PRESENTATION DOCUMENT

Introduction to Risk Management

Bank of Lao - Session 4 of 4

ASSET / LIABILITY MANAGEMENT

5th September 2008

What is risk management and why does it matter to us?

1 1

Capital Capital Structure Structure Overview Overview

2 2

What What is is risk? risk?

3 3

How How do do we we manage manage risk? risk?

4 4

What What does does this this mean mean for for us? us?

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1. 1. Capital Capital Structure Structure Overview Overview

2. 2. What What is is risk? risk?

3. 3. How How do do we we manage manage risk? risk?

4. 4. What What does does this this mean mean for for us? us?

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1 1

Capital Capital Structure Structure Overview Overview

Capital is the basis of a financial institution

 There are three types of capital Invested capital, Institutional capital (retained earnings and reserves), Debt capital  Capital serves a variety of purposes A source of security and a buffer against risk and losses A resource for expansion and growth  Capital must be, and remain, adequate to cover liabilities and losses (expected and unexpected) Capital must grow in proportion to assets to serve more customers with loans and maintain capital adequacy Capital to risk-weighed assets = Invested capital + reserves + retained earnings Risk-weighted assets with 0% weight to cash, government securities and 100% weight to unsecured loans
Source: Ledgerwood

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1 1

Capital Capital Structure Structure Overview Overview

Using its capital, a banking institution can borrow to acquire assets, including loans to clients. The balance sheet shows how this is done. . .
Assets = Liabilities + Net worth (Capital)

Debt Performing assets Other peoples money Savings

Our money Other Assets

Assets

Liabilities

Capital

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1 1

Capital Capital Structure Structure Overview Overview

The balance sheet shows how this is done

Assets
Assets Assets
Cash Cash and and due due from from banks banks Short-term Short-term investments investments in in market instruments market instruments Total Total loan loan portfolio portfolio (Loan (Loan loss loss reserve) reserve) Other Other short-term short-term assets assets Long-term Long-term investments investments Net Net fixed fixed assets assets Source: Winship

Liabilities +
Explanation Explanation

Net worth (Capital)

  Cash Cash on on hand, hand, call call deposits, deposits, current current accounts, accounts, etc etc (usually (usually paying paying little little or or no no interest) interest)   Interest-bearing Interest-bearing deposits deposits in in financial financial instruments instruments (usually (usually for for purposes purposes of of liquidity liquidity management) management)   Total Total outstanding outstanding balances balances of of loans loans to to clients, clients, including including loans loans past past due due but but not not written written off off   A A negative negative asset asset account account providing providing for for estimated estimated future future losses losses on on problem problem loans loans not not yet yet written written off off   Accounts Accounts receivable, receivable, accrued accrued interest interest on on loans loans etc etc   Investments Investments or or other other long-term, long-term, illiquid illiquid assets assets that that usually usually earn earn returns returns   Buildings, Buildings, & & equip, equip, net net of of acc. acc. depreciation depreciation and and land land

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1 1

Capital Capital Structure Structure Overview Overview

The balance sheet shows how this is done

Assets
Liabilities Liabilities
Savings Savings accounts accounts (compulsory) (compulsory) Savings Savings accounts accounts (voluntary) (voluntary) Time Time deposits deposits Loans, Loans, commercial commercial (often (often also also split by term) split by term) Loans, Loans, subsidized subsidized Other Other short-term short-term liabilities liabilities Other Other long-term long-term liabilities liabilities Source: Winship

Liabilities +
Explanation Explanation

Net worth (Capital)

  Compulsory Compulsory savings savings usually usually required required as as a a condition condition for for loans loans   Cash Cash deposits deposits from from members members or or the the general general public public   Certificates Certificates of of deposit deposit held held by by members members or or the the general general public public   Loans Loans to to the the institution institution at at market market rates rates from from banks banks or or other other financial financial institutions institutions   Concessional Concessional loans loans from from donors donors and and others others   Accounts Accounts payable, payable, accrued accrued interest interest to to be be paid paid on on loans loans and and deposits, deposits, etc etc   Mortgages Mortgages on on property,etc. property,etc.

