Microfinance Risk Management Handbook

MICROFINANCE
RISK MANAGEMENT
HANDBOOK
Craig Churchill and Dan Coster
With Contributions from:

Victoria White, Terrence Ratigan, Nick Marudas,
Emily Pickrell and Calvin Miller
2001
TABLE OF CONTENTS
Table of Contents
Table of Contents ............................................................................................................... i
M Risks M .........................................................................................................................1
Introduction ....................................................................................................................... 2
What is Risk Management?....................................................................................................................................2
Structure of the Handbook and How to Use It...............................................................................................4
Chapter 1: Risk Assessment Framework ......................................................................... 6
1.1 Institutional Risks...............................................................................................................................................6
1.1.1 Social Mission .................................................................................................................................................7
1.1.2 Commercial Mission........................................................................................................................................7
1.1.3 Dependency......................................................................................................................................................7
1.2 Operational Risks...............................................................................................................................................8
1.2.1 Credit ..............................................................................................................................................................8
1.2.2 Fraud..............................................................................................................................................................8
1.2.3 Security............................................................................................................................................................8
1.3 Financial Management Risks...........................................................................................................................9
1.3.1 Asset and Liability .........................................................................................................................................9
1.3.2 Inefficiency .......................................................................................................................................................9
1.3.3 System Integrity ...............................................................................................................................................9
1.4 External Risks .....................................................................................................................................................9
1.4.1 Regulatory .......................................................................................................................................................10
1.4.2 Competition...................................................................................................................................................10
1.4.3 Demographic..................................................................................................................................................10
1.4.4 Physical Environment....................................................................................................................................10
1.4.5 Macroeconomic...............................................................................................................................................10
1.5 Conclusion.........................................................................................................................................................10
Chapter 2: Institutional Risks and Controls...................................................................14
2.1 Social Mission Risk..........................................................................................................................................14
2.1.1 Mission Statement.........................................................................................................................................15
2.1.2 Market Research...........................................................................................................................................16
2.1.3 Monitoring Client Composition and Measuring Impact .................................................................................17
2.1.4 Managing Growth.........................................................................................................................................18
2.2 Commercial Mission Risk..............................................................................................................................19
2.2.1 Setting Interest Rates.....................................................................................................................................20
2.2.2 Designing the Capital Structure.....................................................................................................................20
2.2.3 Planning for Profitability...............................................................................................................................21
2.2.4 Managing for Superior Performance...............................................................................................................22
2.2.5 Monitoring for Commercial Mission Risk .....................................................................................................23
2.3 Dependency Risk .............................................................................................................................................24
2.3.1 Strategic Dependence......................................................................................................................................25
2.3.2 Financial Dependence....................................................................................................................................26
2.3.3 Operational Dependence ................................................................................................................................27
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CARE MICROFINANCE HANDBOOK
Cash Management........................................................................................................................................... 27
CARE Core Costs: “PN 85”.......................................................................................................................... 27
Institutional Culture........................................................................................................................................ 28
Technical Assistance ....................................................................................................................................... 29
2.3.4 Dependency Risk Controls.............................................................................................................................30
Exit Strategy..................................................................................................................................................... 30
Independent Structure .................................................................................................................................... 31
Recommended Readings......................................................................................................................................32
Chapter 3: Operational Risks and Controls................................................................... 34
3.1 Credit Risk .........................................................................................................................................................35
3.1.1 Credit Risk Controls.....................................................................................................................................35
Loan Product Design...................................................................................................................................... 36
Client Screening............................................................................................................................................... 38
Credit Committees .......................................................................................................................................... 42
Delinquency Management.............................................................................................................................. 43
3.1.2 Credit Risk Monitoring.................................................................................................................................45
3.2 Fraud Risk..........................................................................................................................................................46
3.2.1 Types of Fraud..............................................................................................................................................46
3.2.2 Controls: Fraud Prevention ...........................................................................................................................48
Excellent Portfolio Quality............................................................................................................................. 48
Simplicity and Transparency .......................................................................................................................... 49
Human Resource Policies............................................................................................................................... 50
Client Education.............................................................................................................................................. 51
Credit Committees .......................................................................................................................................... 51
Handling Cash ................................................................................................................................................. 52
Collateral Controls .......................................................................................................................................... 54
Write-off and Rescheduling Policies ............................................................................................................. 54
3.2.3 Monitoring: Fraud Detection.........................................................................................................................55
Operational Audit ........................................................................................................................................... 55
Loan Collection Policies ................................................................................................................................. 56
Client Sampling ............................................................................................................................................... 57
Customer Complaints..................................................................................................................................... 58
3.2.4 Response to Fraud.........................................................................................................................................59
Fraud Audit...................................................................................................................................................... 59
Damage Control.............................................................................................................................................. 60
3.3 Security Risk ......................................................................................................................................................60
Chapter 4: Financial Management Risks and Controls ............................................... 63
4.1 Asset and Liability Management..................................................................................................................63
4.1.1 Interest Rate Risk .........................................................................................................................................64
4.1.2 Foreign Exchange Risk.................................................................................................................................65
4.1.3 Liquidity Risk ..............................................................................................................................................67
4.2 Inefficiency Risk...............................................................................................................................................69
4.2.1 Inefficiency Controls .......................................................................................................................................69
Budgeting......................................................................................................................................................... 69
Activity Based Costing.................................................................................................................................... 71
Reengineering .................................................................................................................................................. 72
4.2.2 Inefficiency Monitoring...................................................................................................................................73
Efficiency and Productivity Ratios................................................................................................................ 73
Monitoring Human Errors............................................................................................................................. 75
4.3 Systems Integrity Risks...................................................................................................................................75
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TABLE OF CONTENTS
Chapter 5: External Risks ............................................................................................... 77

5.1 Regulatory Risks...............................................................................................................................................78
5.1.1 Banking Regulations .....................................................................................................................................78
Usury Laws....................................................................................................................................................... 78
Financial Intermediation................................................................................................................................. 79
5.1.2 Other Regulatory Risks.................................................................................................................................80
Directed Credit................................................................................................................................................ 80
Contract Enforcement.................................................................................................................................... 80
Labor Laws ...................................................................................................................................................... 80
5.1.3 Regulatory Monitoring and Response.............................................................................................................81
5.2 Competition Risks............................................................................................................................................81
5.2.1 Monitoring Competition Risks ......................................................................................................................81
5.2.2 Competition Risk Responses..........................................................................................................................82
5.3 Demographic Risks .........................................................................................................................................82
5.4 Physical Environment Risks..........................................................................................................................84
5.5 Macroeconomic Risks.....................................................................................................................................84
Chapter 6: Management Information Systems ............................................................. 87
6.1 System Components: What Does an MIS Include?...............................................................................87
6.1.1 Accounting Systems .......................................................................................................................................88
Chart of Accounts........................................................................................................................................... 89
Cash vs. Accrual Accounting......................................................................................................................... 90
Fund Accounting ............................................................................................................................................ 90
General Software Design Consideration ...................................................................................................... 90
6.1.2 Portfolio Management Systems ......................................................................................................................91
6.1.3 Linking Accounting and Portfolio Systems....................................................................................................92
6.2 Financial Statement Presentation.................................................................................................................93
6.2.1 Voucher Preparation.....................................................................................................................................93
6.2.2 Frequency of Financial Statements.................................................................................................................93
6.2.3 Financial Statement Adjustments..................................................................................................................94
Accounting Adjustments ............................................................................................................................... 94
Adjusting for Inflation and Subsidies ........................................................................................................... 98
6.2.4 Constant Currency...................................................................................................................................... 100
6.3 Reporting ........................................................................................................................................................ 100
6.3.1 Key Issues in Report Design ....................................................................................................................... 100
6.3.2 Reporting Framework................................................................................................................................. 101
Recommended Readings................................................................................................................................... 103
Annexes...........................................................................................................................104
Annex 1: Checklist by Category of Risk ...................................................................................................... 105
Annex 2: Sample Chart of Accounts Inflation and Subsidy Adjustment Worksheet....................... 109
Annex 3: Inflation and Subsidy Adjustment Worksheet ........................................................................ 112
Annex 4: Sample Balance Sheet and Income Statement........................................................................... 113
Bibliography ................................................................................................................... 115
iii
Table of Figures
Figure 1: Three-step Risk Management Process ...................................................................................................3
Figure 2: Categories of Microfinance Risks ............................................................................................................7
Figure 3: Organization of Microfinance Risks by Chapter...............................................................................11
Figure 4: The Four Ms of Controlling Social Mission Risk..............................................................................15
Figure 5: Market Research Tools.............................................................................................................................17
Figure 6: Monitoring Client Composition.............................................................................................................18
Figure 7: Evolution of Capital Sources for a Microfinance Program ...........................................................21
Figure 8: Sustainability and Profitability Ratios...................................................................................................24
Figure 9: Types of Operational Risks .....................................................................................................................34
Figure 10: Reducing Credit Risk through Product Design Features..............................................................37
Figure 11: The Five C’s of Client Screening .........................................................................................................38
Figure 12: Methods for Screening Client’s Character ........................................................................................40
Figure 13: Alexandria Business Association: Delinquency Penalties .............................................................44
Figure 14: Portfolio Quality Ratios.........................................................................................................................46
Figure 15: Examples of Microlending Fraud .......................................................................................................47
Figure 16: Controls in Handling Loan Repayments...........................................................................................53
Figure 17: Loan Collection Policies.........................................................................................................................57
Figure 18: Example of Currency Devaluation Impact ......................................................................................66
Figure 19: Budget Comparison Report..................................................................................................................70
Figure 20: The Parts of an MIS ...............................................................................................................................88
Figure 21: Chart of Accounts Structure.................................................................................................................89
Figure 22: Criteria for Evaluating Loan Tracking Software.............................................................................92
Figure 23: Key Reports by Shareholder Category ........................................................................................... 102
iv
INTRODUCTION
M Risks M
Under pressure to expand her portfolio, Faith skipped important steps in the loan approval process such as
visiting the applicants’ businesses. When the group did not show up on their first repayment day, Faith
started looking for them, but to no avail. They were gone.
A cholera epidemic in the township resulted in a complete ban on public meetings. Without meetings, there
were no repayments; and without repayments, portfolio quality plummeted.
Jose the loan officer had quite a scam going. He printed up a fake receipt book and went door-to-door
collecting late payments. He kept telling his branch manager that he couldn’t find the people or that they were
having difficulties because of illness in the family or business problems. In the meantime, he was using the
cash to set himself up as a moneylender, charging twice the rates of his employer.
The NGO, Loans-R-Us, wasn’t willing to charge a high enough interest rate to cover costs, and yet it wasn’t
improving efficiency enough to bring costs down. It was regularly losing money and eventually the donors got
tired of subsidizing it. When the door was finally closed, 50 people were out of jobs and 10 communities no
longer had access to the financial services that they depended on to help grow their businesses.
A gang had surreptitiously watched the repayment process for weeks and knew exactly when to intervene and
grab the bag of money. The money and the thieves were gone before anyone realized what happened.
Management at the Micro Credit Trust (MCT) knew that many of its clients would have preferred
individual loans, but believed that the group was such an efficient delivery mechanism that the organization
didn’t do anything about it. Then People’s Bank appeared on the scene, offering individual loans at lower
interest rates, without having to attend numerous meetings and training sessions. Before MCT could react, it
had lost half of its clients to the competition.
People’s Bank grew much faster than it had projected. Before long, it had a stack of loan applications and
not enough money to satisfy the demand. When delays started creeping into the disbursement process, word
got around fast and borrowers stopped repaying.
Help Yourself was a new Microfinance Institution that was absolutely determined to become self-sufficient
and independent of donors and international NGOs. Subsequently, it established a very strong Board of
Directors comprised of influential people from the business and government community. The board fully
controlled Help Yourself’s relatively weak executive staff and before long was forcing staff to give large loans
to its friends and relatives, who assumed that the MFI was not serious about actually collecting loan
repayments.
Under political pressure to help the poor, the government passed a usury law to cap interest rates at 25
percent. No financial institution in the country could cover their costs of issuing $50 or $100 loans at that
rate, so rather than helping the poor, this misguided policy reduced the availability of institutional financial
services to the very people it was trying to help.
1
Introduction
A
ll microfinance institutions (MFIs) are vulnerable to risks like those described on the
previous pages. While MFIs cannot eliminate their exposure to risks, through an
effective risk management process, they can significantly reduce their vulnerability.
CARE’s Microfinance Risk Management Handbook provides guidance for managers of

CARE affiliated microfinance programs to develop a risk management system. The
handbook describes institutional structures, management systems, and internal controls that
should be in place in all microfinance programs. It outlines required and suggested policies
and procedures for managing and governing MFIs in a way
that minimizes an organization’s vulnerability and maximizes This handbook is
the chances of fulfilling its potential. intended to foster
good management
The overriding objective of this handbook is to foster good and accountability
management and accountability. This will encourage cost-
effectiveness, high portfolio quality, and minimal risk of loss or misuse of funds. The
primary audience for this handbook is MFI managers and board members, who are
responsible for maintaining the health of a microfinance institution. CARE SEAD Project
Managers and their supervisors, internal and external auditors, as well as project evaluators
should also find the handbook helpful.
What is Risk Management?

A risk is an exposure to the chance of loss. Risks are not inherently bad. Sometimes, it is
necessary to take risks to accomplish worthy and meaningful goals. This is especially true in
microfinance where loan officers take risks every day by lending money to people without
credit histories, without business records and often without collateral. One has to take risks
to operate a successful microfinance institution—but it is important to take calculated risks.
Risk management, or the process of taking calculated risks, reduces the likelihood that a loss
will occur and minimizes the scale of the loss should it occur. Risk management includes
both the prevention of potential problems and the early detection of actual problems when
they occur. As such, risk management is an ongoing three-step process: 1
1
For a six-step version, see Campion (2000).
2
INTRODUCTION
Figure 1: Three-step Risk Management Process
Identify Current
and Future
Vulnerabilities
Monitor
Effectiveness Design and
Implement
of Controls
Controls to
Mitigate Risks
1. Identify Vulnerabilities: Before managing risks, it is necessary to identify the

organization’s vulnerability points, both current and future. An important aspect of
assessing risk is to predict exposure in the short, medium and long term. To help
MFIs identify their vulnerabilities, this document contains a risk assessment
framework that addresses financial and institutional development issues.
2. Design and Implement Controls: Once an MFI has identified its vulnerability
points, then it can design and implement controls to mitigate those risks. Because
MFIs operate in different environments, and because CARE works with a diverse set
of microfinance partners, the controls outlined in this handbook tend not to be
specific or prescriptive. By understanding why a certain control should be in place,
MFI managers and directors can tailor the control to their local environment. For
example, taking collateral to control credit risk may be appropriate in some markets,
whereas in other markets a group guarantee is a more appropriate control.
3. Monitor Effectiveness of Controls: Once the controls are in place, then the MFI
needs to monitor their effectiveness. Monitoring tools consist primarily of
performance ratios that managers and directors need to track to ensure that risks are
being managed.
This three-step risk management process is ongoing because vulnerabilities change over
time. Risks also vary significantly depending on the institution’s stage of development. An
MFI with 2,500 borrowers will experience different challenges
from an organization with 25,000 outstanding loans. As Risk management
participants in a new industry, MFIs cannot afford to become is ongoing
complacent if they want to avoid being toppled by innovations, because
competition, and new regulations among other things. How often vulnerabilities
is “ongoing”? That will vary by country context, but at the very change over time
least the board should conduct an annual risk assessment update.
3
Besides analyzing the current state of the organization, risk management involves using a
crystal ball to anticipate possible changes in the internal and external environment during the
short-, medium- and long-term. Since no one can accurately predict the future, it is
recommended that you consider best, worst and average case scenarios for each of the three
time periods. While it is probably excessive to prepare for the absolute worst-case scenario,
risk management involves taking a conservative approach in preparing for potential
outcomes. Managers and directors who only plan for best-case scenarios are deluding
themselves and are setting their organization up for perpetual disappointments.
It is important to note that microfinance institutions cannot completely eliminate their

exposure to risks. Any effort to do so would be prohibitively expensive, thus creating a
vulnerability to another set of risks. Managing risk involves the search for the appropriate,
though elusive, balance between the costs and effectiveness of controls, and the effects that
they have on clients and staff.
Structure of the Handbook and How to Use It

The Handbook is divided into six chapters. The first chapter presents a framework for
conceptualizing microfinance risks, and the next four chapters discuss the controls required
to mitigate the four major categories of risks: institutional risks, operational risks,
financial management risks, and external risks. The final chapter describes the
accounting and other systems required for effective risk management.
At the end of most sections is a set of questions that can be used as a control checklist. This
checklist may be useful for managers and board members in conducting a self-assessment of
whether sufficient controls are in place to mitigate various risks. External technical support
agents, like CARE, can also use the checklist to conduct risk management assessments of
their partners. These checklists are summarized and cross-referenced in the appendix by the
individuals responsible for ensuring that the controls are in place. At the end of each
chapter is a list of resources and recommended readings, which is also summarized in the
bibliography that follows the annexes.
The handbook can be used as a mentoring-training guide, a reference manual and a self-
assessment tool. For example:
ê The board of directors can use this handbook as a framework for conducting a risk
assessment of the organization, which is one of its major responsibilities.
ê MFI managers can use the handbook to learn why various controls and systems are
needed and apply the suggested guidelines to their local circumstances. There is not one
way of doing things, so the handbook provides recommendations rather than hard and
fast policies.
ê Supervisors and auditors could use the handbook as a checklist of procedures and
systems that should be in place. Checklists have been inserted at the end of most sections
to remind readers of key systems, controls and procedures.
4
INTRODUCTION
ê Project designers should use the handbook to describe expected controls and procedures
that will exist by the end of a project.
This document is a work in progress. Just as microfinance is a constantly evolving arena, so

will its subsequent risks, controls and monitoring mechanisms change over time. If you find
that sections have become outdated, or new risks and controls have emerged, please bring
this to the attention of CARE’s SEAD Unit so they can make necessary revisions.
5
Chapter 1: Risk Assessment Framework
M
ost microfinance institutions are small and unprofitable, and they operate without
systems that adequately reduce risk. Although the microfinance literature focuses
on success stories, such as BancoSol in Bolivia or BRI’s microfinance units in
Indonesia, these organizations are exceptional. For microfinance programs
striving to fulfill their dual mission of sustainability and outreach to the poor, CARE
suggests implementing the risk assessment framework that addresses two agendas:
1. Financial Health
2. Institutional Development
A standard risk assessment of a financial institution typically addresses the first issue only.
In assessing the financial health of a bank or other financial institution, one would consider
the organization’s asset and liability management, including credit risk, as well as operational
risks such as fraud and inefficiency.
Microfinance risk assessment also needs to embrace an institutional development

perspective. As MFIs evolve from donor dependency to commercial independence, clear
vision, reliable systems, effective governance and staff capacity become critical in their ability
to manage risk.
This integrated risk assessment framework for MFIs, which analyzes institutional
development and financial health issues, is organized into four categories of risk:
institutional, operational, financial, and external (see Figure 2). This framework provides
managers and directors of microfinance institutions with a step-by-step means of assessing their
organization’s current and potential vulnerabilities.
1.1 Institutional Risks

Microfinance success is defined as an independent organization providing financial services
to large numbers of low-income persons over the long-term. An assessment of risks against
this definition results in three categories of institutional risk: social mission, commercial
mission, and dependency.
6
CHAPTER 1
Figure 2: Categories of Microfinance Risks
Institutional Risks
Social Mission
Commercial Mission
Dependency
Financial
Operational Risks Management Risks
Credit Asset and Liability
Fraud Inefficiency
Security System Integrity
External Risks
Regulatory
Competition
Demographic
Physical Environment
Macroeconomic
1.1.1 Social Mission

While all MFIs do not have the same mission statements, in general they have a dual
mission: a social mission and a commercial mission. Their social mission is to provide
valued financial services to large volumes of low-income persons that will enable them to
improve their welfare. Microfinance institutions are vulnerable to social mission risk if they
do not have a clearly defined target market and monitoring mechanisms to ensure that they
are providing appropriate financial services to their intended clientele.
1.1.2 Commercial Mission

The commercial mission of MFIs is to provide financial services in a way that allows the
organization to be an on-going concern; that is, to exist for the long-term as a self-sufficient
organization. MFIs are exposed to commercial mission risk if they do not set interest rates
high enough to cover costs and if they are not managed as a business.
The social and commercial missions sometimes conflict with each other. For example,
offering larger loans might make it easier to become sustainable, but this could undermine
the social mission to serve low-income and harder-to-reach people who traditionally demand
smaller loans. The microfinance challenge is to balance the social and commercial missions
to achieve them both.
1.1.3 Dependency
Dependency risk is similar to commercial mission risk, but it is most pronounced for MFIs
started and supported by international organizations such as CARE, particularly when the
7
microfinance activities are operated as a project rather than as an independent organization.

These MFIs are vulnerable to dependency on support provided by the external organization.
While this support may initially seem like an advantage, it can significantly undermine efforts
to build an independent institution that will exist for the long-term.
1.2 Operational Risks

Operational risks are the vulnerabilities that an MFI faces in its daily operations, including
portfolio quality (credit risk), fraud risk and theft (security risk).
1.2.1 Credit
As with any financial institution, the biggest risk in microfinance is lending money and not
getting it back. Credit risk is a particular concern for MFIs because most microlending is
unsecured (i.e., traditional collateral is not often used to secure microloans).
To determine an institution’s vulnerability to credit risk, one must review the policies and
procedures at every stage in the lending process to determine whether they reduce
delinquencies and loan losses to an acceptable level. These policies and procedures include
the loan eligibility criteria, the application review process and authorization levels, collateral
or security requirements, as well as the “carrots and sticks” used to motivate staff and
compel borrowers to repay. In addition to analyzing whether these policies and procedures
are sound, it is also necessary to determine whether they are actually being implemented.
The best policies in the world are meaningless if staff members are not properly trained to
implement them or choose not to follow them.
1.2.2 Fraud
Any organization that handles large volumes of money is extremely vulnerable to fraud, a
vulnerability that tends to increase in poor economic environments. Exposure to fraud is
particularly acute where money changes hands. These vulnerabilities in a microfinance
institution can be exacerbated if the organization has a weak information management
system, if it does not have clearly defined policies and procedures, if it has high staff
turnover, or if the MFI experiences rapid growth. The management of savings deposits,
particularly voluntary savings, creates additional vulnerability in that a failure to detect fraud
could lead to the loss of clients’ very limited cash assets and to the rapid deterioration of the
institution’s reputation. In the detection of fraud, it is critical to identify and address the
problem as quickly as possible to send a sharp message to staff before it gets out of hand.
1.2.3 Security
As with vulnerability to fraud, the fact that most MFIs handle money also exposes them to
theft. This exposure is compounded by the fact the MFIs tend to operate in environments
where crime is prevalent or where, because of poverty, temptation is high. For example, in
high volume branches the amount of cash collected on a repayment day can easily exceed
the average annual household income in that community.
8
CHAPTER 1
1.3 Financial Management Risks
1.3.1 Asset and Liability

The financial vulnerability of an MFI is summarized in asset and liability risks, which include
interest rate, liquidity, and foreign exchange risks. Interest rate risk rises when the terms
and interest rates of the MFI’s assets and liabilities are mismatched. For example, if the
interest rate on short-term liabilities rises before an MFI can adjust its lending rate, the
spread between interest earnings and interest payments will narrow, seriously affecting the
MFI’s profit margin. MFIs operating in inflationary environments are particularly vulnerable
to this type of risk. Liquidity risk involves the possibility of borrowing expensive short-
term funds to finance immediate needs such as loan disbursement, bill payments, or debt
repayment. MFIs are most vulnerable to foreign exchange risk if they have to repay loans
in a foreign currency that they have converted to local currency and therefore are earning
revenue in the local currency.
1.3.2 Inefficiency
Efficiency remains one of the greatest challenges for microfinance institutions. It reflects an
organization’s ability to manage costs per unit of output, and thus is directly affected by both
cost control and level of outreach. Inefficient microfinance institutions waste resources and
ultimately provide clients with poor services and products, as the costs of these inefficiencies
are ultimately passed on to clients through higher interest rates and higher client transaction
costs.
1.3.3 System Integrity

Another aspect of financial management risk is the integrity of the information system,
including the accounting and portfolio management systems. An assessment of this risk
involves checking the quality of the information entering the system, verifying that the
system is processing the information correctly, and ensuring that it produces useful reports
in a timely manner.
1.4 External Risks

Although MFI managers and directors have less control over external risks, they should
nonetheless assess the external risks to which they are exposed. A microfinance institution
could have relatively strong management and staff, and adequate systems and controls, but
still be prone to major problems stemming from the environment in which it operates.
External risks are usually outside the control of the MFI, however it is important that these
risks are perceived as challenges that the MFI should address, rather than excuses for poor
performance.
9
1.4.1 Regulatory
Policy makers, banking superintendents and other regulatory bodies are becoming
increasingly interested in, and concerned about, microfinance institutions. This concern is
heightened when MFIs are involved in financial intermediation—taking savings from clients
and then lending them out to other clients or institutions. Regulations that can create
vulnerability in an MFI include restrictive labor laws, usury laws, contract enforcement
policies, and political interference.
1.4.2 Competition
In some environments, microfinance is becoming increasingly competitive, with new players,
such as banks and consumer credit companies, entering the market. Competition risks stems
from not being sufficiently familiar with the services of others to position, price, and sell
your services. Competition risk can be exacerbated if MFIs do not have access to
information about applicants’ current and past credit performance with other institutions.
1.4.3 Demographic
Since most MFIs target disadvantaged individuals in low-income communities, microfinance
managers need to be aware of how the characteristics of this target market increase the
institution’s vulnerability. In assessing demographic risks, consider the trends and
consequences of illness and death (including HIV/AIDS), education levels, entrepreneurial
experience, the mobility of the population, social cohesiveness of communities, past
experience of credit programs, and local tolerance for corruption.
1.4.4 Physical Environment

Some areas are prone to natural calamities (floods, cyclones, or drought) that affect
households, enterprises, income streams and microfinance service delivery. In addition, the
physical infrastructure—such as transportation, communications, and the availability of
banks—in the MFI’s area of operations can substantially increase its vulnerability.
1.4.5 Macroeconomic
Microfinance institutions are especially vulnerable to changes in the macroeconomic
environment such as devaluation and inflation. This risk has two facets: 1) how these
conditions affect the MFI directly and 2) how they affect the MFI’s clients, their business
operations, and their ability to repay their loans.
1.5 Conclusion
The management and board of a microfinance institution should consider each of the risks
identified in this chapter as vulnerability points. It is their responsibility to assess the
institution’s level of exposure, prioritize areas of greatest vulnerability, and to ensure that
proper controls are in place to minimize the MFI’s exposure. The next four chapters'
10
CHAPTER 1
address the controls and monitoring tools required to manage each of these four categories
of risk.
Figure 3: Organization of Microfinance Risks by Chapter

Chapter 2 Institutional Risks Social Mission
Commercial Mission
Dependency
Chapter 3 Operational Risks Credit
Fraud
Security
Chapter 4 Financial Management Risks Asset and Liability
Inefficiency
System Integrity
Chapter 5 External Risks Regulatory
Competition
Demographic
Physical Environment
Macroeconomic
Chapter 6 then presents the accounting and portfolio management systems required creating
an effective risk monitoring system. The fact that it comes at the end of this document
should not lessen its importance. The implicit basis for effective risk management is
transparency. If an MFI does not have accurate and timely information that it can analyze
through a variety of different lenses, then it cannot manage its risks. Chapter 6 provides
guidance in how to enhance transparency through information systems.
11
The Ultimate Risk Management Controls:

