Risk Evaluation and MFI Evaluation

1
Risk Evaluation and MFI Evaluation

• Microfinance Independent Study
• 10/29/2006

2
Evaluation Methodologies

• ACCION CAMEL Studied in this lecture
• WOCCU PEARLS
• World Council of Credit Unions
• gt36,000 credit unions and 108 million members in
  91 countries
• 45 financial ratios protection, effective
  financial structure, asset quality, rates of
  return and costs, liquidity, signs of growth
  driven by financial performance wholly
  quantitative

3
Evaluation Methodologies

• PlaNet Ratings GIRAFE
• 26 indicators grouped under governance and
  decision making process, information and
  management tools, risk analysis and control,
  assets including loan portfolio, funding (equity
  and liabilities), efficiency and profitability
• E and F biggest drivers, then G
• 57 qualitative factors
• Governing is important

4
Evaluation Methodologies

• MicroRate oldest organization created
  specifically to evaluate MFIs (1996)
• Identify key risk areas and their drivers
• Compare MFIs performance with that of its peers
  on an adjusted basis
• Make this information available to the market
  where possible
• Looks at lending operations and portfolio
  quality, organization and MIS, and financial
  performance

5
Evaluation Methodologies

• M-CRIL Micro-Credit Ratings and Guarantees India
  Ltd
• Geared more towards credit risk and repayment
  capacity
• Focus on 30 indicators covering three main areas
• Organizational and governance aspects, managerial
  and resource strength, financial performance
  (including credit performance and asset quality,
  mobilization of funds, liquidity, sustainability,
  and profitability)

6
CAMEL Methodology

• Adopted by North American bank regulators to
  evaluate the financial and managerial soundness
  of U.S. commercial lending institutions.
• Regular commercial banks will be benchmark
• Capital Adequacy
• Asset Quality
• Management
• Earnings
• Liquidity Management

7
ACCION CAMEL Methodology

• Primarily internal assessment tool
• Sets performance standards
• Analyzes and rates 21 key indicators
• 13 Qualitative (53 of total rating)
• 8 Quantitative (47)
• Rating 0 to 5, 5 being excellent
• Henceforth, will be called CAMEL

8
What CAMEL Doesnt Measure

• Target Market
• Size of target market (scale)
• Maintaining market share while only minimally
  increasing number of clients not penalized
• Appropriate outreach in terms of loan size
• Geographic location of clients and density of
  microfinance market
• Based on dense, urban areas
• Lending methodology
• (1) Institutional, (2) Competitive environment
  and (3) Macroeconomic evolution
• Regulation

9
CAMEL Requirements from MFI(See handout for
details)

• Financial statements
• Budgets and cash flow projections
• Portfolio aging schedules
• Funding sources
• Information about Board of Directors
• Operations/staffing
• Macroeconomic information
• Camel makes SIX adjustments (not included in
  presentation)

10
CAMEL Adjustments

• Scope of microfinance activity
• Loan loss provision
• Loan write-offs
• Explicit and implicit subsidies
• Effects of inflation
• Accrued interest income

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(1) Adjusting for Scope of Microfinance Activity

• Segregate microfinance activity
• Differentiate between microfinance and
  non-microfinance revenues, expenses, assets,
  liabilities

12
(2) Adjusting Loan Loss Provision

• Loan loss provision provides no tax benefit to
  NGOs, and is therefore just a profit loss
• Rescheduled loan portfolios require more
  stringency

13
(3) Adjusting Loan Write-Offs

• Net effect on BS 0 write off loan from
  portfolio and reduce loan loss provision
• Because most MFIs are unregulated, write-offs are
  not performed often
• Loans may remain in portfolio even long after
  past due
• May be reluctant to perform write-offs because
  they may not be provisioning properly
• Once loan is past 180 days due, write it off