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1 1

Capital Capital Structure Structure Overview Overview

The balance sheet shows how this is done

Assets = Liabilities + Net worth (Capital)

Capital Capital
Paid-in Paid-in equity equity from from shareholders shareholders (if (if any) any) Donated Donated equity equity Retained Retained earnings earnings (losses) (losses) Other Other capital capital accounts accounts

Explanation Explanation
  Equity Equity contribution contribution of of owners owners   Equity Equity received received through through cash cash donations donations from from sources sources that do not receive stock that do not receive stock   Accumulated Accumulated earnings earnings -- not not including including cash cash donations donations   Any Any special special reserves/other reserves/other capital capital accounts, accounts, plus plus any any non-financial operations retained earnings non-financial operations retained earnings

Source: Winship

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1 1

Capital Capital Structure Structure Overview Overview

The return comes from performing assets

Interest Interest & & Fee Fee Income Income Net Net Fin. Fin. Revenue Revenue

Cost Cost of of Funds Funds Variable Variable Cost Cost

Return on Equity
Net Net Profit Profit Net Net Worth Worth

Leverage (Equity Multiplier)

Profit Margin Return on Assets

Net Net Profit Profit Revenue Revenue

Net Net Profit Profit

Operating Operating Cost Cost

Revenue Revenue

Tax Tax

+
Fixed Fixed Cost Cost

Total Total Assets Assets Net Net Worth Worth

Net Net Profit Profit Total Total Assets Assets

Asset Turnover
Revenue Revenue Total Total Assets Assets Revenue Revenue Performing Performing Assets Assets

Total Total Assets Assets

+
Other Other Assets Assets

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A bank uses leverage to maximise return on capital while controlling risk

Assets = Liabilities + Capital Assets = Liabilities + Capital

e g ge a r a r e e v v e Le L

Revenue

Cost

Net Profit

Revenue

Cost

Net Profit

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1. 1. Capital Capital Structure Structure Overview Overview

2. 2. What What is is risk? risk?

3. 3. How How do do we we manage manage risk? risk?

4. 4. What What does does this this mean mean for for us? us? For For partner partner MFIs? MFIs?

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2 2

Risk Risk

What can a properly functioning financial institution do?

 A properly functioning financial institution can issue new loans at a reasonable price pay salaries, electricity bills, rent, etc. repay loans taken from other institutions (donors, banks) return depositors money on request expect to continue functioning in the future Stable: Stable: likely likely to to remain remain liquid liquid in in the the future future Liquid Liquid meeting meeting everyday everyday financial financial obligations obligations

 What could stop an institution from doing this? A large number of clients do not make loan repayments as expected Lenders to the institutions do not extend a new loan as expected A large number of depositors unexpectedly withdraw their deposits

Risk Risk

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Risks can be divided into number of categories

 Asset Asset Risk Risk  Operating Operating Risk Risk  Liquidity Liquidity Risk Risk  Interest Interest Rate Rate Risk Risk   Foreign Foreign Exchange Exchange Risk Risk  Other Other Risks Risks

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Risk Risk

Asset Risk is the risk that assets which are expected to generate a return will not the problem of delinquent or non performing loans
 Delinquent loans affect cash flows revenue expenses profitability  Increased asset risk from loans concentrated in geographies and markets no collateral

Source: Winship

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2 2

Risk Risk

Delinquent loans increase costs significantly

1 1 Guy takes a 3,000 loan, 46 months, monthly repayment of 75  Guy repays for 14 2 2 months only  What to do? How do we 3 3 recover loss? New loans. Revenue from one 3,000 loan Cost of one 3,000 loan = 450 = 270

Expected
Interest 3,450

Actual
1,050

Loss
2,400

Contribution of one 3,000 loan = 180 Earn 180 per loan 2,400 2,400 loss loss

450
Default Default

312 2,088 138 912

Principal

3,000

Need Need 14 14 successful successful new new loans loans to to recover recover loss loss from from Guys Guys loan loan

