Financial Services Working Group

Update of Key Ratios to the SEEP Framework

Draft for Review - July 2 2009

Summary Overview:

The following eight (8) new ratios have been selected as an update to the 18 core ratios listed in the 2005
publication of SEEP’s Measuring Performance of Microfinance Institutions: A Framework for Reporting,
Analysis and Monitoring. This is an initial working draft for review and comment by SEEP Financial
Services Working Group members. The end objective is to reach consensus on an updated set of ratios
and release a “second edition” of the SEEP publication as well as an update to the Frame reporting tool.
Please note that the page numbers refer to the 2005 SEEP manual, also attached for reference or available
for download on the SEEP website here: http://www.seepnetwork.org/Pages/Frame.aspx.

To be included in Table 4.1 Summary of the SEEP 18 (page 66):

Term Formula Explanation

R8 Equity to Assets
Capital Adequacy Ratio (CAR)
R9 Uncovered Capital Ratio (UCR)
Adjusted Uncovered Capital
Ratio (UCR)
Asset/Liability Management
Total Equity
Total Assets - Cash and due from banks
Total Capital
Risk Weighted Assets
PAR>30 days - Impairment Loss Allowance
Total Equity
PAR>30 days - Impairment Loss Allowance
Total Capital
This ratio is a measure of the solvency of the MFI.
It helps asses its ability to meet its obligations
and absorb unexpected losses. The adjusted
ratio, called the Capital Adequacy Ratio (CAR)
measures more accurately (and in line with Basel
II calculations) the amount of capital and the risk
level of assets. Thus, it becomes a better
indicator of the solvency of the MFI to meet its
obligations and absorb unexpected losses.
Indicates how the MFI is managing its level of risk
relative to the amount of capital it has. The lower
the ratio the better. The adjusted ratio includes a
better assesment of the capital that the MFI has
to cover potential losses derived from the
deterioriation of the PAR that has not been
provisioned.

To be included in Section 4.2 Asset/Liability Management Ratios (page 71):

R8 Capital Adequacy Ratio

Total Equity B32

Equity to Assets =
Total Assets - Cash and due from Banks B12 - B1

Why This Ratio Is Important

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The Equity to Assets ratio is a simple measure of the institution’s solvency. It indicates the amount of
capital that an MFI has to cushion against future losses and ensure it is able to cover its expenses and
obligations over the long-term. It can also provide a relative indication of how well capitalized an
institution is in comparison to its peers.

The amount of capital required is generally based on the MFI’s own assessment of expected losses and its
financial strength to absorb unexpected losses. Expected losses should generally be covered through
provisions by the company’s accounting policies which remove expected losses from both assets and
equity. Thus the ratio measures the amount of capital required to cover additional unexpected losses to
ensure that the MFI is well capitalized for potential shocks.

Effect of the Adjustments (according to Basel Accord)

Capital Adequacy Total Capital B32 A DJ

Ratio (CAR) = Risk Weighted Assets B12 A DJ (RWA )

The Capital Adequacy Ratio (CAR) adjusts the Equity to Assets ratio both in the numerator and the
denominator. Total Equity is adjusted as per Basel Accord guidelines and allows the inclusion of
supplementary capital such as general loan loss reserves, asset revaluation reserves and subordinated debt.
It also deducts goodwill to provide a more tangible measure of total capital.

For assets, the adjustment weights assets by their level of risk, acknowledging that some financial assets
are inherently less risky and require less capital to be reserved for unexpected losses. The adjustment also
considers off-balance sheet commitments which currently benefit the institution but may generate future
liabilities and thus require that certain capital be reserved.

As mentioned before, the amount of capital required is generally based on the MFI’s own assessment of
expected losses and its financial strength to absorb unexpected losses. One definition of unexpected loss
is the worst-case financial loss or impact that a business could incur due to a particular loss or risk. Such
losses are typically not projected to occur during the normal course of business and can arise from either
risks inherent in the business of the institution or from external factors. Internal factors might include the
type of lending performed (i.e., crop loans constituting a higher probability of default than group loans),
the collateral held against potential loan portfolio losses or diversification of operations (by geography,
revenue source, etc.). External factors might include weather-related shocks, political crises or economic
shocks such as high inflation or bank failures.

