ABSTRACT The main objective of microfinance institutions

ABSTRACT
The main objective of microfinance institutions (MFIs) is to provide financial services to the poor and non-bankable population. Microbanking in Isabela however remains a difficult business. Although MFIs may be flourishing in commercial terms, few are profitable. Many MFIs in Isabela face major constraints in their pursuit of effectively delivering microfinance services profitably.
Microfinance institution in third world countries are new off – springs from the banking industries whose contributions cannot be over emphasized. This stems from the fact that they have helped in alleviating the poverty menace in the third world countries such as Philippines. Most microfinance institution in spite of their contribution towards helping prospective Filipino investors in establishing their own businesses are saddled with a number of challenges, chiefly among them include: how to manage risk in their operations; and pragmatic ways of mitigating risk management in Microfinance institutions. A number of microfinance in the country has been operating outside the confinements of the laws regulating financial institutions. The researcher aimed at collecting data, both primary and secondary using research techniques and methods. It was recommended that the research findings would be used to identify risk areas in microfinance institutions as well as collaterals should worth in value more than the facilities provided by the borrowers; the findings of the research shown that most of the microfinance institutions experienced the different types of risk, credit risk, financial risk, operating risk, capital management risk, etc. The research also showed that there was a need of training and development on the part of both management and borrowers because this will affect the operational efficiency of the institution and in effect will cause the profit to decrease. It is concluded that Isabelinos have benefited from the activities of microfinance institutions.

If management in the microfinance industry understands the risks in the industry and has the tools to manage these risks, together with the understanding of the profile of the ideal client, it will enable them to ensure sustainability of their businesses as well as address the financial needs of the lower income end of the market in Philippines in the best possible way.

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CHAPTER 1
THE PROBLEM AND ITS BACKGROUND
Background
It is widely recognized that the exclusion of the poorest lenders, particularly in the rural areas, from the tradition, financial banking system is one of the main obstacles for sustainable development and poverty reduction. Indeed, it is almost impossible for rural poor people who live in riskier environments and who lack assets collateral, formal wage job and limited credit history loans to obtain credit from traditional banking system because lending to them became very risky and very costly. There is little controversy in the literature about the fact that formal financial sector has little incentives to provide financial services to poor clients. Generally and according to economic theory, the exclusion of poor people from traditional bank can be explained by the high level of asymmetric information such as adverse selection and moral hazard, which raises problems of screening, monitoring and enforcement. Excluded from formal financial institutions, poor people generally have to rely on loans from informal moneylenders, who are more likely to exploit the poor by providing loans on enormously high interest rates. To make the world a better place and to enhance international development, the United Nations Organization (UNO) announced in 2000 the millennium development goals, aimed to reduce poverty by half by the year 2015. In this regard, microfinance has recently attracted growing attention and has proven worldwide to be a promising tool to alleviate poverty. These Microfinance institutions (MFIs) have the function of providing financial services to the low-income households who have long been deemed “unbankable”, including the self-employed and customers without collateral assets. Dedicated to improving the lot of the poor in developing countries, MFIs provide to them the much needed credit loans of small amount to finance their entrepreneurship projects, to finance their consumption, to cope to illness or for the education of their children without any collateral requirement. It has been proven that microfinance programs have a great contribution in reducing poverty. More importantly, it has been proven that Microfinance can be viewed as a development strategy tool by enabling poor entrepreneurs to initiate their own business, teaching them how to protect the capital they have, to deal with risk, and to expand the circle of their economic activities. Availability of a microcredit schemes increases the number of small enterprises, which in turn creates employment opportunities for the poorest and stimulates therefore economic development and social inclusion. Apart from their social mission success, MFIs have appeared to be a potentially viable and profitable business and have unregistered a well-known success of some third-world programs in generating impressive repayment rates. Achieving self-sustainability means that the MFI should be self-sufficient, be able to cover all its present costs and make profits on services that they offer. In order to become a permanent and to maximize their sustainability, MFIs must apply high interest rate, largely higher than market rates. This can be at expense of social aims, because high interest rate can exclude poor people particularly those living in rural or marginal areas. These dual objectives in serving poor clients with relatively small loans and achieving self- sustainability even profit represent one of the most widely discussed dilemmas among microfinance academics and practitioners. To face such a dilemma, it is vital for MFI stability to find the best practice, improve the efficiency of their portfolio risk management as well as apply accurate pricing policy, which allow for finding a better equilibrium between sustainability and outreach.

In business, the only constant is change. In a world of change, successful businesses and financial institutions have learned that it is wise to be prepared for unexpected events, in other words, to manage risk. While risk management has been a part of business planning for large businesses and financial institutions for some time, it is a fairly new discipline among microfinance institutions (MFIs). This new focus is the result of recent crises and experiences and represents a new understanding of the importance of anticipating unexpected events, rather than merely reacting to them. In the wake of recent tragedies, MFIs around the world have had to cope with an array of financial, political, and weather-related crises, and MFI managers have learned the importance of risk management. For example, typhoon in Batanes, floods in Metro Manila, and war in the Mindanao and have had devastating effects on the microfinance industries in those places. Whatever the emergency or the place, the effects are the same: higher costs, liquidity problems, and loss of assets. MFIs with risk management plans in place before the emergency are more likely to survive, remain stable, continue serving their clients, and even prosper.

Risk taking is an inherent element and integral part of financial services in general and of microfinance in particular and, indeed, profits are in part the reward for successful risk taking in business. On the other hand, excessive and poorly managed risk can lead to losses and thus endanger the safety and soundness of microfinance institutions and safety of microfinance institution’s depositors. Consequently, microfinance institutions may fail to meet its social and financial objectives. This implies that proactive risk management is essential to the long term sustainability of microfinance institutions (MFI). Therefore, it is believed that effective risk management allows MFIs to capitalize on new opportunities and to minimize threats to their financial viability. Microfinance institutions consciously take risk as they perform their role of financial intermediation in the economy. Consequently, they are exposed to a spectrum of risks, which include credit risk, interest rate risk, liquidity risk, and capital management risk. Managing these risks is essential for their survival and profitability. Rather than focusing on current or historical financial and operational performance management and regulators now focus on an organization’s ability to identify and manage future risks as best predictor of long term success of financial institutions.

