Introduction of the CAMELS method for risk management
Capital adequacy: This measures the financial soundness thereby giving the investors, a glimpse of the overall financial position of the MFI. This determines whether the company’s existing capital funds have the potential to absorb the expected risks and the losses. This aspect measures as to whether the MFI is financially sound and whether it has the necessary funds in the form of equity and reserves to offset the risks as mentioned above. Financial solvency portrays the image of the Institution in the eyes of the investor. The investor is not concerned about the risks the Institution faces. She/he is only interested in the amount of returns generated by the institution in the form of dividends. That is the reason why many companies strive to have an acceptable level of capital adequacy. In recent times, the MFIs who had a low capital adequacy faced huge losses during the event of demonetization. Hence, it is very crucial for the Institutions to have sufficient amount of capital to insulate themselves from any macro-economic changes. That is the reason why after the crisis which happened in Andhra Pradesh in the year 2010, RBI has laid down a strict regulatory framework and has made it mandatory for all the MFIs to have a minimum capital adequacy of 15 percent. It is a must for any financial institution to maintain adequate levels of capital which are in proportion to the risks faced. Capital adequacy of an MFI can be assessed through the following indicators:Leverage: This is defined as the relationship between the existing capital to the risk weighted assets of an MFI. This is also called as Capital Adequacy Ratio (CAR) or Capital Risk to Assets Ratio (CRAR). The existing or equity capital comprises of two components which are Tier I Equity and Tier II Equity. Tier I Equity is the amount of funds that are available on a permanent basis and that which can be easily raised in the market CITATION Inv181 l 16393 (Investopedia, 2018). The MFI need not stop functioning as the equity has the potential to absorb the losses. The items include paid up chare capital, share premium, statutory and revenue and other disclosed free reserves. On the other hand, Tier II Equity is that which is used when the business operations are being wound up. Once the funds from Tier I Equity are exhausted, the Tier II Equity absorbs the losses. The items in this include the revaluation reserves, investment reserves, general provisions and loss reserves. Another component is the Risk Weighted Assets. These are generally the assets or off balance sheet exposures of an MFI which are given weights according to the amount of risk carried by them. Typically for an MFI, the assets are the loan advances done to the clients, the net fixed assets, cash holdings, etc. So, Risk Weighted Assets are calculated as follows: 100 percent on Loan Portfolio, 50 percent on the Net Fixed assets and zero percent on the cash holdings. In most of the times, this particular ratio will be published in the annual reports of the MFI. The higher the CAR, the stronger is the MFI although a very high CAR depicts that the MFI is very conservative in its approach and that it has not utilized its capital to its fullest potential. The next indicator is the ability to raise equity. Fund raising has till date primarily been through donor grants, subsidies from the government, debt capital, etc. It has also been argued that such traditional sources may restrict an MFI to utilize its full potential. These also create some barriers in the form of slow growth rates, huge operational fund shortages which leads to a longer break-even period. The period of demonetization which had a very negative toll on the functioning of the MFI, had a very devastating effect on the ability of the MFIs to raise funds. But after about 2 years of this event, MFIs have again firmly established themselves on their feet and are positive to raise equity. CITATION Atm18 l 16393 (Ray, 2018). This is a qualitative assessment done to evaluate the ease with which the MFI is able to raise funds in times of need from the capital market. The final indicator is the adequacy of reserves maintained by the MFI. This projects the amount of reserve funds held by the company as a conservative policy as against any unexpected downturns in the sector or any unexpected losses. This is coherent with the capital adequacy ratio which was mentioned earlier. So, if the MFI has a higher CAR, it implies that the reserve funds maintained by the company is adequate for covering any sudden changes. The next indicator is the debt ratio which determines the amount of debt funds which the company has issued as against its total assets. A low debt ratio is considered as an ideal state wherein the company’s assets are not burdened by the high usage of debt. Having a high debt ratio puts the MFI on the verge of default risk.
Asset Quality:The overall condition of the bank is determined by the asset quality. Being a very critical indicator, it needs lot of scrutiny from the MFI’s perspective. Also referred to as Loan quality, it comprises of all the loans and advances made by the MFI to its clients. Since loans are classified as assets in the balance sheet, they carry a huge amount of risk. Delinquencies in repayment, non- repayment, default, etc. all these affect the asset quality. Poor asset quality in the form of non-performing loans and advances slows down the overall economic activity CITATION DeB12 l 1033 (De Bock, 2012). Asset quality is also implicative of the inherent credit risk faced by the MFI. A study done by the Federal Deposit Insurance Corporation places a lot of importance towards the evaluation and rating of asset quality and assessing the MFI through the following aspects such as the administration of assets, diversification towards other geographical areas, the internal and external factors, the concentration of assets in different states, tie up with information systems and internal controls, etc. Two factors namely the portfolio quality and the credit administration program is considered as one of the pivotal factors affecting the overall asset quality. The analysis of assets is basically divided into three components: the portfolio quality, portfolio classification and that if fixed assets. Under the portfolio risk assesses the portfolio of the company. Portfolio is divided into classes which is PAR;30, PAR;60 and PAR;90. The PAR;90 means that the loans are not going to be paid by the clients and that it has become a bad debt. Productivity of long term fixed assets form the quality of the portfolio. The turnover of these fixed assets may act as a major analytical factor in case of the fixed assets. The policies for the company’s infrastructure, which is the final qualitative indicator indicates whether the loans have met the needs of the customer as well as the clients.
