undefined | unit 5 risk management in rural finance

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UNIT-5RISK MANAGEMENT IN RURAL FINANCE Q1) Define risk management in rural financing? What are the objectives associated with it?A1) When discussing rural finance in the rural india, the foremost issue that merits mention is that loans to agriculture are generally offered only by specialized agricultural banks, since commercial banks and microfinance institutions largely refrain from financing the sector. There are many reasons for this, the most important of which is that this finance is strewn with risks, some of which the state is most likely to address. Hence, the governments hold ownership of these banks and their capital, and finance and support them.Agriculture remains a dominant activity in many rural economies of the poorest nations in the world. A large majority of the poorest households in the world are directly linked to agriculture in some fashion. Risks in agriculture are most certainly not independent in nature. When one household suffers bad fortune it is likely that many are suffering. These common risks are referred to as correlated risk. When agricultural commodity prices decline everyone faces a lower price. When there is a natural disaster that destroys either crops or livestock, many suffer. Insurance markets are sorely lacking in most developing and emerging economies, and rarely do local insurance markets emerge to address correlated risk problems. Objectives of Risk Management1. Ensure the management of risk is consistent with and supports the achievement of the strategic and corporate objectives.2. Provide a high-quality service to customers.3. Initiate action to prevent or reduce the adverse effects of risk.4. Minimize the human costs of risks, Where reasonably practicable.5. Meet statutory and legal obligations.6. Minimize the financial and other negative consequences of losses and claims.7. Minimize the risks associated with new developments and activities.8. Be able to inform decisions and make choices on possible outcomes. Q2) What the type of risks are associated with the Micro financial Institutions? Explain.A2) There are a number of risks that an MFI has to face these risks could be of delinquencies, frauds, staff turnover, interest rate changes, liquidity, regulatory, etc. But all these risks can broadly be classified into four major categories;1. Credit risk : Although credit risk is inherent to all loan of the MFI, it materializes in the loans which start showing overdue. An amount is called ‘overdue’ if it is not received by the MFI on its scheduled time. Every loan that an MFI provides has a fixed schedule for repayment. This is called the Repayment schedule, which provides the schedule of payment and acts as the reference point for the MFIs to estimate their overdue. 2. Operational risk: Operational risk relates to the risks emanating from the failure of internal systems, processes, technology and humans or from external factors such as natural disasters, fires, etc. Basel Committee on Banking Supervision defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”. Earlier, any risk, which was not categorized, as credit risk or market risk was considered to be operational. However, this was a vague definition of operational risk. As per the new definition strategic risk is not considered under Operational risk. 3. Market risk: Market risks are risks of financial nature, which occur due to fluctuations in the financial market or due to mismatch in assets and liabilities of an organization. As the MFIs become bigger in size and complex in terms of their asset and liability composition market risks become more pertinent. The assets and liabilities composition of MFIs, expose them to various kinds of market volatilities. As a result changes in market conditions, through external to MFIs, impact them either favorably or unfavorably and are therefore risks. For MFIs there are three most important market risks. a. Liquidity riskb. Interest rate risk andc. Foreign exchange risk 4. Strategic risk: Strategic risks are risks related to weak governance, weak leadership, poor strategic decisions as well as risks due to regulatory and administrative reasons. These are high impact risks and can adversely affect the organization for the long-term. Q3) What is PAR? How could we could calculate this?A3) Portfolio at risk or PAR tries to measure the amount of loan outstanding that the MFI stands to lose in case an overdue client does not pay a single installment from the day of calculation of PAR. PAR is the proportion of loans with overdue clients to the total loan outstanding of the organization. PAR% = (Loan outstanding on overdue loans/Total loan outstanding of the MFI) x 100PAR is further refined by MFIs to make it meaningful by including aging in it. So MFIs often calculate PAR30, PAR 60, and PAR 90, etc. PAR30 means outstanding of all loans, which have overdue greater than 30 days as a proportion of total outstanding of the MFI, similarly PAR60 means outstanding of all loans, which have overdue greater than 60 days as a proportion of total outstanding of the MFI and so on and so forth.Therefore each month each one of them makes principal repayment of Rs 1,000. After five months of loan disbursement, it is necessary than 5 installments had to be paid which means each client should have paid back Rs 5,000 of the principal amount. But say the actual repayment was as shown in the table below.

