Investors looking to put their money into microfinance face the daunting task of determining which institutions are most suitable for their investment objectives. Unlike traditional investments, there are few benchmarks and little commentary on the best-performing microfinance institutions (MFIs). A lack of transparency on the risk, financial and social performance, and management of MFIs presents a significant barrier for investors.
In this blog we will look at Impairment Expense Ratio and how it can contribute towards defining the overall quality of the portfolio.
Impairment Expense Ratio
This measure gives an indication of the expense incurred by the institution from anticipated loan losses for the period proportional with the size of the loan portfolio. An improvement in overall portfolio quality can reflect a decrease in the Impairment Expense Ratio. For regulated MFIs, local banking and tax laws will prescribe the minimum rate at which they must maintain their loan loss reserves. Unregulated MFIs, on the other hand, follow a wide variety of provision expense practices, including making no provisions at all (this is rare), provisioning a certain percentage of new loans, or linking provisions to portfolio quality.
The level of impairment (provision) expenses must be analyzed together with the Risk Coverage Ratio (see the following indicator, Risk Coverage Ratio) to determine the MFI’s estimate for loan losses and what they actually incurred. If loan loss reserves on the balance sheet fall relative to the Portfolio at Risk, then impairment expenses are probably too low. Impairment expense is proportional to the risk profile of borrowers. Best practices suggest calculating provisions based on the number of days in arrears of each loan.
The Impairment Expense Ratio is commonly referred to as the Provision Expense Ratio or Provision for Credit Losses within the traditional banking sector. This ratio is important as it affects working capital and is monitored closely by regulators.
In the next blog we will look at Risk Coverage Ratio and how it impacts the overall portfolio of a MFI.