Financial Risk: Deposit-Taking MFIs
Financial Risk Types and Definitions
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.
Liquidity Risk
Policies
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Formal set of policies and procedures to manage liquidity risk | Formal set of policies and procedures to manage liquidity risk | Formal set of policies and procedures to manage liquidity risk |
Limits
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Concentration limits with respect to lenders | Concentration limits with respect to lenders | Concentration limits with respect to lenders |
| Concentration limits with respect to depositors | Concentration limits with respect to depositors | Concentration limits with respect to depositors |
| Liquidity limits | Liquidity limits | Liquidity limits |
| • Net liquid assets with respect to total assets | • Net liquid assets with respect to total assets | • Net liquid assets with respect to total assets |
| • Net liquid assets with respect to deposits up to 90 days | • Net liquid assets with respect to deposits up to 90 days | • Net liquid assets with respect to deposits up to 90 days |
| • Net liquid assets with respect to concentration of deposits | • Net liquid assets with respect to concentration of deposits | • Net liquid assets with respect to concentration of deposits |
| • Net liquid assets with respect to volatility of sight deposits | ||
| Limits on coverage of time bands under behavioral and dynamic scenarios | Limits on coverage of time bands under behavioral and dynamic scenarios |
Risk Management Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Coherent product and funding strategies to avoid maturity mismatches | Coherent product and funding strategies to avoid maturity mismatches | Coherent product and funding strategies to avoid maturity mismatches |
| Funding plan | Funding plan | Funding plan |
| Liquid investment accounts | Liquid investment accounts | Liquid investment accounts |
| Pre-approved credit lines | Pre-approved credit lines | Pre-approved emergency local and international credit lines |
| Liquidity contingency plan | Liquidity contingency plan |
Risk Monitoring Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Mapping of liquidity risks (at least every two years) | Mapping of liquidity risks (at least every two years) | Annual mapping of liquidity risks |
| Daily monitoring of liquidity levels | Daily monitoring of liquidity levels | Daily monitoring of liquidity levels |
| Monthly projected cash flow report | Weekly projected cash flow report | Weekly projected cash flow report with backtesting |
| Monthly report of concentration in lenders | Monthly report of concentration in lenders | Weekly report of concentration in lenders |
| Monthly report of concentration in depositors | Monthly report of concentration in depositors | Weekly report of concentration in depositors |
| Monthly behavioral liquidity report | Monthly behavioral liquidity report | Monthly behavioral liquidity report |
| Monthly report of main liquidity indicators, including: | Monthly report of main liquidity indicators, including: | Monthly report of main liquidity indicators, including: |
| • Trend analysis | • Trend analysis | • Trend analysis |
| • Limits comparison | • Limits comparison | • Limits comparison |
| • Net liquid assets with respect to total assets | • Net liquid assets with respect to total assets | • Net liquid assets with respect to total assets |
| • Net liquid assets with respect to deposits up to 90 days | • Net liquid assets with respect to deposits up to 90 days | • Net liquid assets with respect to deposits up to 90 days |
| • Net liquid assets with respect to concentration of deposits | • Net liquid assets with respect to concentration of deposits | • Net liquid assets with respect to concentration of deposits |
| • Net liquid assets with respect to volatility of sight deposits | ||
| Monthly report of sight deposits’ volatility | Quarterly report of sight deposits’ volatility | |
| Monthly dynamic liquidity report | Monthly dynamic liquidity report with backtesting and stress-testing |
Interest Rate Risk
Policies
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Commitment to manage interest rate risk | Formal set of policies and procedures to manage interest rate risk | Formal set of policies and procedures to manage interest rate risk |
Limits
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Interest rate spread limits | Interest rate risk exposure limits | Interest rate risk exposure limits |
| • Net interest income sensitivity | • Net interest income sensitivity (with basis risk adjustment) | |
| • Sensitivity of economic value of equity |
Risk Management Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Coherent product and funding strategies to avoid interest repricing mismatches | Coherent product and funding strategies to avoid interest repricing mismatches | Coherent product and funding strategies to avoid interest repricing mismatches |
| Interest rate contingency plan | ||
| Derivative instruments to manage interest rate risk |
Risk Monitoring Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Mapping of interest rate risks (at least every two years) | Mapping of interest rate risks (at least every two years) | Annual mapping of interest rate risks |
| Quarterly interest rate spread analysis, including: | Quarterly interest rate spread analysis, including: | Quarterly interest rate spread analysis, including: |
| • Limits comparison | • Limits comparison | • Limits comparison |