Good Governance and Quality Human Resources
This handbook contains a host of controls to mitigate the specific risks to which a microfinance
institution is exposed. There are two overarching controls, however, that deserve special
mention because they cut across numerous risks and serve as critical building blocks on which
many of the other controls are based.
Good Governance: The board of directors plays a critical control function in a microfinance
institution. One of the board’s key responsibilities is to analyze risks and ensure that the MFI is implementing
appropriate controls to minimize its vulnerability. This handbook is a valuable tool for directors to
comprehensively review possible risks and to pinpoint the areas of greatest vulnerability.
Unfortunately, the microfinance industry is not particularly well known for its effective
governance, which presents its own set of risks. In the search for effective governance, consider
the following guidelines:
ê The board should be comprised of a group of external directors, with diverse skills and
perspectives that are needed to govern the MFI. The composition should balance the dual
mission of microfinance, with some directors more concerned with the social mission and
others focused primarily on the commercial mission.
ê It is critical that board members dedicate sufficient time to fulfill their functions. It is not
appropriate to appoint directors solely for their “political” value; while it might seem nice to
have the names of famous people in the annual report, if they do not actually attend board
meetings and play a meaningful role, then they are not providing good governance.
ê There needs to be a clear separation of roles and responsibilities between the board and
management. The board oversees the work of senior managers and holds them accountable,
which includes setting performance targets and taking disciplinary action if necessary.
ê The board should meet often enough to keep a close eye on the organization. During
periods of change, this may mean weekly meetings. In mature, stable MFIs, quarterly
meetings might suffice, especially if there is an executive committee of the board that is in
more frequent contact with management.
ê Boards should be regularly rejuvenated so that new ideas and fresh energy are injected into
the organization. This can be accomplished through term limits and/or a performance
appraisal system that encourages inactive and ineffective directors to step down.
Trained and Motivated Personnel: The other “building block” control is the MFI’s
employees. As a service industry, the delivery of microfinance products is just as important as
the products themselves. An MFI can dramatically reduce its vulnerability to most risks if it has
well-trained and motivated employees. This is accomplished through a three-pronged strategy:
ê Hiring: The first step is finding the right people. In hiring field staff, you are probably not
going to find people with microfinance expertise, so instead you should look for certain
values (honesty, commitment to the target market, a willingness to get their shoes dirty),
personality characteristics (outgoing, team player), and aptitudes (combination of “hard”
and “soft” skills). Once you identify the ideal traits of a loan officer, then you can design your
12
CHAPTER 1
screening techniques accordingly. When you find a few of the ideal people, then figure out
where they came from to see if there are more of them out there. Sometimes certain schools,
religious groups or social organizations are excellent sources of new employees.
ê Training: Once you have hired the right people, the next step is to train them well. Training
often focuses on the nuts and bolts of doing a job—such as what forms do you fill out for
what purposes—but to serve as an effective control, training should impart much more than
just technical skills. New staff orientation is the ideal time to indoctrinate your employees, to
bathe them in the institution’s culture, to cultivate their commitment to the organization, its
mission and its clients, and to teach and practice the social skills needed to perform their jobs,
such as group mediation and facilitation, adult education, customer service, and time
management. Training should not end once the loan officer hits the streets. To retain quality
people, and to ensure that they grow and develop as the organization evolves, it is necessary to
provide regular in-service training as well. In the search for increased efficiency, MFIs are
constantly looking for ways to streamline operations and cut corners; they should resist any
temptation to short-change the training of new or existing employees.
ê Rewarding : It is difficult to keep employees motivated and enthusiastic about their work.
MFIs should view their best employees the same way they view their best customers: once you
have them, do every thing possible to keep them. An MFI that wants to retain staff needs to
position itself as the employer of choice. This involves providing a competitive compensation
package, but it is much more than just wages. Salaries are already the biggest line item in most
MFI budgets—so it is necessary to find creative ways of rewarding and motivating staff.
Other factors that influence an employee’s satisfaction, and therefore their willingness to
remain with the employer, include:
ê Benefits such as health insurance and vacation time
ê An institutional mission where people feel that they can make a difference
ê Workplace design that is comfortable and conducive to productivity
ê An institutional culture that is unique so that employees feel like they are part of a special
team
ê Recognition of individual and group accomplishments
ê Staff development and job enrichment opportunities
13
Chapter 2: Institutional Risks and

Controls
Institutional
Risk
Financial
Operational Management
Risk Risk
External Risk
I
nstitutional risks come in two types. The first type involves the institution’s mission,
which has two aspects of its own: the social and commercial. Microfinance is a
powerful development strategy because it has the potential to be a long-term means for
fighting poverty and inequity. One of the greatest challenges in designing and running
microfinance operation is to balance the dual mission so that your MFI: a) provides
appropriate financial services to large volumes of low-income persons to improve their
welfare (social mission); and b) provides those services in a financially viable manner
(commercial mission). Too heavy a focus on one or the other, and microfinance will not live
up to its potential.
The second institutional risk is the dependency of a microfinance program on international

support organizations such as CARE. MFIs that rely on strategic, financial, and operational
support from international organizations are at risk because the longer those links continue,
the harder it is to break them—yet no one should be under the illusion that those links can
continue indefinitely. Microfinance programs that were created as CARE projects, rather
than separate institutions, are particularly vulnerable to dependency risk.
2.1 Social Mission Risk

The social mission of microfinance institutions is to 1) provide appropriate financial services
2) to large volumes 3) of low-income persons 4) to improve their welfare. These four
elements are highlighted in the left-hand column in Figure 4. The right-hand column lists
the controls and monitoring tools that MFIs need to mitigate social mission risk.
14
CHAPTER 2
Figure 4: The Four Ms of Controlling Social Mission Risk

Social Mission Controls and Monitoring
Provide Appropriate Financial Services Market Research
To Large Volumes Managing Growth
Of Low-Income Persons Mission Statement
To Improve Their Welfare Measuring Impact
2.1.1 Mission Statement

The process of controlling social mission risk begins by identifying the target market. In its
mission statement, the governing body of the MFI has to clearly articulate whom the
institution wants to serve and why it wants to
serve them. The mission statement should
also indicate that the organization intends to Commercial Banks and Social Mission
serve this market for the long term as an Do all microfinance institutions have to have a
independent and self-sufficient institution. social mission? Many commercial banks, including
This mission statement then serves as a CARE’s partner in Zimbabwe, are beginning to
guiding light for managers and employees as serve the microenterprise market without a strong
they apply it in their daily activities. sense of social mission. Banks may be motivated to
serve low-income persons because they have been
In developing the mission statement, it is pushed down market by increasing competition at
the upper end, or because they see microenterprises
important to strike a balance between the
as a profitable niche market, or for public relations
social and commercial mission. If the reasons—but they are rarely concerned about
organization narrowly defines the target alleviating poverty. It remains to be seen whether
market, then it may have difficulty achieving microfinance players who only have a commercial
sufficient scale and efficiencies to fulfill its mission will be successful. It is logical though that
commercial mission. For example, if the MFI an organization that deeply cares about its clients
only wants to serve refugees or people with and serves them on a commercial basis will be more
HIV/AIDS, then the potential market for its successful over the long term than an MFI that is
services may not be large enough to create a purely profit-driven.
sustainable institution, or it may be too
expensive to identify and deliver services to a market that is geographically disparate, or the
risks of serving a narrowly defined target group may be too high.
The composition of the board of directors can contribute significantly toward ensuring
that the institution has a good balance, both in its mission statement and how it goes about
fulfilling its mission. It is difficult to find individuals who embody the dual mission of
microfinance, so boards are often constructed to be balanced, with roughly half of the
directors personifying a social bias and the other half with a commercial bent. This may
create some tense board meetings, but it tends to produce appropriate microfinance policy.
15
ê Does your organization have a clear mission statement that balances the social and commercial objectives and
identifies the target market?
ê Do employees know the organization’s mission statement and use it to help guide their actions?
ê Does the composition of the board reflect the dual mission of microfinance?
2.1.2 Market Research

Once the organization identifies its target market, the next step is to understand the needs of
those persons to ensure that it provides them with appropriate services. If the mission is to
serve the poor, an MFI must determine what services the poor want and need. Microfinance
institutions should have the capacity to conduct quality market research. This will allow
them to learn about the needs, opportunities, constraints and aspirations of their intended
clients. Market research is not a once-off activity. The needs of an institution’s target
market will evolve over time. The MFI needs to keep in touch with those changing needs
and to respond accordingly. Microfinance institutions should have an ongoing commitment to
improvement.
Figure 5 provides a summary of the tools used by microfinance institutions to gather

information from current, former, and prospective clients to determine whether they are
providing appropriate financial services, and to solicit suggestions regarding how to
continuously improve those services.
Each MFI has to decide which of these tools are appropriate

given their scale and stage of development. It is unlikely Lost customers are a
that all nine will be needed at once, but it is helpful to rely valuable source of
on three or four market research methods to ensure that you information about
are getting consistent and reliable results. Of the nine, exit what is wrong with
interviews are probably the most important. Lost your products
customers are a valuable source of information about what
is wrong with your products and services, and sometimes by demonstrating an interest in
their opinions you can even attract those clients back.
One of the main purposes of conducting market research is to collect sufficient information
to tailor an MFI’s products and services to the requirements of the target market. To
determine if the financial products and delivery systems are designed appropriately, consider
the following questions:
ê Does your organization use appropriate screening mechanisms to ensure that it is serving the intended target
market?
ê Are the loan sizes appropriate to the needs of the clients?
ê Do you offer a large enough range in loan sizes so that the best clients do not grow out of the program?
ê Do the requirements for accessing a loan (i.e., collateral, meetings, business plan, forced savings) address the
institution’s need to control credit risk (see next chapter) without being excessively demanding on clients?
ê Is it convenient for the target market to access services, in terms of the amount of time required, location of services
(i.e., branch locations), and the timing of those services (i.e., office hours)?
16
CHAPTER 2
ê How do you conduct useful market research activities on a regular basis to keep in touch with the changing needs of
your target market?
ê How does your organization demonstrate a commitment to constant improvement?
Figure 5: Market Research Tools

Tool Explanation
1. Questions on loan Collect information with each loan application from a) new clients
applications regarding their expectations and their experiences with competitors’
products; and from b) old clients about whether their expectations
were met and how the organization can improve
2. Complaint and suggestions Incorporate customer comment cards and/or a customer service
system desk
3. Customer satisfaction Send a short questionnaire to a representative sample of clients, or
surveys to all clients who recently purchased a service along with a thank
you note from the loan officer
4. Individual interviews Hire a market research consultant to conduct interviews with a
sample of current, former and prospective customers
5. Focus groups Gather a small group of clients for an informal discussion on how
the institution can improve its services
6. Client advisory committee Form a committee of client representatives at the branch level to
give regular feedback on products and services
7. Mystery shopping Employ “mystery shoppers” to pose as customers and to evaluate
your organization’s customer service
8. Exit interviews Determine why clients are not continuing to access your services by
interviewing or surveying former clients
9. Staff feedback loop Develop a system by which field staff actively solicit complaints
and suggestions; they should regularly (often daily) document the
feedback they receive, both positive and negative, and then this
information is centrally collated and analyzed
Adapted from Churchill and Halpern (2001).
2.1.3 Monitoring Client Composition and Measuring Impact

Management and the board should have some way of determining whether the organization
is serving the market that it is intended to serve and whether its services are having the
desired effect.
The two most common indicators used to monitor client composition are average loan size
and the percent of women clients. It is also useful to track average loan size specifically for
first time borrowers, because while the average loan size for all clients often rises as the MFI
matures the loans to first-time borrowers should remain fairly steady. If this value is
rising—certainly if it is rising faster than inflation—then the MFI may be migrating away
from its original target market.
17
Figure 6: Monitoring Client Composition
Primary Indicators Secondary Indicators

Average Outstanding Balance Monthly or Annual Household Income
Average Loan Size (disbursed) Household Assets
Average Loan to 1 st Time Clients Enterprise Asset Base
Percentage of Women Clients
In the process of choosing appropriate indicators, such as from the list in Figure 6, it is
important to consider the balance between the social and commercial missions. Some data,
such as household income and enterprise asset base, may be easily available because loan
officers need that information to conduct the credit analysis. If loan officers are expected to
collect information that is not essential to make sound credit decisions, however, they may
have difficulty being efficient and carrying large enough case loads to create a sustainable
institution.
ê What indicators do you use to ensure that you are serving the intended target market?
ê Is this information collected in a cost-effective manner?
ê How does the board monitor the client composition?
ê What information, if any, does your organization consistently collect regarding the impact of your services on
clients?
ê How often does senior management go to the field to talk with clients and staff?
2.1.4 Managing Growth

While many MFIs are interested in serving large volumes of people, in their efforts to do so,
they commonly encounter three types of problems:
1) Capacity Constraints: Some MFIs operate in markets with a large pent up demand
for microfinance. To respond to the demand, an organization may grow very
quickly, only to realize that it does not have the capacity or the systems to satisfy
the demand. These MFIs often experience bottlenecks in the disbursement
process and risk losing credibility in the market place. Before expanding, MFIs
need to ensure that they have the systems to cope with the projected volume of
applications. If the demand exceeds expectations, and it is not possible to
expand capacity, then the MFI needs to find a way of tempering demand,
perhaps by raising interest rates, lengthening the pre-loan process, or limiting the
number of applications a loan officer can submit each month.
2) Premature Expansion: Other organizations operating in similar environments
expand before they have fine-tuned their lending methodology, only to find out
after it is too late that they have large volumes of poor quality loans on the
streets. MFIs must ensure that their loan product is well designed and that the
lending methodology is working before they step on the gas and expand. It is
also important that they resist pressure from donors and others to grow before
they are ready.
18
CHAPTER 2
3) Reaching a Plateau: The opposite growth problem is also prevalent: some MFIs hit
a growth plateau where they get stuck. No matter how hard they try, they cannot
seem to push their expansion to the next level even though they have not
saturated the market. Some get stuck at the 2500 to 3000 active client mark.
Others get stuck at the 5000 to 6000 mark. In some cases, these organizations
need to improve their marketing efforts. A closer examination, however, will
often indicate that the organization has a client retention problem, which will
suggest that the product is not designed appropriately for the market.
To monitor for this third risk, MFIs should track Retention Rate:
their client retention rates on a monthly basis.
For the length of the period, annual is most (# of Loans Made during the Period – Number
commonly used, even for short-term loans, of First Time Borrowers)
because a 12-month period neutralizes the affect /
of seasonal fluctuations. There is no industry (Active Clients (beginning of period) + # of
benchmark that would be particularly useful with Loans Made – Active Clients (end of period))
this indicator. It is more important for the
institution to monitor its retention rate trend. As
with other performance indicators, it is useful to disaggregate the retention rate by type of
product, loan cycle and branch to determine if desertion is a bigger problem in certain
segments of the institution’s client base.
ê How has your retention rate changed over the past year and what are the primary reasons for that change?
ê Does your organization currently have excess capacity, which suggests that you should be poised for growth, or do
you need to build capacity before continuing to expand?
2.2 Commercial Mission Risk

Although intended to serve the poor, microfinance is a business operation that must run on
business principles. This means that a microfinance institution should make decisions based
upon sound business rules, not on charitable sentiment. If an institution’s managers and
board members do not share a business-like perspective, the MFI will be extremely
vulnerable to commercial mission risk.
It seems counter-intuitive that an organization dedicated to helping the poor needs to charge
high interest rates and strive for profitability. The commercial approach makes sense,
however, if you adopt a long-term view. Many of CARE’s development initiatives are short-
term projects with a specific end date. Microfinance, on the other hand, has the unique
ability to provide developmental services on an ongoing basis if it is designed and
implemented properly. With microfinance activities, it is critical to adopt a long-term
perspective because clients do not just want loans for the next three to five years. They
want—and deserve—a safe place to save their money and a convenient place to borrow
funds indefinitely. The only way to provide them with this extremely valuable service over
time, and generate its important development benefits, is by fulfilling the commercial
mission of microfinance.
19
Controls for commercial mission risk include: setting interest rates, designing the capital
structure, planning for profitability, and managing for superior performance.
2.2.1 Setting Interest Rates

In determining their interest rates, MFIs, like all financial institutions, need to cover four sets
of “expenses”:
a) Operating expenses
b) Cost of capital (including adjustments for inflation and subsidies)
c) Loan losses
d) Intended surplus (for retained earnings and/or dividends to shareholders)
If, for example, operating costs amount to 20 percent of average outstanding portfolio, the
cost of capital is 10 percent, and loan losses are 2 percent, then the MFI has to charge an
effective interest rate of 32 percent just to break even. In fact, it should charge a slightly
higher rate so that it can generate a small surplus (perhaps 5 to 15 percent) that can be used
to replace old equipment, open new branches, develop new technologies, etc.
Many mature MFIs are not charging interest rates that are high enough to cover these four
costs, and therefore they have to be subsidized. In fact, many MFIs do not have a clear
understanding of each of these costs. In effect, they are passing their subsidy on to their
clients in the form of an interest rate that is lower than the cost of providing the loan. While
it is nice to give poor people a break, that is not the purpose of microfinance and it is not
sustainable. Microfinance programs need to charge appropriate interest rates that cover the
full costs of providing the services.2
2.2.2 Designing the Capital Structure

The social mission drives some MFIs to provide appropriate financial services to large volumes
of low-income persons. To provide a large number of loans, even very small loans, it
requires a large amount of capital for the loan portfolio, as well as ongoing investments into
the MFI such as upgrading the information system. This raises the question, where do MFIs
get the funds they need to build an institution and fuel the growing demand for microcredit?
Initial capital often comes in the form of grants from donors. Donor grants are an
excellent source of capital for new programs, but are not a long-term solution. Donor
capital is finite and fickle. Concessionary loans are a related source of capital that also
have their time and place, but again are not a reliable source for the long-term.
Retained earnings are another common source of capital. For MFIs that are generating a
surplus of income over expenses, they can plow their “profits” back into their loan
portfolios (or make other necessary investments). This requires being able to generate a
2
It is unrealistic to expect new MFIs to charge an interest rate that is high enough to cover its costs.
Microfinance institutions need to reach certain economies of scale (roughly five to ten thousand clients)
before they can become profitable. A start-up therefore needs capital to pay for operating deficits until it
reaches break-even, perhaps in the form of investor equity, high risk debt, or grants.
20
CHAPTER 2
surplus in the first place, and it is unlikely that MFIs will produce such a large surplus to
completely fund their growth.
Commercial loans are available to some microfinance programs. These are usually
available to unprofitable programs only with some form of external guarantee, such as a
donor-supported loan guarantee fund. Once MFIs become sustainable, they may be able to
access commercial loans using their portfolio or other assets as collateral. As non-profit
organizations, however, MFIs cannot typically get commercial loans at very favorable rates
or in large enough amounts to fund their growth. Consequently, many microfinance NGOs
are considering establishing regulated financial institutions.
Figure 7: Evolution of Capital Sources for a Microfinance Program
Transformation
Commercial
Grant Concessionary Commercial Loans Retained Investor Loans and
Funds Loans with Guarantees Earnings Equity Customer
Savings
The transformation into a regulated financial institution creates opportunities for an MFI to
access two other sources of capital. First, it may allow them to attract equity from
shareholders, which more favorably leverages commercial loans. Second, as a regulated
financial institution, the MFI may be able to accept savings for financial intermediation.
Many MFIs accept savings from their clients, but unless they are regulated financial
institutions, they should not be using that pool of funds for lending.
Figure 7 depicts a common evolution of an MFI’s source of funds, starting with grants and
eventually weaning away from donor-supported funding sources. To monitor its
effectiveness in controlling commercial mission risk (i.e., achieving financial self-sufficiency),
MFIs should properly account for and recognize subsidies in their financial statements.
Chapter 6 provides guidance on making appropriate subsidy adjustments.
It is important to note that, while transformation opens up opportunities for MFIs to access
additional and perhaps more stable sources of capital,
CARE does not expect all of its partners to create
Creating Ownership: Planning from
regulated financial institutions. It is not an appropriate the Bottom Up
solution in all-regulatory environments or for all
institutions that provide microfinance services. Since most targets and ratios highlighted
in the business plan need to be achieved
by the field staff, it is essential that they
2.2.3 Planning for Profitability are involved in the process of identifying
what they think are realistic and
It takes a considerable amount of planning to produce a achievable goals. Branch managers and
profitable microfinance institution and mitigate their teams will feel more motivated to
commercial mission risk. The first step in the planning achieve targets if they are involved in
process is a strategic plan that outlines where the setting them.
organization is going over the next three to five years,
21
and why. Typically the board is actively involved in the strategic planning process. Then
management creates a business plan that answers the question: how will the organization
accomplish its strategic plan? While the business plan may cover the same length of time as
the strategic plan, it will be much more detailed in Year 1 than it will be for subsequent
years.
The Year 1 details then serve as the foundation for the annual budget. The business plan
also produces a monthly or quarterly work plan that management reviews regularly and
updates and adjusts accordingly. This ensures that the business plan is not just a nice report
that collects dust on the shelf, but rather a working document that guides and propels the
organization forward. As time passes, the initial projections should be updated with actual
numbers to help managers adjust their plans and budgets accordingly.
The business plan should include a detailed projection model that predicts when the
organization will achieve self-sufficiency and under what circumstances. These projections
are not only important to help set targets, but they can also be used to explain to all
employees that the organization can afford to cover its costs, but to do so it needs to fulfill
certain assumptions. For example, the projection model can help identify how many
borrowers, what size portfolio, what average loan size and term, etc. that organization will
need to achieve self-sufficiency. This process can also help determine how many loans need
to be processed per week and how many clients each credit officer needs to maintain. With
this information in hand, MFI management should take a careful look at its systems,
documentation requirements, the paper trail and approval processes, and aspects of its
lending methodology to determine how to streamline things to make self-sufficiency a
reality.
2.2.4 Managing for Superior Performance

To reduce the institution’s vulnerability to commercial mission risk, management needs to
drive the organization to achieve superior levels of performance. Managing for superior
performance allows an MFI to get the most out of its employees. This is critical in achieving
both the social and the commercial mission. If the MFI has highly productive and efficient
staff members, the institution will be able to generate more revenue for a fixed set of
expenses, while maintaining small average loan sizes. Once the organization is profitable—
revenue is greater than expenses—then any additional improvements in productivity and
efficiency can allow it to lower its interest rates.
The process of managing for superior performance involves collectively setting

performance targets at all levels within the organization, monitoring the achievement of
targets, and rewarding accomplishments. You can only manage well if you have a system to
measure the effectiveness of what is being managed.
To fulfill the institution’s commercial mission, the retention of The retention of

quality staff members is even more important than retaining quality staff
clients. Try to calculate the costs of losing good people, which members is even
includes hiring and training replacements, higher loan losses and more important
lower productivity of green employees, and the negative impact than retaining
staff turnover has on customer loyalty. While this estimation will clients
22
CHAPTER 2
rely heavily on educated guesses, it will probably show that an MFI cannot afford to lose its
best employees. And if employees leave to work for another MFI, you are in effect
subsidizing the competition.
Managing for superior performance also involves mitigating the effects of certain human
resource risks, such as:
ê A Thin Labor Market: Not being able to find enough affordable employees with the
requisite skills
ê The Peter Principle: Promoting people to their level of incompetence (good loan officers
do not necessarily make good branch managers)
ê Which Comes First? If the MFI is not financially secure and stable, it may have difficulty
attracting the quality of staff that it needs, but if it cannot attract the right people, it will
have difficulty achieving self-sufficiency
To determine whether your human resource policies and systems are effective, consider the
following controls:
ê Develop a means of regularly identifying employee development and motivational needs

ê Invest heavily in your employees by providing quality staff training and sending them on
observation visits to MFIs in other countries
ê Establish a family-like institutional culture in which the employee and the institution are
fully committed to each other
ê Create internal communication channels such as a two-way performance review process,
regular employee satisfaction surveys, and an employee advisory committee to advise the
human resource department
ê Monitor employee turnover ratios
ê Conduct exit interviews with departing staff members to determine the real reasons why
they are leaving
2.2.5 Monitoring for Commercial Mission Risk

To monitor whether an MFI is sustainable and generating a surplus, CARE recommends
that organizations monitor the sustainability and profitability ratios summarized in Figure 8.
Efficiency and productivity indicators are also important; these are addressed in Chapter 4.
23
Figure 8: Sustainability and Profitability Ratios
Sustainability
Operational Sustainability Operating income / (Operating expenses + provision for loan losses
+ financing costs)
Financial Sustainability Operating income / (Operating expenses + provision for loan losses
+ adjustments for inflation and subsidies)*
Interest Spread (Gross (Operating income – financing costs) / Average performing assets
Financial Margin)
Profitability
Return on Assets Net income / Average assets
Return on Equity Net income / Average equity

*For more details about adjusting for inflation and subsidies, see Chapter 6.
ê Is the interest rate set high enough to cover the MFI’s full costs?
ê Do you have a business plan to achieve self-sufficiency in a reasonable amount of time?
ê Do you update the plan and use it regularly to make management decisions?
ê What steps do you take to ensure that your employees are motivated and enthusiastic about their work?
ê Is your human resource system effective and how do you know?
ê Do you have job descriptions and annual performance appraisals for all employees, including senior management?
ê Does your organization set challenging, yet achievable, performance targets for all layers of the organization, and
does it monitor and reward achievement of these targets?
ê Do you monitor sustainability and profitability indicators, and if so are they trending in the right direction?
ê Are you moving toward accessing commercial sources of capital and reducing reliance on subsidized funding
sources?
ê Do you properly account for subsidies and in-kind donations?
2.3 Dependency Risk

The objective of CARE SEAD program managers is to create independent, sustainable
microfinance institutions. But how does an institution define independence? CARE is a
robust international organization, yet there is continual concern over potential dependence
on one or two major donors. The dependency risk is greatest for any MFI that begins life as
a project of CARE, but the risk also exists for MFIs that are legally independent of CARE.
The risk of dependency can be evaluated at three levels: 1) strategic planning, 2) financial
resource mobilization, and 3) operational management. For any given MFI the dependency
risk may be focused in one or more of these areas, but a truly independent organization must
be the master of all three.
24
CHAPTER 2
2.3.1 Strategic Dependence

CARE is a multi-sectoral relief and development agency, not a specialized microfinance
organization. The decision to pursue microfinance in a given country is based on a Long-
Range Strategic Plan (LRSP) that matches CARE’s many comparative and competitive
advantages within the development context of the host country. Microfinance is never the
only activity for a CARE country office (CO). CARE program managers often view
microfinance as a component of a larger development strategy. There are certain advantages
to this approach at an analytical level, but there are also several risks that MFI and CARE
managers must keep in mind.
First, country office program managers may view the MFI strategy as subordinate to
the short and medium-term objectives of other programs in the CARE portfolio. For
example, an MFI could be pushed into extending credit to farmers in rural areas to
meet the needs of participants in a CARE development project even though rural
loans could undermine the long-term financial and institutional sustainability of the
MFI.
Second, there may be a timing mismatch between CARE’s “long range” strategic
planning process and the time it takes for an MFI to achieve financial sustainability.
Changes in country office and regional management during and between LRSP periods
can add insecurity and inconsistency to the business planning cycle of an MFI that
depends on CARE for financial or technical support.
Finally, when CARE is the actual or effectively the owner of the MFI, local managers
and board members can be marginalized by the dominant position of CARE within
the governance structure. Board members with little personal stake in the MFI and
even less experience in microfinance may be easily persuaded to defer to CARE for
strategic and operational decisions.
ê Do you have an independent governing body?

ê Does your organization have a plan to establish itself with an independent legal structure?
ê Do you share clients with other CARE programs? If so, is the strategy driven by the business plan of the MFI
and does it contribute to long-term sustainability or do projections show a continuing need to cross-subsidize this
population?
ê Does your organization have the capacity and commitment to develop its own business plan?
ê Is CARE’s role in the governance and management structure best described as supportive or dominating?
25
Responsibilities of an Independent Board of Directors

The board’s responsibilities consist of five categories of activities:
Legal obligations: The board ensures that the MFI fulfills its legal obligations and protects it
from unnecessary liability and legal action.
Strategic direction: The board ensures that the institution’s mission is well defined, reviewed
periodically, and respected over time. The board works to enhance the image of the institution
and ensures that an appropriate planning process takes place.
Fiduciary: The board serves as the institution’s steward. It should ensure that the institution has
adequate resources to implement agreed-on plans. The board guarantees the long-term viability
of the institution.
Oversight: The board governs, not manages. It appoints and oversees the managing director.
The board monitors operations and business performance. The board evaluates the institution’s
performance in relation to other MFIs. The board assesses and responds to internal and external risks,
and protects the institution in times of crisis.
Self-assessment and renewal: The board should regularly assess its own performance. Board
renewal is one of the most important outcomes of the self-assessment process.
Adapted from Campion and Frankiewicz (1999).
2.3.2 Financial Dependence

A CARE country office has a distinctly different strategy for mobilizing financial resources
than an independent microfinance institution. The two strategies can find themselves in
conflict. This conflict may be hidden by a high degree of apparent consent between CARE
and the MFI, yet financial dependence, however agreeable to the MFI, will ultimately
undermine the long-term objective of self-sustainability.
CARE generates the bulk of its financial resources by developing project proposals and
winning grants from institutional donors. Larger, more complex projects typically win
bigger grants and pay for a greater percentage of core costs for the CARE country office.
But microfinance projects have the opposite tendency. As a successful MFI grows in scale
and profitability, the need for donor subsidies diminishes towards zero. CARE may receive
grant funding to continue a technical partnership, but the contribution to core costs quickly
becomes negligible. While CARE does not encourage dependency simply to secure grant
funding, the lost donor income will have an impact on the viability of the country office. At
a minimum it can be said that there is no business incentive for a CARE country office to
push a young MFI towards independence.
The MFI may also be reluctant to see a reduction in CARE’s grant funding. Ideally an
independent microfinance institution will acquire its financial resources through retained
earnings, equity investments, or taking on commercial debt. Yet CARE’s ability to raise
money may discourage MFI managers from aggressively pursuing a more sustainable
financial management strategy. At worst, CARE financial support may be seen as insurance
26
CHAPTER 2
against losses due to mismanagement or inefficiency and directly inhibit the MFI from
achieving optimal levels of performance.
ê What percentage of your operating expenses is covered by money received from or through CARE?
ê Do you have an independent contract for financial resources from a donor or commercial lender?
ê Is your organization reducing its dependence on donor/CARE subsidies by as much as estimated in the business
plan? If not, why not?
ê Is CARE the only entity that has raised investment capital and operational subsidies for your organization?
2.3.3 Operational Dependence

Operational dependence has both functional and cultural aspects. A functional
dependence occurs when a routine task of the organization is performed or authorized by
staff outside the MFI’s management structure. For example, if the CARE finance
department manages important treasury functions, a functional dependence exists.
Functional dependence is normally easy to spot and efforts should be made to estimate the
fair market value of any services provided by CARE to the MFI. But the MFI should have a
plan to assume responsibility for all CARE functions within the shortest possible time,
preferably from the start of operations.
For MFIs that operate as projects of CARE the functional dependence can be assumed to be
nearly complete as all authority for MFI activities is derived from CARE management.
However, even in these cases the functional dependence can be reduced if the MFI develops
the internal capacity to complete all tasks incumbent on any private business enterprise
lacking only the legal authority to do so independently.
Cash Management
Cash management issues can arise in projects with CARE-owned MFIs, when the MFI
financial management system is not separated from the CARE CO system. In these cases
the CARE Financial Controller is likely to make cash management decisions regarding cash
flows through the MFI, rather than allowing the MFI to manage its own cash. As a result,
cash management decisions may be made in the best interests of the CARE CO, to the
detriment of potential MFI revenues. Additionally, MFI managers become dependent on
CARE financial managers to manage their cash. Regardless of structure or relationship with
CARE, it is imperative that MFIs manage their own cash, as an internal treasury
management capacity is essential for institutional survival.
ê Does your organization have its own independent financial system?