Source: Ledgerwood

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2 2

Risk Risk

Operating Risk arises from unforeseen expenses

 Fraud Clients Staff Few checks  Errors Manual systems Changing systems

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2 2

Risk Risk

Liquidity Risk is the potential for an institution to be unable to meet obligations to pay, or do so only at high cost
Cash Flows in Period Managed High Outgoings Low Incomings

Start

In

Out End

Start

In

Out End

Start

In

Out End

Failure has a high cost: borrowing costs, lost customers, embarrassment, potential to undermine depositor confidence  However, the institution must ensure there are not excess idle funds (subject to opportunity cost)

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2 2

Risk Risk

Interest Rate Risk exists because assets and liabilities may not match in rate or term
100 70
At At 10% 10%

Assets

Liabilities

Capital

20
Revenue Finance Cost Operating Cost

10
Net income

700 1,000 300

At At 5% 5%

50 35 -5
Net income

20
Revenue Finance Cost Operating Cost

Foreign Exchange Risk exists when liabilities and assets are in different currencies, subject to changing rates
Source: Winship

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Example of interest sensitivity

Prior period New period interest interest rate rate 10% 5% Interest earned: New interest earned: 1,000,000 100,000 50,000 Gross Income falls by 50,000 700,000 300,000 n/a 70,000 n/a 35,000 Financial costs fall by 35,000

Balance sheet:

Loans outstanding Debt Equity

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2 2

Risk Risk

Other forms of risk also exists

 Donor risk  Regulatory risk Government views on informal financial institutions may change e.g. (after an election) Central Bank  External Risks E.g. conflict

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2 2

Risk Risk

Risk affects the institutions ability to preserve, and generate a return, on its capital
Interest Interest & & Fee Fee Income Income Net Net Fin. Fin. Revenue Revenue

Cost Cost of of Funds Funds Variable Variable Cost Cost

Return on Equity
Net Net Profit Profit Net Net Worth Worth

Leverage (Equity Multiplier)

Profit Margin Return on Assets

Net Net Profit Profit Revenue Revenue

Net Net Profit Profit

Operating Operating Cost Cost

Revenue Revenue

Tax Tax

+
Fixed Fixed Cost Cost

Total Total Assets Assets Net Net Worth Worth

Net Net Profit Profit Total Total Assets Assets

Asset Turnover
Revenue Revenue Total Total Assets Assets Revenue Revenue Performing Performing Assets Assets

Total Total Assets Assets

+
Other Other Assets Assets

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1. 1. Capital Capital Structure Structure Overview Overview

2. 2. What What is is risk? risk?

3. 3. How How do do we we manage manage risk? risk?

4. 4. What What does does this this mean mean for for us? us?

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Risks should be addressed systematically and routinely

Plan
  Plan Plan ahead ahead on on basis basis of of identified identified assumptions assumptions

Adjust

  Change Change MFI MFI to to meet meet risk risk profiles profiles it it faces faces

Monitor

  Carefully Carefully track track relevant relevant risk risk factors factors

Quantify

  Consider Consider possible possible effect effect of of changing changing factors factors

Source: Winship

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3 3

Managing Managing Risk Risk

Asset and Liability Management ensures the required spread between interest income received and interest expenses paid
 Formal banks often have an assets and liabilities committee (ALCO) sets policies and guidelines to establish the risk tolerance of the organisation involves operations management and treasury managers meets frequently to review the current positions against target risk profile and forecast expected future positions  If the organisation is currently, or expected to be, outside risk limits the ALCO decides how to correct Potentially change balance sheet structure Potentially change policies (less common)

Source: Ledgerwood

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An acceptable risk profile can be defined and monitored using indicators

Risk Risk Profile Profile Protection Protection of of assets assets Financial Financial structure structure Asset Asset quality quality Return Return and and costs costs Liquidity Liquidity Growth Growth
Source: WCCU PEARLS

Measure Measure
360   Provisions Provisions to to cover cover PAR PAR360

Goal Goal
  100% 100%    

E EX XA AM MP PL LE E

   

30 -- 360 360 Provisions Provisions to to cover cover PAR PAR30 Net Net loans loans // total total assets assets

