Financial Crisis Glossary – a Guide to the Buzzwords of the Crisis

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Nov 2008
Washington DC, United States , November, 05 2008 - Every day there's a new word entering the lexicon--some of it well established terminology from accounting and economics, some of it the creative buzz of a crisis, and the rest just plain jargon. Here we take a look at some of the most common terms affecting microfinance.

Credit Crisis or Credit Crunch

A credit crisis, or credit crunch, is a sudden reduction in the general availability of loans (or credit), or a sudden increase in the cost of obtaining loans from banks. As a result of an increased perception of risk, microfinance institutions may find the costs of loans increasing.

In March, the New York Times provided a simple explanation of how the housing crisis rippled out to become a much broader credit crisis.

Counter-cyclical

Conventional wisdom is that microfinance is counter-cyclical and moves in the opposite direction to the overall economy. Statistical evidence from Adrian Gonzalez published in MicroBanking Bulletin shows that microfinance institutions tend to be less vulnerable to economic downturns. But the idea that microfinance institutions are less prone to suffer from international macroeconomic events than institutions in the developed world may well come unstuck in this crisis. Few people are predicting that microfinance will come through unscathed (in contrast, for example, to the Asian financial crisis of 1997).

It seems reasonable to think that there may be a link between the degree of integration and the exposure microfinance has to the formal financial sector's woes. What's clear is that the impact will vary from country to country and that institutions could suffer from a liquidity crisis.

De-coupling

China and the world's other large emerging markets were until recently widely considered to be immune to the travails of the economic superpowers. Until, that is, the fallout began. One lesson we've surely learned from this crisis is that global economies are deeply intertwined. And if there's one myth that's been destroyed it's the idea of de-coupling. Though their overnments have accumulated vast quantities of foreign-exchange reserves, stock markets have plunged in emerging economies, such as China, South Africa, and Brazil, and many currencies have fallen sharply.

Insolvency

Insolvency is inability to pay one's debts. It can be defined two different ways:
  • Cash flow (liquidity) insolvency--being unable to pay debts as they fall due.
  • Balance sheet insolvency--having negative net assets; liabilities exceed assets.

Insolvency is not another word for bankruptcy, which is a determination of insolvency made by a court of law.

Leverage

Leverage, or gearing, is borrowing money to reinvest in an attempt to increase the returns to equity. If the return on assets (ROA) is higher than the rate of interest on the loan, then the return on equity (ROE) will be higher than if it did not borrow. On the other hand, if ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor than otherwise would have been available. The potential for loss is also greater, because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid. Deleveraging is the action of reducing borrowings.

The Economist calls excessive and excessively pro-cyclical leverage "the chief villain" of the current financial crisis.

Liquidity Crisis

When a business finds there's not enough cash to pay for day-to-day operations, grow the business, or meet debt obligations when they are due, it's suffering a liquidity crisis and may look to an injection of cash to prevent business failure. The decision whether to "trade through" a liquidity crisis or declare bankruptcy depends on whether the business is considered viable. The lender is often the ultimate arbiter of whether or not a business survives a liquidity crisis.

For this reason, international financial institutions like IFC are creating emergency liquidity funds to offer microfinance institutions an immediate stable source of funds.

NINJA Loans

Loans provided to borrowers with no income, no job, no assets, so that the only security is the value of the homes. Such loans were heavily marketed to subprime borrowers in the United States. When the bottom fell out of the housing market, the whole house of cards collapsed. The credit losses on the mortgages, and on the pyramids of complicated debt products built on top of them, are still mounting.

Portfolio at Risk (PAR)

The danger in this crisis is that portfolio quality will be severely impacted by clients' inability to repay loans. High delinquency makes financial sustainability impossible. The standard international measure of portfolio quality in banking is PAR beyond a specified number of days. In microfinance, 30 days is a common breakpoint. If a loan has been at risk for more than 30 days (PAR30)--i.e., a full or partial payment of principal is more than 30 days past due--it is considered to be higher risk. PAR (30 days or one payment period) above 10 percent is usually a sign of problems for an MFI.

Real Economy

The real economy generally refers to the nonfinancial economy--for example, manufacturing, trade, and services.

Remittances

Remittances, a critical source of funds for families living in developing countries, have been soaring in recent years, helped by lower money-transfer costs. But the economic downturn in developed countries will likely lead to reduced remittances to developing countries.

For example, the Inter-American Development Bank (IDB) projects money transfers will contribute 1.7% less to household incomes in Latin America in 2008 than they did in 2007. The slowdown comes as inflation is rising in most Latin American countries.

As a result there will be less of a cushion for poor families, and microfinance portfolios will likely feel the knock-on effects.

Responsible Lending

Responsible lending is the increasingly popular term to describe the lending policies and practices of financial institutions that take steps to ensure that clients are treated fairly and benefit from the loans they receive. Central to the responsible finance concept is an affirmative effort by the lender to avoid over-indebting clients, by offering well-designed products and carefully establishing ability to repay (including attention to other debts and obligations).

The growing movement toward responsible lending in the microfinance industry couldn't be more timely. Thirty-nine investor institutions recently signed up to an agreement for six key Client Protection Principles as part of a broader industry initiative to make explicit commitments to minimum agreed standards around the treatment of clients. The Principles complement other ongoing activities across the industry, including the work of retail microfinance providers, national associations, the Social Performance Task Force, the "Beyond Codes" Project and Microbanker's Oath promoted by The Center for Financial Inclusion at ACCION, WOCCU's International Credit Union Consumer Protection Principles, and CGAP's Disclosure Guidelines for funds that specialize in microfinance.

Securitization

From mortgages to car loans, to credit cards, to microcredit loans--financial assets can be packaged, pooled, and sold to investors as securities. While it's a relatively new phenomenon for microfinance, in the United State the value of pooled securities overtook the value of outstanding bank loans in 2001. One important motivation for securitization is that it can be a cheaper method of raising capital. But there are a host of legal and business issues microfinance institutions should consider before going down the securitization road to fulfill their capital needs.

Shadow Banking System

The shadow banking system--money market funds, securities dealers, hedge funds, and the other nonbank financial institutions that have defined "new finance" in the past decade--has been radically altered by this crisis. Collateralized debt obligations (CDOs), collaterized loan obligations (CLOs), and a range of new fangled, and unregulated, debt products are likely to come under greater scrutiny as a result. The importance of core banking principles--strong customer relationships, solid accounting, effective management, staff incentives and recruitment--have all been reaffirmed.

Subprime loans

A subprime loan is a loan offered at a higher rate of interest for people who do not qualify for prime rate interest rates (the rates charged by banks to their most “creditworthy” borrowers). Often, subprime borrowers are turned away from traditional lenders, because of their low credit ratings or other factors that could suggest that they might default on the loan.

Microfinance loans have shown that poor clients can pay back loans at remarkable rates -- on average 98% -- in the right conditions.

Source : CGAP
 

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