Clients	Disbursed	Due	Principal Paid	Principal Overdue	Principal Outstanding
1	10000	5000	2000	3000	8000
2	10000	5000	3000	2000	7000
3	10000	5000	5000		5000
4	10000	5000	4000	1000	6000
5	10000	5000	5000		5000
Total	50000	25000	19000	6000	31000

To calculate PAR, we have to take the following steps;• Identify loans with overdue; in the given example loan 1,2 and 4 have overdue• Find outstanding on overdue loans and add; in example outstanding on overdue loans (1, 2, and 4) are 8,000 7,000 and 6,000. On adding them we get 21,000• Divide sum of outstanding of overdue loans by total outstandingArrear rate; Arrear rate is the principal overdue as a proportion of the total loan outstanding of the MFI.Arrear rate = (Total overdue/Total loan outstanding) x 100.In the given example it is Rs 6,000/Rs 31,000 = 19.35%This ratio tells the proportion of loan portfolios the MFI is currently losing, i.e. the principal amount that should have been recovered out of the total portfolio but has not been recovered.Repayments rate; Repayment rate on the other hand is the ratio of the amount received by the organization against the total amount due.Repayment rate ;( Total principal collection during a period – prepayments)/Total amount due for the period) x 100Prepayments, if any have to be deducted from the collections, as this amount was not due for the period. Prepayment is the principal amount paid by clients before it was due.As mentioned earlier, all these ratios, MFIs and financial institutions lay maximum emphasis on PAR and consider it as the best indicator for risk. This is because PAR is a forward-looking ratio and provides an estimate of the total loss that an MFI is likely to make should the risky clients default. While the arrear rate and repayment rate only provide information on current loss and indicate the past performance. Arrear rate and repayment s rate are not able to capture the future risk.Q4) What are the causes of high credit risk?A4) The credit risk is a function of multiple variables of which the client profile is only one. In fact, risk emanates from reasons external to the organization such as client running away, any accident happening with the client migration, loss of business/crop, etc, and reasons internal to the organization such as MFIs policies, processes, systems, and culture. Some of the major reasons for delinquencies observed in MFIs are discussed below. 1. Poor MIS – MIS on loan outstanding, collection, etc plays a critical role in generating reports and making them available in minimum time to the right people. If an MFI does not have a good MIS, it may not know how much to collect, it may not know its overdue or age-wise overdue. A weak reporting system on overdue will result in delayed input on overdue to the top management and consequently result in delayed action by the top management. Sometimes weak MIS also results in the generation of the inaccurate reports. If the correct and timely information is not generated and report the problem cannot be dealt with resulting in delinquencies getting aggravated. 2. Poor screening of borrowers – Poor choice of clients results in delinquencies. If a client with a bad reputation or history of defaults are selected then it can result in delinquencies 3. Weak appraisal – Poor or weak appraisal of loans is one of the major reasons for delinquencies. Before giving any loan, the client’s repaying capacity, the status of the business, and cash flows must be assessed. This helps in taking loan decisions that whether a client should be given a loan and about an appropriate volume of the loan. A poor appraisal can lead to loans going to unworthy clients or disbursement of a higher amount of loans. Loans given beyond repaying capacity puts clients in stress situations as they do not have sufficient income to repay installments resulting in delinquencies. 4. Unclear communication about product and methodology- Clear communication of policies and procedures is very important. If the clients do not know the policies and procedures it can result in confusion and delinquencies even if clients are capable of paying 5. No immediate follow-up – MFI having a strong overdue follow-up system can control over due to a large extent. It also gives a clear message to the clients that the MFI is serious on repayments and thus prevents future occurrences. MFIs that are weak in overdue follow up to give a signal that it is not serious in overdue collection resulting in other clients imitating. Also if the overdue are immediately followed up the chances of recovery are quite high but if the case becomes old then the chances of recovery also go down. 6. Mixing other social activities with micro-finance – Sometimes delinquencies may also result if MFIs carry out grant-based activities along with micro-finance with the same set of clients and with the same staff. Mixing activities of two different nature confuse the client wherein one activity is being provided free while repayment is asked on micro-finance. This confuses the clients who may think that loans to be given to them may also be granted for them and they need not return it. Also enforcing repayments and discipline through a staff who is involved with the community in other social activities also will be very difficult and hence results in delinquencies.7. Poor product – Delinquencies occur if the product is not suitably designed. If the repayments do not match with the cash flow of the client then it may result in delinquencies. Client cashflow means that when do the clients receive income and when they need to spend. In the agriculture economy, clients may need to spend during the sowing season and hence need money. While they may receive income during harvest. Another important point is if the repayment period is too long or too short or frequency of payments and installments size are not well thought off, it can all lead to delinquencies. 