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


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


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?


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


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)


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


7/34

- 6 -

The balance sheet shows how this is done Assets = Liabilities + Net worth

(Capital)

LiabilitiesLiabilities

Savings accounts (compulsory)Savings accounts (compulsory)


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


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)


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)


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


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


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?


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


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


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


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


16/34

- 1 5 -

Operating Risk arises from unforeseen expenses

Fraud

Clients

Staff

Few checks

Errors

Manual systems

Changing systems

RiskRisk22


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


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


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


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


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


22/34

- 2 1 -


2. What is r isk?2. What is risk?


4. What does this mean for us?4. What does this mean for us?


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


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


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


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


27/34

- 2 6 -

Operating Risk management is linked to the improvement agenda

New MIS

Internal audit

Management oversight



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


Liquidity ratio =

Cash + expected cash inf lows in the period

Anticipated cash outflows in the period> 1

Source: Francis


29/34

- 2 8 -

and involves cash management


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


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


31/34

- 3 0 -

Other forms of risk are also important to manage

Donor risk

Regulatory risk



32/34

- 3 1 -


2. What is risk?2. What is r isk?


4. What does this mean for us?4. What does this mean for us?


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


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

mf management5sept08

Documents