The best way for an institution to anticipate unexpected losses is to assess previous experience, either
internally or externally, with unexpected losses suffered by engaging in a similar type of business activity
or operating in a similar type of environmental, economic, political, business and context. All of these

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elements must be taken into account when selecting an appropriate target level of the Capital Adequacy
Ratio.

To be included in Chapter 3 on Analytical Adjustments (page 53):

3.7 Capital Adjustments

Total Capital should be formed by Tier 1 and Tier 2 Capital (defined below) taking into account the
limits and restrictions as well as the deductions mentioned below:

Tier 1 Capital Tier 2 Capital

Paid-in Capital B22 Undisclosed reserves See definition
Donated Equity B23 Asset revaluation reserves B30
Retained Earnings B26 General loan-loss reserves See definition
Disclosed Reserves B29 Hybrid (debt/equity) capital instruments See definition
Subordinated debt See definition

Donated Equity should be earned in order to be considered as Capital. Unearned donations should be held
as liabilities.

Definitions: The following definitions are taken from the Basel Accord. They should be included in the
appendix of the document.

(i) Undisclosed reserves: Unpublished or hidden reserves may be constituted in various ways
according to differing legal and accounting regimes in member countries. Under this heading are
included only reserves which, though unpublished, have been passed through the profit and loss
account and which are accepted by the bank’s supervisory authorities. They may be inherently of
the same intrinsic quality as published retained earnings, but, in the context of an internationally
agreed minimum standard, their lack of transparency, together with the fact that many countries
do not recognize undisclosed reserves, either as an accepted accounting concept or as a legitimate
element of capital, argue for excluding them from the core equity capital element.

(ii) Revaluation reserves: Some countries, under their national regulatory or accounting
arrangements, allow certain assets to be revalued to reflect their current value, or something
closer to their current value than historic cost, and the resultant revaluation reserves to be
included in the capital base. Such reserves may be included within Tier 2 capital provided that
the assets are considered by the supervisory authority to be prudently valued, fully reflecting the
possibility of price fluctuations and forced sale. A discount of 55% on the difference between the
historic cost book value and market value is agreed to be appropriate in the light of these
considerations.
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(iii) General loan-loss reserves: General loan-loss reserves are created against the possibility of
losses not yet identified. Where they do not reflect a known deterioration in the valuation of
particular assets, these reserves qualify for inclusion in tier 2 capital. Where, however, provisions
or reserves have been created against identified losses or in respect of an identified deterioration
in the value of any asset or group of subsets of assets, they are not freely available to meet
unidentified losses which may subsequently arise elsewhere in the portfolio and do not possess
an essential characteristic of capital. Such provisions or reserves should therefore not be included
in the capital base.

(iv) Hybrid debt capital instruments: In this category fall a number of capital instruments which
combine certain characteristics of equity and certain characteristics of debt. Each of these has
particular features which can be considered to affect its quality as capital. It has been agreed that,
where these instruments have close similarities to equity, in particular when they are able to
support losses on an on-going basis without triggering liquidation, they may be included in
supplementary capital.

(v) Subordinated term debt: Basel II is agreed that subordinated term debt instruments have
significant deficiencies as constituents of capital in view of their fixed maturity and inability to
absorb losses except in a liquidation. These deficiencies justify an additional restriction on the
amount of such debt capital which is eligible for inclusion within the capital base. Consequently,
it has been concluded that subordinated term debt instruments with a minimum original term to
maturity of over five years may be included within the supplementary elements of capital, but
only to a maximum of 50% of the core capital element and subject to adequate amortization
arrangements.