The goal of Risk Management is to measure and manage risks across a diverse range of activities used in financial sectors. Risk can be defined as a hazard, a chance of bad consequences, loss or exposure to mischance. Risk is an integral part of financial services. When financial institutions issue loans, there is a risk of borrower Defaul Zumbach, G., (2006). When banks collect deposits and lend them to other clients, they put clients’ savings at risk. Any institution that conducts cash transactions or makes investments risks the loss of those funds. Development finance institutions should neither avoid risk (thus limiting their scope and impact) nor ignore risk. Like all financial institutions, microfinance institutions (MFIs) face risks that they must manage efficiently and effectively to be successful. According to Tay, A., Wallis, K., 2007, if the MFI does not manage its risks well, it will likely fail to meet its social and financial objectives. When poorly managed risks begin to result in financial losses, donors, investors, lenders, borrowers and savers tend to lose confidence in the organization and funds begin to dry up. When funds dry up, an MFI is not able to meet its social objective of providing services to the poor and quickly goes out of business.
Managing risk is a complex task for any financial organization, and increasingly important in a world where economic events and financial systems are linked. Global financial institutions and banking regulators have emphasized risk management as an essential element of long-term success, Perignon, C., Smith, D., (2010). Rather than focusing on current or historical financial performance, management and regulators now focus on an organization’s ability to identify and manage future risks as the best predictor of long-term success. For the micro-financial institutions, effective risk management has several benefits; 1) Early warning system for potential problems: A systematic process for evaluating and measuring risk identifies problems early on, before they become larger problems or drain management time and resources. Less time fixing problems means more time for production and growth; 2) More efficient resource allocation (capital and cash): A good risk management framework allows management to quantitatively measure risk and fine-tune capital allocation and liquidity needs to match the on and off balance sheet risks faced by the institution, and to evaluate the impact of potential shocks to the financial system or institution. Effective treasury management becomes more important as MFIs seek to maximize earnings from their investment portfolios while minimizing the risk of loss; and 3) Better information on potential consequences, both positive and negative: A proactive and forward- thinking organizational culture will help managers identify and assess new market opportunities, foster continuous improvement of existing operations, and more effectively align performance incentives with the organization’s strategic goals.

For MFIs, better internal risk management yields similar benefits. As MFIs continue to grow and expand rapidly, serving more customers and attracting more mainstream investment capital and funds, they need to strengthen their internal capacity to identify and anticipate potential risks to avoid unexpected losses and surprises, Tay, A., Wallis, K., (2007). Creating a risk management framework and culture within an MFI is the next step after mastering the fundamentals of individual risks, such as credit risk, operational risk, financial risk, and liquidity risk. Further, more clarity about the roles and responsibilities of managers and board members in risk management helps build stronger institutions. A comprehensive approach to risk management reduces the risk of loss, builds credibility in the marketplace, and creates new opportunities for growth.

Risk and return are two interdependent aspects in the activity of a company, so the question is assuming a certain level of risk to achieve the profitability that it allows. Return can only be assessed but on the basis of supported risk. This risk affects economic asset returns first, and secondly of capital invested. Therefore it can be addressed both in terms of business, as the organizer of the production process driven by intention to increase property owners and adequate remuneration of production factors and the position of outside financial investors, interested in carrying the best investment, in financial market conditions with several areas of return and different risk levels.

Risk assessment should consider managing change: people change, methods change, the risk change (Morariu, A., Crecan?, C., D., (2009). Consequently, profitability is subject to the general condition of risk where the organization operates. Risk takes many forms, each affecting the agents’ economic activity on a lesser or greater extent. For economic and financial analysis at the micro level presents a particular interest those forms of risk that can be influenced, in the sense of reduction, through the actions and measures the economic agents can undergo.
Statement of the problem
Small, medium and even large MFIs find it difficult to minimize business risk, manage risk, to predict the outcome of credit transactions and the impact to the profitability of the institution. This may probably be due to the volatility of its client base, the unknown factors in terms of client profile and the lack of corporate risk tools. Especially the smaller and medium size role players find it difficult to manage business and credit risk cost effectively in a pro-active manner. This may lead to the departure of these role players from the industry, the over indebtedness of the microfinance client base and non-sustainable business operations.
Business risk in this study will consist of the following main industry risks:
The risk of micro loans being written off due to the lack of repayments;
The risks regarding rapid growth of an MFI;
Risks relating to debtor management systems in the MFI environment; and
Cash flow risks for MFIs.
This study is conducted to know the impact of risk management on the profitability of microfinance institution in Isabela. The study would like to find the answers to the following specifications:
How is risk management related to the following factors:
Age
Gender
Status
Period of employment
Size of the institution (i.e. number of employees, Capital)
What are the most threatening risks for microfinance businesses today?
What are appropriate risk tools to manage the highly risk microfinance industry?
What predicting equation can be used to minimize the risks involved in MFI?
What are the risks involved in the institution?
How these risks affect the profitability of the institution?
Does managing risks requires high level of confidence?
Objectives of the study
The general objective of the study is to determine the impact of risk management on profitability of microfinance institutions in Isabela.

The specific objectives are to:
Identify the relationship between the risk management and the following factors:
Age
Gender
Status
Period of employment
Size of the institution (number of employees, Capital)
Specify the most threatening risks for microfinance businesses today.

Define appropriate risk tools to manage the highly risk microfinance industry.

Come up with predicting equation that can be used to minimize the risks involved in MFI?
Evaluate the risk involved in MFIs?
Assess if those risks affect the profitability of the institution.

Determine if managing risks require high level of education.