14
(4) Adjusting for Explicit and Implicit Subsidies

• Cash donations reclassified as capital on BS
  (like equity injections)
• Subsidized debt refers to MFI that carries
  interest rate that is 75 or lower than (a)
  three-month CD or (b) average short-term loan
  rate in the financial system
• If borrows at commercial rates weighted average
  of alternative commercial funding rates should be
  calculated and then discount the subsidized debt
• If borrows subsidized use average interest on
  short-term loans in market to discount
• Subsidized facility adjustments

15
(5) Adjusting for Effects of Inflation

• Two major effects
• Real value of fixed assets will keep pace with
  inflation
• Real value of equity will be eroded to the extent
  that equity is tied up in monetary assets
• Some countries allow for fixed assets and equity
  to be adjusted to keep up with inflation CAMEL
  fully adjusts for inflation

16
(5) Adjusting for Effects of Inflation

• (inflation rate) (average net fixed assets)
• Gain for institution, credited as revenue
• Increases value of assets, debit revaluation of
  assets
• (inflation rate) (average equity)
• Loss for institution, debited on IS
• Credited on equity account under adjustments to
  equity
• If revalue of assets gt revalue of equity, then
  net gain otherwise, net loss

17
(6) Adjusting for Accrued Interest Income

• Rarely needed, but eliminates interest income
  accruals on portfolios post due over 30 days from
  IS and BS
• Only necessary if MFI accrues interest
• Cumulative adjustment debited on BS from prior
  period Retained Earnings (SE) and credited to
  Accrued Interest (Asset)

18
CAMEL Indicators and Weights
19
CAMEL Scoring(1) Capital Adequacy CA

• Measure the financial solvency of an MFI by
  determining whether the risks it has incurred are
  adequately offset with capital and reserves to
  absorb potential losses.
• Leverage (Quant) 5
• Adequacy of reserves (Quant) 5
• Ability to raise equity (Qual) 5

20
CA Leverage 5

• Relationship between risk-weighted assets and
  equity
• Risk assets/Equity is usually 12.5x
• Ranges from 5.41 in Ecuador and 17 in Nicaragua
• Microfinance should be LOWER
• Delinquency rates may be lower, but more volatile
• Operating expenses as of assets are higher for
  MFIs
• Ability to obtain additional from
  shareholder/donors more difficult

21
CA Leverage 5

• Risk Weighting (100 2x risk of 50)
• Multiply each asset by each weight and sum to get
  numerator of leverage ratio

22
CA Leverage 5

• Generally, for either NGOs or private enterprises
  with low access to private equity, scoring as
  follows

23
CA Ability to Raise Equity 5

• Need to replenish equity could arise as result of
  deterioration in asset quality or growth rates
  that go beyond profits reinvested in the business

24
CA Adequacy of Reserves 5

• Reserves absorb losses that are separate from
  general business risk (i.e., separate from risk
  of inflation lowering profits)
• (1) Loan losses, (2) foreign exchange
  fluctuations, (2) employee benefits
• For-profit reserves reduce tax burdens
  therefore highly regulated
• Non-profit not applicable, so they have
  incentive to
• Not reduce profits by a loan loss provision
• Not signaling to donors that asset quality is
  deteriorating

25
CA Adequacy of Reserves 5

• Actual Loan Loss (after CAMEL-adjusted write-offs)

CAMEL-adjusted Loan Loss Reserve
26
CA Adeqaucy of Reserves 5

• Consider other necessary reserves, such as
  employee benefits or foreign exchange losses

27
CAMEL Scoring(2) Asset Quality AQ

• Refers primarily to the quality of the
  institutions main asset, the loan portfolio,
  although the productivity of the entitys fixed
  assets and long-term investments are also
  important.
• Portfolio-at-Risk (Quant) 8
• Write-offs (Quant) 7
• Portfolio Classification System (Qual) 3
• Productivity of Long-term Assets (Qual) 1.5
• Infrastructure (Qual) 1.5

28
AQ Portfolio-at-Risk 8

• Total payments past due / total portfolio
• Refer to Michelles slides on PAR, particularly
  as related to arrears
• PAR ranges from 1.05 in Chile to 11.15 in
  Argentina, with average of 11 Latin American
  countries 5.18

29
AQ Write-offs 7

• Loan loss rate
• (loan write-offs for period recovered loans in
  the period) / relevant portfolio
• Relevant portfolio approximation of
  outstanding portfolio from which loans being
  written off originated
• So take loan portfolio of time when loans were
  issued!