ê Do you make cash management decisions independently from CARE?
CARE Overhead Core Costs

CARE, as well as other development organizations, must cover its core operational costs. As
a decentralized organization, it operates on the principle that every country office must be
27
able to pay for its own management structure from the country office revenues. A country
office must keep central management costs to an efficient minimum and maintain a project
portfolio that is large enough to cover these shared costs.
Within CARE, project costs are generally shared among projects on a prorated basis. Effort
must be made to ensure that the costs reflect fair fees in relation to the services provided to
the project. This is especially important for MFIs since many of the overhead support
activities typically done by CARE within a project are (and should be) directly handled by the
MFI such as general management, financial management of day-to-day operations, etc.
Even for projects that are not fully independent, their operations should be structured and
managed as an MFI and not as a part of the CARE Country Office.3 The Economic
Development Unit advocates that the project constructs financial reports (balance sheet and
income statement) to represent the financial position of the MFI apart from CARE and the
project.
ê Does the MFI have its own financial system?

ê Are the financial and programmatic reporting expectations and procedures clear between the MFI and
CARE?
ê Are the CARE country office core costs reasonable?
ê Is there a written and well-understood agreement between the MFI and the CARE country office on fees
to be paid for support services provided by CARE?
Institutional Culture
Operational dependency may also manifest itself in the institutional culture of the MFI. The
corporate culture of CARE as a relief and development NGO is necessarily different than
the business-orientation of a successful microfinance institution. In many countries CARE
staff are paid better than equivalent jobs in the government or even the private sector, largely
to compensate for the insecurity of working for a grant-dependent, non-profit organization.
CARE is not required to operate projects at a profit, but merely needs to negotiate sufficient
donor support to pay for budgeted costs. Therefore, CARE employees do not necessarily
have a personal stake in holding down operational costs and there is no universal measure of
efficiency.
By contrast, the survival of a business-oriented MFI depends on employees feeling a real

sense of ownership over the activities and assets of the institution. In most cases, salaries
and benefits have to be set below the norms established for CARE staff, consistent with the
MFI’s need for profitability and the promise of more stable, long-term employment.
Success (and job security) or failure (and potential unemployment) is as clear as the MFI’s
profit and loss statement.
3
For specific financial guidelines on how to account for Country Office overhead costs, please refer to the
CARE Financial Guideline Manual.
28
CHAPTER 2
Not surprisingly many employees of MFIs are tempted by the CARE culture. This tendency
is particularly difficult to manage when the MFI is legally a project of CARE. It is very
difficult to convince personnel who were hired by CARE that they should later become
employees of a fledgling local organization. CARE country office regulations may stipulate
salary and benefit structures that cannot be sustained by the MFI. SEAD program managers
must have the flexibility to create an independent compensation schedule, staff incentives, and human resource
manual based on the need for institutional profitability, the market realities of the local
environment, and the dignity and performance of the individual employees.
Institutional culture is also influenced by the image or brand name recognition of an

institution. Some employees may find it easier to use CARE’s name with clients and
counterparts than work to establish the identity of a new microfinance institution. This can
have a negative effect on repayment discipline, especially if CARE has distributed gratuitous
relief during emergencies in communities served by the MFI.
ê Do field staff members consider themselves employees of CARE or the MFI? If it is the former, what are the
implications?
ê What percentage of their time do loan officers spend in the field? If it is less than half of their time, does the
association with CARE somehow make them think that they have administrative positions and should be sitting
behind a desk rather than getting their shoes dirty?
Technical Assistance
A person learns to drive a car by being behind the steering wheel. S/he needs instruction on
its operation and its controls prior to turning on the ignition. However, the process of
training continues after the car is under the control of the new driver. Technical assistance
(TA) is needed to mentor the driver through difficulties. Mentoring as a means of technical
assistance can be much more difficult and challenging than actually driving. One of the
challenges in the mentoring process is gradually decreasing the involvement of the mentor so
as to reduce the potential for dependency.
Technical assistance is normally focused on four primary aspects, which are:

ê Tools: Having the things needed to operate, such as adequate staff, systems, procedures
ê Training: Developing the skills of management and staff
ê Coaching and mentoring: Using the ongoing operations as a setting for learning and dialogue
(apprenticeship)
ê Monitoring: Ensuring accountability through follow-up on clear expectations and joint
analysis of the results
Technical assistance plays a fundamental role during early operations. Effective TA results
in a transfer of skills and systems, and builds local capacity so that the MFI can advance
toward independence. The role of the technical assistance provider should decrease over
time so that the institution becomes less vulnerable to dependency risk.
Microfinance managers and directors should not assume, however, that once they learn how
to run an MFI, they no longer need technical assistance. MFIs often reach capacity plateaus,
or they encounter unforeseen and intractable difficulties. If they want to make the leap from
29
10,000 to 20,000 clients, or introduce a new product, or use technology to create efficiencies,
then they may benefit from external expertise. If client retention rates are plummeting or
delinquency rates are rising, they may want to hire a consultant to get to the bottom of
things. CARE may provide this external technical assistance, or it may come from other TA
providers, either local or international.
While CARE may take the lead role in training MFI staff at the start of the project,
eventually the MFI must determine its own staff needs and develop its capacity to hire, train,
and mentor its own staff. This implies the need for strong in-house training capacity that
can replenish skills as staff move on and respond to a changing market environment.
There is an important difference between using technical assistance and being dependent on
it. To avoid dependency risk, MFIs should be the ones to determine the role of the TA
providers. The TA contract should be for a specific time period and every effort should be
made to transfer skills from the TA provider to local staff.
ê Is your organization building its capacity to operate independent of ongoing technical assistance?
ê Does your organization have the ability to identify its own needs and to contract appropriate technical expertise to
address those needs on its own terms?
2.3.4 Dependency Risk Controls
Exit Strategy
The risk of dependency is greatly increased in the absence of a clear vision of where one is
going. If an external organization like CARE provides services to a microfinance institution,
it should include an exit strategy to withdraw its support over a specified period of time.
Without this strategy, the risk is for CARE to take its MFI partner(s) down a path of
dependency, which is not healthy for partner organizations.
Since CARE supports microfinance activities in a variety of different environments, there is

not a general “blueprint” for organizational evolution. It may be appropriate to create a
credit union in one country, a bank in another, and an NGO in a third. But there is one
basic principal that should be followed to minimize the potential for dependency: local
ownership. This does not have to mean ownership in an economic sense. At a minimum,
ownership means that local personnel have the skills, resources and motivation to continue
managing operations in CARE’s absence.
This principle does not mean that CARE must absolve itself of all ownership and links in
order to complete the process of transfer. In many cases the best approach for CARE may
be to remain involved as a board member, investor and/or possible lender to the MFI.
It would be a serious mistake for CARE to transfer ownership and especially funds to an
organization that is not equipped to manage its operations without oversight. The CARE
“donor project” mentality often creates pressure to do exactly that as the project funding
cycle winds down. This can be detrimental to the long-run health of the MFI.
30
CHAPTER 2
ê Does CARE have an exit strategy?

ê Are there clear indications of local ownership such that Identity and Institutional Culture
microfinance service operations will likely continue in
MFIs that begin as CARE projects may struggle to
CARE’s absence?
establish an independent identity and distinct
corporate culture.
Independent Structure
A very critical first step toward the development 1. Name: The MFI should choose a separate
name as soon as possible and avoid the
of a self-sufficient microfinance institution is to necessity of identifying itself as “CARE”
separate the microfinance activities from the 2. Office Space: The MFI should not share space
CARE structure as soon as possible, preferably with other CARE projects.
from inception. To be classified as independent, 3. Recruitment: At startup the MFI may want to
a structure should have the following four recruit some experienced CARE staff, but
elements: a separate financial system, a distinct caution should be used in such cases as a large
governing body, human resource department, number of transfers from CARE projects may
and an independent legal structure. hinder efforts to establish a fresh, business-
oriented corporate culture.
Generally, no loans should be issued and no 4. Orientation and Training: Newly hired staff
savings generated until the program or project should receive a thorough orientation designed
to instill a sense of the vision, purpose and
has its own independent financial system. It is principles of the MFI, not CARE.
better to maintain accounting and loan ledgers 5. Quality of Leadership: MFI directors and
by hand in an independent local structure than managers must reinforce corporate values and
to use computerized systems in a project that is lead by example.
run by CARE.
An independent MFI must have a designated or

defined governing body. This may take the form of a board of directors, or the elected
officials of a cooperative or association, or if the project is not yet a legal entity, an “ad hoc”
advisory board that assumes oversight responsibilities and expects to evolve into a board of
directors. If possible, CARE should be a part of this governing body at the beginning, but
the local management should make operational decisions.
A microfinance institution consists primarily of people: lots of loan officers and perhaps
tellers, a handful of middle managers, some back office personnel, and senior management.
For these people to have the appropriate skills and motivation, the MFI must have an
independent human resource department that writes job descriptions, recruits and screens
applicants, designs compensation systems, orients and trains new staff, provides ongoing
training and staff development, coordinates a performance review process, and promulgates
the institution’s culture.
It may not be possible or advisable for the local institution to form an official legal
structure in the early stages, but it should at least articulate a general organizational
development plan. The transfer of legal ownership is relatively easy if the other two
pieces—the MFI’s financial systems and governing body—are independent of CARE, and if
checkpoints for eventual transfer of ownership are clearly outlined. Legality is less an issue
in mitigating dependency risk than the mindset of employees, management, and directors.
Consequently, if legally possible, employees should be hired by the MFI, not by CARE.
31
Recommended Readings
Setting Interest Rates
Castello, Carlos, Katherine Stearns and Robert Peck Christen (1991). Exposing Interest Rates: Their True
Significance for Microentrepreneurs and Credit Programs. Discussion Paper No. 5. Somerville, MA:
ACCION International. Website: www.accion.org.
Rosenberg, Richard (1996). Microcredit Interest Rates. CGAP Occasional Paper, No. 1. Washington, DC,
USA: Consultative Group to Assist the Poorest. Website: www.cgap.org.
Performance Ratios
Bartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios I: Analyzing
Profitability in Microcredit Programs. GEMINI Technical Note No. 7. Bethesda, MD: Development
Alternatives, Inc. Website: www.mip.org.
Christen, Robert Peck (1997). Banking Services for the Poor: Managing for Financial Success. Somerville, MA:
Ledgerwood, Joanna (1999). M icrofinance Handbook: An Institutional and Financial Perspective. Washington
DC: The World Bank. Email: books@worldbank.org. See pages: 205 – 232.
Ledgerwood, Joanna and Kerri Moloney (1996). Financial Management Training for Microfinance Organization:
Accounting Study Guide. Toronto: Calmeadow. Website: www.calmeadow.org. Available from PACT
Publications.
SEEP Network and Calmeadow (1995). Financial Ratio Analysis of Micro-Finance Institutions. New York:
PACT Publications. Email: books@pactpub.org.
The MicroBanking Bulletin. A semi-annual publication. Email: microbanking@calmeadowdc.org.
Governance and Management

Campion, Anita and Cheryl Frankiewicz (1999). Guidelines for the Effective Governance of Microfinance
Institutions. Occasional Paper No. 3. Washington DC: The MicroFinance Network. Email:
mfn@mfnetwork.org. Available from PACT Publications. Email: books@pactpub.org.
Rock, Rachel, Maria Otero and Sonia Saltzman (1998). Principles and Practices of Microfinance Governance.
USAID’s Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc.
Website: www.mip.org.
SEEP Network (1993). An Institutional Guide for Enterprise Development Organizations. New York: PACT
Publications. Email: books@pactpub.org.
Market Research
Brand, Monica (1998). New Product Development for Microfinance: Evaluation and Preparation. USAID’s
Microenterprise Best Practices Project. Bethesda, MD: Development Alternatives, Inc. Website:
www.mip.org.
Brand, Monica (1999). New Product Development for Microfinance: Design, Testing and Launch. USAID’s
www.mip.org.
Churchill, Craig F. and Sahra S.Halpern, (2001). Building Customer Loyalty: A Practical Guide for Microfinance
Institutions. Technical Note No. 2. The MicroFinance Network: Washington DC. Email:
SEEP Network (2000). Learning from Clients: Assessment Tools for Microfinance Practitioners. USAID AIMS
Project. Draft Manual. Website: www.mip.org.
32
CHAPTER 2
Waterfield, Charles and Ann Duval (1996). CARE Savings and Credit Sourcebook. Available from PACT
Business Planning and Managing Growth

Churchill, Craig F. (1997). Managing Growth: The Organizational Architecture of Microfinance Institutions.
Sheldon, Tony and Charles Waterfield (1998) Business Planning and Financial Modeling for Microfinance
Institutions. Washington, DC, USA: Consultative Group to Assist the Poorest. Website:
www.cgap.org.
33
Chapter 3: Operational Risks and Controls
Institutional
Risk
Financial
Risk Risk
External Risk
O
perational risks are the vulnerabilities confronting a microfinance institution in its
daily operations that can ultimately result in the loss of its assets. At its core, an
operational risk is the concern that an MFI will lose its money through bad loans,
fraud and theft. This chapter describes controls and monitoring activities to reduce
the three types of operational risks summarized in Figure 9.
Figure 9: Types of Operational Risks
Operational Risk Type of Loss Primary Perpetrator
1) Credit Risk Loss resulting from poor portfolio quality Clients
2) Fraud Risk Loss resulting from deceit MFI staff members
3) Security Risk Loss resulting from theft Non-MFI persons
To reduce vulnerability to operational risks, microfinance institutions develop policies and

procedures that form the core of the organization’s internal control system. These controls
usually include preventive and detective aspects. Preventive controls inhibit undesirable
outcomes from happening. Examples of preventive controls include:
ê Hiring trustworthy employees who can make good credit decisions

ê Ensuring that loans are backed by appropriate collateral or collateral substitutes
ê Segregating staff duties to prevent intentional wrongdoing
ê Requiring authorization to prevent improper use of resources
ê Maintaining proper record keeping procedures to deter improper transactions
ê Installing sufficient security measures (i.e., locks, guards, safes) to protect cash and other
assets
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CHAPTER 3
Detective controls identify undesirable outcomes when they do happen. Examples of

detective controls are:
ê Reconciling bank statements with cash receipts

ê Monitoring early warning signals for signs of pending portfolio quality problems
ê Implementing delinquency management policies to prevent late payments from
escalating into bad debts
ê Monitoring staff performance to ensure policies and procedures are followed
ê Visiting clients to ensure that their loan and saving account balances and transaction
dates correspond with the MFI’s records
Arriving at the appropriate balance of preventive and detective controls involves judgment.
Preventive controls avoid problems before they occur, but detective controls are generally
easier to implement. For example, it is easier to do monthly bank reconciliation than to
prevent employees from pocketing repayments.
There are also important cost implications to consider. MFIs cannot eliminate losses due to
operational risks. Some loans are bound to go bad and some staff members will
undoubtedly succumb to temptation. Controls designed to minimize the losses from
operational risks need to be carefully analyzed for their cost-effectiveness—some controls
may be more expensive than they are worth.
3.1 Credit Risk

Credit risk, the most common and often the most serious vulnerability in a microfinance
institution, is the deterioration in loan portfolio quality that results in loan losses and high
delinquency management costs. Also known as default risk, credit risk relates to client
failure to meet the terms of a loan contract.
One microloan does not pose a significant credit risk because it is such a small percentage of
the total portfolio. Since most microloans are unsecured, however, delinquency can quickly
spread from a handful of loans to a significant portion of the portfolio. This contagious
effect is exacerbated by the fact that microfinance portfolios often have a high concentration
in certain business sectors. Consequently, a large number of clients may be exposed to the
same external threat, like a crackdown on street vending or a livestock disease. These factors
create volatility in microloan portfolio quality, heightening the importance of controlling
credit risk.
3.1.1 Credit Risk Controls

Credit risk management can be divided into the preventive steps lenders take before issuing a
loan and the use of incentives and disincentives after loan disbursement to extract timely
repayment. Prior to issuing a loan, a lender reduces credit risk through controls that reduce
the potential for delinquency or loss, such as loan product design, rigorous client screening,
and client orientation to expectations and procedures. Once a loan is issued, a lender’s risk
35
management expands from controls that reduce the potential for loss to controls that reduce
actual losses. As such, delinquency management procedures are key components of credit
risk management. This section addresses four key credit risk controls: (1) loan product
design, (2) client screening, (3) credit committees, and (4) delinquency management.
Loan Product Design

MFIs can mitigate a significant portion of default risk by designing loan products that meet
client needs. Loan product features include the loan size, interest rate, repayment schedule,
collateral requirements and any other special terms. Loan products should be designed to
address the specific purpose for which the loan is intended. For example, a loan to purchase
inventory for a neighborhood grocery store might have a different repayment schedule and
use different collateral than a loan for a sewing machine. A loan for purchasing seeds and
fertilizer to grow maize may have another structure, perhaps with repayment coming in a
lump sum at harvest time. Loan products for non-business purposes, such as housing,
emergency, education, and consumption smoothing, also require different design features.
In designing loan products to minimize credit risk, consider the characteristics summarized
in Figure 10. For new clients, MFIs commonly adopt conservative product design features,
In Search of the Right Balance:

The Costs of Credit Risk Controls and their Effect on Customer Satisfaction
Microfinance institutions should strive to find the appropriate balance between managing credit
(and fraud) risks, the costs and effectiveness of each control, and the attainment of customer
satisfaction.
For example, many MFIs require new clients to repay their loans in weekly installments. This is
considered an important control for credit risk because smaller installment sizes are easier to
repay and frequent repayments are easier to monitor. But how much more effective in
controlling credit risk are weekly repayments than biweekly? Is it effective enough to endure
the costs of having twice as many repayment transactions? Does the benefit of assumed lower
loan losses justify the high costs (time and money) to clients in the form of travel and lost
business? What effect does this control have on customer satisfaction and loyalty?
MFIs should explore the same series of questions for all of their credit risk controls, such as
forced savings, staggered disbursements, months of pre-loan training, etc. in an effort to
significantly reduce the costs to both the client and the institution while hopefully improving
the effectiveness of the controls. Often MFIs assume that certain controls are necessary to
exact timely repayment, but they have not determined exactly how important they are, nor have
they analyzed whether they are worth the cost.
36
CHAPTER 3
such as small loan amounts, short loan terms, and frequent repayment periods. This is
particularly true if clients lack business records (i.e., they cannot provide evidence of their
capacity to repay) and cannot offer collateral.
Once the client establishes a track record with the lender, the MFI often increases the
flexibility in loan terms to make the product more appropriate to client needs. This change
reflects a balance between risk and control. New clients are categorized as high risk. Once
they establish a credit history with the MFI, they can be considered a lower risk and the
lender can reduce some of its controls.
Figure 10: Reducing Credit Risk through Product Design Features

Many MFIs require that applicants meet certain criteria that are known to reduce credit
risk. For microenterprise loans, for example, prospective borrowers are often expected
Eligibility to have been in business for at least six months to demonstrate that they have a
Requirements commitment to their businesses and some experience. Other eligibility requirements
include business documentation (i.e., bank statements, sales receipts) and a business
plan.
MFIs must ensure that the loan amount is within the client’s capacity to repay. One of
the most common product design flaws in microfinance is automatically increasing loan
Loan Amounts sizes. A second issue, though less common, is issuing multiple loans (where the client
accesses loans from multiple sources) with an aggregate installment beyond client
capacity to repay.
One way to address the capacity issue is to extend the loan term to make installments
smaller. This approach, however, has to be balanced with the fact that access to the
Loan Terms next loan is a primary repayment incentive. If the prospect of a next loan is too far
away, some clients may lose a key incentive to continue repaying this loan.
Repayment frequency (i.e., weekly, monthly) allows the MFI to control credit risk. The
more frequent the repayment, the more in-tune the institution is to its portfolio quality.
Repayment The discipline of frequent repayments allows the MFI to more tightly control credit risk.
Frequencies However, repayment frequency must be balanced with transaction costs to the client
and the institution, as well as the type of loan.
Collateral is the primary mechanism lenders use to reduce credit risk. However,
microfinance clients often do not have traditional collateral, such as property deeds.
Collateral Instead, MFIs use non-traditional collateral (i.e., personal guarantees, household assets,
Requirements forced savings) and collateral substitutes (i.e., peer group lending methods) to reduce
credit risk.
The price of the loan reflects a balance of various issues, including costs of delivery and
risk level. In general, loans that are more costly and riskier require higher rates of
Interest Rates interest. MFIs that price their products too low will not be able to cover their costs,
and Fees and eventually will go out of business. If they price their products too high, however,
they may have difficulty attracting sufficient lower-risk clients to maintain a healthy
portfolio.
The process of loosening these controls also rewards timely repayment. The MFI should
inform clients from day one that their ability to access more accommodating services
depends on their repayment history. If they repay on time, they can access preferred
37
product features such as larger loan sizes, lower interest rates, and less frequent repayment
periods.
Another positive benefit of reducing controls for low risk, repeat borrowers is that it helps
to reduce client desertion. Desertion refers to clients who choose not to take a new loan
after paying off an existing loan. Some of these clients may leave your organization because
a competing MFI offers loan products better suited to their needs. MFIs that do not make
appropriate accommodations for these clients find that they lose the borrowers they most
need to keep. It is very important that an MFI conduct “exit interviews” with at least a
portion of clients that do not apply for a new loan. The MFI needs to know if there is a
growing trend of client desertion because of certain undesirable characteristics of MFI
services or positive characteristics of competitor services, either of which may necessitate
change in product design or service delivery.
ê What characteristics of the product design are intended to control credit risk?
ê Are those characteristics appropriate for different segments of the target market (i.e., new clients and repeat
clients)?
ê Are the features of the loan product reviewed regularly to determine if they should be modified?
ê Are exit interviews conducted with clients who are leaving client groups or discontinuing to use the MFI services?
Client Screening
The first step in limiting credit risk involves screening clients to ensure that they have the
willingness and ability to repay a loan. When analyzing client creditworthiness, microfinance
institutions typically use the five Cs summarized in
Figure 11. If any of these components is poorly analyzed, credit risk increases. To limit this
risk, institutions develop policies and procedures to analyze each component.
Figure 11: The Five C’s of Client Screening

(1) Character An indication of the applicant’s willingness to repay and ability
to run the enterprise
(2) Capacity Whether the cash flow of the business (or household) can
service loan repayments
(3) Capital Assets and liabilities of the business and/or household
Access to an asset that the applicant is willing to cede in case

(4) Collateral of non-payment, or a guarantee by a respected person to repay
a loan in default
A business plan that considers the level of competition and the

(5) Conditions market for the product or service, and the legal and economic
environment
These five components are relevant to all types of lending institutions. The weight assigned
to each component will vary depending on the lending methodology (i.e. solidarity group,
village banking or individual), the loan size, and whether it is a new or repeat customer.
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CHAPTER 3
Not everyone who applies for a loan is a good credit risk. Regardless of the lending
methodology, loan officers should be expected to make wise credit decisions.
Unfortunately, in some MFIs, staff members act more like loan administrators than loan
officers do. If all of the paperwork is in order and the applicants have fulfilled whatever
savings and meeting requirements there might be, then they automatically receive a loan.
This often results in poor portfolio quality. Loan officers and their immediate supervisors
should consider the 5 Cs when making credit decisions and they should be held accountable
for those decisions.
Character: In microfinance, character is the single most important means of screening new
applicants. By assessing a client’s character, the lender gains important insight into the
client’s willingness to repay. Although the MFI does not want to put clients in a difficult
situation, clients with good character will find a way of repaying their loans even if their
businesses fail. The importance of character as the key trait to select new borrowers is
heightened by the fact that many microenterprises do not have sufficient records to
demonstrate their capacity to repay.
Screening for character varies by the lending

methodology. In group-lending programs, the Character Assessment at Bank Rakyat
group assumes responsibility for selecting Indonesia’s Microfinance Units
members of strong motivation and character
because members guarantee each other’s loans. At BRI’s microfinance units, most loan
With individual lending, besides interviewing rejections are based on character, not
business assessment. Rejection occurs if the
neighbors and opinion leaders in the community, credit officer learns that the applicant is not
loan officers also need to ensure that information respected in the community or has
provided by the applicant is internally consistent. misrepresented himself in the application.
This is often tested through a three-stage method Almost without exception, loan officers
whereby applicants provide information about identified the neighbor’s assessment of the
themselves and their business in a loan applicant’s character as the most important
application. Then the loan officer visits the means of predicting a new applicant’s future
household and/or business to, among other repayment behavior—more important than
things, verify that the application information is the business assessment.
correct. Finally, the loan officer checks other Churchill (1999).
sources regarding the reliability of the
information, such as a landlord regarding the size of rent and the length of residence, or a
supplier regarding the frequency and size of inventory purchases.
Figure 12 summarizes methods for character screening.
39
Figure 12: Methods for Screening Client’s Character
ð Check personal and community references to assess the applicant’s

reputation.
ð Use peer groups in which clients select other group members who they
believe are honest and reliable.
ð Maintain a blacklist of past poor performers to avoid repeat lending to
bad clients.
ð Interview client to understand his or her motivation for borrowing
money.
ð Check credit history with suppliers, other credit organizations, or with
credit bureau, if available.
Campion (2000).
Capacity: To assess an applicant’s capacity to repay, loan officers conduct both business
and household assessments. One challenge in determining the business’ capacity to repay is
the fungibility of money: what the client says she will use the loan for and what she actually
uses the loan for may be different. Because the lines between a microentrepreneur’s
business and household activities are often blurred, it is important for the loan officer to
understand the flow of funds within and between the two.
It is difficult to assess the repayment

capacity of a low-income applicant. Loan Use Verification?
Estimates of income and expenses may Another control to address the fungibility of money
not be reliable, and applicants often do problem is for the loan officer to visit the business
not have supporting financial records. after it has received the loan to verify how the loan was
Experienced loan officers develop used. This method may not be recommended as a
methods of improving the quality of these formal procedure because it can reduce the institution’s
estimates by determining the basis on efficiency and can be perceived as patronizing. Even
which they are made and then testing so, it is appropriate for an MFI representative to make
whether the assumptions are valid. spot visits to clients and inquire about the success of
the business.
However, wide variations may still exist
between estimated and actual cash flow of
a business, even if the applicant is not intentionally misleading the loan officer.
To overcome these challenges, some MFIs assess a client’s capacity to repay without taking
into account the effect of the loan on the business. That means that the current net income
of the business is a certain multiple of the proposed installment amount; in other words, the
applicant estimates that the business is already generating enough revenue to repay the loan.
MFIs also use small initial loan sizes and an ongoing process of collecting information to
overcome the challenge of assessing the applicant’s repayment capacity. Initial loan sizes
tend to be smaller than the applicant requests because the loan officer does not have good
information to assess repayment capacity. Clients are then asked to maintain basic business
information on income and expenses so that loan officers can make credit decisions based
on more reliable information and tailor subsequent loans to the cash flow of the business.
40
CHAPTER 3
With small loan sizes, it is appropriate that the applicant’s character is the key screening
element. As loan sizes increase, however, there needs to be a shift from “soft” information
like character to harder information such as capacity. To make good credit decisions,
therefore, it is important that loan officers collect information over time that will allow them
to understand of the capacity of their clients’ businesses.
Capital: Besides assessing the cash flow of the business to determine if it has the capacity to
repay a loan, many MFIs collect information on the assets and liabilities of the business to
construct a simple balance sheet. This allows the loan officer to determine if the business is
solvent and how much capital the client has already invested in the business. With the
smallest loans, this component is probably the least important, but its significance increases
as loan sizes increase. In some cases, loan sizes are linked to the equity in the business.
Some MFIs also conduct an asset inventory to reduce credit risk. Although they may not say
so explicitly, loan officers convey the message that, if the client does not repay, the
institution might seize these assets. This is known as implicit collateral.
Collateral: One reason for the development of the microfinance industry is that traditional
banks do not serve persons who cannot offer traditional collateral. Many microlending
methodologies use peer groups, restrictive product terms and compulsory savings as
collateral substitutes. Subsequent lending innovations provide microloans with non-
traditional collateral, such as household assets and cosigners. Pawn lending and asset
leasing are other methods of overcoming collateral constraints.
Perhaps more important than the type of collateral is how it is used. In microfinance,
collateral is primarily employed as an indication of the applicant’s commitment. It is rarely
used as a secondary repayment source because the outstanding balance is so small that it is
not cost-effective to liquidate the collateral, much less legally register it if such a service is
available. Only when clients are not acting in good faith do microlenders take a hard line
Business and Household Assessments