1.4IMPORTANCE AND BENEFITS OF THE STUDY
From a theoretical perspective, the study gives access to a theoretical framework to assist in managing and minimizing business risk for microfinance business in a cost efficient way. The study will determine the probability of predicting if a microfinance client will perform well or if the client will default. It will also serve as a basis for further research on the microfinance industry and related risks.
From a practical perspective, the study is useful to owners, directors and managers of MFIs to manage the whole process of risk in a cost efficient and economically effective way. The study will also supply potential investors with the knowledge to better understand the potentially high risk environment and clear some misperceptions regarding the industry.
This study covers explanations regarding the assumptions made and discusses the limitations to the proposed study. It also includes a list of definitions and key terms and provides a literature review that is relevant to risks for microfinance enterprises. The research design and methods are also explained.
CHAPTER 2
Hypothesis of the study
There is a significant relationship between risk management and profitability of microfinance institution in Isabela. Their relationship is direct. This means that well – managed risks will result to a high level of profitability of MFIs. Vice versa, poorly managed risks will cause a low level of profitability.

CHAPTER 3
Definition of terms
Microfinance
Microfinance is the provision of a range of financial services to the lower income section of the population who do not meet the requirements to gain traditional finance (Shastri, 2009:136). Traditional finance refers to financial products from banks.
Microfinance is the supply of loans and saving services to the poor (Schreiner, 2002:591). Saving services are subject to the fact that the entity possesses a banking license.
It can also be defined as money lending on a small scale to consumers for starting a small business, paying for student fees, burial payments, buying building supplies, buying furniture, clothing and other necessities (Kasbergen, 2009:2).

Risk
Risk relates to the probability that a problem will occur or that there is uncertainty on objectives (Cendrowski and Mair, 2009:9). A problem refers to a different outcome in relation to the wanted outcome. There is a direct correlation between uncertainty and the level of risk.
Risk management
Risk management deals with the identification, assessment and determination of various strategies that help mitigate the adverse effects of risk on the organization. Management uses risk management as a strategic tool to mitigate the loss of property and increase the success chance of the organization.

Financial risk management. The process of financial risk management can be defined as minimizing exposure of a firm to market risk and credit risk using various financial instruments. Financial risk managers also deal with other risks related to foreign exchange, liquidity, inflation, non-payment of clients and increased rate of interest. These risks affect the financial position of the enterprise.
Credit Risk management. Managing credit risk is one of the fundamental work of the financial institution. Credit portfolio management is largely becoming essential for the enterprise to keep track of risk. It Deals with the risk related to the probability of nonpayment from the debtors.

Capital management risk. It is a strategic framework that checks the potential risks that have adverse impacts over the capital. These risks could be in terms of risk related to resources (capital) that will be used to run the operations, pay the obligations (current and non- current), etc.

Liquidity risk management refers to managing risk that an entity meets in difficulties in procuring the necessary funds to meet commitments related to financial instruments. Liquidity risk may result from the inability to quickly sell a financial asset at a value close to its fair value.

Interest rate risk is the risk that future cash flows will fluctuate because of changes in market interest rates. For example, if a variable rate debt instruments, such fluctuations are to change the effective interest rate financial instrument, without a corresponding change in its fair value.

Profitability
It is the ability of the business to generate profit. It measures the ability of institution to generate profit in relation to sales, investments, assets, equities, or share capital.

CHAPTER 4
Review of related literature
The purpose of this literature review is to synthesize and contextualize information. It will also provide a basis for later recommendations in this study. The aim of the study is to combine and analyze different risks in the microfinance environment in order to create a framework which can assist in the effective management of these risks. In order to do this, it is important to identify the main aspects of the research. This section will also provide an overview of the context for the proposed study.
4.1Microfinance Institution
The dual mission of a MFI is to serve the poor and to be financially sustainable (Mersland, 2009:2). The fundamental products and services of MFIs are investing, lending and insurance. These are well established financial topics, even though they have not received enough attention in financial journals (Brau, 2004:1).

Micro lending is a combination of the terms micro and lend, each meaning the following:
Micro – Extremely small in scale or capability;
Lend – To give temporarily or allow having for a limited time (Van Heerden, 2008:17).
This subsequently means disbursing relatively small loans and other financial products that will be repaid over an agreed period of time (Van Heerden, 2008:17).
MFIs focus on giving lower income people access to financial products. The different role players in Isabela vary in size from small single branch institutions to massive entities with banking licences. According to Brau (2004:11) all these MFIs in have the following aspects in common:
They service the same lower income end of the market;
Their main stock item is money;
They want to be profitable and sustainable in the future;
They have the urge to grow and expand;
They are all regulated by the same act; and
They all have an appetite for relatively high risk.
The most common products that these entities sell include:
Personal loans;
Enterprise development loans;
Housing loans;
Cell phone products and airtime;
Insurance products (including life, household, motor and personal insurance);
Funeral cover;
Study loans and
Investments and savings (Capitec, 2010).
Microfinance, according to Otero (1999) is “the provision of financial services to low-income poor and very poor self-employed people”. These financial services according to Ledgerwood (1999) generally include savings and credit but can also include other financial services such as insurance and payment services. Schreiner and Colombet (2001) define microfinance as “the attempt to improve access to small deposits and small loans for poor households neglected by banks.” Therefore, microfinance involves the provision of financial services such as savings, loans and insurance to poor people living in both urban and rural settings who are unable to obtain such services from the formal financial sector.

Microfinance and its impact in development
Microfinance has a very important role to play in development according to proponents of microfinance. UNCDF (2004) states that studies have shown that microfinance plays three key roles in development. It:
? helps very poor households meet basic needs and protects against risks,
? is associated with improvements in household economic welfare,
? helps to empower women by supporting women’s economic participation and so promotes gender equity.

