Question

The Bank of Ghana has scheduled a forum to discuss the current state of microfinance
institutions (MFIs) in the country. You are expected to submit a paper at the forum focusing on
two broad areas, namely financial needs of the poor in the Ghanaian society and risk
management practices of MFIs.
a) Explain four (4) factors that affect financial services needs of the poor in Ghana.

b) Discuss five (5) types of risk that MFIs face in their operations.

Answer 1

a) The four factors that affect financial services needs of the poor in Ghana.

Microfinance
Microfinance consists primarily of providing financial services including, savings, micro-credit, micro insurance, micro leasing and transfers in relatively small transactions designed to be accessible to micro-enterprises and to low-income households. Microfinance may be complemented by non-financial services, especially training, to improve the ability of clients to utilize the facilities effectively.

Microfinance can be defined as "the provision of a broad range of financial services such as deposits, loans, payment services, money transfers, and insurance to poor and low-income households and, their micro enterprises" (Baten, 2009).

Broadening and deepening financial inclusion in Ghana is important for ensuring inclusive growth and achieving the objectives of the Financial Sector Strategic Plan. Deeper and more inclusive financial sectors allow poor households to manage risks and smooth consumption; they provide opportunities for very micro and small enterprises to survive and grow; they can bridge geographical dispersion by providing access to savings and payment services to populations in rural and remote regions. Ghana fares well on some indicators of financial inclusion compared to other Sub-Saharan African countries, and is comparable to lower middle-income countries. However, it lacks a clear strategy for financial inclusion and development of microfinance institutions (MFIs) and other methodologies of making financial services more widely available. Microfinance - the provision of savings, credit, and other financial products to the poor - grew rapidly in Ghana during the 2000s in existing institutions, performing well by international benchmarks for MFIs and raising the percentage of the population that is financially included.5 While the universal banks have the bulk of the assets of the financial system, microfinance institutions (MFIs) reach more clients (around 8 million) through over 3,000 outlets spread throughout the country. Although not all such institutions were directly regulated by the Bank of Ghana (BoG), capacity building, oversight and monitoring support from MFI Associations and donor-supported programs helped ensure stable growth. During the late 2000s, however, new types of unregulated microfinance service providers proliferated, increasing the number of operators who lacked sufficient capacity, skills, governance, transparency, and accountability to act as responsible financial intermediaries. This posed a risk to the sector, with increasing incidents of reported fraud, insolvency, and loss of savings by low-income households. In 2011, Bank of Ghana (BoG) initiated measures to bring all types of MFIs under a consistent regulatory framework by issuing Guidelines for MFIs. This summarizes the situation and development of microfinance institutions in Ghana, reviews progress and problems in implementing the Bank of Ghana (BoG) regulations for MFIs, highlights current risks and challenges, and proposes strategies for mitigating risks. The analysis includes three different levels: Bank of Ghana (BoG) and Government of Ghana (GoG); MFIs and their associations; and the public. It is aimed at providing information on the complex issues in the microfinance sector as a basis for dialogue on concrete reforms.

4 Factors Affecting Innovation for Financial Services

Platforms rising

The rise of customer choice will have profound implications on the design and distribution of products, and will likely force companies to shift roles. Platforms that offer the ability to engage with different financial institutions from a single channel may become the dominant model for the delivery of financial services. The rise of these platforms, such as open banking, will likely reshape financial services from clearly defined organizations to interchangeable entities. This may require that platform owners are capable ecosystem managers, balancing the needs of the product manufacturers with customer demand.

2. Financial regionalization

Differing regulatory priorities, technological capabilities and customer needs are challenging the narrative of increasing financial globalization and making way for regional models of financial services suited to local conditions. Even global firms may need distinct strategies to cultivate regional competitive advantage and integrate with local ecosystems. Meanwhile, fintechs will likely face serious obstacles to establishing themselves in multiple jurisdictions, even as technology lowers barriers to entry. Incumbents may become attractive partners for fintechs seeking to enter new markets as they look for opportunities to rapidly acquire scale.

3. Systemically important techs

Efforts by incumbent financial institutions to emulate the core capabilities of large technology firms will likely lead to an increasing reliance on those same large technology firms. For example, as financial institutions seek to enhance customers’ digital experiences and unlock data and revenues from customer platforms, they are increasingly dependent on large techs’ cloud-based infrastructure to scale and deploy processes and to harness artificial intelligence as a service. As financial institutions seek new advantages to grow their competitive footprint, they will be left with tough choices: become dependent on large technology companies or risk falling behind on technological offerings if they minimize engagement to protect independence.

