MICROCAPITAL PAPER WRAP-UP: Asset and Liability Management for Deposit-Taking Microfinance Institutions, Kara Bloom

Asset and Liability Management for Deposit-Taking Microfinance Institutions, by Kara Bloom, Published by CGAP, June 2009, Available at: http://www.cgap.org/gm/document-1.9.34818/FN55.pdf

The author acknowledges that financial risk can yield high profits, but urges microfinance institutions (MFIs) to maintain proper asset and liability management (ALM) to find a level of risk the institution can bear. As the financial activity of MFIs grows more complex and funding increasingly comes from commercial sources, the careful examination of the balance sheet can help MFIs measure and evaluate risk. Risk, in this case, is defined as a mismatch between assets and liabilities. In this paper, the author examines three types of risk: liquidity, interest rate, and foreign exchange. Although each type of risk is distinct, ALM strategies for all types include gap analysis to match assets and liabilities over time and volatility analysis to determine the typical fluctuations in the discrepancy between assets and liabilities. The multifaceted approach to ALM proposed by the author includes an official risk-management strategy written by the MFI based on the institution’s own priorities, matching tables for assets and liabilities, and the institution a special committee for ALM. The author provides several matching tables as examples of how to compare assets and liabilities.

Claiming that the priority of an MFI ought to be the creation of straightforward products for its client base, unlike the average commercial bank, the author states that ALM should lean towards reacting to discrepancies between assets and liabilities rather than willfully create them. The author believes that MFIs ought not to rashly attempt profiting from financial risk. But if risk is taken, it should be limited to credit risk rather than interest rate or foreign exchange risk. MFIs also differ from commercial banks in terms of assets. MFIs generally maintain long-term, fixed rate assets in the form of loans. In order for assets to match liabilities, liabilities too must exhibit these characteristics, taking the form of either stable savings deposits, bonds, or equity.

The author admits that it is difficult for MFIs to match assets and liabilities. If the MFI can calculate the profitability impact of a mismatch, then the institution at least has awareness of the risk and, allowing the risk to persist, can set a limit for risk the institution is willing and able to undertake within a specific time frame.

Going on to describe the various forms of risk, the author states that liquidity risk is the most significant financial risk because an MFI could never survive a liquidity crisis. While MFIs often pour liquidity into the loan portfolio, the author insists that MFIs maintain liquidity reserves in case of a crisis. Because there is a time gap in the maturing of loans and deposits, the author describes gap analysis which determines how liabilities, which mature at a different rate, can compare with assets over time. While loans have long term maturity, depositers have the right to withdraw savings at any time. On average, there is a base of deposits that the MFI can expect to maintain. The author also recommends volatility analysis of deposit liabilities to determine the rate of withdrawals and the amount of deposits that can be relied upon.

The second major type of risk discussed is interest rate risk. The author describes its manifestation for MFIs as the repricing of assets or liabilities due to fluctuations in interest rates. In order to price the assets correctly, the MFI must know how much of its budget will come from profits and how much will come from new financing. Unlike the case of liquidity risk, where the MFI must consider that savings deposits might be claimed at any time, savings deposits in the case of interest rate risk can reduce the cost of funds by precluding the need for new financing at a new cost.

On the balance sheet itself, changes in assets and liabilities due to interest rate appear as changes in equity. If MFIs calculate the average and maximum volatility of interest rates as well as expected profits, it is better prepared to undertake risk. Another method of assessing interest rate risk is duration gap analysis, which reveals the market value change of assets and liabilities due to interest rate changes. Although this method directly applies to bonds, MFIs can treat assets and liabilities like bonds to assess the magnitude of the effect on profit. Duration analysis is intended to assist MFIs in matching the duration of assets and liabilities rather than their maturities.

The last type of risk evaluated is foreign exchange risk, which arises out of a mismatch in the currencies in which assets and liabilities are expressed. Often, the loan portfolio is in local currency while liabilities are a mix of foreign and local currency. If local currency is tied to another currency like the US dollar, there is effectively no risk to protect against since the exchange rate will remain the same. Again, risk can be minimized when the currencies are matched. Measurements of foreign exchange risk maybe made in two ways. In net open foreign exchange position, Assets and liabilities in different currencies can be separated into multiple columns; in each column, liabilities can be subtracted from assets to determine the difference for each currency. Afterwards, the net open foreign exchange position can be compared with capital. In the second method, the MFI could calculate the impact of devaluation of a certain currency. Volatility analysis of exchange rates can be useful in this calculation. Beyond these measurements, MFIs can conduct liquidity gap analysis on each currency, which can reveal the maturity of foreign currency liabilities. To protect against risk, the MFI can deal in forwards, swaps, and options.

Although external regulation can encourage proper ALM, the author believes that it is the responsibility of each MFI to sensibly and carefully evaluate the risk level the institution can handle. The author concludes the article by describing how ALM strategies can be incorporated into the operations of an MFI. Chiefly, this involves the creation of a team dedicated to ALM that brings together all the parties involved in the balance sheet. For all types of risk, the author insists that the team agree on a limit for the amount of risk the MFI is willing to undertake. The author urges regular gap analysis on all types of risk and especially stresses the need for the calculation of liquidity ratios as well as an official plan for a liquidity crisis. Although good ALM can improve the resilience and performance of an MFI, the author acknowledges that MFIs cannot always perfectly manage assets and liabilities. Nonetheless, this is no excuse to not try.

By Goda Thangada, Research Assistant

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