8. Natural disasters – Delinquencies can also happen as an aftermath of a natural disaster such as floods, drought, earthquakes, or epidemic. 9. Corruption – Corruption at field staff levels such as taking bribe for loans or frauds can result in delinquencies. A staff taking favor from clients cannot enforce discipline or strict repayments. If the staff is committing fraud it will also show up as delinquency. 10. De-motivated employees – If the working conditions or incentive systems are not good, it will result in staff de-motivation and ultimately delinquencies. Motivated staff can make a lot of difference in enforcing policies in the field but the staff is de-motivated then they will not put sufficient efforts to enforce policies with the clients resulting overdue. Q5) How Delinquencies affects the Micro Finance Institutions?A5) Delinquencies adversely affect MFI in a variety of ways. They are 1. Loss of portfolio for the MFI – the major impact of delinquency is the loss of portfolio. The money given to a client by the MFI is lost if the client defaults. MFI lends to clients and interests along with the principal. However, default by the client can result in even the principal getting lost. 2. Loss of interest income – if a client does not repay its loan then the MFI loses interest income as well. Interest is the main source of income for an MFI and loss of it directly impacts its profitability and sustainability. 3. Growth hampered -an MFI having overdue has to invest a lot of its time and other resources in recovering the overdue. This diverts the focus of the MFI from expansion and growth to controlling the overdue thereby hampering its growth. 4. Cost escalation – in order to recover overdue MFI has to spend its staff time recovering overdue. Extra visits by staffs at the various level also adds to travel costs. 5. De-motivated staff – increase in overdue de-motivates the staff. The staff of a branch having no overdue are zealous as they expand the operations, get incentives and promotions. While staffs associated with bad portfolio are mostly engaged in overdue recovery, growth is slow; staff does not get incentives and instead may be criticized for poor performance resulting in de-motivation. 6. Cash flow mismanagement – MFI disburses new loans or meets its liabilities such as repayments of its owing to banks, through repayments that it receives from the field. If the repayments are timely then the MFI will not be able to collect enough cash from the field and hence will not be able to meet disbursement target or even payback to its lenders. MFI plans its disbursements assuming a certain amount of collection from the field but there are defaults then it disturbs these plans. This makes cash planning and fund management very difficult. 7. Loss credibility of the MFI – an MFI suffering from delinquency may lose reputation and credibility with other peer MFIs, lenders, and donors. Most of the investors put a lot of weightage on portfolio quality as it is the most important asset for the MFI and this is where the investors ‘money will be utilized. Poor portfolio quality makes investors uninterested and fundraising becomes difficult. Q6) In what ways Credit Risk of MFI could be managed? A6) The following are the ways of managing Credit Risk of MFI-Clarity of visionWe saw that delinquencies have widespread impacts and are harmful not just for the MFI but also for others. It is therefore important to manage credit risk. In order to keep credit risk under acceptable limits, an MFI must have clarity on its business. From visions and missions statement to the fine policies for the day-to-day operations, everything they should be clearly said/written and documented to avoid any confusion. A clear mission statement gives the right direction to the organization and it does not mix up too many things creating confusion. The clear mission helps the MFI defining its path and where it wants to go. Lack of clarity in mission can result in loss of focus. Such an MFI may get involved in diverse activities, without knowledge of what it wants to achieve. Segregation of Business functionsMFIs should also be aware that different interventions on the field would have an impact on each other. It is, therefore, important to maintain clear segregations among programs of different natures. The social activities should be separate from micro-finance and the community should not be confused with the two programs. Product DesigningAppropriate product