Loan officers visit applicants to observe the business in action, and assess how the applicant interacts
with customers and the condition of business equipment. Since microentrepreneurs are unlikely to
have the documentation required by traditional banks, microlenders collect information through
observation. Rather than take information at face value, through this interview process the credit
officer can probe when responses do not seem realistic or do not have internal consistency.
The process of assessing applicants’ businesses, and in most cases their households as well, achieves
five main purposes. First, the assessment determines if the applicant is creditworthy by collecting
objective data regarding the business, the applicant’s outstanding debts, and the household’s cash
flow. Second, it provides information to ensure the product is designed to the applicant’s credit
needs and capacity. Third, the assessment allows the credit officer to collect subjective information
about the applicant’s character to develop a “gut feel” if the applicant is trustworthy. Fourth, this
process plays a role in educating the client about the lender’s motives and mechanisms. Fifth, the
assessment helps to forge a positive working relationship between client and loan officer.
Churchill (1999).
41
stance and seize collateral. Consequently, MFIs tend to be less concerned about the ratio of
the loan size to the value of collateral than how the clients would feel if the collateral was
taken from them. As the loan size increases, however, this soft approach to collateral needs
to change so those larger loans are indeed backed by appropriate security.
Conditions: The fifth component, conditions, is often the hardest for loan officers to
assess. Many MFIs adopt a microenterprise development approach to microfinance, which
means that they are as concerned with improving the business as recovering their loan. As
such, the process of assessing the level of competition, the size of the client’s market, and
potential external threats, can play an important role in helping the client to make smart
business decisions and help the loan officer to make good credit decisions.
Since loan officers do not usually have the expertise to analyze the conditions of all types of
businesses, the primary means of controlling the credit risk posed by business conditions is
to require that applicants be in business for a certain number of months (usually 6 to 12
months) before they are eligible for a loan. This requirement means that applicants will have
sufficient experience to answer questions about market conditions. The existing business
requirement also makes it easier to assess repayment capacity and business capital needs.
ê What screening techniques does your organization use to minimize credit risk?
ê How do those screening techniques vary by loan number and loan size?
ê Are those techniques consistently applied in all branches?
ê If it makes secured loans, does the program have appropriate policies and systems for dealing with collateral?
Credit Committees
Establishing a committee of persons to make decisions regarding loans is an essential control
in reducing credit (and fraud) risk. If an individual has the power to decide who will receive
loans, which loans will be written off or rescheduled, and the conditions of the loans, this
power can easily be abused and covered up. While loan officers can serve on the credit
committee, at least one other individual with greater authority should also be involved.
For larger loans, a committee of three or more individuals is appropriate. A credit

committee typically includes senior and middle managers, but it might also include
community leaders, local bankers and even clients. The credit committee has the
responsibility not only for approving loans, but also for monitoring their progress and,
should borrowers have repayment problems, getting involved in delinquency management.
This way the credit committee lives with the implications of its decisions.
Additionally, MFIs should have written policies regarding Before recommending

loan approval authority. These policies should specify an application, loan
the loan amounts that can be approved with two officers have to have a
signatures, loan amounts requiring additional signatures, high degree of
and who has the authority to approve loans. This reduces confidence that the
risk of loans being inappropriately approved. loan will be repaid
With group lending methodologies, the group usually fulfills part of the credit committee’s
function. Since group members guarantee each other’s loans, it is important that they be
42
CHAPTER 3
involved in the approval process. But MFIs should not abdicate all responsibility for loan
approval to the group. Borrowers are unlikely to have the skills to make good credit
decisions, and therefore the loan officer needs to be familiar with the businesses and should
facilitate the discussion.
Ultimately, the MFI’s money is at risk, so loan officers and their immediate supervisors need
to sign off on all credit decisions and feel comfortable that the money will be repaid. Loan
officers should feel comfortable: a) rejecting entire groups if the members do not know and
trust each other very well or if they do not appreciate the importance of joint responsibility;
b) encouraging good group members to expel inappropriate members; and c) promoting
smaller loan sizes that members are confident that they can repay. To act in this way, loan
officers need the tools and the training to conduct business and character assessments, to
facilitate group discussions, and to test the group’s commitment.
ê Are the loan approval policies strictly followed?

ê Does the credit committee have sufficient experience to make good decisions?
ê Is the credit committee involved in loan monitoring and delinquency management?
Delinquency Management
The first three types of credit risk control—product design, client screening and credit
committees—are intended to prevent delinquency and eventual loan losses. However, it is
unrealistic to plan on designing an ideal product and selecting ONLY the best clients in
order to avoid loan delinquency. Some loans invariably become delinquent and loan losses
will occur. To minimize such delinquency, CARE’s Economic Development Unit
recommends the following six delinquency management methods:
1) Institutional Culture: A critical

delinquency management method Creating a Culture of Repayment in Mozambique
involves cultivating an institutional The loan officers in CARE’s CRESCE program in
culture that embraces zero- Mozambique follow up with clients in the evening of the
tolerance of arrears and immediate first day that a payment is missed. If the client refuses to
follow up on all late payments. pay, his/her photo is then placed in the window of the
MFIs can also remind clients who MFI office. These tactics, while strong, help build the
have had recent delinquency reputation that the MFI is very serious about payments
problems that their repayment day being made, and being made promptly.
is approaching.
2) Client Orientation: A logical first step toward developing a zero-tolerance institutional

culture is to communicate this concept to each new client before she receives a loan. An
orientation curriculum should be prepared along with graphics and teaching aids to simply
and clearly describe the terms of services being offered, the expectations of each client, and
procedures that will be followed in the case of arrears.
3) Staff Incentives: Creating staff involvement in discouraging delinquency, through a staff

incentives system, can be effective. Financial incentives entail minimum portfolio quality
criteria for incentive eligibility and should have a greater weight for portfolio quality than for
portfolio quantity. In addition, staff should carry bad debt in their portfolio for a significant
43
period of time (at least six months) to ensure that they are held accountable for making
credit decisions. Non-financial incentives include branch and loan officer competitions and
special recognition for top performers.
4) Delinquency Penalties: Clients should be penalized for late payment. This could include
delinquency fees pegged to the number of days late and limiting access to repeat loans based
on repayment performance. An example of these types of penalties from the Alexandria
Business Association in Egypt is summarized in Figure 13.
Figure 13: Alexandria Business Association: Delinquency Penalties

Number of Days (cumulative) Sanction
3+ days late (first loan) A repeat loan is refused
< 5 days late (repeat loan) No consequences
6 to 9 days late (repeat loan) A penalty of one month interest and the next loan
amount may be kept constant
10+ days late (repeat loan) A 2nd penalty of one month interest and further
loans will likely be refused
5) Enforcing Contracts: An MFI will quickly lose control of portfolio quality if it fails to enforce
its contracts. MFIs should not have any policies in their contracts that they are not prepared
to enforce. While certain accommodations can be made for borrowers who are willing but
unable to repay, any uncooperative behavior from delinquent clients should quickly escalate
to the most severe penalties that the MFI could enforce, including the use of the local
judicial system if appropriate. Clients should be oriented to penalties and delinquency
procedures before receiving their first loans, so they know exactly what to expect if their
loans become delinquent.
The Carrot Approach: Repayment Incentives

The stick of delinquency management needs to be balanced with the carrot of repayment
incentives. The primary incentive microlenders use is to reward clients in good standing with
access to subsequent loans, which often means larger loans. Preferred services for repeat
clients may also include lower interest rates, faster loan approval, and access to parallel credit
products such as seasonal loans.
The most tangible incentive is interest reimbursement. For example, the BRI units offer a
prompt payment incentive for clients who pay on time for six consecutive months, which
amounts to one quarter of the interest payment during that period. In effect, the units charge
the delinquency fee up front, and then reimburse clients who repay on time.
6) Loan Rescheduling: Given the vulnerability of the target market, it is common for borrowers
to be willing but unable to repay. After carefully determining that this is indeed the case (i.e.,
concluding that clients are not cleverly pulling on one’s heartstrings), it may be appropriate
to reschedule a limited number of loans. Only done under extreme circumstances, this may
involve extending the loan term and/or reducing the installment size. MFIs must be
transparent about their rescheduling policies and they must report their portfolios
44
CHAPTER 3
accordingly. Portfolio quality indicators and provisioning requirements should clearly

distinguish between regular and rescheduled loans.
ê Does the program have a culture that is intolerant of delinquency?

ê Is there a formal orientation of clients and staff to expectations, policies and procedures?
ê Are loan officers well trained in effective delinquency management strategies?
ê Are delinquency penalties and loan contracts enforced?
ê Are staff members properly rewarded to maintain high standards of portfolio quality?
ê Does the MFI have an appropriate and transparent rescheduling policy?
Agriculture Lending
Most successful MFIs serve primarily traders—people who have a stall in a market place or a small
grocery shop attached to their house. This is because there is a good fit between their businesses’
needs and the standard microcredit product (i.e., small amounts that gradually increase over time,
short loan terms, frequent repayments). Some MFIs have also figured out how to modify this
product to meet the working capital needs of manufacturers.
Few MFIs, however, have successfully adapted a microloan product to manage the credit risks
associated with lending to small farmers. While this is certainly an important market in many
regions, it is recommended that extreme caution be taken by MFIs trying to lend for agricultural
purposes. Some tips include:
• Carefully monitor the percentage of agriculture loans in the portfolio (not more than
10 to 20 percent)
• Diversify away from single crop lending
• Avoid relying on balloon payments at the end of the term
• Consider the entire household’s cash flow when making a credit decision, not just the
farm income
3.1.2 Credit Risk Monitoring

To monitor portfolio quality, CARE’s EDU recommends, at a minimum, that an MFI
monitor portfolio quality ratios on a monthly basis. These include Portfolio at Risk, Loan
Loss Ratio and Reserve Ratio. Additionally, an MFI should be aware of the number and
value of loans that have been rescheduled and should maintain an aging of delinquency report.
The recommended ratios are listed in Figure 14.
45
Figure 14: Portfolio Quality Ratios

Portfolio at Risk: this ratio should be used as the Value of outstanding balances of
primarily indicator for monitoring portfolio quality. all loans in arrears______
Value of loans outstanding
Loan Loss Ratio: indicates the extent of unrecoverable

loans over the last period. Amount written off______
Average loans outstanding
Reserve Ratio: indicates adequacy of reserves in

relation to portfolio. Loan loss reserve_______
Value of loans outstanding
Loan Rescheduling Ratio: indicates the extent of

loans that have been rescheduled in the last period. Amount of loans rescheduled___
Average loans outstanding
Because of the small loan sizes, microfinance portfolios are not typically exposed to the
same concentration of risk as traditional banks, where individual loans should not represent
a significant portion of the portfolio. However, MFIs need to monitor their loan portfolio
composition and quality by region, business sector, loan cycle number and loan size to
reduce the institutions' vulnerability to external threats that may affect a large portion of
their clients. For example, if 25 percent of the portfolio goes to coffee farmers and the price
of coffee beans drops, a quarter of the portfolio will likely be at risk.
3.2 Fraud Risk

All microfinance institutions will at some point experience fraud perpetrated by staff
members, perhaps in cahoots with clients. Wherever there is money, there is an opportunity
for fraud. MFIs should not assume that they could eliminate fraud. However, through
proper controls they can reduce their vulnerability to fraud. This section first summarizes
common types of fraud, and then discusses controls for preventing and detecting fraud.
3.2.1 Types of Fraud

Preparing a complete list of possible fraudulent acts is not possible. However, it is useful to
categorize fraudulent activities by the lending process in which they can occur:
1) loan disbursement,
2) repayment,
3) collateral procedures, and
4) Closure activities.
46
CHAPTER 3
Figure 15: Examples of Microlending Fraud
Disbursement Repayment Collateral Closure

ð Loan officer issues ð Loan officer ð Loan officer ð Forced savings
loans to “ghost” collects payment, collects collateral refunds do not
clients. issues receipt, but but does not find their way back
ð Cashier makes does not deposit. deposit it in to the clients, and
loan to himself. ð Agents collecting storage area. borrowers forget
loan payments do ð The storekeeper to ask for them.
ð Loan officer
charges clients an not deposit them appropriates the ð Loan officer
unofficial “fee” to in a timely manner. collateral and collects payments
apply for a loan. ð Loan officer conceals it by on loans that have
charges unofficial making false been officially
delinquency fees. entries in the written off.
warehouse
records.
Microfinance fraud certainly is not limited to the organization’s lending activities. In fact, an
MFI may be even more vulnerable to fraud associated with savings because it is harder to
detect. Fraud can also occur in managing the business operations of the branch, such as
misuse of petty cash, false claims for travel reimbursement and kickbacks from procurement
contracts.
Internal control policies and procedures are designed to cost-effectively reduce the risk of
fraud committed by an employee on his own, but they are generally not cost-effective in
reducing risk stemming from collusion among employees or from “management override.”
The latter occurs when a high level employee uses his/her authority to incite a lower level
employee to violate control policies or procedures, enabling the high level employee to
commit fraud. An example is a finance manager ordering the cashier to give him the key to
the safe for some reason.
Risk of fraud stemming from collusion among employees or from management override is
usually reduced through “soft” controls, instead of formal control policies and procedures.
Examples of “soft” controls include senior management emphasizing and demonstrating
ethical conduct and high levels of control consciousness, an environment of open
communication, and swift action against anyone committing fraud.
It is important to note most fraud is detected by employees of

the operation where the fraud is committed, and not by auditors. Coworkers, not
Therefore, MFIs should create a work environment that provides auditors, detect
incentives for employees to report suspected fraud to the most instances
appropriate level of management. MFIs should also establish of fraud
formal policies and procedures on how and to who to report
suspected fraud. There are a number of “red flags” that make MFIs more vulnerable to
fraud, such as:4
4
Adapted from Valenzuela (1998).
47
ð An MFI with poor portfolio quality will have difficulty distinguishing between bad loans
and fraudulent loans because of the large number of loans in arrears.
ð A weak information system exposes the institution to fraud. If an MFI cannot detect
delinquency at the loan officer level then it could have significant problems with
fraud.
ð A change in the information system is a time of particular vulnerability. To protect against
fraud when an MFI introduces a new MIS, it is common practice to run the old and
the new system in parallel until both have been audited.
ð Weak internal control procedures create an environment in which fraud can be prevalent.
Many MFIs do not have an internal audit function and their external auditors do not
visit branches, much less confirm client balances. In these MFIs, fraud is likely to be
rampant.
ð MFIs are vulnerable when they have high employee turnover or when staff members are
on leave. When a MFI fires an employee or an employee resigns, the organization is
also vulnerable to that person collecting money from his former clients.
ð If the organization offers multiple loan products, or if its products are not standardized,
staff and clients have an opportunity to negotiate mutually beneficial arrangements.
ð If loan officers handle cash and clients do not understand the importance of
demanding an official receipt, the MFI is vulnerable to wide scale, petty fraud.
ð When an institution experiences rapid growth, it is difficult to cultivate the depth of
integrity that is required among staff.
ê Has your organization experienced fraud? If so, what conditions made your organization vulnerable to fraud?
ê What have you done to try to reduce your vulnerability?
3.2.2 Controls: Fraud Prevention

The CARE EDU suggests the following eight categories of MFI operations controls to
reduce operational performance that can lead to fraud:
1. excellent portfolio quality;
2. simplicity and transparency;
3. human resource policies,
4. client education,
5. credit committees,
6. handling cash,
7. handling collateral, and
8. write-off and rescheduling policies.
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CHAPTER 3
Flexibility: The Double-edged Sword

One of the criticisms of microfinance is that the loan products are so rigid that they do not meet
the needs of the target market. This rigidity results in high client desertion and reduces the
impact that microfinance could have.
In an ideal world, microfinance products could be flexible and customized to individuals’ needs.
But there are some challenges involved in accomplishing the ideal:
ê Efficiency: One of the reasons why microloan products tend to be rigid is to increase the
efficiency of delivering these services. With very small loans, it will not be cost effective to
customize them to each person’s needs.
ê Staff Skills: Many MFIs hire relatively inexpensive labor that can handle routine or rote tasks
without too much difficulty, but may not have the skills to deliver flexible financial services.
ê MIS: The information systems in many MFIs have difficulty coping with straightforward
microloan products. Flexible loan products exacerbate the MIS challenge.
ê Fraud Risk: As an MFI increases the complexity of its financial services, it greatly increases its
vulnerability to fraud risk.
How should MFIs deal with this double-edged sword? There is no easy answer, but by being
aware of the importance of flexibility and the challenges of being flexible, an MFI can try to forge
a middle ground.
Excellent Portfolio Quality

If very few loans are in arrears, the chances that the MFI is experiencing fraud in its lending
activities are significantly reduced. The handful of delinquent loans can be easily checked to
determine if they are fraudulent. But when large volumes of loans are in arrears, and
delinquency management systems get overloaded, then fraudulent loans may go undetected
for long periods of time, which will breed more fraudulent loans.
ê Which branch has the worst portfolio at risk?

ê Could this branch be experiencing fraud?
Simplicity and Transparency

If an MFI’s products and delivery systems are simple and straightforward, it will go a long
way toward preventing fraud. As an organization becomes more complicated and diversifies
its services, there is a much greater likelihood that fraud will proliferate. Fraud is a particular
concern in MFIs where loan officers have significant discretionary authority, such as
determining loan sizes, accepting collateral, and setting interest rates. In this way, an MFI
has to balance being responsive and customizing its services to client needs with the concern
that this will expose the organization to fraud.
A particular area of vulnerability is the discretion that field staff may have regarding the
imposition of delinquency fees. MFIs often charge a delinquency fee for late payment, yet
waive the fee if clients have a good reason for being late. Consequently, it is difficult to
49
monitor whether fees are being paid and pocketed, or whether they are regularly being
waived, in which case they are not serving their purpose. To reduce exposure to fraud,
MFIs should either make the fees mandatory regardless of the reason, or find another way
for penalizing late payers like creating a repayment incentive for those who pay on time.
ê Are loan officers allowed any discretion, such as lowering interest rates, requesting loan size exemptions or waiving
delinquency fees? If so, how do you control for fraud in these circumstances?
Human Resource Policies

An MFI’s human resource policies include hiring, training, compensating, and terminating
staff members. All four activities serve as potential controls for preventing misappropriation
of assets.
Hiring: Microfinance institutions should identify sources of prospective staff members with
high moral integrity, such as certain schools or religious communities, and actively recruit
new staff members from these sources. In addition, MFIs should use staff screening
mechanisms, like personality tests and employee references, to ensure that they are hiring
upstanding citizens. They should also consider conducting background checks.
Training: A critical aspect of bringing on new recruits is to indoctrinate them into the
institution’s culture. This is the ideal opportunity to promote the organization’s core values
of honesty and integrity, and demonstrate the zero-tolerance policy by making examples of
fallen employees who succumbed to temptation and suffered the consequences.
Compensation: Employees should have a strong incentive to perform their job in a responsible
and competent manner. Employees who do not feel sufficiently compensated will be much
less likely to carry out their responsibilities with the needed thoroughness and attention to
detail. Likewise, they are much more vulnerable to committing fraud, especially in
economies where sums that they handle daily represent months or even years of salary. A
competitive salary is a strong preventive control in
deterring sloppy or fraudulent employee behavior. Rotating Staff?
Some MFIs regularly rotate staff members
Termination: Employees’ awareness of potential
between branches as a means of controlling
negative consequences for inadequate job fraud risk. Staff rotation makes it possible for
performance can also be a preventive control, different employees to interact with each client,
especially for employee fraudulent activity. There which should discourage collusion and expose
should be a clear message that staff members will any fraud that has taken place.
be immediately terminated, lose their valuable While this may be an effective way of
source of income and benefits, and be taken to controlling and detecting fraud, it is not
court (if possible) if they perpetrate fraud. Swift recommended because it undermines the
and permanent action in response to even the least relationship between a loan officer and the client.
consequential fraudulent activity sends a clear One of the reasons why clients repay their loans
message to employees that the MFI does not is to avoid disappointing their loan officer. Loan
officers should have a close rapport with their
tolerate fraud of any type. PULSE, a CARE
clients to encourage them to keep coming back
microlending program in Zambia, attempts to and to discourage them from not paying their
ostracize former employees by placing their picture loans.
in the office window.
50
CHAPTER 3
ê Are your hiring procedures designed to attract individuals who are honest and well motivated?
ê Are new employees oriented to the MFI culture of honesty and Every loan must be
zero-tolerance? approved by at least
ê Are staff compensation levels reasonable and competitive? two persons who have
both met the applicant
ê Is there an immediate termination policy for staff fraud or
dishonesty?
Client Education
Informing clients of their rights and responsibilities in the loan process is another strong
preventive control. Because target clients tend to be illiterate and/or under-educated, they
are more vulnerable to being defrauded by loan officers, and to not catching errors in the
loan process. This is especially problematic because the loan officer-client relationship is key
to the ultimate success of an MFI. Thus, an essential control for preventing errors and
potential fraud is to actively educate clients of their rights and responsibilities, including:
ê Demanding an official, pre-numbered receipt whenever money or collateral changes

hands.
ê Only giving or receiving money from a designated MFI employee – if possible, this
should always be the cashier.
ê Knowing the appropriate channels to voice complaints and concerns.
Well-publicized campaigns to this effect will not only educate clients, but also make
employees think twice about taking advantage of their customers. In group-lending
programs, it can be reinforcing to have clients provide peer orientations around these issues
to new clients entering the program.
ê Does the institution have an ongoing client education campaign?

ê Are clients aware of their rights?
ê What channels do clients have to voice complaints?
Credit Committees
Credit committees not only play an important role in reducing credit risk, but also are an
essential element of an operational integrity and fraud prevention strategy. Every loan must be
approved by at least two persons. With small loans, the signatures typically come from the loan
officer and the branch manager. The branch manager must take this responsibility very
seriously. When reviewing applications, the branch manager ensures that they comply with
MFI policy and do not contain unreasonable information, such as monthly income levels
that are unrealistic for a particular type of business. To reduce the chances that loan officers
are creating “ghost” borrowers, the branch manager should meet all applicants, preferably
before they receive the loan.
Loan approval authority levels also reduce MFI exposure to fraud. The authority levels
might look like this: all loans below $500 require two signatures (loan officer and branch
manager); loans between $500 and $2,000 require three signatures (previous two plus an
51
external chair of the credit committee); and loans above $2,000 require five signatures (the
previous three plus the operations manager from the head office and a member of the board
of directors). Therefore, if the branch manager and loan officer collude to defraud the
company, they would only be able to steal $500 at a time.
Any person who places his/her signature on an application must realize the significance of
that action. Too often, signing applications, vouchers or other documentation is not taken
seriously. Sometimes senior people do not even look at what they are signing because they
have to approve so many items. This behavior obviously defeats the purpose. If an
organization suffers from this “blind signing,” it needs to revisit its authority levels.
If five signatures provide greater protection from fraud than two, then why does the MFI
not require five signatures for all loans? A fraud prevention and detection strategy needs to
balance the costs of minimizing fraud with the need to reduce vulnerability. The more
people involved in the application review process, the more expensive it is to issue loans.
Since the smallest loans generate only a tiny amount of revenue, the organization would
probably lose money issuing them if five people, including several with higher wage levels,
had to review the applications. To reduce approval costs, some organizations set variable
authority levels for branch managers depending on their level of seniority and their portfolio
quality.
The other factor determining approval authority is quality of customer service. The more
people involved in the review process, the longer it takes to turn around loan applications.
For MFIs to provide prompt service, they need to cut out unnecessary approval layers.
ê Do at least two people meet all applicants and approve all applications?
ê Does the loan approval authority structure balance efficiency, customer service and fraud control?
ê Do managers avoid and actively discourage “blind signing”?
Handling Cash
MFIs face the greatest risk of misappropriation when money changes hands, such as when
the loan is disbursed, repayments are made, and deposits are placed in a savings account.
Here is a list of 12 basic controls recommended to reduce risk of misappropriation for MFIs
that disburse loans directly to clients. If the disbursement is made by a bank or into the
client’s account, certain modifications are required.
1. Use standardized, pre-printed, pre-numbered loan agreement forms, reviewed and

approved by local legal counsel.
2. Prepare loan agreements in quadruplicate, maintaining one copy at the branch, giving
one to the borrower, and sending two to the accounting department.
3. Loan agreements should include borrower name and identification number, unique
loan reference number, loan amount, interest rate, payment schedule, description of
collateral (if applicable), definition of late payment, and penalty for late payment.
4. Access to blank loan agreements should be restricted and carefully safeguarded.
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CHAPTER 3
5. Accounting determines whether the agreement is properly completed. If so,

Accounting prepares and approves a disbursement voucher, and gives it to the
cashier along with a copy of the loan agreement.
6. Before disbursing funds, the cashier matches the loan amount on the agreement with
the amount on the disbursement voucher and determines whether the loan
agreement contains necessary signatures.
7. The cashier prepares, in duplicate, an official pre-numbered disbursement receipt,
containing date, amount, and payee name and signature.
8. The cashier retains one copy of the disbursement receipt and gives the other to the
payee.
9. In disbursing funds directly to the borrower, the cashier checks for evidence that the
person accepting funds is the borrower named in the loan agreement by inspecting a
picture ID and/or comparing the person’s signature to borrower’s signature on the
loan agreement.
10. If compensating controls are not in place to reduce the risk of a cashier keeping loan
disbursements and making loan payments himself, then an accountant should
compare payee signatures on loan disbursement receipts to signatures of borrowers
on loan agreements.
11. If the cashier disburses loan funds to an agent who then gives funds to borrowers,
such disbursements are recorded as advances to agents. The advances are liquidated
when agents present disbursement receipts containing correct loan amounts and
borrower signatures to the accounting department.
12. Accountants must not have access to funds, and cashiers must not have access to
changing accounting records.
Figure 16 provides a list of seven recommended controls for reducing the risk of
irregularities or fraud in the repayment process.
Figure 16: Controls in Handling Loan Repayments

1. Agents collecting loan payments prepare repayment receipts, in triplicate, containing date,
amount, and agent’s and payer’s signatures.
2. Agents retain two copies and give the other to payers.
3. Agents deposit funds to designated accounts in a timely manner. MFIs should have a
policy on where to deposit funds and on the definition of “timely”.
4. Agents request a deposit slip containing date, amount, and signature of person accepting
funds for every deposit made.
5. Agents submit to the accounting department a copy of receipts documenting borrower
payments and deposit slips documenting deposits.
6. Accounting staff match amount of deposit slip with amount of borrower receipt and record
interest and principal based on loan agreement and payment amount on borrower’s receipt.
7. Accounting staff reconciles amount of cash deposited per bank records with cash received
per the accounting records on a monthly basis.
53
Organizations that offer voluntary savings services are particularly vulnerable to fraud.
This is partly because of the high volume of transactions, and also because the deposit
amounts and frequencies are unpredictable. With loan repayments, the organization knows
how much and when they are expected, so if the amounts or dates are different than
expected, they can be investigated. Savings accounts do not have a similar early warning
signal. Yet it is absolutely critical to reduce the potential for savings fraud because it could
undermine customer confidence in the banking institution.
To control for savings fraud, clients must have savings records (i.e., passbooks) that they
keep in safe places. The MFI should have a signature card and a copy of the client’s
identification. The signature on the deposit/withdrawal slip needs to match that on the
client’s savings book and the organization’s account record. A tighter review of larger
withdrawals is also recommended.
ê Are loan officers allowed to collect repayments when in the field?

ê Does the MFI have appropriate polices for handling cash in its loan disbursement and collection procedures? Are
these policies followed?
ê What systems are in place to minimize the potential for fraud with savings accounts?
Collateral Controls
If an MFI secures its loans with collateral, it is vulnerable to potential irregularities or fraud
in the collection, storage and return of collateral. The assigned staff person may collect
collateral but not deposit it in the designated storage area, or collect the wrong type of
collateral, or neglect to collect it at all. Risk associated with collateral can be mitigated
through the following steps:
ð MFIs must have policies and procedures on when to require collateral, whether to
assume custody of collateral versus allowing borrower to maintain custody, where to
deposit and store collateral, and how to value collateral.
ð If the borrower maintains collateral, the loan agent periodically inspects the collateral
for impairment. The loan agreement includes a detailed description of the collateral
and serial or other identifying number of the property, and requires that collateral
must not be sold without prior notice to the loan officer.
ð Procedures must be clearly stated for returning collateral to the borrower upon full
repayment of the loan.
ð Procedures should be recommended to improve the chances that liquidation of
collateral is at the best available price, and that proceeds from liquidation are
deposited intact into the bank.
ê Do you have adequate policies and procedures on collateral control?

