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CERM Unit3 1621 (1) risk landscape and taxonomy

Certified Expert in Risk Management
Unit 3: Risk Landscape and Taxonomy
Certified Expert in Risk Management
Unit 3: Risk Landscape
and Taxonomy
Further Reading
Video Lecture
6. edition 9/2016
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High-Level Risk Identification .................................................... 5
High-Level Risk Dimensions - Initial Definitions ..................... 9
Reputation Risk ......................................................................... 13
Strategy Risk ............................................................................. 19
Exercises.................................................................................... 25
© 2016 Frankfurt School of Finance & Management
Certified Expert in Risk Management
Unit 3: Risk Landscape and Taxonomy
Activity Based Costing
Asset and Liability Management Committee
Asset-Liability Management
Automated Teller Machine
Agence de Transfer de Technologie Financière
Basel Committee on Banking Supervision
Balanced Scorecard
Capital Adequacy Ratio
Microfinance Secretariat at the World Bank
Committee of Sponsoring Organizations of the Treadway
Exposure at Default
Expected Loss
Enterprise Risk Management
Euro currency
Financial Risk Manager - professional designation
Human Resources
International Standards Organization
Key Performance Indicator
Key Risk Indicator
Loss given Default
Microfinance Institution
Management Information System
Microfinance Investment Vehicle
Micro-, Small and Medium Enterprise
Non-Bank Financial Institution
Non-Governmental Organization
Non-Performing Loan
Occupational Health & Safety Advisory Services
Probability of Default
Project Management Institute
PMI Risk Management Professional designation
Professional Risk Manager professional designation
Return On Assets
Return On Equity
Small and Medium Enterprise
Technical Assistance
US Dollar
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Unit 3: Risk Landscape and Taxonomy
Learning Outcomes
This Unit establishes a macro risk map for microfinance and small business
banking. It provides a reference framework for high-level risk identification
and develops initial definitions for all principal sources of risk in traditional
banking book operations. The learning outcomes of this Unit are:
being able to establish a macro risk map and an initial high-level
severity/probability risk profile of your financial institution.
understanding the conventional definitions of all principal risk
dimensions in banking book-only financial services.
describing the transmission function of reputational and behavioral
factors between core risk sources and downstream liquidity and
capital adequacy exposures.
the high cost of microcredit being a key reputational vulnerability in
microfinance, one should be able to correctly calculate annual
effective interest rates on various types of loan products.
designing an inclusive strategic planning process that identifies
suitable strategic initiatives and gives due consideration to the
downside risks of associated adverse scenarios.
© 2016 Frankfurt School of Finance & Management
Certified Expert in Risk Management
Unit 3: Risk Landscape and Taxonomy
© 2016 Frankfurt School of Finance & Management
Certified Expert in Risk Management
Unit 3: Risk Landscape and Taxonomy
High-Level Risk Identification
Sorry, but we decided to make you work through one more rather generic
introductory Unit. We understand that everyone is eager to finally run some
numbers and do a foreign exchange rate stress test, for example. We
promise to keep this short. Yet, a bit more high-level risk discussion now will
help us maintain a holistic perspective on the risk profile of our
organization, while we are digging deep into the details on a particular type
of exposure.
Just a few more
definitions and
This Unit is about establishing a high-level, "macro" risk map for SME
banking and microfinance. The objective is to bring some conceptual order
to the many different dimensions of risk that we hear about in connection
with banking and microfinance. The worst is to be blindsided by unknown
unknowns, i.e. by potential losses arising from categories of uncertain events
that we do not even have on our radar. This would mean that we also do not
have processes and tools in place to measure and mitigate these exposures.
Therefore, it is critical to set up a macro risk map that is as broad and allinclusive as possible and provides a terminological anchor for any and all
possible risk dimensions and events.
For example, the new board member might ask the Risk Manager: "Have
you thought about the risk of loan officers using physical intimidation to
collect from micro-borrowers and a journalist picking up on this and
turning it into a national news story on the abuses of microfinance? And
then many more clients would be refusing to pay these 'microcredit bandits'
as a consequence". The Risk Manager throws up the Macro Risk Map on
the projector and responds: "Yes, that's covered. It is called the reputational
dimension of operational risk and it relates to the adherence of staff to
documented policies and procedures. Any abuse should be picked up
during internal control site inspections or through the client complaint
Again, at this high-level, the macro risk map is about broad coverage of the
risk universe. Any conceivable risk that an institution may face must be
subsumed under one of the top-level risk dimensions that we have identified.
That way, we have some reasonable assurance that the identification and
measurement processes that we put in place will pick up any actual
exposures and give us a chance to manage them, before they can bring
down the house. And since the activities of large-scale commercial deposittaking microfinance are fundamentally similar to those of conventional retail
and SME banks, the macro risk map for microfinance is essentially identical
to a retail banking risk map.
Macro map must cover
entire risk spectrum
The principal difference vis-à-vis the risk landscape of a large full-service
bank is that our MSME banking risk map relates to banking-book activities
only. There is no proprietary trading for short-term gain in marketable
financial instruments (stocks, bonds, commodities, derivatives, etc.) and
there will not be any complex structured credit products, no syndicated
lending, no project finance, no investment banking or securities underwriting.
Off-balance sheet contingent rights and obligations will be minimal. They
might arise only from occasional guarantees received or granted or from
some banking-book related forward and swap transactions, e.g. in order to
hedge some interest rate or foreign exchange rate exposures.
MSME Finance is banking
book only business
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Unit 3: Risk Landscape and Taxonomy
Under BCBS rules on capital adequacy, banks divide their activities into two
main categories, i.e. traditional banking versus trading, whereby banks'
assets and liabilities either belong to the banking book or to the trading
Banking book vs. trading
The banking book is defined by its relationship to traditional client
transactions and instruments such as loans, deposits, guarantees,
international trade finance and payments etc. The banking book also
includes the funding transactions, liquid asset holdings and hedging
instruments that support the client-related business.
In contrast, the trading book contains assets and liabilities that are created
or held for short-term (proprietary) trading including the liabilities that fund
these activities as well as hedging instruments associated with trading book
We should note that the same type of instrument, say a forward transaction
in currencies, can be found in the trading book or in the banking book. It is
the functional purpose of the transaction that determines the classification,
not whether by its nature the instrument has more of a trading room flair or is
a traditional client contract. So, suppose a MFI invests its liquid asset
reserve in government bonds and occasionally buys and sells bond holdings
to accommodate funding requirements from microcredit and deposit
operations. Are these bond holdings in the trading book or in the banking
book? In the banking book, of course. The bonds support the core retail
banking activities as a cash buffer that meets regulatory liquidity
requirements. The MFI is not a market maker in government bonds and the
motive for holding bonds is not to trade them on an intraday basis for shortterm profit.