35% 35% 60% 60% -- 80% 80%

  Liquid Liquid investments investments // total total assets assets 30 /   PAR PAR30 / total total loans loans   Non Non earning earning assets assets // total total assets assets   ROE ROE     Operating Operating expenses expenses // average average assets assets Liquid Liquid reserves reserves // withdrawable withdrawable savings savings

  Max Max 20% 20%   <5%,Max10% <5%,Max10%   Max Max 7% 7%   > > Inflation Inflation     < < 10% 10% Min Min 10% 10%

  Institutional Institutional capital capital growth growth

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3 3

Managing Managing Risk Risk

Managing Asset Risk requires an intense focus on delinquency

 Managing geographic and occupational concentration in portfolio  Managing delinquency  Recovering non performing loans where profitable

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3 3

Managing Managing Risk Risk

Operating Risk management is linked to the improvement agenda

 New MIS  Internal audit  Management oversight

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3 3

Managing Managing Risk Risk

Liquidity management addresses liquidity risk

 The institution must always remain liquid, with Cash + expected cash inflows in the period Liquidity ratio = Anticipated cash outflows in the period

>1

 Liquidity management policies and systems are used to minimise the cost of maintaining adequate liquidity Policy decisions are taken on using stored liquidity or purchased funds A robust system for accurately forecasting cash needs at all branches / districts is required

Source: Francis

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3 3

Managing Managing Risk Risk

and involves cash management

EXAMPLE CASH MANAGEMENT MODEL
Actual February 50 600 80% 480 15 21 516 300 50 30 380 136 (130) 56 50

Beginning cash Loan repayments due Current repayment rate Expected loan repayments Savings deposits Other income Total incoming Expected loan disbursements Expected payments fixed Expected payments variable Savings withdrawal Total outgoing Net change in cash Transfers from (to) investments/borrowings Ending cash Minimum cash buffer

March 56 400 85% 340 14 16 370 400 50 35 100 585 (215) 210 51 50 330 (210) 120

Budget April 51 375 80% 300 18 17 335 275 50 32 20 377 (42) 45 54 50 120 (45) 75

E EX XA AM MP PL LE E
May 54 600 90% 540 15 20 575 300 50 30 10 390 185 (180) 59 50 75 180 255 June 59 400 90% 360 15 18 393 305 50 28 5 388 5 64 50 255 255

Beginning investments (debt) Transfers from (to) operations Ending investments (debt)

200 130 330

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3 3

Managing Managing Risk Risk

Managing Interest Rate Risk requires careful matching of the rates and terms of assets and their funding liabilities
 Interest rate risk becomes important when an institution takes on rate sensitive liabilities, e.g. commercial debt and voluntary savings  Generally, the institution wants to have terms of assets and their funding liabilities match  Gap analysis is central to managing interest rate risk Assets repricing or maturing Liabilities repricing or maturing Gap ratio = Total assets

Source: Winship, Ledgerwood

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3 3

Managing Managing Risk Risk

Other forms of risk are also important to manage

 Donor risk  Regulatory risk

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1. 1. Capital Capital Structure Structure Overview Overview

2. 2. What What is is risk? risk?

3. 3. How How do do we we manage manage risk? risk?

4. 4. What What does does this this mean mean for for us? us?

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Most MFIs have twin objectives of social/community development and financial sustainability will influence Risk Management
 Decisions on capital structure, particularly operating leverage, will be influenced by the community benefits from savings mobilisation  Ongoing operations improvements will change MFIs risk profile MIS improvements and the transition period will affect operating risk Improved information flows may allow different risk parameters, e.g. regarding liquidity management  Becoming a regulated Bank presents new challenges Increased regulatory requirements Increasing liquidity risk with increasing voluntary savings

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Sources
 Booz Allen Hamilton  G. Jay Francis, Principles of Banking, ABA  Joanna Ledgerwood, Sustainable Banking With The Poor, World Bank, 1998  Guy Winship, World Education, www.worlded.org  World Council of Credit Unions PEARLS Toolkit

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