Identifying Risk Exposure

Although hard currency loans may appear to be a relatively cost-effective and an easy source of funding to MFIs operating in local currency, they also create foreign exchange exposure by creating a currency mismatch. Currency mismatches occur when an MFI holds assets (such as microloans) denominated in the local currency of the MFI's country of operation but has hard currency loans, usually U.S. dollars (USD) or euros (EUR), financing its balance sheet.

Currency mismatch creates a situation where an unexpected depreciation of the currency can dramatically increase the cost of debt service relative to revenues. Ultimately, this can:

• leave the MFI with a loss of earnings and of capital,
• render the MFI less creditworthy and force it to hold higher levels of capital relative to its loan portfolio,
• reduce ROE,
• limit the MFI’s ability to raise new funding.

Currency risk is typically aggravated when additional risks are added:

• Interest rate risk: When borrowing in foreign/hard currency is indexed to a reference rate (such as Libor for the Dollar and Euribor for the Euro) resulting in exposure to movements in interest rates as well as foreign exchange rates.
• Convertibility risk: The risk that the national government will not sell foreign currency to borrowers or others with obligations denominated in hard currency.
• Transfer risk: The risk that the national government will not allow foreign currency to leave the country regardless of its source.
• Credit Risk: MFIs in many cases seek to avoid currency mismatch by on-lending to their micro-entrepreneur clients in hard currency so as to match the assets and liabilities on their balance sheets. Setting aside the morally questionable practice of passing risk down to the most vulnerable link in the value chain, this approach in many cases simply hides the risk rather than eliminating it. In the event of a devaluation, the MFI is likely to have the currency risk it passed on come back in the form of higher repayment risk, attendant defaults and a weakening of its credit portfolio.

Since MFIs operate in developing countries where the risk of currency depreciation is highest, they are particularly vulnerable to foreign exchange rate risk. Convertibility and transfer risks, although less common, also are import factors to consider. Data on credit deterioration in the event of devaluation is rather scant but will likely be more severe in the future as leverage increases.

Also See Quantifying Risk - Managing Risk