2. What is r isk?
3. How do we manage risk?3. How do we manage risk?
4. What does this mean for us?4. What does this mean for us?
-
7/28/2019 Mf Management5sept08
33/34
- 3 2 -
Most MFIs have twin objectives of social/community developmentand financial sustainability will influence Risk Management
Decisions on capital structure, particularly operating leverage, will be influenced by the
community benefits from savings mobilisation
Ongoing operations improvements will change MFIs risk profile
MIS improvements and the transition period will affect operating risk
Improved information flows may allow different risk parameters, e.g. regarding liquiditymanagement
Becoming a regulated Bank presents new challenges
Increased regulatory requirements
Increasing liquidity risk with increasing voluntary savings
-
7/28/2019 Mf Management5sept08
34/34
- 3 3 -
Sources
Booz Allen Hamilton
G. Jay Francis, Principles of Banking, ABA
Joanna Ledgerwood, Sustainable Banking With The Poor, World Bank, 1998
Guy Winship, World Education, www.worlded.org
World Council of Credit Unions PEARLS Toolkit