IAS 39 / IFRS 9
While we are on the subject of banking book versus trading book we should
mention that there is a similar overlapping classification system of assets
and liabilities that comes out of IAS 39, which is also being carried forward
into the new IFRS 9. Under IAS 39 / IFRS 9, assets are classified into three
categories: (1) Held for Trading, (2) Available for Sale and (3) Held to
Maturity or Loans & Receivables. Without going into the finer details at this
point, one can roughly equate Held for Trading assets and liabilities to the
Trading Book and everything else to the Banking Book.
Coming back to the banking-book-only risk landscape in micro and SME
banking: If we go with this simplified version of the risk universe, it must be
clear that whatever is not on the macro risk map must indeed be forbidden
territory. Otherwise, we could imagine a treasurer drifting off into day-trading
in speculative penny stocks as a way to "optimize" the yield on the MFI's
liquid asset reserve.
Permitted and prohibited
activities & products
The particular problem of risky treasury investments can be avoided by
clearly defining eligible investment instruments and counterparties for
treasury transactions in the liquidity management policy.
But more
importantly still, the board should remind management first off that
everything the institution does, buys, sells, or invests in must clearly support
the stated mission and mandate. If one cannot explain how short-selling
penny stocks is related to the inclusive low-income financial services mission
of the institution, then it is simply not allowed, end of discussion. Compare
section "2 Business Model and Risk Tolerance" in the model ALM framework
policy provided at the end of Unit 2. This gives an example of how one can
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Unit 3: Risk Landscape and Taxonomy
directly link the mission of the institution to permitted and prohibited activities
and products. Let's look at our attempt to draw up such a macro risk map for
micro- and SME finance in Figure 1.
Strategy & Business Risk
Liquidity Risk
Credit &
Risk & AML /
Interest Rate
Exchange Rate
Strategy & Business Risk
Strategy & Business Risk
Reputation &
Behavioral Risks
Reputation &
Behavioral Risks
Strategy & Business Risk
Figure 1: Macro Risk Map for Microfinance and SME Banking
Figure 1 structures the MSME risk universe into four interdependent risk
the core sources of risk in the grey boxes in the middle,
a transmission layer of reputation and behavioral risks that radiate
out into ...
the downstream dimensions of liquidity, covenant and capital
adequacy risk, and finally ...
a strategy & business risk layer that interacts with all other risk
Four interdependent risk
We find this layering approach quite helpful in thinking about the practical
interdependencies between the conventional risk dimensions encountered in
The boxes at the core are the original sources of risk. This is where
generally the trouble starts: If a MFI goes down in flames, it is almost always
due to a high level of loan losses (credit risk) in combination with fraud and
negligence in following policies and procedures (operational risk). Interest
rate risk and foreign exchange rate risk can also cause major losses for
MFIs, when poor risk management meets bad luck. But we have trouble
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Unit 3: Risk Landscape and Taxonomy
Credit + operational risk
is the killer in
naming an institution that failed strictly because of interest rate or forex risk,
while we could fill books with cases of the deadly credit risk / operational risk
Transmission function of
reputational risk
We placed reputation and behavioral risks in a "transmission layer". This
requires some further explanation: A good reputation for solid finances and
honest, socially responsible client service is never lost out of the blue by an
act of God. The financial reputation suffers, when actual losses incurred by
the institution in the core risk dimensions become public knowledge. In the
same vein, changes in client behavior may be triggered by reputational
damage or by financial losses that emanate from the core risk dimensions.
Now that your MFI is in the news as having financial difficulty, it is not
surprising that depositors might change their prolongation behavior or that
the willingness of borrowers to repay their loans may have suffered.
The loss of reputation and the behavioral changes (lower deposits & lower
loan collections) work like an accelerator for the transmission of losses in the
core dimensions to the downstream risks in the third blue layer. As the
institution is losing client goodwill, is bleeding cash and booking losses, it
becomes increasingly difficult to remain in compliance with liquidity norms,
borrowing covenants and capital adequacy rules.
Strategy is the wraparound risk layer
And finally, strategy interacts naturally with every other risk dimension:
Initiatives like pushing into agri-lending, moving up-market into SME finance,
increasing outreach to poor households in remote areas, rolling out a new
technology platform etc. all have risk/reward profiles that need to be carefully
examined in each of the risk dimensions on the macro map.
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Unit 3: Risk Landscape and Taxonomy
High-Level Risk Dimensions Initial Definitions
Before we unpack each of the key risks in great detail in the following Units, it
will be useful to round out our overview of the risk dimensions on the macro
map with some short initial definitions. For strategy and reputation risk, this
initial review will be a little bit more involved, because we will not come back
to these two more elusive, less quantitative risk dimensions later within a
dedicated Unit.
Credit risk is defined as the possibility that a borrower or other contractual
counterparty might default, i.e. might fail to honor their contractual
Counterparty credit risk in microfinance would relate to investments with
other financial institutions or to the settlement obligation of a bank towards
the MFI resulting from a currency forward transaction, for example. But for
the largest part, naturally, credit risk is related to small businesses and
individual borrowers failing to meet their payment obligations under their loan
agreements with the MFI. Credit Risk is commonly subdivided into a
transaction risk and a portfolio credit risk component.
Transaction risk refers to individual loans and essentially measures (1) the
standalone probability that the borrower will be able to repay as well as (2)
the ultimate loss in the case of a borrower default after use of collateral and
other mitigating factors.
Portfolio credit risk is concerned with measuring correlations between
individual borrower defaults, the effects of diversification, the cyclicality of
collateral values and the implications of reputation and contagion effects in
micro- and consumer credit.
For operational risk we will use the widely accepted BCBS definition as per
Basel II June 2006, no. 644 and the 2011 Sound Principles:
The BCBS defines operational risk as the possibility of “losses resulting
from inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, but excludes strategic
and reputational risk. Legal risk includes, but is not limited to, exposure to
fines, penalties, or punitive damages resulting from supervisory actions, as
well as private settlements.”