designing can also curb credit risk to a significant extent. A poorly designed product puts stress on the client who may not be able to repay the amount. The products have to be designed suitable to the local livelihood context and general household cash flow of the target group. In general, it is good to have frequent repayments as it maintains contacts with clients. If the frequency is too low it results in loss of contact with the client and escalates the risk of delinquencies. The higher the frequency of repayments the better it is from risk perspective however the repayments have to match the cash flow of the client group. One may not go for a daily repayment if people do not earn on daily basis or do not have surplus cash on a daily basis. But repayments not exceeding monthly are generally recommended. This means that at least one installment must be collected each month, a frequency of less than this can enhance risk. MISThe importance of a good MIS cannot be overemphasized. MIS collects data and transforms it into the information which can ensure decision making. MIS should be able to generate overdue information almost on a daily basis. This information should also be reported up to the Head Office level in a timely manner. If the information takes too long to reach the right people, it loses its importance. A strong MIS is very important from the perspective of controlling risk as unless someone knows about delinquency, one cannot take action to manage it. Internal Control SystemDelinquencies also occur on account of policies not being followed or misappropriations. Therefore, a strong internal control system is very important for any financial institution. MFIs deal in a lot of cash and hence without proper monitoring, anyone in the system can try to take advantage. Regular monitoring by staff at various levels as well as an independent internal audit at a regular frequency can significantly control risk. Q7) What is transaction risk? How it could be managed?A7) Transaction risk is related to the individual borrower with which the MFI is transacting. A borrower may be trustworthy, holds good intentions to repay, and may be capable of repaying the loan or the borrower may not be trustworthy or capable of paying, which will result in loss of loan. All loss of loans related to the delinquency of individual clients because of client’s migration, willful defaulting, business failure, etc. is called Transaction risk. As transaction risk is related to individual clients, it has to be controlled by having the right policies at various stages of loans. Transaction risk management starts with the first step of client selection. MFIs focus on selecting the right clients who match their criteria. NFIs develop clear policies and procedures for client identification and selection. The staff at MFI has to be very clear on the process of client selection and group information. It has to be seen that clients who do not enjoy the trust of the community or have dubious past do get into the system. Once the clients have been identified, the next step is grouping formation. At the time of group formation, it is extremely necessary that proper training covering all aspects of the MFI and its products, procedures, and other policy are clearly told to the clients. After the training, it is also necessary to ensure that clients have understood all procedures and there is no confusion. If the policies of the organization are not clear it can lead to delinquencies in the future. MFIs have procedures of training the clients and then conducting a test to verify the client’s understanding.Once the group has qualified the test the next step is of taking loan application and loan appraisal. It is the responsibility of the field staff to see that all information is filled according to the policies in the application form. These policies could be such as loan amount as per the cycle, loan purpose should verify the group member should agree to the loan amount, past repayment history should be good, client’s family income-expenditure should be verified or any other policy that the MFI has. Apart from the loan application, all other documentation has to be in order this may include taking client id, address, and promissory notes.Once the application has been prepared it has to be appraised by a senior person. All loans have to be appraised according to the merit of the enterprise in which it is being invested. While appraising a loan application cashflows, the income of the household and repaying capacity of the household has to be seen. Often it is seen that MFI instead of focusing on the cash flow from the enterprise in which loan is being invested: focus on the cash flow of the entire family. The MFIs then access the household expenditures and based on that decide the final amount to be disbursed. Also, the past repayment history of the client is taken into consideration while taking loan decisions. Other parameters used in loan appraisal are feedback from peers, experience in business, permanent address of the client, and other loans if any from other sources. MFIs also take extra precautions while funding a new business; MFIs are more comfortable in lending