Management: This is yet another important parameter of the CAMEL model. Management refers to situations in which the personnel of the company come together for achieving business goals and objectives. Management consists of the daily operations of the MFI integrated with functions such as planning for a goal with the existing amount of resources, organizing the existing amount of workforce to the plan, motivating the workforce by leading them towards the goal and taking effective control by setting appropriate standards. With the ever changing dynamism persisting in the environment, the role of management becomes extremely critical as it requires management to use the existing resources in a very efficient way. The board of directors and management rating is based on the capability and performance for the following things such as the mission and vision statement of the MFI and its coherence with the social objectives, the risk response and its management by the board, adequate internal policies and procedures set up and its conformance to them, timely assessment of the risks and the effectiveness by the management information systems, the succession policies of the management and its depth, the overall willingness to serve the financial requirements of the society and finally the overall performance and its risk profile. CITATION Har16 l 1033 (Hardin, 2016). The indicators for assessing the efficiency of management are as follows: Active clients per staff member which depicts how many clients on an average are assigned to a staff member, the number of clients who are assigned to a staff member, portfolio to assets which measures the overall return on the portfolio generated through the assets employed, the amount of cost borne by the MFI per client, the average loans disbursed by the MFI on a y-o-y basis, the percentage of loans disbursed on cashless basis, the average portfolio per loan officer, the number of clients served through a single branch, the average portfolio in a branch, the amount of revenues generated through a loan officer.
Earnings: This refers to a MFIs after tax profits. Quality earnings are very crucial for an MFI because this determines the long term performance of the company. It is also an assessment as to how much is the firm’s earnings controllable, consistent and reliable given the dynamic changes in the environment. An investor primarily looks out for how much of earnings, returns and turnover has the company successfully achieved. Based on these indicators, he/she will decide as to whether the company is really sustainable with respect to its growth, profits, etc. and invest in thereby. Not only that, the investor compares the earnings and profit levels with the competitors and then makes the decision. The indicators used for assessing the earnings of the MFI are as follows: Portfolio Yield which shows how much or income is generated by the Gross Loan Portfolio and the amount of interest charged to the borrowers. This ratio indicated the Gross Loan Portfolio’s ability to generate cash from interest, fees and commissions charged CITATION LAN15 l 16393 (Eric, 2015). The next indicator is that of the net interest margin. This is the difference between the average interest charged to the clients and that of the average cost of borrowing. This measures how successful a company is in terms of investment of funds as compared to its expenses. A positive value of the NIM denotes that the MFI has effectively invested its funds whereas a negative value denotes that the funds are not invested properly and that there hasn’t been effective planning done before investing. The investment can be of any time horizon and the place of investment is generally decided by the board. Next is the return on average assets which measures the amount of return generated for every one rupee of asset invested. This ratio depicts whether the assets are efficient in their functioning. Next is the Financial Cost Ratio and the Administrative Cost Ratio which portrays the. These two depict the amount of costs incurred over the sales generated.
Liquidity: This means how quickly is the MFI able to purchase or sell any asset or security without causing any changes in the market price of the asset or security. This is a very crucial aspect which shows how efficiently the MFI meets its financial obligations. This also reveals how much of the short term obligations are met by the long term sources of funds. Liquidity indicators are the current ratio which describes how much of the current liabilities are backed up by current assets. The ideal ratio is 2:1. A ratio which is lower than this depicts a short term liquidity crunch in the near future. Having a low liquidity ratio can hamper the MFI overall performance and affect its profits. The next indicator is the cash ratio. This is quite similar to that of the current ratio. This reveals how much of the cash and marketable securities of the MFI are as against the current liabilities. MFI face liquidity issues and they are in this constant race of making sure that they have effective asset liability management, proper liquidity management controls and adequate compliance with them.
Sensitivity to Market changes: Microfinance as an industry is quite sensitive to dynamic market changes. Changes in the macroeconomic conditions and other volatilities affects this sector the first and the hardest. The reason is that India as a nation is still developing and a large proportion of the population still forms the bottom of the pyramid. These unbanked individuals have only these Non- Banking Financial Corporations and Microfinance Institutions to bank upon for their accessibility to finance for their livelihood. So any unexpected changes in the market first hits the bottom of the pyramid thereby affecting the Microfinance Institutions on a larger scale. The recent political events of Demonetization and Goods and Services Tax (GST) have had a very drastic impact on the functioning of the MFIs. Although this issue of market changes was elaborated with respect to a political scenario, events such as changes in the Interest rates, exchange rates, etc. have had their share of impact on the industry.