| • Repricing gap analysis | • Repricing gap analysis | |
| • Net interest income sensitivity | • Net interest income sensitivity (with basis risk adjustment) | |
| • Sensitivity of economic value of equity | ||
| Quarterly interest rate volatility report | Monthly interest rate volatility report | |
| Quarterly interest rate stress-testing report |
Foreign Exchange Risk
Policies
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Commitment to manage foreign exchange risk | Formal set of policies and procedures to manage foreign exchange risk | Formal set of policies and procedures to manage foreign exchange risk |
| The MFI does not transfer foreign exchange risk to the client | The MFI does not transfer foreign exchange risk to the client | The MFI does not transfer foreign exchange risk to the client |
Limits
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Foreign exchange risk exposure limits | Foreign exchange risk exposure limits | |
| • Net open position | • Net open position | |
| • Stressed FX income sensitivity | • Stressed FX income sensitivity |
Risk Management Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Coherent product and funding strategies to avoid currency mismatches | Coherent product and funding strategies to avoid currency mismatches | Coherent product and funding strategies to avoid currency mismatches |
| Non-derivative instruments to manage foreign exchange risk | Non-derivative instruments to manage foreign exchange risk | Derivative instruments and non-derivative instruments to manage foreign exchange risk |
| Foreign exchange contingency plan |
Risk Monitoring Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Mapping of foreign exchange risks (at least every two years) | Mapping of foreign exchange risks (at least every two years) | Annual mapping of foreign exchange risks |
| Monthly currency volatility report | Weekly currency volatility report | |
| Quarterly foreign exchange risk exposure report, including: | Quarterly foreign exchange risk exposure report, including: | |
| • Net open position | • Net open position | |
| • Stressed FX income sensitivity | • Stressed FX income sensitivity | |
| • Limits comparison | • Limits comparison | |
| Value at risk analysis | ||
| Quarterly foreign exchange stress-testing report |
Investment Portfolio Risk
Policies
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Commitment to manage investment portfolio risk. | Formal set of policies and procedures to manage investment portfolio risk, including selection criteria for investments and institutions, as well as identification of responsibilities (committees, treasurer, risk unit, etc.) | Formal set of policies and procedures to manage investment portfolio risk, including selection criteria for investments and institutions, as well as identification of responsibilities (committees, treasurer, risk unit, etc.) |
Limits
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Investment concentration and exposure limits: | Investment concentration and exposure limits: | |
| • By institution | • By institution | |
| • By maturity | • By maturity | |
| • By type of investment or financial instrument | ||
| • By currency |
Risk Management Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Dedicated person or committee to determine permitted financial institutions, instruments, and concentrations | Committee to determine permitted financial institutions, instruments, and concentrations | Tool (scoring model) and committee to determine permitted financial institutions, instruments, and concentrations |
Risk Monitoring Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Mapping of investment portfolio risks (at least every two years) | Mapping of investment portfolio risks (at least every two years) | Annual mapping of investment portfolio risks |
| Monthly investment portfolio report, including main characteristics of investments | Monthly investment portfolio report, including main characteristics of investments | Weekly investment portfolio report, including main characteristics and indicators of investments, as well as investment portfolio sensitivity analysis |
Capital Adequacy Risk
Policies
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Formal policies on dividend distribution | Formal policies on dividend distribution | Formal policies on dividend distribution |
Limits
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Minimum percentage of annual profits to be capitalized | Minimum percentage of annual profits to be capitalized | Minimum percentage of annual profits to be capitalized |
| Limit for debt-to-equity ratio or adjusted capital over risk-weighted assets | Limit for debt-to-equity ratio or adjusted capital over risk-weighted assets | Limit for adjusted capital over risk-weighted assets |
Risk Management Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Not applicable | Not applicable | Not applicable |
Risk Monitoring Tools
Tier 3 Guidelines |
Tier 2 Guidelines |
Tier 1 Guidelines |
| Monthly monitoring of capital adequacy levels and trends, including: | Monthly monitoring of capital adequacy levels and trends, including: | Monthly monitoring of capital adequacy levels and trends, including: |
| • Debt-to-equity ratio or adjusted capital over risk-weighted assets | • Debt-to-equity ratio or adjusted capital over risk-weighted assets | • Adjusted capital over risk-weighted assets |
| • Trend analysis | • Trend analysis | • Trend analysis |
| • Compared to limits and projections | • Compared to limits and projections | |
| • Stress-testing |
Evaluate