Operational risk in a way is the residual catch-all category of risk. It is as
diverse as the things that can go wrong with people, processes and systems.
It includes fraud by staff, ordinary burglaries, loans not processed and
revenue lost due to a network outage, as well as mundane issues such as
staff leaving the air-conditioning on over the weekend and running up the
electricity bill.
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Unit 3: Risk Landscape and Taxonomy
Always examine
operational risk events in
terms of reputational
We should point out that in microfinance much of the reputational damage
that can be imagined comes from operational risk events. Think of major
fraud, abusive sales practices and service disruptions. Although reputational
risk is broader than just the consequences from operational events, we will
always examine every operational risk exposure and every materialized loss
very thoroughly in terms of its reputational impact.
Let's turn to the market risks in MSME finance.
Market risk is the potential of losses to income or the value of assets,
liabilities and equity arising from changes in market prices. Such market
prices may include reference interest rates, foreign exchange rates, traded
prices of equity shares, prices of precious metals and other commodities etc.
The relevant market risks in MSME finance are interest rate risk in the
banking book and foreign exchange rate risk.
Interest rate risk is a bit of an abstract risk dimension that is often not well
understood by microfinance practitioners. It also has an aura of highpowered financial math about it. This actually creates another risk in itself,
namely that we end up with a nice black box with differential equations inside,
where nobody knows what this thing is even measuring. On the other hand,
one can argue that the market rate component of the microcredit rate
charged to clients is small relative to the required operating cost margins.
So, why worry about market interest rates going up or down by just one or
two percent per annum? In our Unit on interest rate risk, we will try to find a
reasonable middle ground between Nobel-prize winning formulas and just bypassing the whole interest rate risk complexity. Here now, is our definition of
interest rate risk:
Interest rate risk is the danger of an adverse impact on net income and on
the value of assets and liabilities in response to changes in the prevailing
interest rate levels in the market.
Its most important drivers of loss are (1) repricing risk which occurs via
timing differences in the maturity of fixed-rate assets and liabilities and the
repricing dates of floating-rate items and (2) basis risk which stems from the
imperfect correlation in the adjustment of the rates earned and paid on
different instruments with otherwise similar repricing characteristics.
Yes, exactly, it's a little abstract. But don't worry, we will take interest rate
risk apart step by step with lots of hands-on calculation models. Look
forward to Unit 4.3 on interest rate risk.
There is more to currency
risk than just exchange
rate movements
When we speak about foreign currency risk, most people immediately think
of the narrow concept of foreign exchange rate risk. That is guys in sharp
suits in front of a wall of flat-screens playing the EUR/USD exchange rate
with million dollar bets. But there are a number of other elements in the
currency risk picture that should not be forgotten. These other currency risk
dimensions are particularly relevant for emerging markets and developing
countries where microfinance institutions operate. Often, the national
currency is structurally weak and prone to inflation and there is heavy
reliance on a parallel foreign currency in everyday transactions among
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Unit 3: Risk Landscape and Taxonomy
residents (dollarization). Many developing and emerging countries also still
have currency regulation in force or could easily re-introduce such regulation
that limits access to foreign currency and its transfer in and out of the
country. So, here are the definitions for the full spectrum of currency risks
that MFIs and SME banks might face:
Convertibility risk is the possibility that the government or the central bank
restrict access by domestic payers with obligations in hard currency to the
foreign exchange markets thus making it impossible to buy the required
currency, even if the counter-value in local currency was available.
Transfer risk refers to the possibility that the local authorities will not allow
foreign currency to leave the country regardless of its source. This could
mean, for example, that a resident entity might have a USD balance in a
bank account with a local bank, but that it would be forbidden from
transferring these funds to a foreign recipient in order to pay an installment
on a foreign borrowing.
Currency Induced Credit Risk (CICR) arises when residents take on unhedged borrowings in foreign currency: Austrians taking out Swiss Franc
mortgages, Turkish borrowers taking USD car loans, Kenyans borrowing
USD for home improvements etc. The risk consists of a devaluation of the
local currency, which will make debt service on the foreign currency
borrowing more expensive in local currency and ultimately may lead to
default of the borrower.
Foreign exchange rate risk (forex risk) in a narrow sense arises from
unexpected movements in the level of exchange rates that may lead to
losses in the home or reporting currency of the entity concerned. More
specifically, forex risk results from a mismatch between assets and liabilities
in a particular currency and their associated cash flows in respect of size and
We now move on to the definitions of the downstream secondary risks in
the third blue layer in Figure 1. The transmission layer of reputation and
behavioral risks will be discussed in a separate Chapter 3 immediately
Liquidity is defined as the ability to honor all cash payment commitments as
they fall due. Meeting all payment obligations involves the use of current
cash inflows, the stock of cash holdings, borrowing cash and converting liquid
assets into cash. Liquidity risk is shown as a downstream transversal risk
dimension in Figure 1 as a way to emphasize its cross-sectional nature that
interacts with all other risk categories.
Similarly, covenant risk and capital adequacy risk can be seen as crosscutting operating constraints that are not a primary source of risk in
themselves. Instead, they represent a compliance risk that is driven by the
institution’s positioning and loss experience in the core risk areas shown at
the center of Figure 1.
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Unit 3: Risk Landscape and Taxonomy
Covenant Risk is the possibility of breaching a financial limit or constraint
imposed on the entity by creditors in a loan agreement or similar contract. As
a consequence of a covenant breach, creditors may cancel a loan agreement
and demand immediate repayment of the entire balance outstanding, which
might further aggravate the financial situation of the borrower.
Capital Adequacy Risk is the threat of non-compliance with regulatory
capital requirements, which could entail regulatory consequences ranging
from fines to restrictions on activities up to placement under administration
and forced liquidation of the entity.
Before we move on to a more detailed look at the reputation / behavioral and
strategy risk layers, let us try to position all of the risk dimensions in the
macro map defined this far within a risk severity / risk probability
taxonomy. This would be similar to the quadrant chart introduced in Unit 1,
Figure 1. The idea is to classify the risk dimensions into the severity /
probability matrix in their raw form as encountered by a particular MSME
finance institution within its operating environment, before the effect of
specific mitigation measures.