30
AQ Write-offs 7

• Respective ratings

31
AQ Portfolio Classification System 3

• Review portfolio aging schedule and any
  additional risk classifications used
• Institutions often present late payment rate
  total payments past due / total portfolio
• This is optimistic
• Aging schedule is prepared to estimate potential
  losses associated with loans that are past due

32
AQ Portfolio Classification System 3

• Classify borrowers rate collectibility of
  guarantees, client history, loan type and client
  type
• Observed patterns of loan repayment with regard
  to specific lines of business (commerce vs.
  production) or geographic location (rural vs.
  urban)
• Should also be used to set differential
  risk-based interest rates

33
AQ Portfolio Classification System 3

• Most MFIs do not classify their borrowers!

34
AQ Productivity of Long-term Assets 1.5

• Evaluate policies for investing in fixed assets.
  Consider
• Cost savings (rent vs. buying building)
• Inflation adjustments (hedge against inflation?)
• Guarantees (fixed assets backing credit lines?)
• Risk (need to provision for long-term assets?)
• Cost benefit analysis, including financing costs
• Infrastructure growth planning

35
AQ Productivity of Long-term Assets 1.5

• Supporting indicator
• (total fixed assets) / (total assets)
• Typically 5-10 too high could mean investment
  diversion from main line of business

36
AQ Infrastructure 1.5

• Adequate to meet both needs of staff and clients?

37
CAMEL Scoring(3) Management (M)

• Governance/management (Qual) 6
• Human resources (Qual) 4
• Process, Controls and Audit (Qual) 4
• IT System (Qual) 5
• Strategic Planning/Budgeting (Qual) 1.5

38
M Governance/Management 6

• Board of directors and senior management
• Diversity of the technical expertise
• Frequency of board meetings (monthly optimal)
• Participation of board members
• Nature of issues reviewed and voted upon by board
  including portfolio quality, budget, fixed asset
  acquisitions, and new initiatives
• SUM Consolidation of senior management team

39
M Governance/Management 6
40
M Human Resources 4

• Provide guidance and support to operations staff
  in carrying out supervisory responsibilities
• Clearly defined and directly related
• Evaluate incentive system for personnel

41
M Human Resources 4
42
M Process, Controls and Audit 4

• (1) Formalized key processes,
• (2) internal control environment and
• (3) quality of internal and external audits

43
M Process, Controls and Audit 4

• Internal controls encompasses accounting system
  and control policies and procedures
• Accounting records and error checking
• Performance reviews (compare actual to budgeted
  performance)
• Information processing (general controls over
  centers, application controls over individual
  applications)
• Physical controls (security and access)
• Segregation of duties (minimize fraud)

44
M Process, Controls and Audit 4

• Assess competence and objectivity of internal
  auditors
• Perform external audit with independent firm

45
M IT System 5

• Two basic categories
• Accounting general ledger
• Loan tracking lending
• Understand extent to which branch locations are
  linked to a central computer, how the link is
  accomplished, whether link is online and
  real-time extent to which link updates
  applicable software applications, batches
  information, memoposts data (noted on subledger,
  posted later).