in the expansion of existing business rather than investment in new business. Strong loan appraisal often controls the transaction risk to a large extent. After the appraisal, the case may be presented to a Credit Officer and Area Manager. Or sometimes it could be just a branch level committee or committee composition that can also change with the size of the loan. This means that for loans above a certain size credit committees could be at regional level rather than branch level or even head office level for very high loans. There is no fixed rule about the credit committee composition by the main idea is that every loan that is disbursed should be a very thought out decision taking all potential risk aspects into consideration.For larger size loans particularly in individual loans, MFI may resort to taking some security such as personal guarantees, taking post-dated cheques, or even some assets. These guarantees and securities also help in managing transaction risks.After disbursement of the loan, many MFIs also carry out loan utilization checks to see if the loan has been utilized for the purpose the loan has been given.Once the loan has been approved the disbursement has to take place strictly in accordance with the organization policies. MFIs have policies of disbursement through cheque or cash, disbursement to take place only at a branch or lonely at group meetings, signatures of clients to be taken at the time of disbursement, issuing of passbook and issue of repayment schedule at the time of disbursement. Again a clear disbursement procedure can help in controlling frauds or corruption at the time of disbursement and can control transaction risk.After disbursement, there have to be clear policies on the collection and deposition of money. There are lots of delinquencies on account of unclear or weak collecting and money handling policies. A clear policy such as where collection should take place, how money has to be transferred, and depositing money in the bank can also help in controlling risk related to frauds and misappropriation.Transaction risks can be managed effectively with strong internal systems such as overdue management systems, strong management information systems (MIS) as explained above. A strong overdue management system starts with having a good MIS. Once the information is made available the information is analyzed and decisions are taken. With the availability of accurate information, an organization can manage its delinquencies effectively by framing clear policies on overdue management.Overdue management means what actions have to be taken by different levels in overdue situations. It is important to acknowledge here that field staff can play a vital role in managing overdue as field staff is the first one to know whenever delinquency occurs. Field staff who are well trained can manage the overdue situation well thereby cutting the transaction risk.Clear policies on overdue management will help the field staff in reacting to the overdue situation in an appropriate manner. MFIs have policies of enforcing group pressure such as field staff may hold longer meetings to discuss overdue, can ask other members to pool in money. Field staff may call other colleagues, visit the client’s house, etc. Pressure can also be applied by not disbursing fresh loans to a defaulting group or not increasing the loan size in the next cycle. It is important to act sensitive and knowledgeable here – pressure to recover the loan can cause risks itself, e.g. devastating the community or driving the creditor to desperate actions which will not help anybody. The right way to manage collection – i.e. manage the credit risk signaled by overdue –depends on an accurate assessment of the situation at hand.Q8) Distinguish between the roles of finance and operation manager in cash planning.A8) Role of FinanceBookkeeping is one of the main roles of a finance department in any organization. Additionally, a finance department needs to keep track of sales and spending and produce yearly and quarterly statements. Financial operations need to also regularly update managers of other departments within an organization about the financial state of the business.Financial reports must remain accurate, verifiable and objective. Management relies on the income statement, which shows the company´s financial results, to calculate budgets. Moreover, the finance department needs to help the organization secure necessary funding and distribute profits in the form of dividends. Duties of a Finance ManagerA finance manager oversees all money-related functions with a business, including the billing and accounting departments. Additionally, finance managers will typically monitor the mark-up of products and services to ensure the profitability of the company. The finance manager also reviews the budget and helps to make decisions about cuts and increases in spending, according to the Bureau of Labor Statistics. Further, finance managers prepare and interpret financial reports and help to forecast the company´s financial future. Role of OperationsThe role and duties of an operations department often vary depending on the size and industry of the company. The