Wednesday, August 05, 2015

How Well are Not for Profit MFIs served by Existing Ratings?

Specialized institutional ratings developed for MFIs in 1999. These ratings were distinct from conventional credit ratings. As Ledgerwood etc. state in the New Microfinance Handbook, these were adapted to MFIs in that they did not automatically take a negative view of the relatively small size of MFIs compared to mainstream financial institutions and their uncollateralized loan portfolios[1]. These ratings played an important role in ensuring that MFIs had access to funds – starting from development banks such as SIDBI and subsequently by all commercial banks – during the previous decade.
Gradually as MFIs gained access to commercial funds, many also transformed into larger entities which had commercial objectives. Such MFIs started accessing funds from financial markets and microfinance institutional ratings also started assuming characteristics of standard credit ratings.

At the same time many MFIs have retained their non-profit character – MFIs who are organized as Not for Profit or NPO-MFIs. The two main reasons behind this are:
1.       MFIs have chosen to remain not-for-profit to focus exclusively on their social mission or,
2.       MFIs have not been able to attract funds from mainstream funders given the fact that challenges in their operational area militate against their potential to scale up commercially.

The underlying fact still remains that these organizations serve those clients who are largely ignored by mainstream financial institutions including banks and formal MFIs, because of cost concerns. As these organizations do not have access to commercial capital and generate little to no surpluses, their capital adequacy and financial performance ratios remain weak. This also adversely impacts their ratings. However, many among such MFIs have strong systems, processes and capacity to competently serve those who face exclusion from formal financial institutions. Therefore, there is clearly a need to re-look and design institutional ratings that can help us identify such organizations which can play an important role in financial inclusion.

Contours of Rating of NPO-MFIs

Risk management in MFIs is determined by their capacity to avoid, mitigate, control, tolerate and treat risks. Institutional ratings assess MFIs on these aspects. Sound governance with oversight from competent directors, well defined institutional roles for Directors as well as managers, documented and disseminated processes are qualities that help organizations in developing sound understanding of their risk environment which in turn helps them avoid, mitigate and control risks.

While the capacity of financial organizations to tolerate and treat risks is also served well by the aforementioned attributes, the primary defence they have to tolerate and treat risks is their capital base. The Basel committee recommendations focus on allocation of capital against major risk categories.

The need to have sound governance, systems and processes is important for all financial organizations including NPO-MFIs. However, as stated earlier in this note, the area where NPO-MFIs are at a disadvantage is the level of their capital adequacy. The primary concerns for an NPO-MFI of a given size are:
1.       Ability to sustain operations
2.       Capacity to tolerate materialization of serious risks given that it may be constrained for capital.

Risk Rating of NPO-MFIs may assess whether an institution possesses alternative means to sustain and grow operations as per its business plan and to withstand serious risk events. For example, as Business Correspondents of commercial banks NPOs may be able to achieve their business plan targets. Also, if they have access to formal guarantees against risk related losses from donors or institutional sponsors, they will have a degree of resilience against serious risk events. Institutional ratings for NPO-MFIs should be able to account for these and similar factors. This is a topic that deserves serious deliberations and rigorous analysis.



[1]Joanna Ledgerwood, Julie Earne and Candace Nelson, The New Microfinance Handbook: A Financial Market System Perspective, The World Bank 2013