ê Are these policies followed?
Write-off and Rescheduling Policies

Another area of risk is loan write-off or rescheduling. While MFIs usually have stringent
requirements and carefully followed policies for receiving loans, they tend to be more lax in
following up delinquent loans and ensuring that procedures are carefully followed. Loan
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CHAPTER 3
write-off and rescheduling should follow similar procedures: the credit committee should
make all decisions and multiple signatures should be required for a write off or rescheduling
to be authorized.
In the write-off process there are two primary fraud vulnerabilities. First, the MFI needs to
make sure that it is not writing off a fraudulent loan. To control for this risk, each person
involved in the process of recovering the loan needs to document the steps that they took.
This documentation, in a delinquency management log, Everyone involved in
provides evidence that proper steps were taken by several the delinquency
people, and this was indeed a bad loan not a fraudulent management need to
one. Second, once a loan has been written off, the MFI is document the steps
still vulnerable to the unauthorized collection of the that they took to
outstanding balance by its employees. This risk is often recover the loan
controlled by handing over bad debts to a workout
department or an external debt collector whose collection activities may reveal unauthorized
efforts.
ê Does your institution have clear write-off and rescheduling policies that are consistent with a fraud prevention
strategy?
ê Are those policies followed?
ê How do employees document their delinquency management steps?
3.2.3 Monitoring: Fraud Detection

The best prevention strategies in the world are not going to eliminate fraud. This is partly
because the policies may be ignored or flaunted; and partly because, in an effort to balance
the costs of the controls with the potential exposure, the organization is still going to have
areas of vulnerability.
Whenever fraud occurs within an organization, it reflects poorly on the whole MFI and
everyone who works there. Fraud detection is therefore the implicit responsibility of all staff
members, from the chairman of the board and executive Fraud detection is the
director down to the cleaners and drivers. Once an responsibility of all
organization reaches a certain scale (around 100 employees), staff members, from
it can justify having a person or department dedicated to the the chairman of the
function of fraud detection. This responsibility is tasked to board down to the
an internal auditor or internal audit department, which cleaners and drivers
should report directly to the board of directors (or the audit
committee of the board).
Fraud detection involves the following four elements: 1) operational audit; 2) loan collection
policies; 3) client sampling; and 4) customer complaints.
Operational Audit
After creating appropriate controls, the first step in fraud detection is to ensure that those
controls are implemented. Microfinance managers at all levels of the organization must
make sure that persons working under them follow institutional policies. In addition, MFIs
55
Audit Committee of the Board

Some MFIs assign specific board members to an audit committee to oversee internal and
external audits. The audit committee reviews internal and external audit reports and, based on
these findings, assesses the integrity of the financial statements and adequacy of internal
controls. The audit committee reviews the procedures, reports and recommendations that are
generated by the internal audit department and ensures that management takes corrective
actions. In addition, the audit committee reviews the external audit and regulatory reports to
assess the MFI’s overall control environment, and reports its findings and observations to the
full board of directors.
Campion (2000).
should consider conducting regular operational audits to confirm that policies are being
followed. When policies are not followed, it is usually for one of three reasons: 1) the
employee was involved in some sort of fraudulent activity;
2) the employee did not know about the policy or didn’t The internal
understand it; or 3) the employee believed that the policy auditor should
was unreasonable. So while an operational audit might report to the board
detect fraud, it will also identify staff training needs as well of directors
as certain policies that may need to be reevaluated.
An operational audit is a review of all operational activities, procedures and processes,

including human resources, procurement, finance, information systems and any other
operational areas. Internal auditors usually perform operational audits, as they will have
more experience with the general operations of an organization, and will be better prepared
to analyze the structure of operations critically. If an external audit firm is used,
management should be very careful, prior to engaging the firm, to gauge what level of
experience and understanding the external firm has with the organization, microfinance in
general, and operational auditing.
For organizations that are large enough to hire an internal auditor, it is important that this
person or department report to the board of directors, not to management. Without
sufficient independence from management, internal auditors cannot conduct an objective
review of the MFI’s entire operations. By reporting directly to the board, it ensures the
board’s involvement in the internal audit process and it gives credibility and legitimacy to
internal auditors as they conduct their reviews.
Loan Collection Policies

While loan collection policies are primarily seen as a response to credit risk, they also have a
very important role in fraud detection. By involving several different persons in the
collection process, MFIs not only escalate the pressure on the client, but also help to identify
instances of fraud. If the loan officer is the only person who ever interacts with a delinquent
borrower, he could easily be pocketing repayments. Figure 17 provides an example of loan
collection policies designed to detect such a situation.
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CHAPTER 3
Figure 17: Loan Collection Policies

ð Senior management establishes written policies on past due loans that includes when to take
collection efforts and what efforts to take. (make efforts or take actions – not take efforts)
ð Those assigned to collect loans should not have access to changing the accounting records.
ð The loan officer who issued the loan should conduct the first delinquency visit.
ð If that proves unsuccessful, a different agent (usually the branch manager) should perform
the next collection visit.
ð If that visit is unsuccessful, ideally another, more senior person should make the third visit.
This sends the message to the client that the institution’s concern is escalating. It also plays
an important control function since subsequent personnel can make sure that a collection
agent was not pocketing some or all of a past due payment.
Client Sampling
A main aspect of fraud detection is to visit clients to ensure that client and the MFI records
are in agreement. Given the large volumes of customers, internal auditors use selective
sampling of borrowers to identify clients for balance confirmation so that the visits are
biased toward loans that are more likely to be fraudulent. For example, an internal auditor
may select all clients with more than three payments in arrears, 50% of clients with more
than 2 payments in arrears, and 25% with 1 payment in arrears, as well as a number of clients
who are up-to-date. If the MFI reschedules loans, the internal auditor should also visit a
high percentage of those clients as well.
While this sampling technique primarily selects customers who are in arrears, it is important
to also include clients whose loans are current. The internal auditor may find major
discrepancies between information in the client’s file and the reality in the field, which could
expose the organization to credit or fraud risk. Loan officers also might be receiving
kickbacks on loans that do not show up in a delinquency report.
Selective sampling is not possible with voluntary savings accounts because there isn’t a
warning sign that some accounts are more vulnerable to fraud than others. Consequently,
the sample of depositors will probably be larger than the sample of borrowers.
Prior to visiting the specific clients, the internal auditor reviews their files to ensure that the
documentation conforms to the organization’s policies and procedures. When visiting
borrowers for example, the internal auditor compares the disbursement and repayment
information in the MFI’s records with the client’s records,
including current balances, and the amount and date of each Internal auditors
transaction, and the collateral that was pledged. It is also spend the vast
important to compare the information in the file with the actual majority of their
business, including address, type of business, purpose of the time in the field
loan, assets, etc. If there was false documentation, then either
the client took advantage of the loan officer, or they collaborated to give a loan to someone
who was not worthy.
While these visits are primarily for internal audit purposes, they can fulfill other important
functions such as delinquency management, gathering information on customer satisfaction
57
and market trends, and identifying staff training needs. An internal auditor may not be the
most popular person in an MFI, but he can play one of the most critical functions if his job
is well designed, if he has the skills to fulfill multiple roles, and if he spends the majority of
his time in the field.
Customer Complaints
Because the customers of MFIs tend to be poor and uneducated, they are particularly
susceptible to being victims of fraud. But these people are not stupid, and they often realize
that someone is trying to take advantage of them. The problem is that they may not feel
empowered to do anything about it. Even if they want to do something, they may not know
how since their primary contact with an MFI may be the person who is causing the problem.
Another important method for detecting fraud, and for improving customer service, is to
establish a complaint and suggestion system that creates a communication channel through
which clients can voice their opinions. If it is easy for clients to complain, and if their
complaints can by-pass the local branch office, then they will be more likely to report
questionable conduct of loan officers and other field staff. It is then important that this
conduct is investigated by MFI management to address issues and determine if there is
fraud.
ê Does senior management consistently monitor portfolio quality?

ê Does the MFI have standard procedures for delinquency follow up?
ê Are these procedures followed?
ê Does your organization regularly sample clients to confirm savings and loan balances?
ê Does a reliable firm audit the MFI annually?
ê Does the MFI have an internal audit function?
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CHAPTER 3
Risk Management and Scale

As mentioned in the Introduction, risk management is an ongoing process. Vulnerabilities
change over time partly because the institution matures and grows. Many of the controls for
operational risks described in this chapter may be relevant for large MFIs, but are not as
applicable to small organizations or start-ups. In designing a risk management strategy, it is
necessary to determine what is appropriate for the scale of your operations.
For credit risk, for example, a new organization with small loans will rely more on character in
the loan assessment process, but when the loan size increases a collateral based approach is more
appropriate. In a new MFI, the “credit committee” may just consist of the loan officer and her
supervisor, but for larger loans the organization should formalize the review process.
One of the major methods for controlling fraud is through the corporate culture, yet this too
changes as the MFI grows. In a small organization, the managing director sets an example and
personifies the core values of honesty and transparency. This value-driven approach to internal
control must evolve into formal policies and procedures. Managers will assume the auditing
function initially, and then once the organization achieves a certain scale, it can justify hiring an
internal auditor.
Methods for managing security risk depend on the volume of money that passes through the
branch on a daily basis and on the local environment. Even in the safest locations, greater
precautions should be taken as the number and size of the transactions increases.
For new MFIs, it is important to adopt a risk management approach to their operations. While
this approach will probably rely on informal control methods to start, by adopting a risk
management mindset from the beginning it will make it easier to implement more formal systems
as the organization grows.
ê Are internal audits conducted regularly?

ê What is the process by which your organization confirms client savings and loan balances?
ê Do you have a system for collecting, analyzing and following up with customer complaints?
3.2.4 Response to Fraud

If fraud is suspected, in most cases the MFI should conduct a fraud audit and then
implement damage control proceedings.
Fraud Audit
A fraud audit, sometimes called a forensic audit, has the specific aim of determining whether
irregularities have occurred and, if so, their magnitude. A fraud audit generally consists of an
extension of ordinary audit procedures, as proposed by the auditors and, in some instances,
agreed to by the client. The decision to conduct a fraud audit involves considerable
judgment. Two important factors in this decision are the potential magnitude of the fraud
and the extent of evidence of a fraud. Frauds involving potentially very large amounts of
cash with scant evidence are more likely to require a fraud audit than frauds involving small
amounts with considerable evidence. Fraud audits should be conducted by auditors with
specialized training in forensic auditing. Contrary to common belief, most auditors do not
have the training to conduct an effective fraud audit.
59
Damage Control
Fraud and Group Lending
If fraud is identified, the MFI needs to
move into a damage control mode. For MFIs that use a group lending approach may
this to happen quickly, organizations experience instances when group members
defraud each other. This occurs most frequently
should consider developing contingency
when a group representative is responsible for
plans that can be dusted off and put into submitting the repayments for the entire group,
action when the need arises. This and then chooses to hold on to them for a while.
contingency plan should include the Some programs control this risk by having all
following elements: group members make their own repayments, but
this adds transaction costs to the clients, especially
ð What action will the MFI take if the deposit location is not nearby.
against the perpetrator (i.e., Alternatively, group members can be educated to
termination, legal ask to see the official receipt when the
proceedings, efforts to representative returns.
recoup losses)?
ð What approach will the
organization take with clients who were victimized?
ð How can the MFI diminish the negative effects of fraud on its reputation, or
even turn this public relations nightmare into a coup?
ð What changes to the internal control policies need to be made to prevent this
from occurring again?
Some MFIs require new employees to pay a security deposit, which they will lose if they are
involved with fraud.5 This serves both as a deterrent to fraud as well as a means of reducing
the MFI’s vulnerability to losses.
ê Do you have a contingency plan in place so that you can quickly mitigate the damage caused by fraud when it
occurs? If so, what does the plan consist of?
3.3 Security Risk

The third form of operational risk is the exposure of an MFI to theft. Some MFIs never
have difficulty with security risk, whereas others are extremely vulnerable. This risk has two
basic elements:
1) Safety of Cash: Any MFI that disburses and receives money directly is vulnerable
to theft. They need to ensure that cash is protected from theft during office
hours, after office hours and in transit.
2) Safety of Office Assets: Although thieves usually prefer cash, it is not the only asset
that is vulnerable. MFIs need to ensure that they are protecting their computers,
fax machines, photocopiers, and even office equipment like desks and chairs,
from theft.
5
Employees may also lose their security deposit if they leave the organization within a specified period of
time, often 12 to 24 months. If employees leave earlier, their security deposit is used to pay for their
training.
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CHAPTER 3
The most effective control to safeguard cash is not to handle it. Many microfinance
programs conduct all their financial transactions (disbursements, repayments, and savings)
through local banks. This control dramatically reduces the threat of theft, but it also limits
the MFI’s ability to provide valuable services to its customers. They are constrained by the
location of banks, their hours of operation, and their willingness to process large volumes of
small transactions.
For MFIs that do handle cash, they should consult with local security experts and banking
officials regarding controls for reducing vulnerability to theft. Appropriate responses may
vary significantly from branch to branch. Some of the security measures to consider
include safes, vaults, window bars, door locks, teller shields, interior and exterior lighting,
security guards (armed or unarmed), and security alarms and cameras.
MFIs also reduce their exposure through liquidity policies that stipulate the maximum
amount of cash that can be kept in the branch over night. Liquidity policies require an
effective system for transporting money to a central depository and then delivering sufficient
cash to each branch in the morning.
In addition to the systems designed to protect cash, MFIs should also have a fixed asset
register that lists all the organization’s assets, description, date and price of purchase, and
serial number (if applicable). When the internal auditor visits the branch, he should compare
the equipment in the branch with the asset register to ensure that equipment has not been
taken (temporarily or permanently).
ê Has your organization contracted an expert to analyze your security needs on a branch-by-branch basis?
ê What are your organization’s major vulnerabilities to theft, and how are you addressing them?
61
Lending Methodologies
Berenbach, Shari and Diego Guzman (1992). The Solidarity Group Experience Worldwide. Monograph No. 7.
Washington DC: ACCION International. Website: www.accion.org.
Churchill, Craig F. (1999). Client-Focused Lending: The Art of Individual Microlending. Toronto: Calmeadow.
Website: www.calmeadow.com. Available from PACT Publications. Email: books@pactpub.org.
SEEP Network (1996). Village Banking: The State of the Practice. New York: United Nations Development
Fund for Women. Website: www.seepnetwork.org.
Yaron, Jacob, McDonald Benjamin, and Gerda Piprek (1997). Rural Finance Issues, Design and Best Practices.
Washington DC: The World Bank. Email: books@worldbank.org.
Product Development
www.mip.org.
www.mip.org.
Internal Control
Campion, Anita (2000). Improving Internal Control: A Practical Guide for Microfinance Institutions. Technical
Note No. 1. Washington DC: MicroFinance Network. Email: mfn@mfnetwork.org. Available from
62
CHAPTER 3
Chapter 4: Financial Management Risks

and Controls
Institutional
Risk
Financial
Risk Risk
External Risk
T
he risks associated with financial management represent a third area of vulnerability
for microfinance institutions. Distinct from institutional and operational risks,
financial management risks are inherent in the range of strategies and procedures
used by microfinance managers to optimize financial performance. Key risk areas
that emerge from these strategies include:
1) Asset and Liability Management Risks
2) Inefficiency Risks
3) System Vulnerability Risks
This chapter will define each of these key risk areas and provide guidance on how to
adequately monitor and control these risks.
4.1 Asset and Liability Management

In the banking world, asset/liability management (ALM) refers to the management of the
spread, or the positive difference between the interest rate on earning assets and the cost of
funds. Successful management of this spread requires control over: a) interest rate risk, b)
foreign exchange gap, c) liquidity, and d) credit risk. Credit risk is normally the most
important of risk categories for MFIs and was addressed in Chapter 3; the other three are
presented in this chapter.
63
A microfinance institution is only vulnerable to these three risks if it has one of the following
characteristics:
ê It borrows money from commercial sources to fund its portfolio;

ê It funds its portfolio from client savings;
ê It operates in a high inflation environment; or
ê It has liabilities denominated in a foreign currency.
If none of these characteristics apply to your organization, and you do not expect that they
will in the near future, you can skip ahead to Section 4.2.
These components of asset and liability management need to be considered carefully. In

formal financial institutions, a management committee normally carries out ALM, as it
involves both operations and treasury activities. Because most MFIs do not have this kind
of management depth, however, the executive director and financial manager will most likely
carry out ALM within an MFI, with perhaps some support from a board member who has
expertise in this area.
4.1.1 Interest Rate Risk

Interest rate risk arises when assets and liabilities are mismatched, in terms of interest rates
and terms. Interest rate risk is particularly problematic for MFIs operating in high
inflationary environments. If inflation rises, the interest rate on loans may not be sufficient
to offset the effects of inflation. An MFI’s ability to adjust interest rates on its loans is
determined by the degree to which short-term liabilities are used to fund longer-term assets
within the portfolio. If the rates on short-term liabilities rise before an MFI can adjust its
lending rates, the spread between interest earnings and interest payments will narrow,
seriously affecting the MFI’s profit margin.
MFIs should monitor interest rate risk by (1) assessing the amount of funds at risk for a
given shift in interest rates, and (2) evaluating the timing of the cash flow changes given a
particular interest rate shift.
All types of assets and liabilities do not respond to a change in interest rates in the same
manner. Some are more sensitive to interest rate changes than others, a characteristic known
as interest rate sensitivity. For example, small scale savings accounts tend not to be very
interest rate sensitive, as low income clients typically maintain savings accounts more for
reasons of liquidity and safety, than for rate of return. For this reason, if the interest rate
falls, such clients will not necessarily withdraw their savings. On the other hand, bank
certificates of deposit are usually highly interest rate sensitive. Certificates of deposit, or
other time deposits, are usually purchased by investors who are concerned with the rate of
return on their investment, and will thus be more likely to withdraw their savings in the
event of a decrease in interest rates. In other words, such investments tend to be more
interest rate sensitive than small-scale savings accounts. This type of interest rate sensitivity
analysis is important for microfinance institutions that mobilize funds from a variety of
sources.
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CHAPTER 3
For MFIs that serve primarily low-income clients, interest rate sensitivity may be less
important than responding to the timing of any cash flow shifts. Determining the gap
between rate-sensitive assets and rate-sensitive liabilities, or gap analysis, provides a
mechanism for identifying the timing of cash flow shifts. Rate-sensitive assets or liabilities
are those that can be priced either upward or downward over the next few months.
A useful indicator for monitoring interest rate risk is the net interest margin, commonly
called the spread. This ratio calculates the income
remaining to the institution after interest is paid on Net Interest Margin:
all liabilities, and compares the result with either the (Interest Revenue-Interest Expense)
total assets or the performing assets of the /
institution. Average Total Assets
A variation of this ratio is (interest revenue – financial

expenses) / average assets, where financial expenses include interest expense, inflation
adjustment, exchange rate depreciation expense, and a subsidized cost of funds adjustment.
(See Chapter 6, Adjusting for Inflation and Subsidies, for guidance on how to calculate imputed
costs.) This second ratio may be more useful than the first for MFIs with large equity bases
(capitalized by donor funds) or subsidized loans. It is particularly useful to compare this
ratio to the operating expense ratio—total operating expenses / average total assets—to
assess whether the interest rate margin is sufficient to cover operating costs. (See Inefficiency
Risks below for further discussion on the operating expense ratio.)
ê Is the MFI susceptible to interest rate risk?

ê For those MFIs operating in highly inflationary environments, is gap analysis conducted regularly?
ê What is your net interest margin?
4.1.2 Foreign Exchange Risk

Foreign exchange risk occurs when an MFI holds cash or other investments (assets) or debt
(liabilities) in foreign currency. The devaluation or revaluation of these assets or liabilities
has the same effect as interest rates in exposing MFIs to potential gain or loss. If the local
currency has devalued against the foreign currency used, the MFI will have to make up the
difference. This difference constitutes an additional “interest rate” that must be generated
by the institution through its operating income.6 Likewise, if the local currency revalues
against the foreign currency used, the MFI stands to profit from a potential gain.
MFIs primarily need to be concerned about foreign exchange risk when they assume
liabilities denominated in a foreign currency and convert these funds into assets
denominated in a local currency. For example, many MFIs fund their local currency loan
portfolios with dollar denominated loans from donors or commercial sources. When the
assets are converted back to dollars, the MFI faces the effects of foreign exchange risk.
Assume an MFI receives $100,000 as a loan from a commercial bank, and converts these
funds into South African Rand (R) at R6 to the dollar to on-lend to clients. When the
liability comes due, the MFI will have to convert the Rand assets back into dollars. If the
6
Christen (1997), p. 139.
65
Guarantee Funds Rand has devalued against the dollar so that the
rate is now R7 to the dollar, the MFI could be
In Egypt, CARE uses a guarantee fund to
susceptible to foreign exchange losses. Figure 18
minimize foreign exchange risk. In this
example, CARE places a Certificate of highlights the impact of this risk on an institution’s
Deposit in U.S. dollars in a bank in bottom line by comparing a stable currency
Egypt. The bank makes a loan to situation with a devalued currency. Assuming the
CARE’s microfinance partner in the local MFI does not adjust its interest rates in time to
currency, thus eliminating foreign accommodate currency devaluation, the MFI will
exchange risk for the microfinance incur a loss when repaying the $100,000 liability.
institution and for CARE.
In general, MFIs that are not operating in a
multiple currency environment should avoid taking on foreign denominated debt to avoid
this kind of foreign exchange risk. However, if the economy is dollar denominated and
clients conduct transactions in dollars, it may be appropriate for an MFI to offer loans in
dollars, and thus to fund these dollar assets with dollar liabilities. Unless the MFI can match
foreign liabilities with foreign assets of equivalent duration and maturity, the MFI should seek to avoid
funding the portfolio or lending in foreign currency.
Figure 18: Example of Currency Devaluation Impact

Amount lent: $100,000 at 20% USD Scenario 1 - SAR Scenario 2 - SAR
(no devaluation) (devaluation)
Amount lent 100,000 600,000 600,000
Exchange rate at due date - R6/USD R7/USD

Amount due 120,000 720,000 840,000
Principal 100,000 600,000 700,000
Interest 20,000 120,000 140,000
Actual cost of funds* 20,000 120,000 240,000
Client revenue** 420,000 420,000

Operating costs*** 240,000 240,000
Net difference 180,000 180,000
Profit / (Loss) 60,000 (60,000)

* Includes interest expense, revaluation of principal, and revaluation of interest expense
** Assume interest rate of 70%
*** Assume operating cost ratio of 40%
For MFIs with foreign currency exposure, appropriate control mechanisms should be
established. If the devaluation is relatively constant and foreseeable, options include:
1. Add the expected devaluation rate to the nominal local interest rate in any loans offered.
An MFI in Latin America, for example, charges 3.5 percent per month on loans in US
dollars and 4.0 percent a month on local currency loans.
2. Include a provision for devaluation expense on the balance sheet and income statement.
3. Index the interest rate on local currency loans to foreign currency, so that if the local
currency devalues, the value of the loan in the foreign currency must still be repaid.
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CHAPTER 3
(Note that this passes on the risk of depreciation loss to the client, which may ultimately
lead to increased credit risk).
In cases where devaluation occurs suddenly due to shocks to the local financial system, MFIs
that have not appropriately matched their exposure could face bankruptcy.
A key monitoring ratio for institutions facing currency exposure is the currency gap risk
ratio. This ratio helps identify a high exposure if
the MFI has borrowed funds denominated in Currency Gap Risk:
foreign currency that it lends out in local (Assets in Specified Currency - Liabilities
currency. in Specified Currency)
/
ê For MFIs that hold assets or liabilities in foreign currency, Performing Assets
are appropriate control mechanisms in place to mitigate
foreign exchange risk?
4.1.3 Liquidity Risk7

Liquidity refers to an MFI’s ability to meet its immediate demands for cash, such as loan
disbursements, bill payments and debt repayment. Liquidity risk arises when an MFI is
unable to cover a liquidity shortfall. Due to the unique nature of microlending, a temporary
lack of access to adequate loan capital can be serious. In
microlending, a primary reason why borrowers repay their A temporary lack of
loans is to receive subsequent loans. If the institution cannot loan capital can
meet disbursement requests, repayment rates could plummet, result in a dramatic
as borrowers no longer perceive this incentive to repay. spike in portfolio
While some MFIs can access short-term funds to cover these quality problems
liquidity shortfalls, these funds are usually expensive and not
always reliable. Given these circumstances, microfinance managers should generally err on
the side of conservative liquidity management.
Effective liquidity management requires MFIs to achieve a balance between maintaining

sufficient liquidity for sudden cash demands and earning revenue through longer-term
investments. While liquidity management and cash flow management are often used
interchangeably, liquidity management includes the management not only of cash, but also
of short-term assets and liabilities.
A key control for mitigating liquidity risks is cash flow management. Cash flow
management refers to the timing of cash flows to ensure that cash inflow is equal to or
greater than cash outflow. Due to the cyclical nature of credit demand in many countries
(particularly high around holidays, for example) and the propensity for young MFIs to
expand quickly in their early years, an MFI can experience peak loan demand in spurts. To
control for these high demand periods, finance managers need to establish a sound cash flow
management program. This program should ensure that:
7
This section adapted from Ledgerwood (1999), p. 255-256.
67
ð Liquidity needs are planned on the basis of worst-case scenarios to limit the potential
for liquidity crises
ð Policies are set for minimum and maximum cash levels
ð Cash needs are forecast (see budgeting section below)
ð Cash budgets are continuously updated
ð Surplus funds are invested or disbursed as loans
ð Cash is available for savings withdrawals and loans
MFIs with strong track records often manage liquidity by establishing a line of credit with a
local bank. If there is a spike in demand, they can draw down on their line of credit to meet
disbursements. This allows the organization to only incur financial expenses when the funds
are used.
Besides the cash flow projections, the liquidity indicator most appropriate for an institution
depends on the institutional type. If the institution mobilizes voluntary savings, for example,
it will need to ensure adequate liquidity to meet client withdrawal Quick Ratio:
requests and debt service payments, using an indicator such as Liquid Assets
the quick ratio. The quick ratio numerator should exclude any /
liquid assets that are restricted by donors for certain uses, as they Current Liabilities
will not be able to meet savings withdrawal needs.
MFIs can further monitor their overall cash flow by using the liquidity ratio. The liquidity
ratio helps institutions determine if there is
enough cash available for disbursements and Liquidity Ratio:
also whether there is too much idle cash. It (Cash + Expected Cash Inflows In The Period)
should always be greater than 1. Cash inflows /
and outflows should be projected on a Anticipated Cash Outflows In The Period
monthly basis and should include only actual
cash items. Depreciation, provisions for loan
losses or subsidy and inflation adjustments do not affect cash flow.
Finally, MFIs should monitor the allocation between cash and other income generating
assets on a regular basis. The idle funds ratio measures the ratio between funds that are not
earning any revenue (cash and near cash) and income
generating funds. Near cash refers to deposits that earn a Idle Funds Ratio:
very low rate of return, with a maturity of three months or (Cash + Near Cash)
less. For liquidity purposes, a certain amount of idle funds is /
necessary. However, too great an amount will depress the Total Outstanding Portfolio
MFI’s overall return on assets. The appropriate amount will
depend on a number of factors, including the institution’s
level of maturity, other short term investment opportunities, and whether or not the
institution is a regulated financial intermediary and therefore subject to reserve requirements.
ê Does your organization follow a cash flow management program, i.e. cash needs forecasting, budgeting, etc.?
ê Do you monitor its liquidity risk through consistent monitoring of key ratios: quick, liquidity, idle funds?
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CHAPTER 3
4.2 Inefficiency Risk

The first great challenge in microfinance was to minimize the credit risk associated with
providing unsecured loans. Many MFIs have largely succeeded in overcoming this obstacle
and have now set their sights on the next major challenge: improving efficiency. It involves
an organization’s ability to manage costs per unit of
output, and thus is directly affected by both cost control Improving efficiency
and level of outreach. Inefficient microfinance is the next major
institutions waste resources and ultimately provide clients challenge for the
with poor services and products, as the costs of these microfinance industry
inefficiencies are passed on to clients through higher
interest rates and transaction costs.
MFIs can improve efficiency in three ways: (1) increase the number of clients to achieve
greater economies of scale, (2) streamline systems to improve productivity, and (3) cut costs.
The first two goals are closely related; both seek to increase the number of clients, or units
of output, the MFI serves by having staff work harder or, preferably, smarter. In
microfinance organizations that are not managed in a business-like manner, employees often
have excess capacity. And yet, as is human nature, they find ways of filling their days so they
end up being very busy doing things that are not particularly important. A close analysis of
time allocation and time management will often reveal waste.
The third goal addresses the cost side of the equation. Administrative costs, including
salaries and other operating expenses, represent the greatest component of the cost structure
of an MFI. Reducing the delivery costs associated with providing financial services improves
operating efficiency. If these costs can be reduced, the savings can be passed on to clients
through more competitively priced products, ultimately improving customer satisfaction.
4.2.1 Inefficiency Controls
Budgeting
The budget represents the master plan of all expenses that it will take for the MFI to maintain
its operations and all sources of capital used to meet expenses. The budget should be
sufficiently detailed to isolate the cost structure of each element of its operations (branch
office, support unit, senior management, etc.). In a multi-branch MFI, treating branches as
profit centers, which includes providing them with decision-making authority to manage
their own efficiency, is a key building block toward improving efficiency for the entire
organization. Decentralizing day-to-day decision making to branch managers and unit heads
is an effective way to increase efficiency and to spread the responsibility throughout the MFI
for managing costs.
69
Figure 19: Budget Comparison Report