Rate Risk
Credit Risk
party Risk
Transpose macro map to
severity / probability
Figure 2: MSME Finance Risks in a Severity / Probability Matrix
Use matrix for board
level discussions on
risk profile
We should emphasize that the result of the classification into the
severity/probability matrix above will not be universal for every MFI in every
operating context. Figure 2 just gives one plausible result for a "typical"
deposit-taking large-scale microfinance institution. Filling out such a matrix
for your institution might be an excellent exercise in a workshop to get the
board and senior management thinking systematically about the risk profile
of your organization. Of course, one would not stop there. The next step is
to develop specific metrics for each dimension that help quantify exposures
and monitor materialized losses. That is what the following Units 4.1 - 4.5
will be all about.
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Unit 3: Risk Landscape and Taxonomy
Reputation Risk
We now turn to the transmission layer in Figure 1, the area of reputation
and behavioral risks. Just like reputation risk, behavioral risk really is not a
free-standing original source of risk but a latent type of exposure that is
activated by significant losses in other core risk dimensions. This can
happen directly, or indirectly with a detour via reputation risk. A direct
activation could occur via falling market interest rates and an emerging real
estate price bubble. If retail savers are scrambling to join the real estate
party and buy a piece of land or small apartment in order to not miss the
boat, it becomes harder and harder to retain savings deposits even in a lowincome focused MFI. This is an example of interest rate risk directly
activating a behavioral change in depositors. The indirect transmission via
a reputation effect would, for example, first see losses occurring from a large
un-hedged foreign currency borrowing, which are becoming public
knowledge. Savers then begin to worry whether their deposits will be safe at
the MFI and will prefer to not roll-over their time-deposits and even begin to
close-out their passbook accounts. This could lead to a classic chain
reaction as follows: core risk loss -> reputation impact -> change in depositor
behavior -> liquidity crisis -> bankruptcy and liquidation.
For practical purposes, we will generally lump together the reputation and
behavioral stages in this transmission chain. They will almost always occur
together and in various combinations of direct, indirect and second-round
effects. Therefore, we don't want to begin splitting hairs over what came
first, the behavioral change or the reputation impact. Let's just use it as one
word from now and simply say "reputation-and-behavioral risk" or "reputation
risk" for short.
Reputation (and behavioral) Risk is the potential that an organization may
not attain its objectives due to unfavorable perceptions of its activities,
motives and representatives that may arise among various stakeholders and
the general public.
Stakeholders may include clients, members, shareholders, creditors, staff,
suppliers, competitors, regulators, political opinion leaders etc.
Reputation risk is closely linked with another key term in development
finance, i.e. social performance management.
The Social Performance Management Network (spmnetwork.net) defines
Social Performance as the effective translation of an institution’s mission
into practice.
Social Performance Management consists of the processes an institution
uses to translate its mission into practice. These include: (1) setting social
targets, (2) measuring the progress toward these targets and (3) using the
results for strategic decision-making - namely in order to improve products,
services, and delivery channels.
Social performance management is essentially about managing reputation
risk. If you make an honest effort at mitigating reputation risk at its source,
i.e. by eliminating bad corporate behavior and excessive profit maximization,
then you are doing proper social performance management. So, it's about
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Unit 3: Risk Landscape and Taxonomy
Interactions between
reputation and behavioral
serious reputation management, by way of actually earning a good
reputation rather than by means of superficial window dressing.
If we share this understanding of the sources of reputation risk, it is clear that
reputation is:
No reputation windowdressing, please
a long term issue,
an emotional association of the stakeholders to the institution,
about living and implementing the institution’s adopted values, and
putting in place best practices: governance, policies, code of ethics,
health & safety, redress for grievances …
Because reputation risk management is such a long-term sustained
investment in good practices, the temptation is large to resort to quick
fixes. Such fixes would try to shape the reputational perception rather than
cultivate stakeholder affinity by consistently doing the right thing and living up
to the dual commercial and social missions of the institution.
Unfortunately, in microfinance, there is a lot of half-hearted, superficial
reputation management out there:
Need to quantify social
impact of microfinance
funders who are afraid to ask the tough questions about actual
social impact, because they may not like the answers and
MFIs who just want to do a few easy adjustments and otherwise
change nothing.
Hanging up a few complaint boxes just does not cut it
anymore. Since the global financial crisis and the
microfinance excesses in India (see box below), the love
affair between development aid and microfinance has
cooled off. Sponsors of microfinance now want to see a
social mission put into daily practice and hard evidence of
development impact: Can you quantify the social &
development return on microfinance investment? Without
solid evidence of how microfinance services are actually
helping clients improve their livelihoods sustainably, the
grants, technical assistance and subsidized funding just
won’t be coming like they used to.
In fact, social and financial performance in microfinance must not be at odds
with each other. Social performance can also be good business: adding
value to low-income clients’ lives through quality services at advantageous
terms delivered by a well-respected organization with impeccable ethics …
how else are you going to cultivate client loyalty?
© 2016 Frankfurt School of Finance & Management
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Unit 3: Risk Landscape and Taxonomy
A study by Incofin Investment Management (www.incofin.com) on a portfolio
of over 70 microfinance investments points to a positive correlation between
financial and social performance scores:
Figure 3: Financial vs. Social Performance Scores. Scatter diagram and
regression line. Source: Incofin Investment Management.
Reputation Risk Disasters in Microfinance: SKS
implicated in borrower suicides in Andhra Pradesh, India
"Hundreds of Suicides in India Linked to Microfinance Organizations",
Feb 2012
MUMBAI, India (AP) — First they were stripped of their utensils, furniture,
mobile phones, televisions, ration cards and heirloom gold jewelry. Then,
some of them drank pesticide. One woman threw herself in a pond. Another
jumped into a well with her children. Sometimes, the debt collectors watched
nearby. More than 200 poor, debt-ridden residents of Andhra Pradesh killed
themselves in late 2010, according to media reports compiled by the
government of the south Indian state. The state blamed microfinance
companies - which give small loans intended to lift up the very poor - for
fueling a frenzy of over-indebtedness and then pressuring borrowers so
relentlessly that some took their own lives. (…)
Both reports said SKS employees had verbally harassed over-indebted
borrowers, forced them to pawn valuable items, incited other borrowers to
humiliate them and orchestrated sit-ins outside their homes to publicly shame
them. In some cases, the SKS staff physically harassed defaulters, according
to the report commissioned by the company. Only in death would the debts
be forgiven.
