Jan-Hendrik Boerse

Foreign Exchange and Disaster Risk

Management in Microfinance

Institutions

2008

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"We should be managing risks instead of managing crises!"1

Dr. Aberra Deressa,

Minister for Agriculture and Rural Development of Ethiopia

1 Rojers, P.J. (2007) quoted after Dr. Aberra Deressa

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TABLE OF CONTENT

TABLE OF CONTENT

TABLE OF FIGURES

TABLE OF ABBREVIATIONS

1

INTRODUCTION

- 1 -

1.1

ECONOMICS OF MICROFINANCE INSTITUTIONS

- 1 -

1.2

OVERVIEW ABOUT THE FOLLOWING CHAPTERS

- 4 -

2

RISK IDENTIFICATION AND ASSESSMENT

- 5 -

2.1

OVERALL RISK MAPPING IN MFIS

- 5 -

2.2

ANALYSIS OF DISASTER-RELATED RISKS

- 7 -

2.2.1 INTRODUCTION TO DISASTER RISKS

- 7 -

2.2.2 DISASTER-RELATED RISK MAP

- 9 -

2.2.3 ASSESSMENT OF DISASTER-RELATED RISKS

- 10 -

2.3

ANALYSIS OF FX-RELATED RISKS

- 13 -

2.3.1 INTRODUCTION TO FX RISK

- 13 -

2.3.2 FX-RELATED RISK MAP

- 14 -

2.3.3 ASSESSMENT OF THE RISKS IDENTIFIED

- 15 -

2.3.4 EXCHANGE RATE SYSTEMS AND DOLLARIZATION

- 17 -

2.4

MOST COMMON TREATMENT FOR FX AND DISASTER RISK

- 19 -

3

DISASTER RISK MANAGEMENT

- 21 -

3.1

INSTITUTIONAL DISASTER PREPAREDNESS

- 21 -

3.2

TRIGGER CONCEPTS AND PREREQUISITES FOR THE RISK TRANSFER

- 23 -

3.3

EVALUATION OF EXISTING FINANCIAL INSTRUMENTS

- 26 -

3.3.1 CATASTROPHE BONDS

- 26 -

3.3.2 WEATHER DERIVATIVES

- 27 -

3.3.3 CONTINGENT CAPITAL / CONTINGENT CREDIT

- 31 -

3.4

TACKLING DISASTER RISK ON HIGHER OR LOWER LEVELS

- 32 -

3.4.1 DISASTER-MICROINSURANCE

- 32 -

3.4.2 DISASTER LOAN FUNDS

- 35 -

3.4.3 PUBLIC-PRIVATE-PARTNERSHIPS

- 36 -

4

FOREIGN EXCHANGE RISK MANAGEMENT

- 40 -

4.1

SUSTAINABLE RISK ACCEPTANCE

- 40 -

4.2

RISK AVOIDANCE STRATEGIES

- 41 -

4.3

RISK MITIGATION STRATEGIES

- 43 -

4.3.1 CURRENT PRACTICES: OPERATIONAL HEDGES

- 43 -

4.3.2 EVALUATION OF FINANCIAL INSTRUMENTS

- 47 -

4.4

INNOVATIVE CONCEPTS

- 51 -

5

CONCLUSION

- 55 -

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TABLE OF CONTENT

APPENDIX I

Value at Risk ZAR-USD 5-year analysis

APPENDIX II

Degrees of Dollarization (1996 ­ 2001)

APPENDIX III

Memo Trueb, J., August 19, 2007

APPENDIX IV

Overview about FX risk management strategies

APPENDIX V

Memo Zuidberg, J., September 19, 2007

BIBLIOGRAPHY

A) Non digital sources

B) Digital sources

TABLE OF INTERVIEWS

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TABLE OF ABBREVIATIONS

TABLE OF FIGURES

Figure 1:

Average loan size / GNI per capita

Source:

Microfinance Information Exchange, Inc. (MIX), based on

the 2005 Benchmarking

Page:

2

Figure 2:

Breakdown of specialised MFIs

Source:

Meehan, J. (2004), p.3 (modified)

Page:

3

Figure 3:

MFI Risk Map

Source: self-provided

Page:

5

Figure 4:

Great Natural Catastrophes 1950-2003

Source:

http://www.ourworldfoundation.org.uk (05.08.2007)

Page:

7

Figure 5:

Indian Climatic Disaster Risk Map

Source: http://commons.wikimedia.org (05.08.2007)

Page:

9

Figure 6:

Hazard modeling (left) and Loss estimation (right)

Source:

N.p., World Bank (2006), pp.36-37

Page:

10

Figure 7:

Liquidity flow during a disaster

Source: self-provided

Page:

11

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TABLE OF ABBREVIATIONS

Figure 8:

Liquidity needs distribution

Source:

N.p., World Bank (2006), p.37 (modified)