123 Microfinance Institution
Summary Actual-to-Budget Income Statement For the Period Jan 1 to Dec 31 2000
2000 Actual 2000 Budget % Budget
INCOME
Interest income on loans 300,789 380,000 79.2%
Loan Fees and Service Charges 32,000 35,000 91.4%
Late fees on loans 12,000 10,000 120.0%
Total credit income 407,760 425,000 95.9%
Income from investments and other 8,909 5,000 178.2%
Income from other financial services 0 0
Total other income 4,380 5,000 87.6%
Total Financial Income 412,140 430,000 95.8%
FINANCIAL COSTS
Interest on debt 58,000 52,000 100.8%
Interest on deposits 1,900 3,000 119.0%
Total Financial Costs 63,000 55,000 114.5%
GROSS FINANCIAL MARGIN 349,140 375,000 93.1%
Provision for Loan Losses 31,200 30,000 104.0%
NET FINANCIAL MARGIN 317,940 345,000 92.2%
EXPENSES
Salaries and benefits 162,000 157,000 103.2%
Administrative expenses 120,000 118,000 101.7%
Depreciation 3,000 3,000 100.0%
Other 300 500 60.0%
Total Operating Expenses 285,300 278,500 102.4%
NET FINANCIAL SERVICES OPERATING MARGIN 32,640 66,500 49.1%
GRANT INCOME 18,700 25,000 100.0%

Total grant income for Financial Services 20,000 25,000 80.0%
NET INCOME FOR SERVICES 52,640 91,500 57.5%

EXCESS OF INCOME OVER EXPENSES 54,140 81,400 66.5%
Subsequently, the budget needs to be developed, understood and “owned” by a wide range
of senior staff in the MFI. Senior managers need to be oriented to think, plan and operate
routinely from a budget perspective to enable the MFI to become commercially minded and
efficient. Toward this end, it is essential for senior managers to participate in reviewing
actual expenses and revenues compared to the budget to develop a working understanding
of the cost structure of the operations and to be held accountable for achieving the targets
set forth on their own budget worksheets.
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A budget comparison report (see
Figure 19) compares the actual income and expense to the budgeted amount for the time
period (usually either monthly or year-to-date). A third column indicates the variance or the
percentage of the actual to the budgeted amount. The primary purpose of this report is to
allow the board and staff to monitor performance relative to the approved budget.
Managers need to carefully monitor income and expenses relative to budget on a monthly
basis. Major discrepancies may call for mid-year adjustments or even urgent revisions to the
annual operating plan. Since the budgeting process generally follows the chart of accounts,
so does this report format.
Activity Based Costing

As MFIs mature, they often introduce new financial products to meet the evolving needs of
their target market. When they do so, they should seriously consider establishing an activity
based costing (ABC) system that allocates both the
direct and indirect related costs to a specific revenue
generating activity. Information about the allocation Conducting ABC
of expenses gives a more accurate picture of how costs To measure activity-based costs, one
and revenues relate to each other. ABC provides allocates administrative expenses
information to understand the relative costs to deliver based on the amount of time spent on
different products and to identify which products an activity in a representative month.
generate the highest profit and which are relatively This information, collected from staff
wasteful. members at all levels within the
organization, is gathered either
through employee interviews or
This information is invaluable in pricing products and
through time sheet documentation.
developing risk management strategies. For example, The next step is to multiply each
an MFI may decide to employ a loss-leader pricing person’s time ratios by their direct and
strategy that intentionally under-prices one product indirect costs. When the calculations
that will attract customers, who will then hopefully are completed, all administrative costs
purchase other, more profitable products. that appear on the income and
expense statement must be allocated.
Even an MFI that only offers one product can benefit Adapted from Gheen et al (1999).
from an ABC analysis if the “activity” is defined more
narrowly. Instead of comparing the costs between two
or more products, you can analyze the costs of different aspects of one product. For
example, you may want to determine the costs that go into marketing, screening, disbursing
and repaying the loan to see if there are ways to streamline the delivery and repayment
process. Or you may want to compare the costs of serving new clients vs. repeat borrowers,
measure the additional costs required to manage delinquent loans, or compare the costs of
delivering the same service from different branches.
Activity based costing is also an appropriate means of analyzing product pilots. For
example, an MFI may want to test the effectiveness of three sets of controls designed to
manage credit risk. In this case, effectiveness involves comparing the costs of the controls
with the resulting portfolio quality.
71
Reengineering8
Most MFIs have systems and procedures that may have made sense at one stage in the
organization’s development. As the MFI grew and diversified, those practices continued
because “that’s what we’ve always done,” without a thoughtful and holistic analysis of what
makes sense today, in the current market environment, given the MFI’s current and
projected structure. Consequently, the MFI has inefficiencies eroding its bottom line that
need to be cleaned up.
The process for cleaning up inefficiencies is called reengineering, or redesigning business

processes through streamlining, consolidating, reorganizing roles and responsibilities, and
automating. Reengineering varies widely in scope and form. It can involve the entire
organization or select units, though it works best when approached holistically.
Reengineering can focus on a specific business process (such as customer service or new
product development) or the institution’s entire operations. The depth and breadth depends
on the extent of the problem and management’s willingness to undertake meaningful, and
often painful, change.
In designing a reengineering process, it is useful to establish phases because it allows an MFI

to test its modified processes and benefit from lessons learned before implementing the
changes institution-wide. One of the major areas of focus of reengineering is on employee
optimization: organizing tasks and allocating them among different staff levels to maximize
productivity (see box).
The greatest challenge to successful reengineering is the lack of strong leadership to manage
organizational resistance to change. This resistance often results when the organizational
culture and support systems are not aligned with the new work model, undermining
employee trust and their commitment to change. Initial resistance also stems from residual
Reengineering at Mibanco
In anticipation of increased competition, ACCION International guided its Peruvian affiliate, Mibanco,
through a reengineering process so it would be prepared to stave off competitive threats.
An important focus of the reengineering was at the branch level, where an analysis of the daily activities
of loan officers indicated that they were spending 2/3 of their time in their office, (participating in credit
committees, underwriting, and processing loan applications) rather than in the field generating new
loans. Part of this misallocation of time resulted from the homogenized way that applications were
analyzed, including the structure and timing of the credit committee.
To address this issue, reengineering established criteria, based on loan size, loan officer experience, and
delinquency track record, to delegate more authority to senior credit officers with low-risk loans. This
reduced the number of loans that required committee approval. Some administrative functions were
pushed down to less expensive administrators. These changes resulted in a better utilization of loan
officers, increasing their time in the field by 65 percent.
Adapted from Brand (2000)
8
Adapted from Brand (2000).
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CHAPTER 3
sentiments of previous change efforts, as well as the misperception that reengineering means
job loss.
The success of reengineering is tied to how it is undertaken. The most critical factor is senior
management’s ability to lead the effort, articulate the desired outcomes, and explain the
rationale for change. When employees understand the rationale and the road map for
reengineering, they can help facilitate, rather than resist, change.
Soliciting employee participation in assessing the problem and generating solutions is critical
for staff to take ownership of the new business model. Internally generated ideas are usually
complemented with external best practices to establish benchmarks and goals.
Reengineering often begins with a brainstorming session to identify desired improvements
before documenting “as-is” business practices. For this reason, reengineering almost always
involves outside consultants, who bring the expertise, creativity, and objectivity, to help
improve ingrained processes and cultures. Finally, a successful reengineering effort leaves in
place a culture of continuous improvement that seeks to regularly enhance the business so that
organization does not have to undergo a drastic and perhaps painful reengineering process
again.
ê Does your organization develop an annual budget?

ê Is the annual budget used and updated regularly?
ê Do you actively compare the budgeted to actual numbers and identify cost over-runs?
ê (For MFIs that offer multiple products) Do you do activity-based costing?
ê Have you analyzed your systems and procedures to identify and eliminate inefficiencies?
4.2.2 Inefficiency Monitoring
Efficiency and Productivity Ratios

Besides institutionalizing mechanisms for controlling costs, MFIs should monitor key
efficiency ratios. To analyze its level of efficiency, an MFI should compare its current
performance to two other data sets: 1) the organization’s past performance (trend analysis)
and 2) similar organizations identified as industry leaders (industry benchmarks). The
following efficiency indicators represent recommended monitoring tools for inefficiency
risk.9
Operating Expense Ratio: The operating expense Operating Expense Ratio:

ratio gives a general overview of how efficiently the Total Operating Expenses
MFI uses assets. The numerator, total operating /
expenses, includes administrative expenses, loan loss Average Total Assets
provisions and financial costs. An alternative ratio
for MFIs, particularly those that only offer lending
services, is total operating expenses to average loan portfolio.
9
For current benchmarks refer to The MicroBanking Bulletin, a semi-annual journal that includes
performance ratios based on data from more than 100 leading MFIs from around the world.
73
Administrative Expense Ratio: The administrative expense ratio provides a good idea of
relative efficiency when comparing MFIs because
non-productive guarantee funds and year-end Administrative Expense Ratio:
spikes can cloud comparisons between operating Total Administrative Expense
expense ratios. /
Average Loan Portfolio
Salary Expense Ratio: Salary expenses, which include direct salaries and staff benefits,
tend to represent the largest expense in MFIs,
averaging 60 percent of total administrative Salary Expense Ratio:
expenses. Salary Expenses
/
Average Loan Portfolio
Bank Efficiency Ratio: This ratio analyzes the
extent to which total income (net interest and other income before loan loss provision) is
consumed by expenses. This helps MFIs to
focus not just on how expenses affect
Bank Efficiency Ratio:
efficiency, but also the impact of revenue. This Total Expenses (before taxes)
ratio shows how many dollars are earned for /
each dollar spent. The majority of US financial Net Interest Income (before provisions)
institutions have efficiency ratios at or below 55 + Other Income
percent.10
Average Cost Per Client or Per Loan: The average cost per client or per loan is
particularly useful as it identifies transactions costs on a per unit basis. Unlike the other
indicators, which are relative to portfolio or assets, this
indicator helps to show poverty lenders—MFIs with Cost per Client:
really small loans—whether their inefficiency is due to Total Administrative Expenses
high costs or small loan sizes. /
Average Number of Clients
Number of Clients (or Loans) per Loan Officer (or
Field Staff, or Total Staff): This basic productivity indicator has numerous variations on
the same theme: how many units can employees manage?
Number of Field Staff (or Loan Officers) as a Percentage of Total Staff: This ratio
enables the MFI to ensure that it is focusing its resource on its core business, delivering
financial services, without a large back office or overhead.
No one indicator independently captures all of the aspects Do not artificially

of efficiency that need to be monitored, so it is important to increase average
review a set of efficiency and productivity ratios. Since the loan size to improve
denominator for most of the efficiency ratios is either total your efficie ncy
portfolio or total assets, one way to improve efficiency
might be to increase the average loan size. While the loan size tends to increase naturally
over time as the client base consists of more repeat clients, an artificial increase in loan size is
not recommended because it leads to two other risks that were discussed above. Assuming
10
Brand and Gerschick (2000).
74
CHAPTER 3
that the MFI is offering an appropriate product for its target market, an artificial increase in
loan size can overburden them and result in credit risk. Another means of raising average
loan sizes is by providing larger loans to a different segment of the market, which could
result in mission risk.
Monitoring Human Errors

One of the greatest contributors to inefficiency is simple human error. Errors due to haste,
carelessness, and poor training occur throughout the paper trail. Even minor mistakes like
transposing a receipt number are expensive to resolve. The extra time that employees take
to make sure they are doing things correctly is usually an enormous investment in efficiency.
MFIs should keep an error log to track the mistakes that occur and the estimated costs that
it took to resolve them. The error log becomes the basis for ongoing training, staff
discipline, as well as possible reengineering targets.
ê Does the MFI actively monitor its operating efficiency through key ratio analysis?
ê Does your organization maintain an error log that allows it to identify and rectify common mistakes?
4.3 Systems Integrity Risks

The financial health of an institution is primarily monitored through key financial statements
and management reports. The reliability of both source data and the information contained
in these financial statements and management reports is critical to this process. Without
assurances that these key reports are accurate, an MFI is flying in the dark. External audits
provide definitive assessments of the reliability of financial reports and systems in an MFI.
MFIs should typically have a financial audit conducted on an annual basis. This audit
involves a review of all financial statements, including the balance sheet, income statement,
and cash flow statements to check the accuracy and reliability of accounting records, in order
to safeguard company assets. This type of audit, if done to fulfill regulations or
requirements, must be done by an external audit firm. The financial audit reviews historical
data, and does not make projections about future financial information.
ê Is the MFI audited annually by a reliable audit firm?
75
Efficiency, Activity Based Costing and Reengineering
Brand, Monica and Julie Gerschick (2000). Maximizing Efficiency: The Path to Enhanced Outreach and
Sustainability. Monograph No. 12. Somerville, MA: ACCION International. Website: www.accion.org.
Asset and Liability Management
Bartel, Margaret, Michael J. McCord and Robin R. Bell (1995). Financial Management Ratios II: Analyzing for
Quality and Soundness in Microcredit Programs. GEMINI Technical Note No. 8. Bethesda, MD:
Development Alternatives, Inc. Website: www.mip.org.
Ledgerwood, Joanna (1996). Financial Management Training for Microfinance Organization: Finance Study Guide.
Toronto: Calmeadow. Website: www.calmeadow.org. Available from PACT Publications.
Ledgerwood, Joanna (1999). Microfinance Handbook: An Institutional and Financial Perspective. Washington
DC: The World Bank. Email: books@worldbank.org..
External Audits
CGAP (1999). External Audits of Microfinance Institutions: A Handbook. Technical Tool Series No. 3.
Washington DC: CGAP. Website: www.cgap.org. Available from PACT Publications.
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CHAPTER 6
Chapter 5: External Risks
Institutional
Risk
Financial
Risk Risk
External Risk
E
xternal risks are considerably different than the other sets of risks to which a
microfinance institution is exposed because the organization has less control over
them. Therefore, instead of highlighting monitoring and controls, as has been done
with the other risks, for external risks it is necessary to discuss how to monitor and
respond. The five sets of external risks addressed in this chapter are:
Regulatory Competition Demographic Macroeconomic Natural Environment
A note of caution must be attached to a discussion of external risks. It is fairly common for
MFIs that are not doing particularly well to point to external causes for their plight, such as
the following excuses for poor portfolio quality:
ê These clients have never borrowed money before

ê The clients are used to handouts
ê Our clients are so poor that it is hard for them to repay their loans
ê The economy is so bad that it is hurting their businesses
Statements like these indicate a need to better understand microfinance. The purpose of
microfinance is to serve poor people who do not have experience with credit and who live in
difficult conditions. The rationale behind the design of a
microloan product is to overcome these challenges. If a External risks
microloan product is not working, unless there has been a represent challenges
significant and recent change in the local conditions, the problem to overcome, but they
probably lies with the product or its delivery, not the market. are not excuses for
These external risks represent challenges that management and poor performance
the board need to identify and respond to, but they are not
excuses for poor performance.
77
It is also worth noting that, while you may be operating under difficult conditions, there is
probably another MFI out there that has succeeded in overcoming the same challenges. The
lesson from their experiences: challenges can be addressed and overcome.
5.1 Regulatory Risks

Various governmental bodies may have some influence over the activities of microfinance
institutions. The regulatory risks discussed in this section are summarized in the following
table:
Banking Regulations Other Regulatory Risks

Usury Laws Directed Credit
Financial Intermediation Contract Enforcement
Labor Laws
5.1.1 Banking Regulations

In the last twenty years, MFIs have developed new technologies—such as group lending
methodologies and streamlined delivery systems—to provide financial services to excluded
populations. These developments were possible because MFIs had considerable freedom to
innovate and experiment beyond the purview of most regulatory bodies. Now that
microfinance institutions are growing in scale and number, regulators and policymakers are
becoming increasingly interested in them.
This attention has the potential to be constructive. Appropriately designed regulations can
create an enabling environment within which microfinance can blossom. However, the
opposite reaction is also a possibility. Microfinance is different from traditional banking in
many ways. Policymakers who do not appreciate the unique characteristics of microfinance
are likely to impose inappropriate regulations that could stifle the industry.
Within this context, there are two areas of banking regulation to which microfinance
institutions are particularly vulnerable: usury laws and regulations regarding financial
intermediation.
Usury Laws
Many jurisdictions have usury laws that limit the interest rate that financial institutions can
charge on loans. These laws tend to put a ceiling on interest rates that is lower than MFIs
need to charge in order to cover their costs.
Microfinance institutions need to charge interest rates high enough that low-income
communities can have access to financial services for the long term. Donor subsidies are
not sufficient to meet the global demand for financial services and they are a fickle source on
which MFIs cannot rely. The only long-term solution is to generate enough income from
78
CHAPTER 6
your loan portfolio to cover administrative and financial costs. To do so, most MFIs charge
real annual effective interest rates that range from 20 to 60 percent. This wide range depends
on many factors including the local labor market, loan sizes, and the institution’s size. These
rates are typically higher than most usury ceilings.
Financial Intermediation
Regulators are primarily responsible for two things: 1) to preserve the integrity of the
financial system and 2) to protect the savings of depositors. In general, the microfinance
industry believes that as long as MFIs do not mobilize voluntary savings from the public,
they should not be regulated as a banking institution. If the MFI goes bankrupt, it will only
lose the money of donors and investors, neither of whom regulators are obligated to protect.
A gray area emerges when an MFI requires compulsory savings as a part of its lending
methodology. In this case, as long as it is not intermediating or on-lending those funds, then
the MFI generally should not fall under the authority of bank regulators. But as a
microfinance institution matures, clients may
demand access to voluntary savings products. In
addition, the institution may encounter funding EDPYME in Peru
constraints, in which case it might use the deposits In an effort to build the capacity of
that it has mobilized as loan capital. If these microfinance NGOs, and to make them
conditions occur and the MFI goes bankrupt, then eligible to borrow from the government’s
it could lose the savings of depositors. If it is a line of credit, the Peruvian banking
large institution, its poor health could even superintendency created a new category of
undermine the integrity of the financial system. financial institution called an EDPYME.
Regulators should be concerned when MFIs start
entering the territory of financial intermediation. For a small minimum capital requirement, it
is possible to create a regulated financial
institution that only provides credit. Once
Many common banking regulations for financial an EDPYME demonstrates that it is well
intermediaries are not applicable to microfinance managed, it can request permission to offer
institutions. For example, security and other services like passbook savings.
documentation requirements, portfolio examination
methods, and performance standards are CARE’s partner, EDYFICAR, became one
completely different for commercial banks than of the first EDPYME in Peru.
would be appropriate for microfinance institutions.
MFIs that rush to become regulated so that they
can offer savings services may find banking regulations force them to adopt new policies
that are prohibitive to serving their intended market.
ê Are there usury laws in the country preventing the MFI from charging cost recovery rates?
ê Is the MFI intermediating savings?
ê Is it legally permitted to do so?
ê Is the regulatory environment appropriate / accommodating?
79
5.1.2 Other Regulatory Risks
Directed Credit
Directed credit risk is when local policy makers will legislate or otherwise pressure an MFI to
lend to certain individuals for political reasons. Successful microfinance institutions, which
tend to have strong community support and significant outreach, may be attractive vehicles
for policy makers who see the potential to use MFIs for political purposes, sometimes under
the guise of “regulations.” Few things could undermine a microfinance institution faster
than political pressure to provide credit or other services to particular communities or
individuals. It is imperative that MFIs retain their independence regarding where they
operate and to whom they lend. MFIs are especially vulnerable during an election period
when incumbent politicians may try to use them inappropriately.
Contract Enforcement
Contract enforcement risk is the possibility that the MFI will not have the legal means of
enforcing its loan contracts in the local legal system. For An MFI needs to
microfinance institutions to be successful lenders, they must enforce its loan
enforce their credit contracts. When borrowers default on their contracts to have
loans, the MFI goes through several stages of delinquency sufficient “teeth” to
management to recover its money whereby retribution typically maintain portfolio
escalates. The MFI hopes that it can rely on the legal system to quality
support its efforts. If the MFI cannot legally enforce contracts
by seizing collateral or taking defaulters to court, then it is deprived of important options in
its delinquency management strategy.
Labor Laws
Labor law risk is the concern that labor regulations will prevent MFIs from containing salary
costs or dismissing employees, even if it is warranted for cost reasons or for internal control
purposes. Salaries represent the single largest budget item for most MFIs. The sustainability
of the organization often depends on its ability to hire inexpensive staff; credit
methodologies are often designed to be implemented by a moderately skilled staff. In
environments where labor regulations inappropriately inflate salary costs, MFIs will have
significant difficulty achieving self-sufficiency.
MFIs also need to be able to take appropriate actions with staff members who do not
perform appropriately, particularly when fraud is involved. If the institution cannot dismiss
staff members who have committed fraud and is unable to seek appropriate retribution, the
MFI will not be able to operate optimally.
ê Is there political pressure to lend to certain target groups?

ê Are contracts easily enforceable?
ê Do labor laws constrain the organization?
ê If unionized, are the union stewards familiar with the MFI’s projection model (i.e., have they been shown the
implications of different salary increases on the institution’s sustainability)?
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5.1.3 Regulatory Monitoring and Response

Regulatory risks are considered external risks because microfinance institutions, particularly
small to moderately sized ones, tend to have little influence over the regulatory environment.
Individual MFIs tend to only exert authority in the policy arena if they have very influential
board members who are big players in the local political scene.
However, an industry association or network of MFIs can often have an active and even
influential voice in shaping public policy. It is also effective to work through a local body
that can represent the national microfinance industry. A downside of this active industry
role is the potential to be distracted from the MFI’s operational activities. Therefore a
careful assessment of the potential regulatory risks will determine the appropriate
involvement at the industry level.
To remain in good standing with regulators, it is advisable to conduct a regular compliance

audit to review conformity with external requirements, policies and procedures, and
financial or otherwise relevant legislation. Compliance audits can be done by internal or
external auditors, and require a lower audit skill level than operational audit, as compliance
auditing requires less need for exercising professional judgment.
5.2 Competition Risks

In some environments, microfinance is becoming increasingly competitive, with new players,
such as banks and consumer credit companies, entering the market. The three main sources
of competition risk are:
ê Lack of knowledge of whether a competitor is providing a similar service to a similar

market
ê Lack of familiarity with a competitor’s services to adequately position, price and sell
one’s own services
ê Lack of sufficient information about clients’ current and past credit performance with
other institutions
Without this information, an MFI can experience client desertion and a loss of market share,
which can hamper an MFI’s ability to expand.
5.2.1 Monitoring Competition Risks

If an organization has high retention rates, then it is probably protecting itself from
competition risks today. But the market can change very quickly if a new competitor arrives
on the scene with a more attractive product. To monitor your organization’s vulnerability to
competition risks, it is imperative that you keep a close watch on other service providers and
prospective providers, including banks, consumer credit companies, and suppliers.
To monitor for competition risk, it is necessary for an MFI to collect information about its
competitors. It should ensure that it has current and accurate information about the
products and services of other institutions in the market. A mystery shopper approach can
81
be used to collect product and service details from other MFIs. Some of the other methods
of measuring customer satisfaction can also be used to learn about the service provided by
the competition, such as exit interviews and focus groups.
One of the easiest ways of monitoring the competition is through questions on loan
applications. Some MFIs routinely ask with each loan if the applicant has ever borrowed
from formal or informal sources, including friends, neighbors, moneylenders, suppliers,
banks and other MFIs. If applicants answer affirmatively, they are asked follow up questions
to understand the nature of the other products and the clients’ analysis of the strengths and
weaknesses of each.
5.2.2 Competition Risk Responses

With feedback from clients and other sources about competitors in hand, the MFI should
use that information to reduce its vulnerability to competition risks. The type of
information it receives will determine the appropriate response, which might include:
ð Refining its credit products: Longer and/or shorter terms, different loan sizes, lower
interest rates or fee arrangements, various forms of security
ð Incentives for retention: Provide repeat clients with preferred services, such as fast loan
approval, lower interest rates
ð Offering new products: Introduce new credit and savings products that are designed to
meet a wider range of household needs besides just self-employment
ð Improving access: Change office locations, add satellite offices, extend hours of
operation
ð Improving service: Train staff on customer oriented service delivery techniques
Another response to market risks is a credit bureau, a mechanism for sharing information
between MFIs regarding credit histories and current Market Share:
level of indebtedness. This industry database could be a Number of Outstanding Loans (or
function for the local network. If this database exists, Clients) of the MFI
then it would also be possible to produce another /
indicator to monitor market risks: market share. Total Number of Outstanding
Loans (or Clients) in the Industry
ê Do you track client retention rates?
ê How do you collect information about your competition?
ê Do you routinely collect customer satisfaction information and use that to modify your products and services?
ê Do you have access to an industry-wide bad debtors list or credit bureau?
5.3 Demographic Risks

Providing financial services to low-income persons in disadvantaged communities is not
easy. If it were easy, then banks would have done it long ago. It is risky to serve this market
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because the market itself is risky. The products and services need to be designed to
minimize the vulnerability of both the client and the institution.
Best practices in microfinance methodologies tend to be adopted in one region based on

what was successful in another. When conducting a risk assessment, consider whether the
organization is sufficiently addressing local characteristics that might generate special
challenges. Several factors should be considered:
ê Education level of clients: If clients lack literacy and numeric skills, they may be
greater credit risks and are probably more vulnerable to fraud. Special systems and
controls should be used in serving illiterate borrowers.
ê Entrepreneurial attitude and aptitude: Some societies have a strong tradition of
informal markets, such as in West Africa; others, like post-communist countries, do not
have this expertise. Client training may form a larger component of the service delivery in
regions that have less entrepreneurial expertise.
ê Social cohesion: Character assessments and peer pressure are important aspects of
most microlending methodologies, yet the ability to exert pressure or collect good
character information varies significantly from one region to the next, even in the same
country. In cohesive communities, where everyone knows each other’s business, it is
easier to analyze an applicant’s character and to use the borrower’s standing in the
community to exert repayment pressure, even with an individual lending methodology. It
is much more challenging to serve transient populations in communities where people do
not know or trust each other very well, and where there is a higher likelihood that a
borrower will disappear.
ê Societal attitudes towards fraud: The level of tolerance in the political and business
culture for corruption and lack of transparency must be factored in when determining
appropriate controls for reducing risk.
ê Prevalence of crime: In low-income communities, particularly in urban areas, the
prevalence of crime can create a significant challenge for MFIs. The security and controls
required to reduce this vulnerability can be quite expensive.
ê Past experiences with NGOs and credit providers: Different countries have different
attitudes and expectations regarding non-governmental organizations. If the MFI is
perceived as an extension of an international aid agency, this might create the perception
that loans are “gift money,” and appropriate training is needed to dissuade clients of this
notion. This notion would be reinforced if the market had previous experiences with
credit facilities that were not operated on a commercial basis.
ê Occurrences of illness and death: In some regions, a major cause of credit risk is
associated with the poor health of clients or their family members. This is especially true
in HIV/AIDs prevalent countries. To address this issue, some organizations allow
repayment “slides,” in effect rescheduling loans due to illness if the client has a note from
a health care professional. Other organizations are entering partnerships with insurance
companies to either provide clients with health care coverage, or to pay for outstanding
balances in cases of illness and death, or both.
83
The demographic risks can also extend to an organization’s employees. One of the
implications of working in an area with minimal levels of education is that recruitment and
training of MFI staff can be particularly challenging. This has an impact on both the
operating costs (staff may be expensive in relation to their productivity) and also on the
design of management, information and control systems. This situation creates another
balancing act: on the one hand, the MFI wants to be more responsive to its clients by
offering more customized products and services; on the other hand, if the organization
offers a diverse set of services, the more difficult it will be for field staff to implement and
the greater the exposure to fraud and credit risk.
5.4 Physical Environment Risks

The physical environment of low-income communities exacerbates the risks involved in
delivering financial services. The local conditions raise two different sets of issues that need
to be considered in a risk assessment:
ê Infrastructure challenges: The infrastructure in which the MFI operates significantly

impacts the organization’s ability to maintain efficient operations with tight controls. Key
factors include the availability of electricity, telephone, transportation systems and banking
facilities. Perhaps the best control to overcome these challenges is to operate in a limited
number of areas that are near each other. It is extremely difficult to manage risk if you
operate in numerous distant regions with poor communication.
ê Natural disaster risks: Some areas are prone to natural calamities (floods, cyclones, or
drought) that affect households, enterprises, income streams and microfinance service
delivery. Countries that experience repeated natural disasters will require specific risk
management strategies, such as requiring business diversification, accessing disaster
insurance, creating disaster relief funds, encouraging savings, and developing appropriate
rescheduling policies.
It is interesting to note that the mitigation strategy for infrastructure challenges could be
exactly the opposite of the strategy for natural disaster risks. While poor infrastructure may
encourage an MFI to cluster operations in a small geographic area, this increases the
vulnerability to localized natural disasters.
Besides the affect that disasters might have on an MFI’s clients, it is also important to
protect against the affects that they might have on the institution itself. An MFI should
consider its own insurance needs, for flood or fire, as well as appropriate protection of its
information system and records.
5.5 Macroeconomic Risks

Microfinance institutions are especially vulnerable to changes in the macroeconomic
environment such as devaluation and inflation. This risk has two facets: 1) how these
conditions affect the MFI directly and 2) how they affect the MFI’s clients, their business
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operations, and their ability to repay their loans. The poor tend to be more vulnerable to
economic fluctuations than other segments of the population. Microfinance institutions
protect themselves from these challenges by keeping loan terms short, by pegging interest
rates to a relevant index, and/or by lending in foreign currency (and hence passing on the
risk to the clients).
85
Regulation and Supervision
Berenbach, Shari and Craig Churchill (1997). Regulation and Supervision of Microfinance Institutions: Experience
from Latin America, Asia and Africa. Occasional Paper No. 1. Washington DC: MicroFinance Network.
Email: mfn@mfnetwork.org. Available from PACT Publications. Email: books@pactpub.org.
Rock, Rachel, Maria Otero and Sonia Saltzman (1997). From Margin to Mainstream: The Regulation and
Supervision of Microfinance. Monograph No. 11. Somerville, MA: ACCION International. Website:
www.accion.org.
Rosenberg, Richard and Robert Peck Christen (2000). The Rush to Regulate: Legal Frameworks for Microfinance.
Occasional Paper No. 4. Washington DC: CGAP. Website: www.cgap.org.
Van Gruening, Hennie, Joselito Gallardo and Bikki Randhawa (1998). A Framework for Regulating
Microfinance Institutions. Working Paper 206. Washington DC: The World Bank. Email:
books@worldbank.org.
Competition
Churchill, Craig F. ed. (1998). Moving Microfinance Forward: Ownership, Competition and Control of Microfinance
Institutions. Washington DC: MicroFinance Network. Email: mfn@mfnetwork.org. Available from
PACT Publications.
Rhyne, Elizabeth and Robert Peck Christen (1999). Microfinance Enters the Marketplace. Monograph.
Washington DC: USAID. Website: www.mip.org.
Challenging Environments
Brown, Warren and Geetha Nagarajan (2000). Disaster Loan Funds for Microfinance Institutions: A Look at
Emerging Experience. USAID’s Microenterprise Best Practices Project. Bethesda, MD: Development
Doyle, Karen (1998). Microfinance in the Wake of Conflict: Challenges and Opportunities. USAID’s
www.mip.org.
Nagarajan, Geetha (1998). Microfinance in the Wake of Natural Disasters: Challenges and Opportunities. USAID’s
www.mip.org.
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Chapter 6: Management Information

Systems
T
o properly control risks, an MFI needs a strong information system. As discussed in
the introduction, risk management is a dynamic three-step cycle in which MFIs identify
their risks, design and implement controls to mitigate these risks, and establish systems
to monitor them. These monitoring systems are then used to help identify additional
risks, setting in motion a dynamic process.
Management information systems (MIS) lie at the heart of this dynamic, serving as the
primary link between these three elements. Whether computerized or manual, an effective
MIS provides critical information for risk identification, acts as a mechanism for
systematizing business processes and controls, and offers a tool for monitoring
organizational performance and pinpointing future risk areas. As such, MIS is the
foundation for effective risk management.
This chapter provides guidance on the following three key issues relating to management
information systems:
1. System Components: This section introduces the primary components of an MIS,

the accounting and portfolio management systems, as well as related subjects such as
the chart of accounts, cash vs. accrual accounting, fund accounting, and criteria for
evaluating loan-tracking software.
2. Financial Statement Presentation: The second section focuses on financial

statements, providing advice on vouchers, frequency of financial statement
preparation, and the key adjustments needed to accurately present the financial
position of an MFI.
3. Report Preparation: The chapter concludes by outlining important considerations

in report preparation, including the key issues in report design and recommendations
for a reporting framework.
6.1 System Components: What Does an MIS Include?