One woman drank pesticide and died a day after an SKS loan agent told her
to prostitute her daughters to pay off her debt. She had been given 150,000
rupees ($3,000) in loans but only made 600 rupees ($12) a week. Another
SKS debt collector told a delinquent borrower to drown herself in a pond if
she wanted her loan waived. The next day, she did. She left behind four
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Unit 3: Risk Landscape and Taxonomy
One agent blocked a woman from bringing her young son, weak with
diarrhea, to the hospital, demanding payment first. Other borrowers, who
could not get any new loans until she paid, told her that if she wanted to die,
they would bring her pesticide. An SKS staff member was there when she
drank the poison. She survived. (…)
The deaths came after a period of hyper-growth leading up to the company's
hugely successful August 2010 initial public offering. Originally developed as
a non-profit effort to lift society's most downtrodden, microfinance has
increasingly become a for-profit enterprise. As India's market leader, SKS
has pioneered a business model that many others hoped to emulate. But the
story of what went wrong at SKS has led current and former employees and
even some major shareholders to question that strategy and raises
fundamental questions for the multibillion-dollar global microfinance industry.
Social performance is
both opportunity and
vulnerability in
Although social performance and reputation risk should be a concern in any
business which relies on the goodwill of a broad-based clientele, MSME
finance is special in this respect. This is because expectations have been
raised about the power of MSME finance in uplifting millions of poor in
developing countries. MFIs absorb massive subsidized funding, grant capital
and "free" technical assistance. Most MFIs have social objectives enshrined
in their corporate mission and vision statements.
Nothing is more
disappointing and disastrous for the reputation of a MFI than to be found out
as a dressed-up loan sharking operation with Muhammad Yunus posters on
the wall. 1
The single biggest reputation risk factor in microfinance is the high cost of
microcredit. All it takes is that the media run a story about your institution
and the exorbitant interest rates that are being charged to poor people and
you can have a reputation firestorm on your hands. The problem with this
particular reputational vulnerability is that all too often, it is true. The
effective cost of microcredit really is scandalously high.
For years, microfinance practitioners have been singing themselves to sleep
on this issue with the usual arguments: The cost of outreach is so high, so
we must charge high rates to recover costs. If we don't recover the cost,
then microfinance is not sustainable. And somehow that is a problem not
just for us who work in microfinance, but also for the poor clients. Rates
don't really matter because the loan amounts are so small. Annual effective
rates are not realistic, because loans are generally for shorter periods than
one year. Clients don't care about the high rates, because it is about
convenience and access.
Microcredit rates do
matter, of course
Really? We are not convinced and firmly believe that the price of microfinancial services does matter. If lending $200 to a poor family is supposed
South African microlender Blue Financial Services (www.blue.co.za) would be
my best example of a cynical loan sharking business that was able to tap into
development finance funding just by talking a bit of microfinance jargon and
putting photos of women with fruit stands in their annual report. Blue also has
operations in Ghana, Uganda, Zambia, Botswana and other African markets.
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Unit 3: Risk Landscape and Taxonomy
to be a life changing development intervention, how can paying $250 a year
interest for using the $200 working capital be irrelevant? How can cost not
be the single most important index of quality in a dematerialized financial
Ok, but which reputable microfinance institution would charge more than
100% per annum interest? A great many of them, actually. Consider the
following real example from a community-based savings and loan company
in Ghana :
GHS 1,000 microloan for 9 fixed monthly installments at 3% per
month "flat", 15 GHS upfront charge, 5 GHS monthly membership.
What is the effective annual rate?
The shocking result is 105.55% effective per annum, fully compounding as
per EU consumer credit directive.
In the exercises section at the end of this Unit we will give detailed
instructions and plenty of additional examples of how to calculate US-style
Annual Percentage Rates (APR) and correct EU-style effective rates.
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Unit 3: Risk Landscape and Taxonomy
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Certified Expert in Risk Management
Unit 3: Risk Landscape and Taxonomy
Strategy Risk
Finally let's discuss strategy risk (or strategic risk) in more detail, because
we will not come back to strategy in a separate Unit. In Figure 1 we depicted
strategy and business risk as the grey all-enveloping risk layer: Strategic
decisions may have an impact on exposures in every known dimension and
may even activate new, hitherto unknown types of risk. There is also a
direct feedback from risk to strategy, because strategies largely succeed
or fail because of the risks that they entail and that may materialize at the
most inopportune moment.
As the corporate practice of risk management evolves, directors and
members of supervisory boards have become increasingly aware of their
fiduciary obligation to manage risks that could prevent the organization
from achieving its strategic objectives. This fiduciary wake-up call manifests
itself in two ways:
It is becoming increasingly common that directors in MSME finance
institutions request Directors & Officers insurance coverage paid by
the institution, which would protect them from stakeholders who might
seek redress for dereliction of fiduciary duty as a board member.
More productively maybe, board members and international investors in
microfinance are pushing for more formalized approaches to risk
management and a better alignment between strategy and risk.
This push for better governance of risk means in effect that the
consideration of risk must be woven directly into strategy setting. How else
can a board properly determine strategy, other than by considering the risk
dimension alongside every strategic option? Again, it is about the conscious
simultaneous deliberation of strategy and risk, not about minimizing risk at all
cost. We must keep in mind that what in retrospect are the biggest strategic
successes in microfinance, were at decision-time often also the riskiest
Beasley & Frigo point out that successful deployments of ERM in strategic
planning seek to maximize value when setting strategic goals by finding an
optimal balance between performance objectives and related risks. 2 As
management assesses various strategic alternatives designed to reach
performance goals, it evaluates related risks across each alternative to
determine whether the potential returns are commensurate with the risks that
each alternative brings with it. It also considers how one strategic initiative
might introduce risks that are counterproductive to goals associated with
another strategy. With this information, management is in a better position to
study the resulting enterprise-wide risk profile and ensure that it remains in
line with the risk appetite and supports the overall desired strategic direction.
Mark Beasley & Mark Frigo "ERM and its Role in Strategic Planning and
Strategy Execution", p.34. In Fraser & Simkins eds., Enterprise Risk
Management. 2010.
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Unit 3: Risk Landscape and Taxonomy
Strategy risk management a fiduciary duty
Deliberation of risk must
be woven into every
strategic decision
Now consider an example of a strategic decision in microfinance. A
leading MFI in Cambodia is entertaining an offer from a bank in Singapore
to become their low-income banking front end in the Cambodian market.