46
M IT System 5
47
M Strategic Planning and Budgeting 1.5

• Short- and long-term financial plans
• Starts with goals/objectives
• Identify elements that differentiate institution
• Analyze operational environment (macro and micro)
• Define institutional objectives
• Identify risks/obstacles in reaching objectives
• Formulate strategies to manage risks
• Analyze implications of strategies in terms of
  resources (financial, infrastructure, HR)
• Convert all to quantitative terms

48
M Strategic Planning and Budgeting 5

• Actual measures should regularly be compared to
  budgeted numbers

49
CAMEL Scoring(4) Earnings E

• Operate profitability to attract resources of
  shareholders and depositors
• Return on equity (Quant) 5
• Operational efficiency (Quant) 8
• Return on assets (Quant) 7
• Interest rate policy (Qual) 4

50
E Return on Equity 5

• Adjusted ROE
• (Adjusted Net Income) / (Average Adjusted Equity)
• Measures institutions ability to increase equity
  base through earnings from operations adjusted
  for effects of inflation, appropriate levels of
  loan loss provisions, accrued interest income,
  explicit and implicit subsidies

51
E Return on Equity 5

• Range from low in Mexico of -10.6 to high of
  17.98 in Peru and average of 11.8

52
E Operational Efficiency 8

• (total operating expenses) / (average loan
  portfolio) 100
• Measures efficiency
• Ranges from 4.7 in Chile to 14.3 in Brazil,
  with 9.4 Average

53
E Adjusted Return on Assets 7

• (Adjusted net income) / (Average assets)
• Independent of the level of leverage (unlike ROE)
• Ranges from -.67 in Mexico to 1.64 in Colombia,
  with average of .93

54
E Interest Rate Policy 4

• Rates should be set based on an analysis of rates
  charged by various sources of funding, cost of
  funds and financial margins necessary for
  profitability (see lecture on loan pricing)

55
CAMEL Scoring(5) Liquidity Management LM

• Traditionally defined as ability to meet
  obligations as they come due
• Demands on liquidity include
• Loan portfolio growth
• Purchase of fixed assets
• Withdrawals of deposits
• Planned runoff of certificates of deposits
• Dividend payments
• Scheduled loan payments
• Salaries and utility bills

56
CAMEL Scoring(5) Liquidity Management LM

• Liability Structure (Qual) 8
• Availability of Funds to Meet Credit Demand
  (Qual) 4
• Cash Flow Projections (Qual) 3
• Productivity of Other Current Assets (Quant) 2

57
LM Liability Structure 8

• Analyze tenor, interest rate, payment terms, and
  sensitivity to changes in the macroeconomic
  environment

58
LM Liability Structure 8

• Gap Ratio for Repricing of
• (Assets/Liabilities)
• Measures gap between rate-sensitive assets and
  rate-sensitive liabilities, defined as those that
  reprice during a specified period
• Relative to repricing, not full term
• Analyze within context
• If institutions assets gt liabilities, then
  increase in rates results in opportunity to
  increase profits

59
LM Liability Structure 8
60
LM Liability Structure 8

• Maturities Gap Full-term gap between assets and
  liabilities
• If lt1, then concern over availibility of
  resources to fill gap
• Liquidity Ratio
• (stored liquidity class short-term
  investments
• overdraft-type lines of credit from other
  financial institutions) / (end of period loan
  portfolio)
• Note Liquidity ratio must be balanced between
  liquidity and profitability!

61
LM Liability Structure 8
62
LM Availability of Funds to Meet Credit Demand
4

• Restrictions on credit are one of the principal
  cases of late repayment!
• Measures degree to which institution has
  delivered credit in a timely and agile manner.

63
LM Cash Flow Projections 3
64
LM Productivity of Other Assets 2

• (Interest Income received on cash and cash
  equivalents over past 12 months) (average
  monthly cash cash equivalent balances
  liquidity cushion)(average three-month CD rate)
  (liquidity cushionaverage saving rate)

65
LM Productivity of Other Assets 2

• Liquidity Cushion
• (operating expenses financial expenses
  depreciation loan disbursements loan
  repayments)/52 4
• Measures whether the MFI maximized use of its
  cash, bank accounts and short-term investments
• Compare current interest earnings relative to
  what the institution could have earned if it had
  invested the liquidity cushion component of these
  funds in a liquid investment and the balance in a
  more aggressive investment (three-month CDs)
• Cash outflows in liquidity are those incurred in
  12 months assumes 4 weeks is average duration of
  liquidity crisis