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 Risk Coverage Ratio and how it can contribute towards defining the overall quality of the portfolio.
Risk Coverage Ratio
This measure shows what percent of the Portfolio at Risk over 30 days (including all refinanced and renegotiated loans) are covered by actual loan loss reserves. It gives an indication of how prepared an institution is for a worst-case scenario (which would be if all delinquent loans defaulted).
For microfinance institutions, a general guideline for appropriate coverage is 100% of PAR30. Anything above that is considered to be a strong practice. These are much higher levels than maintained by commercial banks. To some extent, these high reserves reflect an attitude of “when in doubt, be conservative.” Microcredit portfolios are typically not backed by collateral so it is important to reserve an adequate amount to offset unrecovered loans.
The Risk Coverage Ratio must be analyzed in conjunction with PAR and the Write-Off Ratio, since all three indicators are interdependent. As the Portfolio at Risk Ratio discusses, the same PAR value can have different risk profiles. A PAR30 of 5% can be highly risky if it contains a large proportion of loans that are seriously overdue, especially past 90 days, or it can be relatively safe if loans are sure to be repaid. As for write-offs, they can reduce PAR with the stroke of a pen. To understand portfolio risk, it is essential to check whether good PAR numbers–and therefore a favorable Risk Coverage Ratio–is the result of good client screening or massive write-offs.
Risk Coverage Ratio, as defined here, is equivalent to the Provision Coverage Ratio in the traditional banking sector. The Provision Coverage Ratio is calculated by taking the total cumulative provisions for the period over the gross non-performing assets as to anticipate the risk for the portfolio.
In the next blog we will look at Efficiency & Productivity ratios and how it impacts the overall portfolio of a MFI.