A management information system is the processes and actions involved in capturing raw
data, processing the data into usable information, and disseminating the information to
users.11 As such, MIS includes all the systems used for generating the information that
guides management in its decisions and actions. Good information is essential for an MFI
to perform efficiently and effectively. MIS must be accurate and easy to use. By
11
Waterfield and Ramsing (1998) p. 3.
87
transforming data, or unprocessed facts, into information through a systematic process,

management information systems provide tools for identifying, controlling and monitoring
key risks within an organization. The better the information, the better the MFI can manage
its risks.
A microfinance institution typically has two main systems: the accounting system, centered
on the chart of accounts and general ledger, and the portfolio tracking system, covering
the performance of accounts for each financial product offered by the institution. These
two systems may or may not be linked depending on the human and financial resources
available to maintain them. In addition, an MFI may also have a client database that permits
detailed impact analysis, as well as a separate human resource module for payroll. These
latter two systems are not dealt with in this handbook.
Figure 20: The Parts of an MIS
Data
Input Input
Accounting data Loan and savings
data
Policies and
procedures
Chart of Accounting system Portfolio system

accounts
Methodology
Information
Choice of Financial Management Choice of

indicators Statements reports indicators
Adapted from Waterfield and Ramsing (1998).
6.1.1 Accounting Systems

The foundation of any financial management system is accounting. Transactions and
accounting ledgers are part of a larger, complex system for controlling funds and reporting
on their sources and uses. Although standard accounting and auditing procedures vary from
country to country, there are basic principles and concepts that determine the underlying
logic of accounting information systems. These include: the structure of the chart of
accounts, cash vs. accrual accounting, fund accounting, and general design considerations.
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Chart of Accounts
To track the flow of funds in an organization, accountants need a chart (or list) of accounts,
which is a structure for posting transactions to different accounts and ledgers. The core of
an institution’s accounting system is its general ledger. The skeleton of the general ledger is, in
turn, the chart of accounts. The design of the chart of accounts reflects a number of
fundamental decisions by the institution. The structure and level of detail determine the type
of information that management can access and analyze. If the chart of accounts captures
information at too general a level, it will not provide information precise enough to generate
sophisticated indicators needed to adequately track performance. On the other hand,
attempting to track too much detail generally means creating too many accounts, resulting in
information that is so desegregated that management cannot identify and interpret the
trends.
MFIs should design their chart of accounts to meet the needs of management, providing
information with a degree of detail that is meaningful for managers at all levels. While the
degree of detail will differ among MFIs, CARE’s Small Economic Activity Development
(SEAD) Unit recommends the account structure presented in Figure 21 as a starting point.
Figure 21: Chart of Accounts Structure

ABCC-DD-EE-FF, where
ABCC = Account
A = Type of account (asset, liability) DD = Program
B = Group (cash, portfolio receivable) EE = Branch
CC = Individual accounts FF = Funder
Waterfield and Ramsing (1998).
The first four digits of each account designate the account number: ABCC.
ê A: The first digit normally refers to the type of account (with 1 indicating assets, 2
liabilities, 3 equity, 4 income and 5 expense).
ê B: The second digit loosely identifies a group with common characteristics, such as
cash, interest and fees receivable, or fixed assets. General ledger accounts typically
progress from assets and liabilities that are most liquid (such as cash-account 1100) to
those that are least liquid (such as fixed assets-account 1700).
ê CC: The next two digits indicate specific accounts in the group, such as petty cash or
checking account, two accounts in the cash group. When possible, related accounts
should have related numbers: for example, if the interest income on rescheduled loans is
account 4040, the loan portfolio for rescheduled loans could be 1240.
Additional digits can also be added to track by branch office, by program, and by funder,
using extended account numbers, such as: DD-EE-FF (see section on Fund Accounting
below).
89
While each MFI’s chart of accounts should reflect its own operations, structure, and
information needs, the CARE SEAD Unit recommends the sample chart of accounts
presented in Annex 1 as a guide for CARE affiliates. In some cases, however, regulatory
bodies will require institutions under their jurisdiction to use a specific chart of accounts.
Cash vs. Accrual Accounting

Accounting systems can be cash-based (accounting for income and expenses when cash
changes hands), accrual-based (accounting for income and expenses when they are incurred),
or modified cash systems (in which most accounting is cash-based, but selected accounts are
accrual-based).
The CARE SEAD Unit encourages all CARE affiliated MFIs to accrue important expenses,
such as personnel benefits and interest payable on loans that may require only annual interest
payments. (See section on Accounting Adjustments for more discussion.)
Fund Accounting
Donors often require detailed reporting by microfinance institutions on the use of funds they
provide. For this reason, CARE encourages
its affiliated MFIs to use fund accounting in Separate Systems: CARE and MFIs
their operations. Creating a chart of As a non-profit, CARE uses a non-profit
accounts with masking techniques that “flow-of-funds” accounting system. This
include or exclude accounts designated by system is not appropriate for MFIs because it
certain digits in the account number provides only accounts for the sources and uses of
extra power in recording and reporting funds. A business operation needs a balance
information and greatly eases reporting on sheet and income statements. For CARE to
donor funds. This setup permits synthesis of develop self-sustaining Savings & Credit
the accounts from the perspective of programs, it must root the systems in the
financial management, while maintaining the business world. This means that microfinance
operations must have a separate accounting
ability to report to each funding source the
system that complies with basic business
use of its particular funds.
principles.
For multi-purpose organizations, such as
programs that provide financial and business development services, the chart of accounts
must allow for the proper segregation of the various
activities. These organizations should clearly separate Separate income and
income and expenses from financial services (savings and expenses for
credit) from non-financial services. microfinance activities
from non-
microfinance activities
General Software Design Consideration
In selecting and evaluating accounting software packages, MFIs should ensure the following:
ê A system that requires a single input of data to generate various financial reports;
ê Software that incorporates rigorous accounting standards (for example, does not accept
entries that do not balance; supports accrual accounting);
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ê A flexible chart of accounts structure that allows the organization to track income and
expenses by program, branch, funding source, etc.;
ê A flexible report writer that allows the organization to generate reports by program,
branch, funding source, etc.;
ê The capacity to maintain and report on historical and budgetary, as well as current,
financial information – a “user friendly” design that includes clear menu lay-outs, good
documentation, and the capacity to support networked operations, if relevant;
ê Reasonably priced local support, either by phone or in person;
ê Relatively modest hard-disk utilization requirements.
6.1.2 Portfolio Management Systems

The second component of an MIS is the portfolio management system, used for tracking
credit and, if applicable, savings products. While well-established accounting practices are
reflected in general ledger software, the variety of lending methodologies, repayment
schedules, pricing policies, and delivery mechanisms used among MFIs has resulted in a
number of portfolio management systems, with varying approaches to the way information
is tracked, the kinds of reports that are generated, and the kinds of features that are included.
Because there are no universal standards for loan tracking systems, and because the
information tracked and reported is relatively complex, this section will not attempt to
identify specific requirements for portfolio management systems. Instead, Figure 22
provides MFIs with a framework for assessing portfolio management software, which will
allow them to compare a wide range of systems to their specific needs.
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Figure 22: Criteria for Evaluating Loan Tracking Software

Ease of use Hardware/software issues
Documentation Programming language
Tutorials Data storage format
Error handling Network support
Help screens Operating system
Interface Access speed
Features Support
Languages Customization available
Setup options Training
Methodology issues Cost issues
Loan product definition
Multiple loan products Reports
Principal repayment methods Existing reports
Monitoring methods Ease of creating new reports
Fund accounting of portfolio Print preview
Data disaggregation Printers supported
Interest calculations Width of reports
Fee calculations
Savings Security
Branch office management and consolidation Passwords and levels of administration
Linkages between accounting and portfolio Data entry and modification
Backup procedures
Audit trails
Source: Waterfield and Sheldon (1997) in Ledgerwood (1999).
6.1.3 Linking Accounting and Portfolio Systems12

Many people expect computerized portfolio and accounting systems to be seamlessly linked
so that all transactions entered in the portfolio system are automatically reflected in the
accounting system. While such a link is ideal, it is expensive and requires maintenance.
Small institutions are probably better off not linking client accounts and the general ledger
by computer. A non-linked system provides another level of internal control, offers more
user flexibility and less computer dependence, and is less expensive because it does not
demand additional programming or software support.
For programs that are not linked, daily reconciliation of the portfolio system with the
accounting system is critical. Transaction reports from the
two systems should be printed and reconciled on a daily basis, For non-linked
to permit the timely resolution of any irregularities. Even for systems, daily
institutions that have linked systems, periodic (at least reconciliation is
monthly) reconciliation is important to ensure that proper critical
information is being recorded in both.
12
This section is drawn from Waterfield and Ramsing (1998).
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6.2 Financial Statement Presentation

To analyze the financial performance of an MFI properly, independent financial statements
(i.e., income statements and balance sheets—see Annex 3 for sample format) should be
prepared on a consistent basis and in accordance with
generally accepted accounting principles. While a number of Independent financial
CARE’s microfinance projects have relied on CARE’s fund statements should be
accounting to generate financial information for them, prepared on a
CARE’s SEAD Unit strongly encourages all microfinance consistent basis,
programs, regardless of where they are in their progression regardless of the MFI’s
from project to independent financial institution, to produce stage of development
and analyze independent financial statements on a regular
basis. Due to the unique structure of many MFIs, a number
of adjustments may be necessary to accurately reflect the institution’s financial position.
This section highlights key issues associated with financial statement preparation, including
voucher preparation, frequency of financial statement preparation, accounting adjustments,
and adjustments for inflation and subsidies.
6.2.1 Voucher Preparation13

Each time a transaction occurs, documentation must be maintained through the preparation
of vouchers to ensure a proper paper trail. While each MFI has its own specific procedures
for voucher preparation, in general, vouchers should be supported by invoices and check
stubs or cash requests and should include the following:
ê Number and nature of voucher

ê Name of department
ê Date prepared
ê Account name and number and amount of money
ê Source and description of transaction
ê Authorized signature
ê Attachment of original bills and cash requests
6.2.2 Frequency of Financial Statements

Effective financial management requires frequent review of financial performance. The
CARE SEAD Unit encourages MFIs to produce profit and
loss statements for the whole institution on a monthly basis.
MFIs should produce
It may also be useful to generate a partial income statement
monthly profit and loss
for each cost center, such as the branches, even though some
statements
program costs, such as head office overhead, are not
incorporated at this level. In addition, CARE encourages
MFIs to produce a balance sheet at least annually, depending on the size of their operations.
13
This section is drawn from Ledgerwood and Moloney (1996).
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6.2.3 Financial Statement Adjustments

To analyze the financial performance of your MFI, your financial statements must be
consistent with generally accepted accounting principles. To do this, it may be necessary to
adjust the balance sheet and income statement to reflect the institution’s actual financial
performance. There are two types of adjustments required: accounting adjustments, which
are necessary to adhere to proper accounting standards; and inflation and subsidy
adjustments, which restate financial results to reflect more accurately the full financial
position of the MFI.
Accounting Adjustments Inflation and Subsidy Adjustments

Loan losses Inflation
Depreciation of fixed assets Operating cost subsidies
Accrued interest In-kind subsidies
Accrued expense Concessionary funding
Donated equity
Accounting Adjustments
Accounting for Loan Losses

MFIs need to maintain very high portfolio quality to ensure long-term financial viability.
Loan delinquency increases costs both through direct losses (assuming the loan is not
repaid, and the loss is passed directly through the income statement as a bad debt), higher
administrative costs (as staff divert time and resources to chasing clients), and reduced
net interest margins (by lowering the institution’s interest income and increasing their cost
of funds).
To reflect the financial performance of an MFI accurately, it is necessary to determine how

much of the portfolio is generating revenue and how much is likely to be unrecoverable.
This is done by examining the quality of the loan portfolio, creating a loan loss reserve, and
periodically writing off loans.
A loan loss reserve (LLR) is the balance sheet reserve account against which bad assets, or
portions thereof, are written-off. In most countries, the LLR account appears as a negative
or contra asset on the balance sheet and is netted against loans for financial reporting
purposes. (Some MFIs maintain the account in the liabilities section of the balance sheet
without netting, a standard that tends to overstate total assets.) The reserve is normally
created and maintained through a charge to provision expense on the profit and loss (P&L)
statement. The reserve for loan losses is synonymous with the allowance for possible loan
losses and the reserve for bad debts.
An MFI’s loan portfolio should be adjusted on a monthly basis to reflect estimates of

possible loan losses. If an MFI does not maintain a loan loss reserve account, its balance
sheet will be overstated, and financial statements will be significantly impacted by any write-
off. Conversely, when an LLR account is maintained, the accountant adjusts the balance
sheet by subtracting the real loss both from the loan loss reserve and from the loan portfolio
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account. As the LLR account is a contra asset account, this double entry has no net effect on
the total asset figure. In addition, if the loan has been appropriately reserved against, the
write-off will have no impact on net income.
Provisioning Policies: The most accurate measure of portfolio risk is derived from an asset
classification process, which provides a basis for determining an adequate level of loan loss
reserves. Because each MFI has its own history of defaults, classification categories will vary.
Normally, financial institutions estimate the amount of expected bad debt they expense to
the loan loss reserve based on the number of days the loan is past due and the institution’s
prior experience. Categories are established and a level of required reserves, expressed as a
percentage of the total unpaid outstanding balance of a classified loan, is assigned to each
classification category. The following provisioning schedule—adapted from CGAP’s policy
framework—provides an example:
Days Late Provisioned Amount

1 – 30 days 10% of unpaid balance
> 180 days 100% of unpaid balance
Loan terms also influence an institution’s provisioning policy. A product with daily
repayments will have a different provisioning schedule from a loan with monthly
repayments. In determining an adequate reserve, MFIs should also consider such factors as
reasonableness of credit policies and procedures, prior loss experience, loan growth, the
quality and depth of management in the lending area, loan collection and recovery practice,
and general trends in the economy.
As an alternative to the classification procedure, an MFI could expense 0.25 percent of the
current portfolio at the end of each month and credit this to the loan loss reserve.
Institutions that do not have any provision for loan losses should open the reserve with a
one-time deduction of five percent of the current portfolio to establish the reserve.
Adjustment for Substandard or Doubtful Loans: The percentage of a loan that must be covered by
the reserve is typically a function of the number of days the loan is past due. A loan with an
installment over 15 days past due, for example, should have 10 percent of its value “on
reserve” in the LLR account, according to the provisioning schedule detailed above. If the
amount in the LLR account is insufficient to cover this value, the account needs to be
topped up by expensing an amount necessary to achieve this value. This addition to the
LLR is charged as provision expense on the P&L and results in reducing the net loan figure.
Adjustments for Loan Losses: Once a loan is classified as a loss, it should be written off the
MFI’s balance sheet. In other words, the total value of the loan should be reduced from the
loan amount and the amount of the reserve. Such assets are considered non-bankable, but
not necessarily non-recoverable; they may still warrant strong collection efforts.
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Write-Offs
An MFI should not write off loans unless they were carefully determined as losses. There is
often a tendency to write off loans as a means of improving the status of its loan portfolio.
While this may reduce the value of the loans in the doubtful category, it shrinks the balance
sheet and does not present an accurate picture of the health of the loan portfolio. The
decision on when to write off a loan should be based on a sound policy established and
agreed to by the board members of an MFI.
Normally, the write-off policy is determined by local accounting custom and requires the
institution to fulfill legal obligations regarding formal attempts to collect overdue loans. For
MFIs involved in financial intermediation (and thus under jurisdiction of the bank
superintendent), they will need to enter into a dialogue with regulators about provisioning
requirements. The application of traditional provisioning criteria may result in insufficient
provisioning as microfinance loans are typically short term, and can be become non-
recoverable within a short period of time. Traditional provisioning may not require the MFI
to write off delinquent loans until they are over a year past due. On the other hand, the
traditional reserve requirements for unsecured loans may require the MFI to provision too
conservatively, so it is important to get regulators to recognize the value of peer pressure and
other forms of non-traditional collateral.
Accounting for Depreciation of Fixed Assets

Depreciation is an annual expense that is determined by estimating the useful life of each
asset. When a fixed asset, such as property and equipment, is purchased, there is a limited
time that it will be useful. (Land theoretically does not lose value over time and therefore it
is not depreciated.) Many countries set standards for depreciation for different classes of
assets. Depreciation expense is the accounting term used to allocate and charge the cost of
this usefulness to the accounting periods that benefit from the use of the asset. Like the
loan loss provision, depreciation is a non-cash expense and does not affect the cash flow of
the MFI.
To make the adjustment, when a fixed asset is first purchased, it is recorded on the balance
sheet at the current value or price. When a depreciation expense (debit) is recorded on the
income statement, it is offset by a negative asset (credit) on the balance sheet, called
accumulated depreciation. This offsets the gross property and equipment, reducing the net
fixed assets. Accumulated depreciation represents a decrease in the value to property and
equipment that is used up during each accounting period.
There are two primary methods of recording depreciation: the straight-line method and the
declining balance method. The straight-line method allocates an equal share of the asset’s
total depreciation to each accounting period. This is calculated by taking the cost of the
asset and dividing it by the estimated number of accounting periods in the asset’s useful life.
The declining balance method refers to depreciating a fixed percentage of the cost of the
asset each year. The percentage value is calculated on the remaining un-depreciated cost at
the beginning of each year.
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For example, assume an MFI has purchased a $2,000 computer, which according to the
country’s depreciation standards, is assumed to have a useful life of three years and has an
estimated value of $500 at the end of three years. Under the straight-line method, its
depreciation per year is calculated as follows:
Cost – salvage value 2,000 – 500 = $500 depreciation per year

Service life in years 3
Under the declining balance method, if the computer were depreciated on a declining
balance at 33.3 percent a year, the first year’s depreciation would be $666.66 ($2,000 x
33.3%). In the second year, the depreciation amount would be applied to the remaining
amount, $1333.34. One third of $1333.34 is $444.40, which would be the depreciation
expense for the 2nd year. This continues until the asset is either fully depreciated or sold.
Accounting for Accrued Interest Revenue14

Revenue that has been earned but not yet received in cash is called accrued revenue. For an
MFI, accrued interest income represents the most common example (other examples of
income receivables include consulting earnings that are paid at the completion of the
assignment or speaking fees that are paid months after the speaking engagement).
Recording interest that has not yet been received is referred to as accruing interest revenue.
Assuming that interest will be received at a later date, accrued interest is recorded as revenue
and as an asset under accrued interest or interest receivable.
While an MFI’s treatment of accrued interest revenue will vary, the CARE SEAD Unit
encourages its affiliates to adhere to the following guidelines:
ð If an MFI does not accrue interest revenue at all and makes loans that have relatively
infrequent interest payments (such as quarterly or bi-annually), it should accrue
interest revenue at the time financial statements are produced.
ð MFIs that have weekly or biweekly payments need not accrue interest revenue, as it
is more conservative not to and may not be material enough to consider.
ð If an MFI has accrued interest on loans that have little chance of being repaid, the
amount of accrued interest on delinquent loans should be
deducted on the balance sheet by crediting the asset where it An MFI should not
was recorded initially (outstanding loan portfolio or interest accrue interest on
receivable) and reversed on the income statement by delinquent loans
decreasing interest revenue (debit). The best practice for an
MFI is not to accrue interest at all on delinquent loans.
ð Some sophisticated accounting software can automatically accrue interest; if such a
system is not available, MFIs should generally avoid accruing interest. In a stable,
limited growth institution, where payments are made frequently, the differences
between cash and accrual accounting are not significant.
14
This section drawn from Ledgerwood (1999), p. 193.
97
Interest revenue is accrued by determining how much interest revenue has been earned but
not yet become due (the number of days since the last interest payment times the daily
interest rate times the balance outstanding, assuming declining balance calculation) and
recording this amount as revenue (credit) and debiting the asset account accrued interest.
Accounting for Accrued Interest Expense

Likewise, financial statements may need to be adjusted to reflect expenses that have been
accrued but not yet paid. Examples of accrued expenses include financing costs on
borrowed funds, annual audit fees, and salaries. CARE’s SEAD Unit recommends that
MFIs accrue significant expenses, assuming their accounting system has the capacity.
Financing costs can represent such an expense. At year-end, MFIs may owe interest on
borrowed funds for the period from the last interest payment to the day the period ends. If
the interest expense is not accrued, the MFI’s financing costs at the end of the year will be
understated, its profitability overstated, and its liabilities understated. To accrue interest
expense, the amount of interest owed as of the date the balance sheet is debited on the
income statement as a financing cost and credited as a liability on the balance sheet in the
accrued interest expense account.
Adjusting for Inflation and Subsidies

Adjustments for both subsidies and inflation should be made to determine the true financial
viability of the MFI. While these adjustments may not be required by official accounting
policies, the CARE SEAD Unit encourages MFIs to perform these adjustments because they
create a clear picture of the MFI’s ability to maintain the real value of its capital. These
adjustments also facilitate a benchmarking comparison with other MFIs that have made
similar adjustments on their financial statements. There are many ways of approximating the
effects of inflation on MFI equity and the effect subsidies have on overall financial
performance. The method suggested here reflects a simplified version of inflation-based
accounting used by The MicroBanking Bulletin. (See Annex 2 for the adjustment worksheet.)
Inflation
Even though inflation is not usually reflected in audited financial statements, MFIs should
treat it as a real cost that can eat away at the value of their equity. Most of an MFI’s assets
are financial assets (loan portfolio being the largest), which are hit hardest when inflation
erodes the value of money. (The value of fixed assets, on the other hand, such as equipment
and land, is assumed to increase with inflation.) As such, the value of an institution’s
financial assets decreases with inflation, while its operating and financial costs increase.
Over time an MFI’s costs increase and its financial assets, on which it earns revenue,
decrease in real terms.
Adjustments for inflation result in changes to both the balance sheet and the income
statement. These include the following:
ð Revaluation of Assets: Because fixed assets do not devalue with inflation, their nominal
value is increased to the extent of annual inflation. The initial value, net of depreciation,
is multiplied by the inflation rate. The result is income that could be received as a result
of inflation, if the assets were to be sold. This revaluation adjustment is registered as
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operating income on the income statement and as an increase in the value of the fixed
asset account on the balance sheet.
ð Calculation of the cost of inflation on the real value of equity: The cost of inflation on equity is
reflected by multiplying the prior period’s closing capital balance by the current year’s
inflation rate. This result is then reflected as an operating expense on the income
statement and as an increase in the value of the capital account, called accumulated
inflation, on the balance sheet.
Subsidies
There are four types of subsidies typically received by MFIs:
• Funds donated to cover operational costs
• Donations in-kind
• Concessionary loans
• Donated equity
MFIs should adjust their financial statements to address each of these subsidies. Unlike
traditional financial intermediaries that fund their loans with voluntary savings and debt,
many MFIs fund their loan portfolios with donated equity or concessionary loans. Many
also receive in-kind subsidies, such as free office space and equipment. Mature MFIs
typically replace the donated equity with market rate debt and find alternative office space
and equipment. To prepare for these eventualities, an MFI should know the status of its
own financial viability, independent of any current subsidies. This will permit more
meaningful financial analysis and allow comparison with other institutions. Adjustments for
subsidies result in a change in the net income on the income statement equal to the value of
the subsidies; they do not ultimately affect the balance sheet.
ð Donations for Operating Expenses: Donated funds for operations should be reported below
the net income line, resulting in a reduction in operating revenue, and therefore, a
reduction in the amount transferred to the balance sheet as current year net surplus. An
offsetting credit entry is made to the balance sheet in the accumulated capital – subsidies
account. (Note: Only the amount “spent” in the year is recorded on the income
statement; any amount still to be used in subsequent years remains as a liability on the
balance sheet, referred to as deferred revenue.)
ð Donations In-kind: In-kind donations such as free office space, volunteer staff, or
employees paid by others should be recorded as an expense on the income statement
and offset in the equity account on the balance sheet in the accumulated capital –
subsidies line.
ð Concessionary Loans: Concessionary loans are loans received by the MFI with lower than
market rates of interest. To determine the appropriate market rate to apply, MFIs
should choose the form of funding that would most likely replace these subsidized
funds. These would include:
• Local prime rate for commercial loans
• 90-day certificate of deposit rate
• Interbank lending rate
• Average deposit rate at commercial banks
• Inflation rate plus 3 to 5 percentage points per year
99
(Note: The MicroBanking Bulletin uses the deposit rate for each country as a proxy for the
market rate.) Adjustments are made to both the balance sheet and the income
statement. The amount of the subsidy is entered as an increase in equity (credit) under
the accumulated capital – subsidies account and as an increase in financial costs (debit).
ð Donated equity: Funds donated for loan capital are often treated as equity, in which case
they are adjusted for inflation. For MFIs that treat donations for loan capital as income,
a subsidy adjustment is made using a market rate for commercial debt or equity (see
Ledgerwood (1999) p. 197 for more information).
6.2.4 Constant Currency

