Early Warning System (EWS) Functions, Features and Use

1. Early Warning System(EWS)Functions, Features and Use October 16, 2014 by Ludwig Ehard

2. 1. Functions, Features and Use of the EWS The Role of EWS in Supervision Functions of the EWS Development of the EWS EWS as a supervisory tool General Features of the EWS Idiosyncrasies of CFI and CFI Areas of the EWS and their linkages Validation calculations prove the necessity of expanding CAMEL Core features of the new EWS: renouncement of weighing, database and benchmarks The Analysis Process General framework for the analysis process Addressing the root cause: the role of policies, instruments and internal control

3. The EWS is the neural system of a CFI The neural system warns us of death by starvation or of dying of thirst. The EWS will warn the CFI of death e.g. by high credit failures or permanently poor performance.

4. Other Associations characterising the purpose of EWS ...

5. The time aspect in EWS EWS other visible without tool assessment tools tool Profitability crisis Liquidity crisis Strategic crisis Insolvency Time to act! t Risk identified Latent risk occurs Financial consequences in case of idleness

6. Four general questions to be answered by the EWS ...whether the CFI is in a sound and healthy condition, and if not, from what kind of illness the CFI suffers, which medicine is the right one and how one can prevent illnesses in future.

7. The implementation of the EWS could trigger substantial changes and follow-ups... ...of the supervisory approach: Risk based supervision ...of the CFIs processes: Strategies and instruments, internal control, MIS, accounting ...of the CFI/sector or industry: Improved soundness!

8. Who are the addressees of EWS? All institutions that are interested in the soundness of an individual CFI and / or the entire CFI sector Supervisory Authorities (CBDA/SARB) (Other State Authorities) Deposit Insurance Systems (Apex Institutions) (CFI Federations, NACFISA) CFI itself

9. Managing a CFI without EWS is like … …driving a car without lights in a moonless, deep black night! If we notice that we are leaving the road, it is too late to avoid a tree or a ditch!

10. EWS is an obligation to the individual CFI as well as to the entire sector. The survival of a CFI always depends on the trust of the clients in the CFI The trust of the clients in the CFI depends on the trust of the clients in the entire sector

11. Objectives of EWS from the perspective of the supervisory authority Identification of unsound CFI Timely location of problem areas and their root causes Increase scopes of action to eliminate the causes of problems Ongoing learning process resolves into permanent improvement of the EWS

12. Supervisory review process and output orientated supervision Old-fashioned: Output oriented supervision Limited to monitoring of compliance to threshold values of specific ratios Root causes of missing threshold values are not investigated Interventions follow standardised procedures that do not take into account the specific circumstances of the CFI Future: Process oriented supervision Supervision focuses on the processes of a CFI Ratios are used to encircle problems that arise from the operating structures of a CFI The assessment of deviations from a given benchmark is not closing the supervision act but triggering the virtual process oriented supervision (on-site-monitoring)

13. How does the EWS differ from regulatory norms?

14. 1. Functions, Features and Use of the EWS The Role of EWS in Supervision Functions of the EWS Development of the EWS EWS as a supervisory tool General Features of the EWS Idiosyncrasies of CFI and CFI-sector Areas of the EWS and their linkages Validation calculations prove the necessity of expanding CAMEL Core features of the new EWS: renouncement of weighing, database and benchmarks The Analysis Process General framework for the analysis process Addressing the root cause: the role of policies, instruments and internal control

15. 1. What constitutes an EWS? Who is the doctor? Who is the patient? What areas are checked? What diagnostic method is used?

16. Do we need specific EWS for CFI? CFI usually ... ...are smaller ...operate in a restricted area ...are less exposed to competition ...serve clients with narrow means or even poor clients ...have small transaction volumes ...focus on short termed business ...are less professionalised ...thus are to be analysed in different manner than commercial banks!

17. Idiosyncrasies of the CFI Industry Broad variability of CFI concerning scope of business and sophistication Lack of transparency concerning profitability and efficiency Turbidity of interest rates and pricing policies Particularly prone to operational risks, especially fraud Increasing exposure to market competition Lack of long termed fixed interest funding opportunities High demand for long termed fixed interest loans Some CFI bear high concentration risks (e.g. Work based CFI – one company) General lack of awareness of interest rate risks and of risks of transformation of terms

18. What areas are to be checked? numerous ratios CAMELS’, PEARLS, BAKIS/SCUTINY (DGRV), other ratios, etc. and suggestions on how to structure the areas of the microfinance EWS These ratio systems are designed to support the overall assessment of MFIs and don’t explicitly incorporate forward looking early warning indicators. A supervisory EWS does not replace CAMELS but rather complements

19. Linkages between EWS-areas 3. Reserves 1. Risk 1 3 2 2. Profitability 5 7 4 4. Competitiveness 5. Operating Efficiency 8 6 9

20. Information areas CAMEL vs. EWS Treatment of respective EWS-Subarea in CAMEL: Monitored Different Approach Insufficientlymonitored Not monitored