Page:

11

Figure 9:

Value at Risk of the South-African Rand

Source: self-provided

Data :

http://www.oanda.com/convert/fxhistory (03.08.2007)

Page:

14

Figure 10:

Payout calculation for multiple hazard events

Source:

N.p., World Bank (2006), p.42

Page:

27

Figure 11:

Application ranges

Source:

N.p., USAID-OAS (1999), Relationship of Return Period to

Annual Probability Distribution of Extreme Wind (modified)

Page:

34

Figure 12:

Layering instruments

Source:

Self-provided on the basis of:

N.p., World Bank (2006), p.37

Page:

35

Figure 13:

Cost of debt with diversified local currency funding

Source:

Zuidberg, J. (2007), p.6

Page:

48

Figure 14:

Overview about FX risk management strategies

Source:

self-provided

Page:

APPENDIX IV

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TABLE OF ABBREVIATIONS

TABLE OF ABBREVIATIONS

ART

Alternative Risk Transfer

CAT Catastrophe

CBOT

Chicago Board of Trade

CCRIF

Caribbean Catastrophe Risk Insurance Facility

CGAP

Consultative Group to Assist the Poor

CME

Chicago Mercantile Exchange

Cp. Compare

DLF

Disaster Loan Fund

e.g. for

example

(lat.: exempli gratia)

ECA

Eastern Europe and Central Asia

et al.

and others

(lat.: et altera)

EUR Euro

FAQ

Frequently asked questions

FLDG

first-loss default guarantee

FMO

Nederlandse Financierings-Maatschappij voor

Ontwikkelingslanden N.V.

FX Foreign

exchange

GNI

Gross National Income

GOLF

Guaranteed Offshore Liquidity Facility

IFC

International Finance Corporation

ISDA

The International Swaps and Derivatives Association

L/C

Letter of Credit

LAC

Latin America and the Caribbean

LIBOR

London Interbank Offered Rate

MBP

Microenterprise Best Pracices

MENA

Middle East and North Africa

MFI Microfinance

Institution

MIGA

Multilateral Investment Guarantee Agency

Mil million

MIX Microfinance

Information Exchange, Inc.

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TABLE OF ABBREVIATIONS

MXP Mexican

Peso

n.d. no

date

N.p. No

publisher

NDF Non-Deliverable

Forward

NGO Non-Governmental

Organisation

No. Number

OFDA

Office of U.S. Foreign Disaster Assistance

OTC Over-the-counter

p. page

PAR

Portfolio at Risk

pp. pages

PPP Public-private-partnership

SBLC

Standby letter of credit

SPV

Special Purpose Vehicle

TCIP

Turkish Catastrophe Insurance Pool

TCX

The Currency Exchange Fund

U.S. United

States

U.S.A. United

States of America

UNCDF

United Nations Capital Development Fund

USAID

U.S. Agency for International Development

USAID-OAS

U.S. Agency for International Development -

Organisation of American States

USD

US Dollar ($)

VAM

Vulnerability Analysis and Mapping

VAR Value-at-risk

WFP

World Food Programme

WWB

Women′s World Banking

yr year

ZAR South-African

Rand

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Introduction

1 Introduction

1.1 Economics of Microfinance Institutions

Microfinance institutions (MFIs) have been largely regarded as

instruments of donor associations for the altruistic distribution of money

in developing countries. In fact MFIs are commercial lending institutions

to be found all over the world ­ in developing and developed countries

likewise ­ that have partly been co-financed by donors as their business

model supports some charitable goals like the reduction of poverty.

Since MFIs become more and more profitable and their portfolio sizes

as well as their numbers of borrowers are growing by up to more than

50% annually, MFIs increasingly seek for additional commercial funding

sources ­ both locally and internationally.2 This increasingly enforces

their self-responsibility for economical sustainability including a

prudential treatment of existing and emerging risks.

The basic principle in credit risk management is that a loan has to be

secured by collateral. This initiates a vicious circle that has often been

interpreted as "the more you got the more you get" with the

consequence that people who got nothing at all will not get any start-up

capital to change this state. When Muhammad Yunus, the Nobel Peace

Prize laureate of 2006, founded the first microfinance institution in 1976

in Bangladesh, his idea was to overcome this basic rule in banking with

a leap of faith that initiated ongoing client relationships.

Today there are around 10,000 MFIs providing micro-loans to poor

people and small enterprises reaching repayment rates up to 100%.3

The global loan portfolio is estimated 7 billion US-Dollar (USD) in

outstanding loans, serving around 13 million clients, and generating

repayment rates of 97% in average. Since loans were formerly provided

to potential micro-entrepreneurs to set up small businesses, they

created assets broadening the demand for additional services. To date

2 Cp. Coppoolse, M. (2007), p.2

3 Cp. in the following N.p., UNCDF (2007)

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