Otero (1999) illustrates the various ways in which “microfinance, at its core combats poverty”. She states that microfinance creates access to productive capital for the poor, which together with human capital, addressed through education and training, and social capital, achieved through local organisation building, enables people to move out of poverty (1999). By providing material capital to a poor person, their sense of dignity is strengthened and this can help to empower the person to participate in the economy and society (Otero, 1999).
The aim of microfinance according to Otero (1999) is not just about providing capital to the poor to combat poverty on an individual level, it also has a role at an institutional level. It seeks to create institutions that deliver financial services to the poor, who are continuously ignored by the formal banking sector. Littlefield and Rosenberg (2004) state that the poor are generally excluded from the financial services sector of the economy so MFIs have emerged to address this market failure. By addressing this gap in the market in a financially sustainable manner, an MFI can become part of the formal financial system of a country and so can access capital markets to fund their lending portfolios, allowing them to dramatically increase the number of poor people they can reach (Otero, 1999).
Wright (2000) states that much of the scepticism of MFIs stems from the argument that microfinance projects “fail to reach the poorest, generally have a limited effect on income…drive women into greater dependence on their husbands and fail to provide additional services desperately needed by the poor”. In addition, Wright says that many development practitioners not only find microfinance inadequate, but that it actually diverts funding from “more pressing or important interventions” such as health and education (2000). As argued by Navajas et al (2000), there is a danger that microfinance may siphon funds from other projects that might help the poor more. They state that governments and donors should know whether the poor gain more from microfinance, than from more health care or food aid for example. Therefore, there is a need for all involved in microfinance and development to ascertain what exactly has been the impact of microfinance in combating poverty.

The impact of microfinance on poverty
There is a certain amount of debate about whether impact assessment of microfinance projects is necessary or not according to Simanowitz (2001). The argument is that if the market can provide adequate proxies for impact, showing that clients are happy to pay for a service, assessments are a waste of resources. However, this is too simplistic a rationale as market proxies mask the range of client responses and benefits to the MFI. Therefore, impact assessment of microfinance interventions is necessary, not just to demonstrate to donors that their interventions are having a positive impact, but to allow for learning within MFIs so that they can improve their services and the impact of their projects (Simanowitz, 2001).
Poverty is more than just a lack of income. Wright (1999) highlights the shortcomings of focusing solely on increased income as a measure of the impact of microfinance on poverty. He states that there is a significant difference between increasing income and reducing poverty (1999). He argues that by increasing the income of the poor, MFIs are not necessarily reducing poverty. It depends what the poor do with this money, oftentimes it is gambled away or spent on alcohol (1999), so focusing solely on increasing incomes is not enough. The focus needs to be on helping the poor to “sustain a specified level of well-being” (Wright, 1999) by offering them a variety of financial services tailored to their needs so that their net wealth and income security can be improved.
It is commonly asserted that MFIs are not reaching the poorest in society. However, despite some commentators’ scepticism of the impact of microfinance on poverty, studies have shown that microfinance has been successful in many situations. According to Littlefield, Murduch and Hashemi (2003) “various studies…document increases in income and assets, and decreases in vulnerability of microfinance clients”. They refer to projects in India, Indonesia, Zimbabwe, Bangladesh and Uganda which all show very positive impacts of microfinance in reducing poverty. For instance, a report on a SHARE project in India showed that three-quarters of clients saw “significant improvements in their economic well-being and that half of the clients graduated out of poverty” (2003). Dichter (1999) states that microfinance is a tool for poverty reduction and while arguing that the record of MFIs in microfinance is “generally well below expectation” he does concede that some positive impacts do take place. From a study of a number of MFIs he states that findings show that consumption smoothing effects, signs of redistribution of wealth and influence within the household are the most common impact of MFI programmes (ibid.).
Hulme and Mosley (1996) in a comprehensive study on the use of microfinance to combat poverty, argue that well-designed programmes can improve the incomes of the poor and can move them out of poverty. They state that “there is clear evidence that the impact of a loan on a borrower’s income is related to the level of income” as those with higher incomes have a greater range of investment opportunities and so credit schemes are more likely to benefit the “middle and upper poor” (1996). However, they also show that when MFIs such as the Grameen Bank and BRAC provided credit to very poor households, those households were able to raise their incomes and their assets (1996).
Social impact analysis
Traditionally, the impact of microfinance projects was assessed by the changes in the income or well-being of the clients. Mansell-Carstens, cited in Rogaly (1996) argues that such a focus is flawed because respondents may give false information. It is also very difficult to ascertain all the sources of income of a client, so a causal effect is difficult to establish, and it is also difficult to establish what would have happened if the loan was not given. Therefore a broader analysis is needed that takes more than economic impact into consideration.
We have seen that poverty and livelihood security consist of economic and social conditions, therefore, when analysing the impact of microfinance, social impact must be assessed. Kabeer (2003) states that wider social impact assessment is important for an organisation’s internal learning process, as an MFI should be aware of the “full range of changes associated with its efforts and uses these to improve its performance”. She considers social impact to relate to human capital such as nutrition, health and education, as well as social networks (2003). Impact must be assessed on each of these issues if a true picture of the impact of microfinance is to be obtained.
However, Kabeer moves beyond individual or household analysis to state that analysis should also be conducted at community, market/economy and national/state levels (2003). She refers to these as “domains of impact” because societies are comprised of different institutional domains each with their own rules, norms and practices which can be influenced by microfinance interventions in different ways (2003). Kabeer (2003) not only refers to domains of impact but also highlights dimensions of change that should be assessed. She lists cognitive change, behavioural change, material change, relational change and institutional change as dimensions of change that need to be taken into account if the wider effects of microfinance interventions are to be understood.