21. What diagnostic methods are used? 1. Garbage in, garbage out timeliness and accuracy of these data are a big issue in microfinance lack of accounting proficiency appropriate IT infrastructures absence of internal control systems incites credit officers and managers to gamble and particularly to whitewash credit reports 2. Selection of indicators Any mechanical usage of ratio systems without incorporation of common sense and further qualitative judgement is a risk in itself. The output of mechanised off-site EWS is therefore not to be considered as a final judgement but as a valuable tool supporting further analysis The EWS should enable the analyst to generate intelligent questions about the operations of an CFI that address the root causes of deficiencies. Instead of leading the analyst astray with a tangled mass of ratios

22. Aggregation of indicators - Rating scores also seem to be a very convenient tool to simplify and standardise the supervision process. - However, it is doubtful whether they are appropriate for early warning: (1) Early warning means early diagnosis The utmost goal of the EWS is not to calculate a precise probability of default but to identify CFIs that face problems. (2) Aggregate scores usually cover only part of the entire business and insufficiently mirror the linkages among ratios. This is why composite ratings can be manipulated once the fixed weights are known.

23. Rating systems are not appropriate for early warning purposes of CFI C Capital A Asset Quality M Management Composite Rating Score Fixed Weights E Earnings L Liquidity S Security

24. Core problem of ratings based on weighted scores A bad liver cannot be compensated by good lounges!

25. The purpose of EWS totally differs from the purpose of rating of banks Key question of rating systems: How to quantify the probability of default of a business bank? Key question of a CFI: How to identify problem CFI? Which steps to take in order to prevent these CFI from defaulting? EWS is not the final judgement. EWS triggers deepened investigations and does not replace investigations.

26. Outlook on the process of setting benchmarks for the EWS Local supervisors are requested to give reasons for deviating as well as for not changing preliminary benchmarks Investigate sectors prone to sector risk! t Proposal of preliminary benchmarks, based on common sense, prudential principles and international experience Discussion of reasons given by local supervisors, amendment of benchmarks Regular institutionalised discussion meetings concerning early warning issues with local supervisors to foster continued improvement of the EWS (benchmarks, ratios)

27. 1. Functions, Features and Use of the EWS The Role of EWS in Supervision Functions of the EWS Development of the EWS EWS as a supervisory tool General Features of the EWS Idiosyncrasies of CFI and CFI Areas of the EWS and their linkages Validation calculations prove the necessity of expanding CAMEL Core features of the new EWS: renouncement of weighing, database and benchmarks The Analysis Process General framework for the analysis process Addressing the root cause: the role of policies, instruments and internal control

28. Stages of the analysis process Description of the CFI as reflected in the EWS Is the data reliable? Entry error? Defect of the accounting system? Trends of a ratio? Benchmarks? Addressing the root cause of deficiencies reflected by the EWS Verification of the preparatory analysis by onsite-inspections, definition of measures and enforcement of measures

29. General framework for addressing the root cause of deficiencies Does the CFI maintain appropriate policies and instruments to control the area? Do these instruments reflect the state of the art of CFI? Are these policies and instruments embedded into an effective and appropriately formalised organisational structure? Are policies, instruments and other formal structures actually practiced in daily business and form part of the corporate culture of a CFI? Do the procedures that are actually practised show any internal control gaps? Are they prone to operational risks, especially fraud risk? Does the management of a CFI deliberately take disproportionately high risks to leverage profit?

30. Policies and Instruments Policies and instruments of a CFI have to be appropriate and match up with the complexity and the size of the business For most of the CFI very simple and basic approaches will be sufficient. Nevertheless such simple and basic approaches covering all material risks have to be in place!

31. Why is the internal control system especially important for microfinance institutions? Large number of small transactions Vulnerable activities often highly decentralised Close relationship between loan officers and customers Staff is often not very well paid Customers are often not familiar with banking procedures

32. Elements of an internal control system Management oversight and control culture Risk recognition and assessment Control activities and segregation of duties Information and communication Monitoring activities and correcting deficiencies

33. Control activities and segregation of duties Control activities are an integral part of all activities of a bank Involving all level of staff Include both control procedures and their verification Lack of segregation of duties: major cause of losses! No transaction should be carried out from origination to booking by one single person Explicitly to be segregated: e.g. approval and disbursement of loans, accounting and management of funds Prerequisite: Provide a detailed and transparent documentation on the organisational structure!

34. Steps Taken to develop the EWS Stocktaking of existing EWS Stocktaking of idiosyncrasies of the CFI Industry and derivation of requirements towards EWS Proposal of an EWS concept, match concept with data available from reports / accounting Prototype, documentation Quantitative and qualitative validation, feedback of focussed group discussion, incorporation of feedback into prototype, ongoing improvement of the EWS Proposal for preliminary benchmarks Shadow programming of some ratios of the EWS prototype in the BI oracle data base Calculation of EWS figures on the aggregate industry level Draft supervisory guidelines Second feedback on EWS in focussed group discussion Discussion on benchmarks and decision (in progress) Incorporation of last feedback in EWS Development of user guidelines, development of training material, training concept

35. Thank you for your attention! Vielen Dank für Ihre Aufmerksamkeit! Ludwig Ehard Director Regional Program – Africa German Co-operative and Raiffeisen Confederation DGRV – Deutscher Genossenschafts- und Raiffeisenverband e. V. Pretoria, South Africa lehard@dgrv.coop