The bank would provide "unlimited" senior debt funding for MSME portfolio
expansion and support joint marketing of trade finance services to small
Cambodian businesses that are importing consumer goods from China, for
example. The CEO and the Credit Manager see the proposal like a
strategic partnership made in heaven:
unlimited long-term funding at attractive rates,
less relationship management effort with various microfinance
investment vehicles just to pick up small lots of senior debt,
no real competitive threat from the partner in Singapore, because
they do not have an operating subsidiary in Cambodia.
At the next Board meeting, however, the CFO and the Risk Manager raise
the following issues:
The CFO is concerned that the MFI might neglect the relationships
with international development finance institutions and have
reduced visibility within global microfinance networks. This could cut
the institution off from grants and technical assistance that would
have helped them keep abreast of international best practices.
The Risk Manager raises the scenario that through no particular
fault of the Cambodian MFI, the bank in Singapore could lose
interest in the Cambodian market and abandon the partnership.
After all, Cambodia is but one of many small emerging markets in
the region and this partnership is a big deal to the MFI, but really
just a small experiment to the partner bank.
Essentially, the partnership could create an unfavorable strategic
dependency. If the bank abandons the arrangement, the MFI would
be hard pressed to quickly replace the funding, particularly if other
sources of long-term borrowing have been neglected. There is also
no guarantee that the bank may not price the funding less favorably
in the future, as a way to extract higher returns, once the local
partner is locked into the partnership.
The Risk Manager is also concerned that the senior managers at
the foreign bank partner really do not understand microfinance and
may have little respect for the social double-bottom line mission of
the MFI. Therefore, they may later pressure the MFI to move away
from the low-income rural markets and push into consumer lending
to more affluent urban populations.
There is also a risk that even though the bank is not present with an
operating unit in Cambodia, some of the MFI's deposit base may be
lost to off-shore accounts in Singapore. This could be the case for
the MFI's best clients whose businesses have grown into regular
SMEs with regular import-export business. If the MFI loses the lowcost deposit float from these businesses, is the overall cost of
funding under the partnership agreement still as attractive as was
first believed?
The Board decides to move ahead with the partnership nonetheless, but
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Unit 3: Risk Landscape and Taxonomy
asks the CEO to negotiate a special client protection clause into the
partnership agreement that includes a revenue sharing on any off-shore
deposits generated from the MFI client base. Separately, the CFO is
instructed to maintain active borrowing relationships with at least three
major international microfinance investors as a way to diversify the
funding base, even though the MFI does not need the incremental
liabilities at this time.
Beasley & Frigo (p. 36f) recommend scenario analysis as the most suitable
approach to assessing strategic business risk. We agree, because a
probabilistic approach to strategic risk management appears rather
pointless. Strategic decisions are singular, time limited events. These
situations are very different from stochastic experiments, where we get to
play a game many times, until we can detect a probability distribution of the
outcomes. Market risk would indeed be more like a stochastic process, but
not strategy risk. In exchange rate and interest rate risk, for example, we
can look at every business day as a new game of chance where rates might
move up, down or sideways.
Evaluating strategic risks
through scenario analysis
The famous Harvard professor Michael Porter in his book "Competitive
Advantage" (1985) defines risk as a function of how poorly a strategy
will perform if the 'wrong' scenario occurs. This perspective on strategic
business risk is very similar to the notion of a stress test. We will frequently
employ stress tests later in other contexts, where we contemplate rare but
potentially catastrophic risk events.
Risk analysis must
"stress-test" strategic
In a strategic decision situation, just like in a liquidity stress test, for example,
it is difficult to say ex ante what the percentage probability will be of the
adverse scenario occurring. But one can nonetheless plausibly imagine how
the scenario would play out, if it did occur. And it would be reasonable to
expect that the organization adopt only such strategies, for which plausible
downside scenarios would still be survivable.
This is all good and well, but you are probably beginning to tire of the
endless permutations of the risk - strategy - process trilogy. We share your
unease about wanting to conceive a winning strategy by means of the risk
management toolbox. The difference between Atari Computers and Apple
Inc. cannot be explained by better strategic risk management processes.
Exactly, how are your Netscape shares doing and where are the Palm Pilots
in the smart phone store?
In the end, it comes down to having the right people with the right vision
make bold strategic decisions at the right time. However, we should also not
pivot to the other extreme and say strategic risks cannot be managed, so
let's just blindly follow our CEO's every strategic twitch in his left toe.
The smart middle ground is in giving senior management space for bold
strategic initiatives, but to nonetheless temper them with a candid,
independent analysis of the downside scenarios, so that not everyone loses
their job on another one of the CEO's brilliant ideas. And since most
companies don't have a visionary Steve Jobs as boss, it would help to
define the strategic initiatives in a broad inclusive consultation.
© 2016 Frankfurt School of Finance & Management
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Unit 3: Risk Landscape and Taxonomy
Thus, the Risk Manager should not just analyze the downside scenarios of
the strategic alternatives proposed by senior management, but he/she
should intervene well before by ensuring that strategic initiatives are
conceived through a consultative strategic planning process. This should
improve the quality of the initiatives under consideration and will
subsequently reduce strategy execution risk, because staff feel empowered
by having contributed to the strategy definition and everyone will have a
better understanding of what they are being asked to implement.
Balanced Score Card for
inclusive financial
A frequently used tool in the strategic planning process that facilitates the
inclusive discourse about strategic initiatives and associated risks is the
balanced score card method (www.balancedscorecard.org).
The balanced scorecard (BSC) is a strategic planning and management
system that is used extensively in industry, finance and nonprofit
organizations in order to align business activities to the vision and strategy of
the organization, improve internal and external communications, and monitor
organization performance against strategic goals. It was originated by Drs.
Robert Kaplan (Harvard Business School) and David Norton as a
performance measurement framework that added strategic non-financial
performance measures to traditional financial metrics to give managers and
executives a more 'balanced' view of organizational performance.
Vision and
Business Processes
Learning & Growth
Figure 4: Balanced Score Card Framework for Financial / Social Double
Bottom-Line Organizations
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Unit 3: Risk Landscape and Taxonomy
The version of the BSC framework in Figure 4 positions the stakeholder
dimension of performance above the financial objectives of the organization.
Financial performance metrics would normally be found at the top of the goal
hierarchy in conventional for-profit organizations. This set-up of the BSC
might better reflect the mission of a MSME financial services provider, where
the economic and social development returns accruing to poor clients are at
least on par with the profit maximization objective.