Zohir and Matin (2004) make a similar point when they state that the impact of microfinance interventions is being under-estimated by “conventional impact studies which do not take into account the possible positive externalities on spheres beyond households”. They propose that impact should be examined from cultural, economic, social and political domains at individual, enterprise and household levels (2004).
McGregor et al. (2000) states that wider social and economic impacts can occur through the labour market, the capital market, the market for goods consumed by poor people, through production linkages and through clients’ participation in social and political processes.
Chowdhury, Mosley and Simanowitz (2004) argue that if microfinance is to fulfil its social objectives of bringing financial services to the poor it is important to know the extent to which its wider impacts contribute to poverty reduction. In the following sections I will examine the findings from wider assessments of microfinance interventions at a household and community level, to show what learning can be gained when impact assessments have a broad scope of analysis.

Risk Management
There are various kinds of risk and the risk management deals with their timely identification, assessment and proper handling. The types of risk management differ on the basis of the nature of operations of a particular organization and other factors like its overall goals and performance. All these types of financial risk management processes and risk management reports play a significant role behind the growth of an organization in the long run.

Commercial enterprises apply various forms of risk management procedures to handle different risks because they face a variety of risks while carrying out their business operations. Effective handling of risk ensures the successful growth of an organization.

Every business face credit risk as it exists whenever payment or performance to a contractual agreement by another entity is expected. Credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms (Safakli, 2007). It is also perceived to be the current and prospective risk to earnings or capital arising from an obligor’s failure to meet the terms of any contract with the Bank or otherwise to perform as agreed. It is found in all activities in which success depends on counterparty, issuer, or borrower performance. It arises any time bank funds are extended, committed, invested, or otherwise exposed through actual or implied contractual agreements, whether reflected on or off the balance sheet (BIS 2009).
In particular, banking sector generally have considerable credit exposure due to their prominence on lending and trading. Traditionally, credit risk is associated with lending, investing, and credit granting activities and concerns the return of borrowed money. However, a great source of credit risk in banks arises from the performance of counterparties in contractual agreements e.g. given a financial obligation, which is not fully discharged, either due to the counterparty disability to fulfil his or her obligations which may result in a loss (Horcher 2005).
Ranjan and Dhal (2003) lectured that horizon of development of credit, better credit culture, positive macroeconomic and business conditions lead to lowering of Non-performing Loans (NPLs). The nonperforming loans of banks are an important criterion to assess the financial health of banking sector. It reflects the asset worth, credit risk and competence in the allocation of resources to the productive sectors.
Financial risk management is the quality control of finance. It is a broad term used for different senses for different businesses or things but basically it involves identification, analyzing, and taking measures to reduce or eliminate the exposures to loss by an organization or individual. Various authors including Stulz (1984), Smith et al (1990) and Froot et al (1993) have offered reasons why managers should concern themselves with the active management of risks in their organizations. The main aim of management of banks is to maximise expected profits taking into account its variability/volatility (financial risk).
Financial risk management is pursued because MFIs want to avoid low profits which force them to seek external investment opportunities. When this happens, it results in suboptimal investments and hence lower shareholders’ value since the cost of such external finance is higher than the internal funds due to capital market imperfections. The following risks are involved in financial structure of the company:
Credit Risk; the analysis of the financial soundness of borrowers has been at the core of banking activity since its inception. This analysis refers to what nowadays is known as credit risk, that is, the risk that counterparty fails to perform an obligation owed to its creditor. It is still a major concern for banks, but the scope of credit risk has been immensely enlarged with the growth of derivatives markets. Another definition considers credit risk as the cost of replacing cash flow when the counterpart defaults. Greuning and Bratanovic (2009) define credit risk as the chance that a debtor or issuer of a financial instrument whether an individual, a company, or a country will not repay principal and other investment-related cash flows according to the terms specified in a credit agreement. Inherent to banking, credit risk means that payments may be delayed or not made at all, which can cause cash flow problems and affect a bank’s liquidity.

Capital Management Risk; Capital requirement is of great importance and these set the guide lines for the financial institutions. It is internationally accepted that a financial institutions should have capital that could cover the difference between expected losses over some time horizon and worst case losses over the same time horizon. Here the worst case loss is the loss that should not be expected to exceed with the some high degree of confidence. This higher degree of confidence might be 99% or 99.9%.The reason behind this idea is that expected losses are normally covered by the way a financial institution prices its products. For instance, the interest charged by a bank is designed to recover expected loan losses. The firm wants to be flexible and at the same time lower the costs for financing .The period of loans is significant in joining with the assets, which are funded with the loan. Here, often a disparity between the durations can be detected. Long-term assets are then funded with short-term and regulating rate loans, leading to a shortfall in cash flows in times of rising interest rates. This element again can lead to an inferior ranking of the company and inferior conditions to get future problems regarding follow-up financing over the rest of the lifetime of the asset can occur. Vice versa long-term financing of short-term assets might lead to access financing when the asset is no longer existing. This causes of needless interest payments for the company (Vickery, 2006).
Liquidity Risk; According to Greuning and Bratanovic (2009), a bank faces liquidity risk when it does not have the ability to efficiently accommodate the redemption of deposits and other liabilities and to cover funding increases in the loan and investment portfolio. These authors go further to propose that a bank has adequate liquidity potential when it can obtain needed funds (by increasing liabilities, securitising, or selling assets) promptly and at a reasonable cost. The Basel Committee on Bank Supervision consultative paper (June 2008) asserts that the fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole, (Greuning and Bratanovic, 2009).

Interest rate risk is the exposure of microfinance institutions financial condition to adverse movements in interest rates. Accepting this risk is a normal part of microfinance institutions business and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose a significant threat to microfinance institutions’ earnings and capital base. Changes in interest rates affect microfinance institutions’ earnings by changing their net interest income and the level of other interest-sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the microfinance institutions’ assets, liabilities and off-balance sheet instruments because the present value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change.

