Financial Risk: Deposit-Taking MFIs

Financial risk is the risk of financial losses and negative social performance related to the maturity, currency, re-pricing, and concentration structure of an MFI’s assets and liabilities. As MFIs face product differentiation among loan assets and more choices in funding sources, it becomes increasingly important to manage these risks effectively. There are four subcategories of financial risk: liquidity risk, market risk (including interest rate risk and foreign exchange risk), investment portfolio risk, and capital adequacy risk.

• Liquidity Risk – Liquidity risk is the risk of financial losses and negative social performance related to the inability to meet current cash obligations in a timely and cost-efficient manner, to have adequate liquidity to fund planned growth and survive through crisis. Liquidity risk often arises because of mismatches in the maturity and concentration profiles, as well as the behavioral nature of an institution’s assets and liabilities.
• Market Risk – Market risk is the risk of financial losses and negative social performance related to changes in the value of an MFI’s assets and liabilities. These changes as determined by fluctuations in interest and foreign exchange rates in the market. Market risk is subdivided into interest rate risk and foreign exchange risk.
  • Interest Rate Risk – Interest rate risk is the risk of financial losses and negative social performance related to unfavorable changes in market interest rates that are caused by mismatches in the re-pricing structure (re-pricing risk) or caused by basis risk—the imperfect correlation between market reference rates and internally managed rates on an MFI’s interest-rate-sensitive assets and liabilities.
  • Foreign Exchange Risk – Foreign exchange risk is the risk of financial losses and negative social performance related to unfavorable changes in exchange rates, usually due to mismatches in the currency structure of assets and liabilities.
• Investment Portfolio Risk – Investment portfolio risk is the risk of financial losses and negative social performance related to an MFI’s investment portfolio. It covers the cases in which larger MFIs have a certain percentage of their assets in financial or non-financial investments. Investment portfolio risk also includes equity investments in MFIs or other companies, if applicable.
• Capital Adequacy Risk – Capital adequacy risk is the risk of financial losses and negative social performance related to the capacity of an institution’s equity base to absorb risk.