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Unit 3: Risk Landscape and Taxonomy
In socially-responsible
MSME finance,
stakeholder objectives
rise to the top
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Unit 3: Risk Landscape and Taxonomy
Review Questions Unit 3
Answer the following questions using the Unit text:
What are the objectives of establishing a macro risk map?
Do you expect major differences between macro-risk maps of the
type in Figure 1 between individual SME banks and microfinance
Would you agree that the translation of the macro risk map to a
severity / probability matrix similar to Figure 2 tends to produce
identical results for a wide range of MSME finance providers across
various national markets?
Why did we call reputation and behavioral risks a "transmission
layer"? Describe what is being transmitted and how.
Give an example of a risk dimension that is generally well suited to
probabilistic analysis and explain why strategy risk is not one of
those risks.
Define the following terms:
credit transaction risk,
credit portfolio risk,
operational risk,
interest rate risk,
10. currency induced credit risk,
11. reputation risk.
Unit 3 - Exercise 1
Let's do a completeness check on the risk identification in the macro
map in Figure 1. Following are a number of risk categories or potential
loss events. Try to subsume them under the proper high-level risk
dimension in the macro map:
A branch is flooded and the server room destroyed by sewage backing
up through the basement.
Euribor interest rates jump 2%, the cost of your EUR variable rate
funding goes up. It is impossible to adjust microcredit rates in local
currency upward because of competitive pressure.
The senior imam at the mosque in one of your key urban markets
mentions microcredit as a usurious practice that is not compatible with
After a few spectacular IPOs on the Kenyan stock market, the Safaricom
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Unit 3: Risk Landscape and Taxonomy
IPO is the next big deal. Even Nairobi taxi drivers are dreaming about
getting rich quickly on the stock exchange. What might this mean for a
MFI raising passbook savings in the slums of Nairobi?
A specialized agro-finance MFI lends exclusively in the "peanut basin"
area of Senegal.
A consumer advocacy group has contacted the MFI about an error in the
interest calculation method on microloans that may have resulted in
overcharging clients relative to the disclosed cost of credit. The issue
affects about 10,000 current and previously settled loans.
Natural disaster, external event, operational risk.
Interest rate risk.
Reputation risk.
Directly transmitted behavioral risk not triggered by prior core risk loss
Case of high portfolio concentration, lack of geographic and industry
diversification, portfolio credit risk.
Legal risk, part of operational risk.
Unit 3 - Exercise 2: Effective Cost of Credit Calculations
Background on Effective Rate Calculations
EU Directive 9948/2/07 on "Credit Agreements for Consumers and repealing
Council Directive 87/102/EEC" defines the "Annual Percentage Rate of
Charge" in Annex 1 as a fully compounding internal rate of return on the loan
product cash flows from the customer perspective. This confirms the
longstanding practice in national consumer protection law in most member
The US Annual Percentage Rate (APR) as per the 1968 Truth in Lending
Act is similar but does not fully compound on a sub-annual basis. The
calculation method for US-style APR and EU-style effective rates are
otherwise identical, i.e. except for the distinction in the compounding for subannual period increments.
The contractual payment interval and interest invoicing frequency determine
the period increment for effective rate calculations. Most commonly in
retail credit, interest is invoiced and installments are collected in monthly
intervals. Hence, interest-on-interest, i.e. "compounding", occurs monthly
and effective rates should be derived for monthly period increments.
However, if interest is invoiced and installments are due on a weekly or
fortnightly basis, then it will be necessary to calculate effective rates based
on 52 or 26 sub-annual periods.
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Unit 3: Risk Landscape and Taxonomy
A calculation tool for effective rates is available at mftransparency.org.
However, we find this tool rather complicated and would recommend that you
perform effective rate calculations yourself using the principles described
here. Then you know that the result is correct and how you got there. It is
really not difficult at all.
The first step in calculating an effective rate is always to establish the
required cash flow profile of the loan product from the perspective of the
borrower: In order to get x cash in hand, how much do I have to pay back and
when? This is easy to capture in a cash flow table in Excel like this:
Period Cash Flow
Let's assume the above cash flow profile was a real loan for three months.
What is the effective annual rate? You type into Excel =RATE(3,-400,1000)
and obtain the result of 9.701%. But attention, this is the period effective rate
for a month. The equivalent annual rate, fully compounding, is found by
=(1+0.09701)^12 - 1 = 203.8% That is shocking, but it is the reality.
When interest rates are generally low, then the difference between the
correct EU-style effective rates and the US-style approximation is small.
However when rates are generally high, as in microfinance, the difference in
disclosed annual effective rates is large: A monthly effective rate of 9.701%
gives 203.8% annual EU-style and 12*9.07% = 116.4% APR US-style. For a
conventional mortgage loan, the monthly effective rate might be 0.5%,
leading to US-style disclosure of 6.0% per annum and EU-style effective of
Why is it correct to use full sub-annual compounding? Because it is the
reality of what the loan costs: An effective rate is supposed to be a unitary
index of the overall costliness of a loan that can be compared across various
different rate conventions and combinations of interest and fees. It answers
the question of how much it costs to have use of 1 dollar for one year under
this particular loan arrangement.
The 203.8% effective rate from above means that it costs 2.04 dollars to have
use of one borrowed dollar for one year. So, the example of 1,000 repayable
in three monthly installments of 400 has the same per-dollar annual cost as a
loan that gives you one dollar today and for which you pay back 3.04 dollars
principal and interest exactly one year later.
If the client in the example (1,000 for 3 months) really needed to use 1,000
for a full year, he would already have to borrow 400 again at the same rate
one month after disbursement. One month later, he would re-borrow the next
400 installment plus the interest and principal payment on the 400 taken the
previous month and so forth. If he kept rolling his debt and interest forward
such that he always has use of exactly 1,000, the client would have paid
exactly 3,038 dollars over the year. That is 2,038 in interest and the 1,000
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Unit 3: Risk Landscape and Taxonomy
principal returned on the last day.
Thus is the reality of the payday loan store customer. They keep coming
back faster and faster to re-borrow the same 500 dollars and easily end up
paying 1,000 over the year for that "service". Now, microcredit is not
necessarily all that different from a payday loan store. Most microentrepreneurs actually have a permanent need for revolving working
capital. They also have a tendency to quickly re-borrow the funds that the
MFI is pulling back in via the short-term, high-rate loan schedule. So,
"(1+monthly effective)^12 -1" is much more realistic than "monthly effective
times 12", also in microcredit.