The Assessment of Risks
The recent financial crisis in 2008/ 2009 has proven that risk management practices are essential for small to large institutions and with Basel II the banking sector is advocating change in risk management policies. Effective risk management must be implemented in order to reduce fraud, stock losses and reduce overall company risk (De Andrade and Thomas, 2007:1577).
According to Cendrowski and Mair (2009:4), there are five steps in the risk assessment process, namely the enumeration of risks, qualitative analysis, and quantitative analysis, implementation of a risk management strategy and the assessment of the risk management strategy.
In order to complete a risk assessment one needs sound information to base one’s assessment on. This information should take on a strong future perspective and not only consist of historic information.
Risk Tools for Microfinance
According to Cendrowski and Mair (2009:11), risk management strategy consists of the following:
Risk identification
This is the process of gathering information in order to identify possible risks. The end result of this process will be a list of potential risks of various problems.
Risk evaluation
In this phase, the consequences of each risk on the list should be determined especially for the different stakeholders, namely customers, suppliers, employees, directors, shareholders and so forth. Once this has been done, the current control measures in place to mitigate these risks should be evaluated. Risk evaluation can be seen from the two perspectives of probability and magnitude. Probability refers to the risk that something will go wrong and magnitude to the extent of damage if something goes wrong.
Risk mitigation
After risks with their consequences have been identified and controls have been evaluated, a risk mitigation strategy should be implemented. This strategy will focus on risks that seem intolerable to the microfinance institution. This process might involve revising current controls, the implementation of new controls or the removal of factors that cause these risks. This section will therefore focus on decreasing the probability that an event occurs and the magnitude thereof if it occurs. If risk tools manage to combine the aspects of probability and magnitude, risks will be minimized effectively.
Profitability Theories
Profitability consists of two words profit and ability. It is necessary to differentiate between the term Profit and profitability at this point. The term Profit from accounting point of view, is arrived at by deducting from total revenue of an enterprise all amount expended in earning that income while the term Profitability is defined as the ability of a given investment to earn a return from its use. The predictions on Profitability are ambiguous. The trade-off theory predicts that profitable firms should be more highly levered to offset corporate taxes Ross (1977). Titman and Wessels (1988) and Fama and French (2002) on the other hand, found profits and Leverage to be negatively correlated. The theories discussed below will explain Profitability
Pecking Order Theory; Donaldson (1961) followed by Myers (1984) suggests that management followed a preference ordering when it comes to financing. His work suggests that the costs of issuing risky debt or equity overwhelm the forces that determine optimal leverage in the trade-off model, the result is the pecking order. This Pecking Order Theory suits large firms with high P and which has enough internal funds in the form of retained earnings and depreciation. These firms follow a stringent dividend policy and a target dividend pay-out ratio. Thus, this theory states that highly profitable firms prefer internal funds and when external funds are required the firm will borrow, rather than issuing entity.

Free cash flow theory; this theory is also framed for matured firms that are prone to over invest. It says that high debt levels will increase value, despite the threat of financial distress, when a firm’s operating cash flow significantly exceeds its profitable investment opportunities Myers (2001). Thus, the profit earning capacity increases the value of the firm despite the threat of financial distress. Firms with a positive free cash flow use this cash flow to lower their debt ratio. Firms with a negative free cash flow increase their debt ratio to respond to the lack of internal funds. The percentage adjustment is smaller for firms with relatively more debt than for firms with relatively low debt.

CHAPTER 5
Conceptual framework
Conceptualization therefore is the idea of inventing or contriving a notion or explanation and formulating it mentally. The figure 1 illustrates a conceptual framework for this study which formed the basis for the literature review.

342900340995Credit Risk
00Credit Risk
Independent Variables Dependent Variables
26765262114550016954502108200
352425316230Capital Management Risk
00Capital Management Risk

169545023177403448050281940Profitability of Microfinance Institutions
00Profitability of Microfinance Institutions

268605124574500352425272415Liquidity Risk
00Liquidity Risk

168592514160500
361950287655Operational
Risk
00Operational
Risk

17049751841500
CHAPTER 6
RESEARCH DESIGN AND METHODS
This chapter presents the research methods, sampling techniques, research instruments and statistical treatment of data employed in the study. This study is based on primary and secondary data. Primary data has been collected from respondents particularly head of microfinance institution by filling up the survey questionnaire. Secondary data for the purpose of the study included information ad reviewed from facts gathered through internet, research studies and from textbooks.

Data Gathering and Research Instruments
Data Collection
Valid and reliable data was collected through questionnaires. The questionnaires consisted of a list of themes and questions to be covered (Saunders et al., 2007:354). The questionnaires were prepared in an experienced, well organized manner and were used to collect primary data which was collected by the researcher.
It is of extreme importance to prepare well and approach the respondents professionally. As the different companies will not want to share any confidential information or trade secrets, the themes and questions must be formulated carefully to not offend the respondents. Possible obstacles in the collection of data for this proposed study may be:
Companies who do not wish to participate due to lack of interest, lack of time and/ or who are scared to answer questions about microfinance risks with an outside person;
Respondents that are not the correct designated persons to answer the questions;
To ask the correct questions in order to retrieve specific answers to the research questions.

The research instrument used was self-administered survey questionnaire distributed to target respondents randomly. The data was collected through the respondents by filling up the questionnaire which included their general information.

Data Analysis
The answers to the questionnaires were stored electronically on a laptop and backed up on an external hard drive. Data needs to be analysed to develop theory from it (Saunders et al., 2007:470). The data was carefully evaluated and organised to ensure the completeness and accuracy of the responses.
The data was categorised in units of data. The categories were grouped according to similarities and differences of the different sized micro lender. Content analysis was used as a method to analyse the data. The key responses in the interviews were identified to form the themes of the study. The similarities and differences in the various responses was analysed and used to develop themes. The quantitative client credit information was analysed by using statistical functions from the Microsoft Excel computer program.
Respondents of the Study
The respondents of the study are the head of microfinance institution (MFIs) in Isabela.

Sample Selection
The researcher specifically used the non – probability which is the purposive method of sampling technique because it gives the researcher the opportunity to purposely choose respondent who in his opinion are thought to be relevant to the research topic. Respondents will be the head or managers of microfinance institution, who in the researcher’s view had enough privy about the topic.