Some MFIs may want to restate their financial statements in constant currency terms.
Constant currency means that, on a year-by-year basis, financial statements continually
reflect the current value of the local currency relative to inflation, permitting year-to-year
comparisons of the real growth or decline in key accounts. To convert prior year data,
amounts are either multiplied by one plus the annual rate of inflation for each year or
divided by the consumer price index for each year (see Christen (1997) pp. 76-80 for more
details).
6.3 Reporting
Having reviewed the key components of an MIS and key issues related to financial statement
preparation, this chapter concludes with guidance on report preparation. Reports are the
primary means for getting information (the key output of the management information
system) to those who need it to perform their jobs and make decisions. This section will
examine two elements of reporting: report design and reporting frameworks.
6.3.1 Key Issues in Report Design 15

The way a report is designed will determine how useful the information is to management.
If information does not reach staff in a useful form, the MIS loses its value. This section
identifies key issues to think about when designing reports.
ð Content: Reports should generally focus on one issue and present all information
pertinent to that issue. (An exception would be a summary operational report.)
ð Categorization and Level of Detail: Present information at different levels of aggregation and
provide comparison information from different branches/units of the institution.
ð Frequency and timeliness: Reports need to be carefully designed around the timing of
information needs in the institution.
15
This section adapted from Waterfield and Ramsing (1998), pp. 25-32.
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CHAPTER 6
ð Identifying information: All reports should have: Rules for Designing Good Reports
standard headers and footers with important
• Use standard letter-size paper whenever
identifying information, unique titles, unique
possible.
report numbers; and should display the date
• Present all information pertinent to an
and time of printing, and the timeframe the issue in a single report rather than spread
information covers. over several reports.
ð Trend analysis: Important reports should • Present information at the appropriate
include trend information. level of aggregation for the user.
ð Period covered: Reports should be generated to • Include identifying headers and footers in
cover different time periods. every report and explanatory legends at the
end.
ð Usability: Ensure report users can easily read
• Study how reports are used and
and use reports. continually improve them.
ð Graph analysis: Generate key graphs, such as
portfolio in arrears and actual and projected Waterfield and Ramsing (1998), p. 29.
activity, on a regular basis and display in
common areas.
6.3.2 Reporting Framework

While the number and mix of reports will depend on an institution’s size, level of operations,
and range of financial products, this section identifies a minimum reporting framework for
all CARE affiliated MFIs. Each MFI has key stakeholders, each of whom will require
information on a timely basis and in a useful form. Each of these stakeholders and their
corresponding information requirements need to be identified up-front and continually
reassessed. Figure 23 identifies six key shareholder categories and 38 reports from seven
categories: A) savings reports, B) loan activity reports, C) portfolio quality reports, D)
income statement reports, E) balance sheet reports, F) cash flow reports, and G) summary
operational reports. For sample reports, see Section 6.3.2 of the CGAP MIS Handbook
(Waterfield and Ramsing (1998)).
101
Figure 23: Key Reports by Shareholder Category

Shareholder Category
Shareholders
Donors and
Branch &
Field Staff
Managers
Managers
Regional
Clients
Senior
Board
Key Reports
A. Savings Reports
A1. Savings Account Activity X X
A2. Teller Savings Report X
A3. Active Savings Accounts by Branch and Product X
A4. Dormant Savings Accounts by Branch and Product X
A5. Upcoming Maturing Time Deposits X
A6. Savings Concentration Report X X
B. Loan Activity Reports
B1. Loan Repayment Schedule X X
B2. Loan Account Activity X X
B3. Comprehensive Client Status X X
B4. Group Membership Report X
B5. Teller Loan Report X
B6. Active Loans by Loan Officer X
B7. Pending Clients by Loan Officer X X
B8. Daily Payments Report X
B9. Portfolio Concentration Report X
C. Portfolio Quality Reports
C1. Detailed Aging of Portfolio at Risk by Branch X
C2. Delinquent Loans by Loan Officer X X
C3. Delinquent Loans by Branch and Product X X
C4. Summary of Portfolio at Risk by Loan Officer X X
C5. Summary of Portfolio at Risk by Branch and Product X X
C6. Detailed Delinquent Loan History by Branch X
C7. Loan Write-off and Recuperation Report X X
C8. Aging of Loans and Calculation of Reserves X X
C9. Staff Incentive Report X X
D. Income Statement Reports
D1. Summary Income Statement X
D2. Detailed Income Statement X
D3. Income Statement by Branch and Region X
D4. Income Statement by Program X
D5. Summary Actual-to-Budget Income Statement X
D6. Detailed Actual-to-Budget Income Statement X X
D7. Adjusted Income Statement X X
E. Balance Sheet Reports
E1. Summary Balance Sheet X X
E2. Detailed Balance Sheet X
E3. Program Format Balance Sheet X
F. Cash Flow Reports
F1. Cash Flow Review X X
F2. Projected Cash Flow X
F3. Gap Report X
G. Summary Operational Reports
G1. Summary Operations Report X X X
Drawn from Waterfield and Ramsing (1998), pp. 32-37
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CGAP (2001). Disclosure Guidelines for Financial Reporting by Microfinance Institutions. Washington
DC: Consultative Group to Assist the Poorest. Website: www.cgap.org.
Ledgerwood, Joanna (1999). Microfinance Handbook: An Institutional and Financial Perspective.
Mainhart, Andrew (1999). Management Information Systems for Microfinance: An Evaluation Framework. USAID’s
www.mip.org..
Waterfield, Charles and Nick Ramsing (1998). Handbook for Management Information Systems for Microfinance
Institutions, CGAP Technical Tool Series No. 1. Website: www.cgap.org.
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Annex 1: Risk Management Checklist

by Category of Risk
Risk Page Number Question
Executive Director
Institution 14 How does your organization demonstrate a commitment to constant improvement?
Institution 14 How often does senior management go to the field to talk with clients and staff?
Does your organization currently have excess capacity, which suggests that you should be
Institution 14
poised for growth, or do you need to build capacity before continuing to expand?
Institution 14 Do you have a business plan to achieve self-sufficiency in a reasonable amount of time?
Institution 14 Do you update the plan and use it regularly to make management decisions?
Do you monitor sustainability and profitability indicators, and if so are they trending in the
Institution 14
right direction?
Institution 14 Do you have an independent governing body?
Do you share with clients of other CARE programs? If so, is the strategy driven by the
Institution 14 business plan of the MFI and contribute to long-term sustainability or do projections show a
continuing need to cross-subsidize this population?
Is your organization building the capacity to operate independent of ongoing technical
Institution 14
assistance?
Does the MFI have the ability to identify its own needs and to contract appropriate technical
Institution 14
expertise to address those needs on its own terms?
Operational 34 Does a reliable firm audit the MFI annually?
Financial 63 Is the MFI audited annually by a reliable audit firm?
Management
External 77 Are there usury laws in the country preventing the MFI from charging cost recovery rates?
External 77 Is the MFI intermediating savings?
External 77 Is it legally permitted to do so?
External 77 Is the regulatory environment appropriate / accommodating?
External 77 Is there political pressure to lend to certain target groups?
External 77 Are contracts easily enforceable?
External 77 Do labor laws constrain the organization?
External 77 Do you track client retention rates?
External 77 How do you collect information about your competition?
Does your organization routinely collect customer satisfaction information and use that to
External 77
modify your products and services?
External 77 Does it have access to an industry-wide bad debtors list or credit bureau?
Executive Director and Board
Does your organization have a clear mission statement that balances the social and
Institution 14
commercial objectives and identifies the target market?
Institution 14 Does the composition of the board reflect the dual mission of microfinance?
Institution 14 How does the board monitor the client composition?
Institution 14 Does your organization have a plan to establish itself with an independent legal structure?
Institution 14 Does your organization have the capacity and commitment to develop its own business plan?
Is CARE’s role in the governance and management structure best described as supportive or
Institution 14
dominating, or some other adjective?
What percentage of your operating expenses is covered by money received from or through
Institution 14
CARE?
Institution 14 Does CARE have an exit strategy?
Are there clear indications of local ownership such that microfinance service operations will
Institution 14
likely continue in CARE’s absence?
Finance Manager
Institution 14 Is the interest rate set high enough to cover the MFI’s full costs?
105

Are you moving toward accessing commercial sources of capital and reducing reliance on
Institution 14
subsidized funding sources?
Institution 14 Do you properly account for subsidies and in-kind donations?
Do you have an independent contract for financial resources from a donor or commercial
Institution 14
lender?
Is your organization reducing its dependence on donor/CARE subsidies by as much as
Institution 14
estimated in the business plan? If not, why not?
Is CARE the only entity that has raised investment capital and operational subsidies for your
Institution 14
organization?
Institution 14 Does your organization have its own financial system?
Institution 14 Do you make cash management decisions independently from CARE?
Institution 14 Are PN85 costs removed from the cost structure of the MFI?
Does the CARE country office have a means of recovering applicable PN85 charges without
Institution 14
directly charging the MFI?
Is there an agreement between the MFI and the CARE country office on fees to be paid for
Institution 14
services provided by CARE?
Financial 63 Is the MFI susceptible to interest rate risk?
Management
Financial For those MFIs operating in highly inflationary environments, is gap analysis conducted
63
Management regularly?
Financial 63 What is your net interest margin?
Management
Financial For MFIs that hold assets or liabilities in foreign currency, are appropriate control
63
Management mechanisms in place to mitigate foreign exchange risk?
Financial Does your organization follow a cash flow management program (i.e., cash needs forecasting,
63
Management budgeting, etc.)?
Financial Do you monitor its liquidity risk through consistent monitoring of key ratios: quick, liquidity,
63
Management idle funds?
Human Resources Manager
What steps do you take to ensure that your employees are motivated and enthusiastic about
Institution 14
their work?
Institution 14 Is your human resource system effective and how does the organization know?
Do you have job descriptions and annual performance appraisals for all employees, including
Institution 14
senior management?
Does your organization set challenging, yet achievable, performance targets for all layers of
Institution 14
the organization, and does it monitor and reward achievement of these targets?
Operational 34 Are loan officers from the community in which they work?
Operational 34 Are your hiring procedures designed to attract individuals who are honest and well motivated?
Operational 34 Are new employees oriented to the MFI culture of honesty and zero-tolerance?
Operational 34 Are staff compensation levels reasonable and competitive?
Operational 34 Is there an immediate termination policy for staff fraud or dishonesty?
Operations Manager
Does your organization use appropriate screening mechanisms to ensure that it is serving the
Institution 14
intended target market?
Institution 14 Are the loan sizes appropriate to the needs of the clients?
Do you offer a large enough range in loan sizes so that the best clients do not grow out of the
Institution 14
program?
Do the requirements for accessing a loan (i.e., collateral, meetings, business plan, forced
Institution 14 savings) address the institution’s need to control credit risk (see next chapter) without being
excessively demanding on clients?
How do you conduct useful market research activities on a regular basis to keep in touch with
Institution 14
the changing needs of your target market?
Institution 14 What indicators do you use to ensure that you are serving the intended target market?
Institution 14 Is this information collected in a cost-effective manner?
What information, if any, does your organization consistently collect regarding the impact of
Institution 14
your services on clients?
How has your retention rate changed over the past year and what are the primary reasons for
Institution 14
that change?
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ANNEXES

Do field staff consider themselves employees of CARE or the MFI; if it is the former, what
Institution 14
are the implications?
Is your interest rate so high that it hurts your clients? How do you know that they can afford
Institution 14
the rates that you are charging?
Operational 34 What are the characteristics of the product design that are intended to control credit risk?
Are those characteristics appropriate for different segments of the target market (i.e., new
Operational 34
clients and repeat clients)?
Are the features of the of the loan product reviewed regularly to determine if they should be
Operational 34
modified?
Are exit interviews conducted with clients who are leaving client groups or discontinuing to
Operational 34
use the MFI services?
If it makes secured loans, does the program have appropriate policies and systems for dealing
Operational 34
with collateral?
Operational 34 Does the credit committee have sufficient experience to make wise decisions?
Operational 34 Is the credit committee involved in loan monitoring and delinquency management?
Operational 34 Does the program have a culture that is intolerant of delinquency?
Operational 34 Does the MFI have an appropriate and transparent rescheduling policy?
Operational 34 Which branch has the worst portfolio at risk?
Operational 34 Could this branch be experiencing fraud?
Are loan officers allowed any discretion, such as lowering interest rates, requesting loan size
Operational 34 exemptions or waiving delinquency fees? If so, how do you control for fraud in these
circumstances?
Does the loan approval authority structure balance efficiency, customer service and fraud
Operational 34
control?
Operational 34 Do managers avoid and actively discourage “blind signing”?
Does the Operations Manager, or other senior manager, consistently monitor portfolio
Operational 34
quality?
Operational 34 Do you have a system for collecting, analyzing and following up with customer complaints?
Do you have a contingency plan in place so that you can quickly mitigate the damage caused
Operational 34
by fraud when it occurs? If so, what does the plan consist of?
Has your organization contracted an expert to analyze your security needs on a branch-by-
Operational 34
branch basis?
Financial 63 Does your organization develop an annual budget?
Management
Financial 63 Is the annual budget used and updated regularly?
Management
Financial 63 Do you actively compare the budgeted to actual numbers and identify cost over-runs?
Management
Financial 63 (For MFIs that offer multiple products) Do you do activity-based costing?
Management
Financial 63 Have you analyzed your systems and procedures to identify and eliminate inefficiencies?
Management
Financial 63 Does the MFI actively monitor its operating efficiency through key ratio analysis?
Management
Financial Does your organization maintain an error log that allows it to identify and rectify common
63
Management mistakes?
Operations Manager and Internal Auditor
Has your organization experienced fraud? If so, what conditions made your organization
Operational 34
vulnerable to fraud?
Operational 34 What have you done to try to reduce your vulnerability?
Does your institution have clear write-off and rescheduling policies that are consistent with a
Operational 34
fraud prevention strategy?
Operational 34 Are those policies followed?
Internal Auditor
Does the MFI have appropriate polices for handling cash in its loan disbursement and
Operational 34
collection procedures?
Operational 34 Are these policies followed?
Operational 34 Do you have adequate policies and procedures on collateral control?
107

Operational 34 Are these policies followed?
Operational 34 Does your organization regularly sample clients to confirm savings and loan balances?
Operational 34 Does the MFI have an internal audit function?
Operational 34 Are internal audits conducted regularly?
Operational 34 What is the process by which your organization confirms client savings and loan balances?
Operational 34 What are your organization’s major vulnerabilities to theft, and how are you addressing them?
Field Staff
Institution 14 Do employees know the organization’s mission statement and use it to help guide their actions?
Is it convenient for the target market to access services, in terms of the amount of time
Institution 14 required, location of services (i.e., branch locations), and the timing of those services (i.e., office
hours)?
What percentage of their time do loan officers spend in the field? If it is less than half of their
Institution 14 time, does the association with CARE somehow make them think that they have administrative
positions and should be sitting behind a desk rather than getting their shoes dirty?
Operational 34 What screening techniques does your organization use to minimize credit risk?
Operational 34 How do those screening techniques vary by loan number and loan size?
Operational 34 Are those techniques consistently applied in all branches?
Operational 34 Are the loan approval policies strictly followed?
Operational 34 Is there a formal orientation of clients and staff to expectations, policies and procedures?
Operational 34 Are loan officers well trained in effective delinquency management strategies?
Operational 34 Are delinquency penalties and loan contracts enforced?
Operational 34 Are staff members properly rewarded to maintain high standards of portfolio quality?
Operational 34 Does the institution have an ongoing client education campaign?
Operational 34 Are clients aware of their rights?
Operational 34 What channels do clients have to voice complaints?
Operational 34 Do at least two people meet all applicants and approve all applications?
Operational 34 How do employees document their delinquency management steps?
Operational 34 Does the MFI have standard procedures for delinquency follow up?
Operational 34 Are these procedures followed?
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ANNEXES
Annex 2: Sample Chart of Accounts

Asset Accounts
1000 Cash and Equivalents 1500 Receivables
1000 Cash in Vault 1510 Accounts receivable
1005 Petty Cash 1520 Travel advances
1010 Cash in Banks 1525 Other advances to employees
1011 Cash in Bank – Operating 1530 Other receivables
1012 Cash in Bank – Lending
1013 Cash in Bank – Savings 1600 Long-term Investments
1050 Reserves in Central Bank 1610 Investment A
1100 Short-term Investments 1612 Investment B
1200 Loan Portfolio 1700 Property and Equipment

1210 Portfolio/Type A 1710 Buildings
1220 Portfolio/Type B 1711 Depreciation, buildings
1240 Restructured loans 1720 Land
1730 Equipment
1300 Reserves for possible losses
1731 Depreciation, equipment
1310 Loan loss reserve
1740 Vehicles
1320 Interest loss reserve (for
1741 Depreciation, vehicles
accrual systems only)
1750 Leasehold improvements
1400 Interest and fees receivable 1751 Depreciation, leasehold
1410 Interest receivable, improvements
current loans
1420 Interest receivable, 1800 Other Assets
non-performing loans 1810 Prepaid expenses
1440 Interest receivable,
rescheduled loans
1450 Commissions receivable
1459 Other loan fees receivable
Liability Accounts
2000 Payables 2400 Loans Payable — Long-term
2010 Trade accounts payable 2420 Loans payable, Bank 1
2012 Accounts payable, members 2422 Loans payable, Bank 2
2014 Accounts payable, employees 2430 Loans payable, other
2450 Lease payable
2100 Interest Payable
2110 Interest payable, loans 2500 Accrued Expenses
2120 Interest payable, passbook savings 2510 Accrued salary
2130 Interest payable, time deposits 2520 Accrued payroll taxes
2150 Interest payable, other 2530 Accrued benefits, insurance
2540 Accrued benefits, leave
2200 Client Deposits 2550 Accrued federal taxes
2210 Collateral savings 2590 Other accrued expenses
2220 Voluntary savings
2230 Time deposits 2600 Deferred Revenue — Program
2610 Deferred interest
2300 Loans Payable — Short-term 2620 Deferred commissions
2320 Loans payable, Bank 1 2622 Deferred loan service fees
2322 Loans payable, Bank 2
2330 Loans payable, other 2700 Deferred Revenue — Grants
2350 Lease payable 2710 Deferred revenue — Grant 1
2712 Deferred revenue — Grant 2
109
Equity Accounts
Incorporated institution Nongovernmental organization
3000 Shareholders’ Capital 3000 Fund balance
3010 (Paid-in Common Stock) 3010 Unrestricted fund balance
Capital 3020 Fund balance, credit program
3020 Common stock at par value 3030 Fund balance, noncredit program
3030 Donated capital, current year
3040 Donated capital, previous years 3100 Gain (loss) from current adjustments
3200 Surplus/(deficit) of income over expenditure
3100 Gain (Loss) from Currency Adjustments
3200 Retained earnings, current year
3300 Retained earnings, previous years.
Income Accounts
4000 Interest Income 4200 Fee Income (non-credit)
4010 Interest income, performing loans 4210 Classroom fees
4020 Interest income, 4220 Income from other fees
non-performing loans
4040 Interest income, rescheduled 4300 Bank and Investment Income
loans 4310 Bank interest
4320 Investment income
4100 Other Loan Income
4120 Income from commissions 4400 Income from Grants
4122 Income from loan service fees 4410 Restricted / Government
4124 Income from closing costs 4420 Restricted / Private
4130 Penalty income 4430 Unrestricted / Government
4140 Income from other loan fees 4440 Unrestricted / Private
4450 Individuals' Contributions
4500 Other Income

4510 Miscellaneous income
110
ANNEXES
Expense Accounts
5000 Financing Expenses 5420 Utilities
5010 Interest on loans 5430 Maintenance and Cleaning
5014 Bank commissions and fees
5020 Interest on client savings 5500 Travel Costs
5030 Other financing costs 5510 Airfare
5514 Public ground transportation
5100 Loss Provisions 5516 Vehicle operating expenses
5110 Loan loss provisions 5520 Lodging costs
5120 Interest loss provisions 5530 Meals and incidentals
5540 Transport of goods
5200 Personnel Expenses 5542 Storage
5210 Salary — Officers 5550 Miscellaneous travel costs
5212 Salary — Others
5214 Honoraria 5600 Equipment
5220 Payroll tax expense 5610 Equipment rental
5230 Health insurance 5620 Equipment maintenance
5232 Other insurance 5630 Equipment depreciation
5240 Vacation 5640 Vehicle depreciation
5242 Sick leave 5650 Leasehold amortization
5250 Other benefits
5700 Program Expenses
5300 Office Expenses 5710 Instructional materials and supplies
5310 Office supplies 5730 Books and publications
5312 Telephone/Fax 5740 Technical assistance
5314 Postage and delivery
5316 Printing 5800 Miscellaneous Expenses
5320 Professional fees 5810 Continuing education
5322 Auditing / Accounting fees 5820 Entertainment
5324 Legal fees
5330 Other office expenses 5900 Non-operating income and expenses
5332 Insurance 5910 Gain/(Loss) on sale of investments
5920 Gain/(Loss) on sale of asset
5400 Occupancy Expenses 5930 Federal taxes paid
5410 Rent 5940 Other taxes paid
5990 Other
111
Annex 3: Inflation and Subsidy Adjustment Worksheet
You get the inflation adjustment expense by multiplying the organization’s equity by the inflation rate—in
effect this is the amount of equity that the MFI lost to inflation. You generate an inflation adjustment
income by multiplying the value of fixed assets by inflation. The Net Inflation Adjustment is the difference
between the two.
Inflation Adjustment
Previous Year’s Equity $0,000,000
Inflation Rate x infl% IMF, International Financial Statistics, line 64x
1. Inflation Adjustment Expense $ 00,000 Effects: Enter as a separate capital account, offsets
change in profit
Previous Year’s Fixed Assets $000,000

Inflation Rate x infl% IMF, International Financial Statistics, line 64x
2. Inflation Adjustment Income $ 00,000 Effects: Increases Fixed Assets, Total Assets
3. Net Inflation Adjustment line 1 – line 2 Effects: Usually increases Total Interest Expense, and
decreases Net Operating Profits (Note: If fixed assets
exceed equity, interest expense will decrease, profits
will increase.)
The cost of funds adjustment is used for organizations that have below market (i.e., subsidized) liabilities.
To calculate the adjustment, take the average balance of liabilities and multiply it by a shadow price cost of
funds—The MicroBanking Bulletin uses the Deposit Rate. This shows roughly what the organization should
have paid as a cost of funds. Subtract from that the actual cost of funds, and the difference is the
adjustment. Additional adjustments should be made for cash and in-kind subsidies.
Subsidy Adjustment
Cost of Funds Adjustment
4. Balance of Liability, year-end 1999 $0,000,000

5. Balance of Liability, year-end 2000 $0,000,000
6. Average Balance of Liability (line 4 + 5)/2
Shadow Price (Deposit Rate) x deposit% IMF, International Financial Statistics, line 601
“Market” Cost of Funds $000,000
Less Actual Interest Paid -$000,000
Cost of Funds Adjustment $000,000 Effect: Increases Total Interest Expense, decreases Net
Operating Profits. Appears on the Balance Sheet as a
separate capital account to offset change in profits.
No change in Total Capital.
Cash Donations Adjustment $000,000 Effect: Reduces Net Operating Profit, increases Net
Non-Operating Profits
In-kind Subsidy Adjustment $000,000 Effect: Increases Total Administrative Expenses

reduces Net Operating Profits.
Source: The MicroBanking Bulletin
112
ANNEXES
Annex 4: Sample Balance Sheet and Income Statement

Balance Sheet
Organization: As of:
ASSETS
1 Cash
2 Interest-bearing Deposits
Loans Outstanding
3 Loans Outstanding: Current
4 Loans Outstanding: Non-Performing
5 Loans Outstanding: Rescheduled
6 Total Loans Outstanding 3+4+5
7 (Loan Loss Reserve)
8 Net Loans Outstanding 6–7
9 Accounts Receivable
10 Other Current Assets
11 TOTAL CURRENT ASSETS 1 + 2 + 8 + 9 + 10
12 Long-term investments
13 Property and Equipment
14 (Accumulated Depreciation)
15 Net Property and Equipment 13 – 14
16 TOTAL LONG-TERM ASSETS 12 + 15
17 TOTAL ASSETS 11 + 16
LIABILITIES AND CAPITAL

LIABILITIES
18 Short-term Debt
19 Client Savings: Passbook
20 Client Savings: Time deposits
21 Deferred Revenue
22 Payables
23 TOTAL CURRENT LIABILITIES 18 + 19 + 20 + 21 + 22
26 Long-term Debt
27 Other Long-term Liabilities
28 TOTAL LONG-TERM LIABILITIES 26 + 27
29 TOTAL LIABILITIES 23 + 28
CAPITAL
30 Grant Capital
31 Shareholder Capital/Paid In Capital
32 Excess (Deficit) of Income over Expenses (prior years)
33 Excess (Deficit) of Income over Expenses (current year)
34 TOTAL CAPITAL 30 + 31 + 32 + 33
35 TOTAL LIABILITIES AND CAPITAL 29 + 34
113
Income Statement
Organization: Period: Cumulative for Year
FINANCIAL INCOME
1 Interest Income on Loan Portfolio
2 Loan Fees and Service Charges
3 Penalties on Loans
4 Total Loan Income 1+2+3
5 Income from Investments
6 Income from Other Financial Services
7 Total Other Financial Income 5+6
8 Total Financial Income 4 + 7
FINANCIAL COSTS OF LENDING FUNDS
9 Interest on Borrowed Funds
10 Interest Paid on Deposits
11 Total Financial Costs 9 + 10
12 GROSS FINANCIAL MARGIN 8 - 11
13 Provision for Loan Losses

14 NET FINANCIAL MARGIN 12 - 13
OPERATING EXPENSES
15 Salaries and Benefits
16 Office Supplies
17 Communication
18 Rent & Utilities
19 Fuel, Travel Costs and Vehicle Maintenance
20 Depreciation
21 Training
22 Other Costs and Services
23 Bank Fee
24 Total Operating Expenses Sum 15…23
25 NET INCOME FROM OPERATIONS 14 - 24
NON FINANCIAL INCOME

26 Operating Grant Income
27 Non-financial Services Income
28 Total Non-financial Income 26 + 27
29 EXCESS (DEFICIT) OF INCOME OVER EXPENSES 25 + 28
114
ANNEXES
Bibliography
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117

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MICROFINANCE

Craig Churchill and Dan Coster

With Contributions from:

Chapter 5: External Risks ............................................................................................... 77

CARE’s Microfinance Risk Management Handbook provides guidance for managers of

What is Risk Management?

Figure 1: Three-step Risk Management Process

1. Identify Vulnerabilities: Before managing risks, it is necessary to identify the

It is important to note that microfinance institutions cannot completely eliminate their

Structure of the Handbook and How to Use It

This document is a work in progress. Just as microfinance is a constantly evolving arena, so

Chapter 1: Risk Assessment Framework

Microfinance risk assessment also needs to embrace an institutional development

1.1 Institutional Risks

Figure 2: Categories of Microfinance Risks

1.1.1 Social Mission

1.1.2 Commercial Mission

microfinance activities are operated as a project rather than as an independent organization.

1.2 Operational Risks

1.3 Financial Management Risks

1.3.1 Asset and Liability

1.3.3 System Integrity

1.4 External Risks

1.4.4 Physical Environment

Figure 3: Organization of Microfinance Risks by Chapter

The Ultimate Risk Management Controls:

Chapter 2: Institutional Risks and

The second institutional risk is the dependency of a microfinance program on international

2.1 Social Mission Risk

Figure 4: The Four Ms of Controlling Social Mission Risk

2.1.1 Mission Statement

2.1.2 Market Research

Figure 5 provides a summary of the tools used by microfinance institutions to gather

Each MFI has to decide which of these tools are appropriate

Figure 5: Market Research Tools

2.1.3 Monitoring Client Composition and Measuring Impact

Figure 6: Monitoring Client Composition

Primary Indicators Secondary Indicators

2.1.4 Managing Growth

2.2 Commercial Mission Risk

2.2.1 Setting Interest Rates

2.2.2 Designing the Capital Structure

Figure 7: Evolution of Capital Sources for a Microfinance Program

2.2.4 Managing for Superior Performance

The process of managing for superior performance involves collectively setting

To fulfill the institution’s commercial mission, the retention of The retention of

ê Develop a means of regularly identifying employee development and motivational needs

2.2.5 Monitoring for Commercial Mission Risk

Figure 8: Sustainability and Profitability Ratios

Return on Equity Net income / Average equity

2.3 Dependency Risk

2.3.1 Strategic Dependence

ê Do you have an independent governing body?

Responsibilities of an Independent Board of Directors

2.3.2 Financial Dependence

2.3.3 Operational Dependence

ê Does your organization have its own independent financial system?

CARE Overhead Core Costs

ê Does the MFI have its own financial system?

By contrast, the survival of a business-oriented MFI depends on employees feeling a real

Institutional culture is also influenced by the image or brand name recognition of an

Technical assistance is normally focused on four primary aspects, which are:

2.3.4 Dependency Risk Controls

Since CARE supports microfinance activities in a variety of different environments, there is