The sum of tier 1 and tier 2 elements will be eligible for inclusion in the Total Capital Calculation, subject
to the following limits and deductions:

- The total of tier 2 (supplementary) elements will be limited to a maximum of 100% of the total of
tier 1 elements;
- subordinated term debt will be limited to a maximum of 50% of tier 1 elements;
- general loan-loss reserves are limited to a maximum of 1.25 % of the portfolio;
- asset revaluation reserves which take the form of unrealized gains on securities will be subject to
a discount of 55%;
- goodwill assets are removed from Capital at 100% of current value

3.8 Risk Weighted Assets According to Basel II Accord

The rationale behind Basel II Accord is that financial institutions should have capital that protects from
potential losses that derive from the risk associated of each asset type held by the financial institution. The
Basel II Accord provides with a Standard Approach to calculate risk-weighted assets (RWA). This
approach considers the credit rating of an asset type a good indicator of its level of risk.
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For a Microfinance Institution, we have used the rationale behind Basel II to assess the risk level for any
investment made by the MFI. For the entire loan portfolio and other less liquid assets we have applied a
100% risk weight. In addition this calculation will also include off-balance sheet/contingent liabilities.
The following table summarized the RWA calculation for an MFI:

Type of Assets Risk Weight Ref

Cash and Due from Banks (less than a week) 0% B1
Trade Investments & Other Investments See Table B2 & B8
Loan Portfolio (net of specific provisions) 100% B3 & B6
Other Assets 100% B7 & B10
Off Balance sheet items See Table N/A

Trade Investments & Other Investments

For Microfinance Institutions, the RWA calculation for the investments account will follow the
Simplified Standard Approach Framework from the Basel II Accord for financial assets issued by
sovereign countries, Central Banks, Multilateral Organizations, Banks, securities firms, corporations,
insurance companies and off balance sheet items.

For financial assets issued by sovereign countries and/or banks and securities firms, the risk weight is
based on the consensus country risk scores of export credit agencies (ECA) and is available on the OECD
website. For exposures with banks and securities firms that are regulated entities, the risk weight is
assigned one category below the country in which they are incorporated. The following table summarizes
the risk weight for both categories. It is important to mention that a cap of 100% has been applied the
riskiest exposures, though the Standard Approach suggests 150% risk weight.1

OECD Classification
Issuer 0-1 2 3 4 to 6 7
Sovereign 0% 20% 50% 100% 100%
Banks and securities firms 20% 50% 100% 100% 100%

For financial assets issued by multilateral organizations the issuer will be eligible for a 0% risk weight if
it is mentioned below, otherwise it will receive a 100% risk weight.

- Bank of International Settlements (BIS)

- International Monetary Fund (IMF)
- European Central Bank (ECB)

1
It is important to mention that we put a cap of 100% for the riskier exposures, though the Standard Approach suggests 150%
risk weight. The Basel Accords apply a risk weighting higher than 100% because they are requiring that more capital be held in
reserve against future losses relative to those assets. Since the benchmark Capital Adequacy Ratio for banks is fixed at 8%,
regulators must assign a risk weight above 100% if they feel 8% is inadequate. A 150% risk weight would mean that 12% capital
is required to be reserved against those assets (8% * 1.5 = 12%). Since no such global benchmark exists for MFIs, the maximum
risk weight was kept to 100%, and MFIs are encouraged to set their own benchmark Capital Adequacy Ratio, which in most
cases is likely to be significantly higher than the 8% benchmark for banks.
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- European Community (EC)

- World Bank Group, including the International Bank for Reconstruction and Development
(IBRD), and the International Finance Corporation (IFC).
- Asian Development Bank (ADB)
- African Development Bank (AfDB)
- European Bank for Reconstruction and Development (EBRD)
- European Investment Fund (EIF)
- The Nordic Investment Bank (NIB)
- The Caribbean Development Bank (CDB)
- The Islamic Development Bank (IDB), and
- The Council of Europe Development Bank (CEDB).

For financial assets issued by corporations and insurance companies the risk weight will be 100%.

For off balance sheet/ contingent liabilities, the value of the commitment issued by the MFI will be
added as an asset at the following rates based on original maturity.

Off balance sheet commitments Risk Weight

Short term ( < 1 year original maturity) 20%
Long term ( > 1 year original maturity) 50%

The following example shows how this calculation should be made.