Back to step 1: we establish the cash flow profile of the loan from the
client perspective. If there is one disbursement and a number of identical
evenly spaced repayments, we have a simple annuity and we can use
=RATE() in order to find the period effective rate.
Technically, this period effective rate is the internal rate of return which sets
equal the present value of the debt service payments to the initial
disbursement received by the client. If the loan payments are not a fixed
installment and/or are not scheduled in fixed intervals, we cannot use
=RATE(). We now must actually put the cash flows into a period-by-period
timetable and calculate the internal rate of return on this flow profile with the
Excel function =IRR(). For example, the IRR of the following profile
Cash Flow
is 2.67% per month or 37.2% per annum.
The cash-flow time table approach is also critical in order to get a handle on
various complicated interest rate and fee conventions. It is not necessarily
illegal to calculate "flat" interest versus declining balance, quote nominal
interest per month rather than per annum, or quote a low interest rate but
charge high service fees.
(For those new to microcredit: 2% per month "flat" interest over 9 months
means that the institution would charge 2% on the initially disbursed amount
every month for nine months together with 1/9 of the disbursed amount in
principal every month.)
When you are all done with the flat/declining/increasing balance
shenanigans, you have to tell the client how much she will get disbursed cash
in hand and how much she will have to pay back and when, all service fees,
document charges, interest and account maintenance included. That gives
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Unit 3: Risk Landscape and Taxonomy
you the cash flow profile, which is the only thing that really matters. The
annualized period IRR of the client cash flow profile is the proper
effective rate!
So far, easy. The tricky part in effective rate calculations is the notion of
connected services. The general rule is that any additional product or
service that the lender requires the borrower to purchase as a precondition to
receiving the loan should be added into the cash flow profile. Suppose the
lender asks that the client purchase a loan booklet for 10 dollars in order to
receive the loan. That's obvious. A loan booklet has no independent value.
The lender would never sell just a loan book without a loan. Therefore, the
loan booklet is just another fee that must be added into the cash flow profile
of the loan.
Next, think of credit life insurance. That's more difficult. If the life insurance
is provided by a captive insurance company owned by the lender, if there is
no cash benefit to the borrower and the insurance covers only the
outstanding balance, then indeed we have an interest replacement therapy
on our hands. The premium then is part of the cost of credit and must be
factored into the cash flow profile of the loan before calculating the IRR.
However, if the lender simply requires that borrowers have life insurance, and
borrowers can bring coverage certificates from another insurance company,
then the insurance is a free-standing financial contract and does not have to
be factored into the cost of credit.
Now the big deal: cash collateral or parallel compulsory savings. In
European consumer protection rules, it is made quite clear that it is
undesirable when banks lend to a consumer and then require that all or part
of the proceeds be deposited with the lender as collateral. Unless the
deposit earns the same effective rate as the loan costs, the differential
between the deposit rate earned by the customer and the rate paid for
borrowing your own money back should be included in the cost of credit.
Technically, that's easy to do, you merge the two cash flow profiles of the
loan and the required concurrent deposit into one. Then you run the IRR
across the net cash flow profile to get the effective cost of receiving the net
liquidity from the customer perspective.
We know of no MFI that actually discloses this type of consolidated effective
rate including the cost of the parallel collateral deposit to the client. Unless
everyone does it this way, it is just too unflattering to be the only one who
shows such a high cost of credit. But it is an interesting calculation
nonetheless that reminds us how expensive microcredit really can be. See
Exercise 2.6.
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Unit 3: Risk Landscape and Taxonomy
Exercise 2.1: Useful Excel Formulas for Loan Schedules
Before you get started on the effective rate calculation exercises below,
please familiarize yourself and experiment in Excel with the following financial
- Period IRR in an annuity
- Annuity payment
- Principal component in an annuity payment at period n
- Interest component in an annuity payment at period n
- Internal rate of return calculated on any equally spaced cash flow
schedule. Not limited to annuities.
=XIRR() - Internal rate of return calculated on an array of dates and
payments. Payment dates may be irregularly spaced.
For those using other language versions of Excel, we provide a table with
formula equivalents in the file FormulaEquivalents.xls.
Exercise 2.2: Annual Effective Interest Rate
USD 1,000 loan over 12 months at 100 dollars fixed monthly installment.
What is the annual effective rate?
Use a direct calculation method first and also try to get the result using a
cash flow table and the IRR function.
Solution: 41.30% p.a.
(See also attached Excel Workbook EffectiveRatesM3_Ex1.xlsx)
Exercise 2.3: Annual Effective Interest Rate
GHS 1,000 10-month loan at 36% p.a. on declining balance with linear
principal payments. What is the Annual Effective Rate?
Hint: This is not an annuity. You have to first figure out the payment
Solution: 42.58% p.a.
(See also attached Excel Workbook EffectiveRatesM3_Ex1.xls)
Exercise 2.4: Annual Effective Interest Rate
GHS 5,000 loan for 15-months, 36% p.a. nominal on declining balance with
annuity-style fixed monthly payments. Plus commission and fees worked into
the monthly payment amount. Commission: GHS 100 up front. Monthly
account maintenance: GHS 5. What is the Annual Effective Rate?
Solution: 50.02% p.a.
(See also attached Excel Workbook EffectiveRatesM3_Ex1.xlsx)
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Unit 3: Risk Landscape and Taxonomy
Exercise 2.5: Annual Effective Interest Rate
KES 100,000 loan for 26 weeks, fixed weekly interest and principal
payments. 2% per month (= 2%/4 per week) flat interest. KES 1,000
application fee withheld from loan proceeds. What is the Annual Effective
Solution: 68.26% p.a.
(See also attached Excel Workbook EffectiveRatesM3_Ex1.xlsx)
Exercise 2.6: Annual Effective Interest Rate
PGK 2,000 microloan for 9 fixed monthly installments at 3% per month flat,
15% parallel collateral savings required that pay 4% p.a., 20 PGK upfront
charge, PGK 5 monthly membership.
What is the Annual Effective Rate, if you factor in the rate differential on the
client's collateral savings?
Assume that the full principal in the collateral savings account is blocked until
the final loan installment is settled.
Solution: 133.02% p.a.
(See also attached Excel Workbook EffectiveRatesM3_Ex1.xlsx)
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Unit 3: Risk Landscape and Taxonomy