CHAPTER 7
RESEARCH FINDINGS
This chapter presents the research findings of the study relating to the risk management of microfinance institutions in Isabela. The findings are based on the responses of 55 respondents of different micro enterprise categories.
The first part will give an overview of the profile in terms of the respondents. The 55 employees are financially, operationally and risk related senior employees of entities.
Profile of the respondents and respondents entities
The profiles of the respondents are described in terms of age, gender, status, period of employment, size of the MFI at the specific institution.
Figure 1. Ages of the respondents.

Almost half or 49% of the respondents ranged from 31 – 40 years old, this means that this is the average age of the head of microfinance institutions and they are the one who will lead to face the risks involved in the institution. 29% of it aged from 41 – 50 years old; 13% were 21 – 30 years old and 9% were 51 years and older.

Figure 2. Gender of the respondents.

From the analysis 38% were male and 62% were female. Female who are dominant get pregnant or frustrated from their families can expose such institution to serious risk which is dangerous to the institutions’ profitability.

Figure 3. Status of the respondents.

It was shown in the figure that 40% of the respondents were single. It was an advantage of institution since single individuals tend to focus on their work and can finished jobs effectively and effectively. 38% of the respondents were married; 16% were separated and 5% of it were widow/er.

Figure 4. Period of employment (years).

Based on the above figure, 49% of the respondents were employed in the microfinance institution for 21 – 30 years. Being on an institution for 21 – 30 years is a long period to master the institution’s operational process. This means that these individuals were already expert in taking risks and they know how to solve credit risk, financial risk, operational risk, capital management and other type of risk.
Figure 5.1. Size of the MFI (number of employees).

The most number of respondents answered that they have size of 21 – 30 employees. Number of employees in an institution has a direct relationship with managing risks. This means that the higher number of employees will require a higher degree of risk management, vice versa, lower number of employees require a lesser degree of risk management.

Figure 5.1. Size of the MFI (Capital).

Most of the MFI or 40% of it owned above P7,000,000 capital . Same is through with number of employees, the amount of capital has also direct relationship with managing risks. This means that the high amount of capital will require a higher degree of risk management, vice versa, low amount of capital require a lesser degree of risk management.

Is institutional risk common to your institution?
Figure 6.

About eighty seven percent (87%) of the respondents view that the institutional risk is common in the organization while thirteen percent (13%) answered that it was not so common to the organization. The respondent agreed that the social mission should be segregated from commercial mission.

Is management aware of financial risk in your organization?
Figure 7.

Fifty five (55) respondents representing 100% were aware of financial risk in their organization but were challenge on how to mitigate the exposure.

Does your institution recognize the need to avert credit risk?
Figure 8

One hundred percent (100%) of the respondents responded that there is a need to avert credit risk but the organization sanctions loans without critical assessments of the clients.

Does capital management risk affect MFI’s profitability?
Figure 9.

One hundred percent (100%) of the respondents agreed that the capital management affect MFIs’ profitability, like working capital management, asset management, etc. so that there will be available funds to pay for the maturing obligations, expenditures and unexpected costs that they will encounter.

Does delay of service delivery to borrowers cause a decline in profit margin of MFIs?
Figure 10.

One hundred percent (100%) answered that delay in service delivery affects the borrowing ability of the clients, hence, decline in profit. Due to this delay, they will transfer to another loan provider that can give the proceeds of their loan easy and hassle – free.

Does the idea of multiple borrowing have effect on the profit of MFIs?
Figure 11.

From the research, seventy percent (75%) strongly agreed that multiple borrowing has effect on the profit of the institution whilst twenty five percent (25%) disagree that borrowing has effect on profit of the institution if and only if the institution has means to mitigate exposure.

Do lack of training and education on the part of both management and borrowers have the tendency to decline MFI’s profit?
Figure 12.

Fifty five (55) respondents representing 100% of the research agreed that lack of training and education on the part of management and the borrowers have a greater tendency to decline profit. One factor of employees’ development is to send them to training and seminars so that they will earn competency and confidence to do the responsibilities given to them. As well, the borrowers must possess knowledge about the lending process and the sanctions in case of non – payment or late payment so that they will be efficient to pay their respective loans. Therefore, managing funds is not easy and it needs rich pool of experience management.

Do borrowers often misuse credit facilities provided by MFI?
Figure 13.

Eighty percent (80%) of the respondents answered that borrowers often misuse credit facilities provided while twenty percent (20%) disagreed that obligors or borrowers often use the credit facilities prudently. This means that borrowers tend to use the money for things other than for things where that money should be use or the purpose for borrowing the money is not realized.

The risks involved in Microfinance institution.

Figure 14.

It was found that credit risk, capital management risk, liquidity risk, operational risk and other risks include interest rate risk are the major risks that are vulnerable to microfinance institution, in which the credit risk is common to all MFIs.

It was apparent that delay in service delivery to borrowers decline profit, the idea of multiple borrowing has tendency to reduce the profit of MFIs, and as well as lack of training and education on the part of both management and borrowers have adverse effect on profit. It was also revealed that, thorough critical assessment and confirmation of clients, checking clients’ credit history, through interviews or background investigation as a means of tracking multiple borrowings of obligors are lacking on the part of some microfinance institutions. The research discovered that the most of microfinance institution are dependent on earning interest income from the loan to borrowers, in which they limit their reliance on a single revenue generation. Buying money market securities, capital market securities and investment diversification are some ways to avoid single revenue generation and tendency to increase the profit. The study presented that provision of credit by MFI has increase productivity in business, this is because majority of loan recipient used the loan received to start up a business or for expansion. It is found that some successful clients are affected (reduction of loanable amount) because some customers misuse the credit facilities for what it is intended to be use and defaulted in repayment of loans. In addition to those risk discussed, it was also found that, most of the workers and managers were young and lack of experience that lead to human errors and fraud caused by these employees. Lastly, some MFI do not accept collaterals or accept collaterals which is lesser of value than the amount of credit facilities given to them.

chapter 8
summary, Conclusion and recommendation
The microfinance industry has come a long way to be the regulated industry that it is today. By effectively managing risks in this industry, good business models can be built and sustained, while the lower income end of the market is serviced with much needed financial products. By doing this the microfinance industry is relieving poverty, creating opportunities and help to build the economy.