4. Additional factors:

• Cost commoditization: Financial institutions may aggressively commoditize their cost bases, removing it as a point of competition and creating new grounds for differentiation
• Profit redistribution: Technology will likely enable organizations to bypass traditional value chains, thereby redistributing profit pools
• Experience ownership: Power will likely transfer to the owner of the customer interface; pure manufacturers must, therefore, become hyper-scaled or hyper-focused
• Data monetization: Data may become increasingly important for differentiation, but static datasets will likely be replaced by flows of data from multiple sources combined and used in real-time
• Bionic workforce: As the ability of machines to replicate the behaviors of humans continue to evolve, financial institutions will likely need to manage labor and capital as a single set of capabilities.

· Self-exclusion/Voluntary exclusion : peoplen face barriers that encourage self-exclusion Price of financial products exclusion: basedn on unaffordable cost or premium, which means high cost of insurance policies and high cost of credit.

· Condition exclusion: households aren deterred by the conditions attached to financial products-which are restricted usefulness. These include being offered insurance policies which contains certain exclusions and bank account where certain amount of minimum balance has to be maintained.

· Marketing of financial products exclusion:n households with no financial products have had no sales approaches

· Psychological barrier: lack of financialn services, the feeling that financial services are not for households on very low incomes was similarly very widespread.

· Additionally, lack of awareness, low income, poverty and illiteracy are the factors that lead to low demand for banking services and consequently are the main reasons for financial exclusion.

b) Five (5) types of risk that MFIs face in their operations.

“Microfinance: not as risky as you think”, Financial Times, 25 May 2007

“Microfinance: Risky and Expensive”, Wall Street Journal, 23 June 2010

Risk has become a critical issue in microfinance, as the sector is growing and evolving into a full-fledged financial industry.

In today’s market with rapid growth and expansion in the industry as well as rising NPLs and asset quality problems, the need for a strong risk management framework is heightened. In this landscape, external stakeholders including regulators, investors, and donors are increasingly demanding stronger risk management frameworks.

Sources of Risk and Vulnerability in Microfinance

1.Borrowers : Borrowers are the first and possibly the main source of risk in microfinance, particularly related to uncertainty and vulnerability of their micro-businesses in the current economic climate, followed by risk factors within the MFIs such as lack of governance, and other risk factors related to market environment (Lascelles et al., 2014). There are two reasons for this claim. First, most of the borrowers of microcredit do not have any financial security to protect them from any loss of exposure to risks. Minor problem with their shop or farm would have devastating consequences to income flows to the poor’s family. As demonstrated in the case of Andhra Pradesh, inability to repay debts to microfinance institutions had caused few poor clients to commit suicide (Shylendra, 2006). This tragic outcome could stem from lack of education on the clients part, but ultimately MFIs should recognize and identify ways to minimize and mitigate risks exposed to their clients.

The second argument is the inherent risk in the nature of businesses many micro borrowers have. The money they borrowed from MFIs is often used for trading activities in the market, petty shop at home, or some craftsmanship activities. These are types of businesses that are vulnerable to both seasonal and business factors i.e. the small scale makes them prone to losses or low sales volume. Should the borrowers fall into slight difficulty, they immediately find themselves unable to repay the loan and meet the weekly or monthly instalments due to MFIs.

For the borrowers, lack of financial security and unpredictability of microbusiness are the two main sources of their vulnerability. For borrowers in the rural farming sector, they are also facing other risks related to weather, pests, climate change, and other natural hazards (Isakson, 2015). In general, micro borrowers must also deal with risks related to the operations of their microbusiness, effective use of loan, commodity price volatility or adverse market conditions, increasing competitions, and other external factors.

Most of the risks related to internal deficiencies have been addressed in most microfinance programmes, especially through group lending strategy that impose peers pressure and control system among the borrowers. In fact, Crabb and Keller (2006) suggest that group lending methodology reduces risk in microfinance portfolio, while individual lending tends to increase risk for MFIs. Hence, for MFIs that are adopting individual lending system there are still more risks that need to be addressed, especially credit risk.

2. Commercialization and Competition of Microfinance Sector

Commercialization is alleged to be responsible for the rising of risk profile among MFIs. It has invited different kind of risk to microfinance, including the international market risk resulted from the exposure of MFIs to international and commercial funding sources. Some studies suggest that commercialization is responsible to the increase in vulnerability of MFIs. This claim is evident from a slight shift in the literature on the effect of external shocks to microfinance institutions. Most studies in 1990s suggest that MFIs are relatively immune and unaffected by few major financial crises, most notably the Asian financial crisis in 1997/98. For instance, Krauss and Walter (2009) using dataset from 1998 to 2006 find that there is no significant relationship between MFIs and global market movements or external shocks. They suggest that MFIs seems to be ‘detached’ from any shocks affecting global capital markets.

