By Rob Kaanen, WSBI/Mastercard Foundation Scale2Save programme
Surviving the liquidity crunch
The COVID-19 pandemic is hitting financial service providers and has an immediate impact on their liquidity management. Cash and cash-like assets help to ensure survival of financial services providers in a liquidity crisis situation, as was pointed out in a previous essay by e-MFP’s Daniel Rozas posted on this website.
Liquidity stress felt by FSPs can come from a surge in deposit withdrawals by customers, continuing operational expenses and maturing debt obligations. At the same time, loan repayments and new deposit inflows will be largely “frozen”. The impact of reduced liquidity is acutely felt by microfinance institutions as they typically do not have access to emergency liquidity funding from the Central Bank, as they are not licensed nor regulated to operate as commercial banks.
The impact analysis of COVID-19 related liquidity stress on microfinance institutions worldwide using the historical data collected via MIX Market and published as part of this liquidity series contributes in a significant way to the discussion on how to best address the liquidity crisis and ensure continuity of viable MFIs. The liquidity run-off analysis and stress test-based approach presented in the article are in line with international standards, for example as issued by the Basel Committee on Banking Supervision for banks through the Principles for Sound Liquidity Risk Management and Supervision (2008, revised in 2019).
Under the liquidity coverage approach introduced as part of the Basel III framework revisions a financial institution should hold a sufficient level of unencumbered, high-quality liquid assets that can be converted to cash to meet the liquidity needs during a time period under a liquidity stress scenario. For internationally active banks, the survival period has been defined as 30 calendar days, by which time it is assumed that appropriate corrective actions can be taken by management and supervisors, or that the bank can be resolved in an orderly way. As MFIs lack direct access to much-sought Central Bank funding, longer survival periods may be more appropriate for actions to be taken that ensure business continuity of the institution. A three to six-month time horizon used in the earlier essay therefore seems to be an appropriate time horizon for liquidity risk analysis of MFIs.
Scale2 Save programme
Scale2Save is a partnership between WSBI and Mastercard Foundation to establish the viability of small-scale savings in six African countries with 11 project partners. The six-year programme aims for 1 million more people banked in those countries through FSP partnerships using innovative models.
The programme sought to evaluate the impact of the COVID-19 crisis on the financial soundness of its partner institutions and assess the implications for the programme. A comparative analysis was performed by benchmarking the liquidity position of the partner institutions in relation to the MIX Market peer group analysis.
Liquidity regulatory ratios for deposit taking MFIs
Prior to benchmarking some of our partner FIs in the context of the MIX Market peer group, we completed a soundness check against the liquidity ratios and indicators used by regulators as part of their prudential supervision of MFIs. Deposit taking MFIs are typically supervised by the Central Bank in their country of operation and are required to report liquidity ratios on a monthly basis. A lack of compliance with these liquidity ratios would already present challenges to the continuity of the MFI in the best of times.
Regulators used a variety of different liquidity prudential ratios. The figure below compares the partner countries in the West African Monetary Union, Nigeria and Uganda:
These “stock-based” balance sheet liquidity ratios have shortcomings in that they may not fully reflect liquidity risk emanating from a specific stress scenario such as the COVID-19 crisis. A dynamic approach using an appropriate COVID-19 stress test scenario and liquidity coverage metrics, as used in the peer group analysis, provides a much-improved perspective on the liquidity risk profile of the FI under the current COVID-19 circumstances.
Liquidity risk profile of our partner financial institutions
Using the latest available financial data, we have compared our partner FIs against the MIX Market peer group analysis presented in the essay published on this site. As our partner MFIs are all deposit taking with deposits / assets greater than 10%, the following metrics prove relevant (All MFIs are based in countries in Sub-Saharan Africa and belong to the larger institution category, with assets > USD 25 million):
The Cash Deposit Ratio: (Cash minus 3-month operating expenses) / deposits
The Cash Debt Ratio: (Cash minus 3-month operating expenses less 10% of deposits) / debt.
We observed a variation in liquidity metrics across our partner institutions where the majority of Scale2Save partner MFIs can cover three months of operating expenses and meet at least 20% of customer deposits. This would put the institutions in the top half of the deposit-taking MFI peer group (N=356), where they are able to meet the 10% of deposit outflows that they may experience as a result of withdrawals by customers in a liquidity stress scenario.
In terms of the ability of our partner MFI to meet maturing debt repayments, we observe quite a large spread, with most in the 50% to 100% debt coverage bracket, which would mean they could comfortably meet the quarter of all debt that is, on average, due in the next six months, where the average maturity of debt from foreign investors to FSPs is 22 months. Those partner institutions that do not meet the 25% maturing debt coverage criteria are obviously of concern and their debt repayment profile warrants further investigation and careful attention.
Quality of cash matters
The quality of liquid assets forms an important assumption in the liquidity run-off analysis. Cash and cash equivalents should be of high-quality, readily available, or that can be easily converted into cash to meet liquidity outflows under the COVID-19 stress scenario.
We undertook a further analysis of the cash and cash equivalents on the balance sheets of our partner institutions. Not surprisingly, we found that 60% to 90% of liquid assets are held in the form of current accounts and term deposits at other domestic financial institutions, usually at a range of different commercial banks. The exception is Nigeria, where MFIs are required to hold between 5% and 10% of deposit liabilities in the form of Treasury bills, and therefore the share of bank deposits in liquid assets gravitate to the lower end of the range.
Having a noticeably large proportion of liquidity held at other financial institutions presents a risk when these institutions themselves encounter liquidity issues and the MFI may not be able to access its funds. Liquidity problems in the banking sector could therefore spill over into the MFI sector. This presents possibly an area where Central Banks could take targeted measures to ensure that liquidity withdrawals by MFI at their banks be honoured in a timely fashion.
The benchmarking analysis provided the programme with a very useful comparison and assessment of the relative position of our partner institutions in the context of a worldwide MFI peer group. In a fast-evolving situation such as the COVID-19 crisis, timely information on the liquidity position will be of the essence. MFIs are encouraged to use the standardized Crisis Assessment Tool (CAT) developed by the MIV coordination group to provide their investors and international cooperation partners up-to-date information on the impact COVID-19 has had on their operations and financial position.
Rob Kaanen is a consultant with the WSBI/Mastercard Foundation Scale2Save programme