The conclusion drawn from the entire study is that, the broad objectives of the research which sought risk management and its impact on the profitability of microfinance institution in Isabela was achieved, it was revealed that through the loans and other benefits which the microfinance gave; productivity in small – scale industries registered an increment. The various objectives were achieved in the study from the outcomes of contents, with reference to some of the analysis from charts as well as in answering the research questions. First, microfinance institutions used the following strategies to fight the delay in service delivery which turns to decrease profitability; a) Just – in – time delivery of services; b) quick processing of documents; c) quick confirmation of information provided during clients’ assessment; and d) trained and well – educated staff to carry out various task. Second, risk management is beneficial to microfinance because it makes the organization proactive and ready to put strategic plans anytime risks arise in order to mitigate great losses on profitability rather checking default rate. Lastly, adequate information was sometimes not taken from borrowers; know your customer norm was also not applicable. This however, put the microfinance institution at a risky position as well as adversely affecting profitability.

A combination of risk tools need to be applied effectively in order to reduce material risks, predict good customer payments and to optimise client behaviour. Microfinance risks in Isabela are therefore manageable with a combination of the risk tools and the best combination will ensure that the profit will increase.

List of references
Agamata, Franklin T., Management Advisory Services, 2009 ed.

BRAU, J.C. & WOLLER, G.M. 2004. Microfinance Institutions: A comprehensive review of the existing literature and an outline for future financial research. Provo. Brigham Young University.

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Chowdhury, P. (2007). Group-lending with sequential financing, contingent renewal and social capital, Journal of Development Economics, 84:487-506.

DE ANDRADE, F.W.M., THOMAS, L. 2007. Structural models in consumer credit. European Journal of Operational Research. Vol. 183. p 1569-1581.
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APPENDICES
SURVEY QUESTIONNAIRE
IMPACT OF RISK MANAGEMENT ON THE PROFITABILITY OF MICROFINANCE INSTITUTION IN ISABELA
PART I: SOCIO-ECONAMIC PROFILE:
A.PROFILE OF THE RESPONDENTS:
NAME: (Optional) _______________________________________________________
AGE: ( ) 21 – 30( ) 31 – 40( ) 41 – 50( ) 51 and older
GENDER: ( ) Male( ) Female
STATUS: ( ) Single( ) Married( ) Separated ( ) Widow /er
Period of employment (years): ( ) 1 – 10( ) 11 – 20( ) 21 – 30 ( ) 31 and above
Size of the MFI:
Number of Employees: ( ) 11 – 20( ) 21 – 30( ) 31 – 40( ) 41 – 50 ( ) 51 and above
Capital: ( ) P1,000,000 and below( ) P1,000,001 – P3,000,000
( ) P3,000,001 – P5,000,000( ) P5,000,001 – P7,000,000
( ) above P7,000,000
B. Is institutional risk common to your institution?
Yes ( )No ( )
C. Is management aware of financial risk in your organization?
Yes ( )No ( )
D. Does your institution recognize the need to avoid credit risk?
Yes ( )No ( )
E. Does capital management risk affect MFI’s profitability?
Yes ( )No ( )
F. Does delay of in service delivery to borrowers cause a decline in profit margin of MFIs?
Yes ( )No ( )
G. Does the idea of multiple borrowing have effect on the profit of MFIs?
Yes ( )No ( )
H. Do lack of training and education on the part of both management and borrowers have the tendency to decline MFI’s profit?
Yes ( )No ( )
I. Do borrowers often misuse credit facilities provided by MFI?
Yes ( )No ( )
J. What are the risks involved in your institution? (On the space provided, you can check more than one risk that involve in your institution?
____ Credit risk
_____Capital Management Risk
_____Liquidity Risk
_____Operational risk
_____Others: Please specify ___________________________
K. of the risks stated above, what is the most threatening risks for MFIs today?
____ Credit risk
_____Capital Management Risk
_____Liquidity Risk
_____Interest rate risk
_____Others: Please specify ___________________________
410527512700
CURRICULUM VITAE
FLER L. MADAYAG

Home Address : Annafunan, Echague, Isabela
Contact Number : +639168909623
Email Address :

PERSONAL DATA
[email protected]
Gender : Male
Date of Birth : March 18,1991
Place of Birth : Annafunan, Echague, Isabela
Civil Status : Single
Religion : Roman Catholic
Citizenship : Filipino

EDUCATIONAL BACKGROUND

Tertiary: MASTER IN BUSINESS ADMINISTRATION
ISABELA STATE UNIVERSITY
San Fabian, Echague, Isabela
On – going
(Finished Academic Requirements)

BACHELOR OF SCIENCE IN ACCOUNTANCY
ISABELA STATE UNIVERSITY
San Fabian, Echague, Isabela
June 2007 to April 2011

Secondary: UGAD HIGH SCHOOL
Sto. Domingo, Echague, Isabela
June 2003 to April 2007
Graduated First Honorable Mention

Elementary: ANNAFUNAN ELEMENTARY SCHOOL
Annafunan, Echague, Isabela
Graduated Second Honorable Mention

WORK EXPERIENCE:
Instructor I
Isabela State University
Echague, Isabela
Accounting Assistant
Global City Car Lease and Transport Corporation
July 2012 to February 2014
SEMINARS, WORKSHOPS AND TRAININGS ATTENDED:

Regional Summit of Marketing, Entrepreneur and Business Administration for ASEAN Economic Integration
February 25, 2015
International Bookkeeping Seminar
September 19, 2014
Regional Governance Forum on Public Sector Reforms and Innovations
August 22, 2014

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