However, there are also competing claim on the impact of commercialization. In a more updated study and using more recent dataset Wagner and Winkler (2013) find the contrary to previous studies. They find that during the global financial crisis of 2008-2009, there has been a negative impact on real credit growth of MFIs across the world, especially those MFIs that enjoyed rapid growth few years before the crisis. This study confirms a presence of boom-bust theory in microfinance.

The prevalent of commercialisation also encourage the emergence of many studies on its impact. This is evident in the increasing interest of many researchers on commercialization and competition in the microfinance sector. Commercialization and subsequent trade-off between sustainability and poverty outreach are among the most widely discussed aspects of the recent microfinance studies. The issue of commercialization has attracted many researchers and observers to explore the topic (Hamada, 2010).

These studies have gradually contributed to the emergence of a new sub-topic of its own within microfinance studies i.e. microfinance as asset class or mission drift. The main reason for such growth of this particular subject is the inconclusive outcome from most studies. There is no definite winner in this debate whether a commercialization is ever presence, or whether the MFIs have indeed been drifting away from its main cause, and most importantly whether the commercialization is bad or good for the poor. The debate is triggered among others by potential implications these studies could have on policy and structural design of microfinance programmes. If the trade-off is indeed established and valid, microfinance stakeholders must choose for one that is most suitable for their circumstances. If the main objective is reaching out to as many poor people as possible, then they must sacrifice or bear with potential lack of profitability or sustainability, and vice versa.

3. External Factors: Socio-Economic and Political Forces

Microfinance sector may also face external risks such as natural disasters, armed conflicts, war, famine, and macroeconomic difficulties. External risks are still the main concern for nearly all microfinance institutions in developing countries. Natural disasters and similar risks may lead to business failure or crop failure, whereby many developing countries have suffered from floods, cyclones, or other calamities that destroyed many of the income generating assets of the poor. Localized epidemics and illnesses could also affect the ability to earn a livelihood or to repay the loans. Calamities in the family might result in loan funds being diverted into non-income generating activities. In a specific case, microfinance sector may also derive risks from its geographical location, as many MFIs operate in the poorest regions in the world, which mostly are also affected by continuous arms conflict, recurring natural disasters, or situated in landlocked countries. For instance, Gunter (2009) and Casselman et al., (2014) illustrate the issues faced by microfinance institutions in post-conflict Iraq, where microfinance is used as both economic re-development tool and peace building apparatus.

The major risks to MFIs are in fact common to all financial institutions and they can be grouped into three general categories: financial, operational, and strategic (see table below).

4. Financial Risks: The main risk category that all MFIs are facing is financial risk, and in particular credit or portfolio risk. MFIs face various and endless uncertainties related to credit risk of their borrowers on a daily basis. Although microfinance is known for its high repayment rate, mainly due to peer monitoring in the group lending structure (Stiglitz, 1990), default or payments delinquency due to lack of good governance or poor financial performance may cause MFIs to face serious problems (Ayayi, 2012).

5. Operational risk, which includes risk due to information technology malfunction and fraud, has little precedent in microfinance. However, this category is an important risk factor that requires careful mitigation and management. One of the contributors to the microfinance crisis in Andhra Pradesh district of India was irresponsible lending in pursuing ‘reckless growth’ and loans recovery by field officers of the MFIs in the district (Mader, 2013).

6. Strategy Risk: Finally, the main issue in the strategic risk is governance. Governance risk is related to a possible influence of shareholders, donors and even regulators on the performance of the MFIs, either financial performance of social performance. This type of risk is particularly devastating for MFIs operating as nongovernmental organizations (NGOs) that are dependent on external parties for funding such as development agencies and donor organization. Empirical studies on governance and ownership also share the same conclusion, that a well-defined governance structure (Mersland and Øystein Strøm, 2009) and to a lesser degree, ownership (Mersland and Strøm, 2008) are important performance determinants for MFIs

For example, common operational risks include:

MFIs does not correctly reflect loan information such as disbursements, payments received, current outstanding balance There are inconsistencies between the loan management system and accounting system data Rescheduled loans are treated as on-time, disguising loan quality problems. Loan tracking information is inadequate with no credit histories or aging balances.

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