operation management generally develops internal policies and procedures and manages the operations staff. Operations managers help to analyze the company´s finances and spending and manage resources. In addition, operations managers monitor the company´s performance and efficiency to make improvements and address problems. Operations can also commonly perform a number of human resources management functions, such as assigning tasks, setting employee priorities and determining staffing requirements. Operations ManagerOperations managers require sound knowledge of many aspects of the business. Apart from good communication skills, operations manager should have experience in strategic planning, resource management, accounting and team leadership, according to Total Jobs. Operations professionals need a broad set of skills. In addition to the understanding of finance, they should have knowledge of marketing strategies, sales techniques and production processes. Operations managers help to coordinate the activities of all the departments within a company. Operations manager's duties also often overlap with the duties of a chief executive officer. Q9) Mention the Revised Guidelines on priority Sector.A9) Reserve Bank of India has comprehensively reviewed the Priority Sector Lending (PSL) Guidelines to align it with emerging national priorities and bring sharper focus on inclusive development, after having wide ranging discussions with all stakeholders. Revised PSL guidelines will enable better credit penetration to credit deficient areas; increase the lending to small and marginal farmers and weaker sections; boost credit to renewable energy, and health infrastructure. Bank finance to start-ups (up to ₹50 crore); loans to farmers for installation of solar power plants for solarisation of grid connected agriculture pumps and loans for setting up Compressed Bio Gas (CBG) plants have been included as fresh categories eligible for finance under priority sector. Some of the salient features of revised PSL guidelines are:

To address regional disparities in the flow of priority sector credit, higher weightage have been assigned to incremental priority sector credit in ‘identified districts’ where priority sector credit flow is comparatively low.

The targets prescribed for “small and marginal farmers” and “weaker sections” are being increased in a phased manner.

Higher credit limit has been specified for Farmers Producers Organisations (FPOs)/Farmers Producers Companies (FPCs) undertaking farming with assured marketing of their produce at a pre-determined price.

Loan limits for renewable energy have been increased (doubled).

For improvement of health infrastructure, credit limit for health infrastructure (including those under ‘Ayushman Bharat’) has been doubled.

Q10) Write a short note on Compliance to RBI guidelines on NBFC- MFI’s.A10) The Non-Banking Financial Company -Micro Finance Institutions (Reserve Bank) Directions, 2011 1. Definition of NBFC-MFIAn NBFC-MFI is defined as a non-deposit taking NBFC (other than a company licensed under Section 25 of the Indian Companies Act, 1956) that fulfils the following conditions: i. Minimum Net Owned Funds of Rs.5 crore. (For NBFC-MFIs registered in the North Eastern Region of the country, the minimum NOF requirement shall stand at Rs. 2 crore). ii. Not less than 85% of its net assets are in the nature of “qualifying assets.” 1 (Only the assets originated on or after January 1, 2012 will have to comply with the Qualifying Assets criteria. As a special dispensation, the existing assets as on January 1, 2012 would be reckoned towards meeting both the Qualifying Assets criteria as well as the Total Net Assets criteria. These assets would be allowed to run off on maturity and cannot be renewed). For the purpose of ii above,“Net assets” are defined as total assets other than cash and bank balances and money market instruments.“Qualifying asset” shall mean a loan which satisfies the following criteria:- 2[a. loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not exceeding Rs. 1,00,000 or urban and semi-urban household income not exceeding Rs. 1,60,000 ;b. loan amount does not exceed Rs. 60,000 in the first cycle and Rs. 1,00,000 in subsequent cycles;c. total indebtedness of the borrower does not exceed Rs.1,00,000 Provided that loan, if any availed towards meeting education and medical expenses shall be excluded while arriving at the total indebtedness of a borrower;]d. 3tenure of the loan not to be less than 24 months for loan amount in excess of Rs. 30,000 with prepayment without penalty;e. loan to be extended without collateral;f. 4aggregate amount of loans, given for income generation, is not less than 50 per cent of the total loans given by the MFIsg. loan is repayable on weekly, fortnightly or monthly instalments at the choice of the borroweriii. Further the income an NBFC-MFI derives from the remaining 15 percent of assets shall be in accordance with the regulations specified in that behalf.iv. An NBFC which does not qualify as an NBFC-MFI shall not extend loans to micro finance sector, which in aggregate exceed 10% of its total assets.

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