Risks | Risk Management

Funding loans always involves risk, the default rates on microfinance loans are estimated at 2 – 5%, which is considerably lower than those on small loans made by commercial banks.

Though the default rate on microfinance loans is low, there is a risk that you may lose all or part of your principal.

Reported current repayment rate of 485.1 Rs lakhs loans outstanding (September 2008).

Source: “Ajiwika.org” – Rating Report 2008-2009

After contributing towards a loan or a guarantee your money takes a specific route through various organizations before first getting to the entrepreneur, and finally returning to its source, you. Since there are different levels in which the funds travel, there are inherent risks associated with each.
Hence there are broadly five kinds of risks you should consider before deciding to support entrepreneurs:

  • Entrepreneur Level Risks
  • Partner Level Risks (MFI)
  • Bank Level Risk(Not relevant for lending)
  • Environment Level Risks
  • Exchange Rate Risk(Not relevant for guarantee)
(I) Entrepreneur Level Risks (Top)
Every entrepreneur has been carefully screened by the MFI partner prior to their profile being posted on the United Prosperity website. Despite this there is still the possibility of default through one fundamental form of risk associated with the entrepreneur level, credit risk .

Credit risk is the risk to earnings or capital due to borrowers’ late and non-payment of loan obligations. Credit risk includes both transaction risk and portfolio risk.

1. Transaction Risk refers to the risk in individual loans.
2. Portfolio Risk refers to the risk inherent in the composition of the overall loan portfolio” 1

Additionally there are two primary causes that result in credit risk, natural and man-made risks.

1.Natural risks
  • Business failure due to crop failure, floods, cyclones, or other calamities that may destroy the income generating assets
  • Localized epidemics and illnesses that could affect the ability to earn a livelihood to repay the loans
  • Calamities in the family that might result in loan funds being diverted into non-income generating activities
2.Man-made risks
  • Theft
(II) Partner Level Risks (Top)
Though United Prosperity does a detailed due-diligence of every partner before signing them up, some risks still remain

1. Organization risks

Before signing on a partner, we ensure that they have proper systems and procedures in place for screening entrepreneurs and for collecting repayments from them. However, despite this there is a possibility that the partner may not be implementing these systems properly, which could lead to potential defaults. This is known as “ Operational Transaction Risks ” (Fernando 2008), which have two primary causes:
  • Human Resource Risk
  • Information and Technology Risk : The potential that inadequate technology and information systems will result in unexpected losses (Fernando 2008).
Though we scrutinize the financials of partners prior to signing them up, for a variety of reasons the partner may go bankrupt and cannot meet its obligations on time, this is known generally as Liquidity Risk

2. People Risks

There are three types of general risks associated with people which are defined broadly as:
  • Fraud Risk : The risk of loss resulting from deliberate deceit by an employee or borrower. There is a possibility that the staff members at our partner organizations might embezzle funds, leaving the partner in a position where they would be forced to default on their loans.
  • Regulatory and Compliance Risk : the risk of loss resulting from a violation of the country’s regulations and laws.
  • Governance Risk : risk that a poor organizational or management structure of the organization results in ineffective decision making.
Portfolio at risk (>=60 days) of 485.1 Rs lakhs loans outstanding (September 2008).

Source: “Ajiwika.org” – Rating Report 2008-2009

(III) Bank Level Risk (Top)
In case of a guarantee the funds contributed are used as collateral and are typically deposited with the lending bank either with their US branch or with a branch in another country. There is a risk that the bank may go bankrupt and we may not be able to recover the funds from the bank as a result of some of the aforementioned causes. Bank_level_risk
(IV) Environmental Risks (Top)
Environmental risks are outside the control of the entrepreneur or partner. Examples of environmental risks include:

1. Political risk
  • Changes in government policy may affect the ability or willingness of borrowers to repay loans.
  • The country, itself may be politically instable, and this instability affects the ability to collect loan repayments.
  • The country or region may be prone to a conflict or a post-conflict situation leading to higher risk .e.g. Afghanistan, Iraq.
2. Natural risk
  • Any natural disaster (floods, cyclones, earthquake, etc) in the area where the loans have been made would reduce the likelihood of loan repayment, unless the loan is rescheduled to give the borrowers more time to pay it back.
3. Regulatory risk
  • Unforeseen or ad-hoc changes in any regulations by authorities could impact the partner’s ability to repay the bank, causing the bank to invoke United Prosperity’s guarantee/loan.
4. Market Risks
  • Changes in the general market conditions could result in financial losses.
(V) Environmental Risks (Top)

In case of lending once you have funded an entrepreneur, your money is converted into local currency and is transferred to locally operating microfinance partner. Entrepreneurs also repay in their local currencies which is collected by local microfinance partner.

For repayment, the local currency is converted into dollars. Over the microloan term, the local currency may depreciate relative to the US Dollar leading to losses. While we are currently encouraging our microfinance partner to hedge the currency risk, that by itself may not be adequate to cover a big fluctuation in the exchange rate.

1 Fernando, Nimal. "Typology of risk in microfinance." Managing Microfinance Risks: Some Observations and Suggestions. July 2008. Asian Development Bank. 15 Jul 2009 <http://www.adb.org/Documents/Papers/Managing-Microfinance-Risks/default.asp>.
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