Ref Account Name Risk Weight As of 12/31/2004 Risk Weighted Assets

B1 Cash and Due from Banks 0% 3,261,195 -
B2 Trade Investments See Table below 10,611,928 6,663,742
B3 Net Loan Portfolio 100% 54,338,636 54,338,636
B6 Interest Receivable on Loan Portfolio 100% 1,604,993 1,604,993
B7 Accounts Receivable and Other Assets 100% 1,610,308 1,610,308
B8 Other Investments See Table below 1,165,420 582,710
B9 Net Fixed Assets 100% 5,567,936 5,567,936
Off Balance Sheet Items
Short term Guarantee 20% 2,000,000 400,000
B12 Total Risk Weighted Assets (RWA) 78,160,416 70,368,325

Example of Trade Investments and Other Investments of a OECD Risk 3 Country

B2 Trade Investments Risk Weight As of 12/31/2004 Risk Weighted Assets
Short Term placements with Domestic Banks 100% 2,715,555 2,715,555
Stock of a Foreign Bank (OECD 2) 50% 7,896,373 3,948,187
B2 Total Trade Investments 10,611,928 6,663,742

B8 Other Investments Risk Weight As of 12/31/2004 Risk Weighted Assets

Long term domestic government bonds 50% 1,165,420 582,710
B8 Total OTher Investments 1,165,420 582,710

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To be included in Section 4.2 Calculating the SEEP 18:

As of As of
Ref. Account Name Formula
31/12/2004 31/12/2003

B32
R8 Equity to Assets Ratio R8 = 64.0% 62.0%
B12-B1

ADJ Capital
Capital Adequacy Ratio R8 = RWA 68.1% 73.6%

P14 > 30 days – A5

R9 Uncovered Capital Ratio R9 = 1.59% 2.28%
B32
ADJ P14 > 30 days – A5
Ratio Adjusted UCR R9 = 1.59% 2.28%
Capital

R9 Uncovered Capital Ratio

PAR>30 days - Impairment Loss Allowance P14 > 30 days – A5

UCR =
Total Equity B32

Why This Ratio Is Important?

As mentioned before, intuitively the amount of capital required by an institution should cover unexpected
losses and provisions should cover expected losses. The Uncovered Capital Ratio (UCR) indicates the
percentage of capital held to cover losses which may be subject a higher level of risk but for which
potential losses have not been provisioned for as expected losses. Most types of risks discussed above
which may lead to unexpected losses are longer-term in nature, and thus an MFI can set a longer-term
policy with respect to a targeted Capital Adequacy ratio. By contrast, portfolio quality can change quickly
and have a significant impact on solvency, so this ratio focuses specifically on this particular risk. The
ratio measures the amount of Capital which may be at an elevated risk of unexpected losses as measured
by PAR > 30 days which has not been provisioned.

A lower ratio (such as 25% or lower) indicates that the institution’s capital is at a lower level of risk from
potential losses. Risk of capital loss increases as the value of the ration increases. Alternatively, a
negative ratio would suggest that the Capital Adequacy Ratio may be conservatively understated and that

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the institution may have additional capital available to cushion against other types of losses even under a
worst-case scenario of loan defaults based upon current portfolio quality.

Effect of the Adjustments (according to Basel Accord)

PAR>30 days - Impairment Loss Allowance P14 > 30 days – A5

Adjusted UCR =
Total Capital Capital

The adjusted ratio has the same use as the UCR, but should be used in conjunction with the Capital
Adequacy Ratio for consistency purposes.

R10 Ratio on foreign currency risk

(This ratio will require additional disclosures for each foreign currency [A to Z] on the MFI’s balance
sheet. MFIs will have to separately report their total assets and total liabilities in each of those
currencies.)

Foreign Currency A Absolute Value (Total Foreign Currency A Assets – (Total Absolute Value (Total Foreign Currency A Assets – Total
Open Position per Foreign Currency A Liabilities) Foreign Currency A Liabilities)
total equity Total Equity B32

Why this ratio is important

This indicator provides information about the institution’s exposure to foreign currency. The ratio of
foreign currency open position to total equity should be no more than 10% - 20 %. If the FX gap is
greater than 10%-20% of total equity, then the institution could face a liquidity crisis or insolvency if
foreign exchange markets move significantly—a risk the institution cannot control. This is particularly
concerning for institutions that are mobilizing customer deposits.

To be included in a new Section [4.5] Savings Ratios (after page 85):

Should this be a new section or inserted in ALM?

R22 Average deposits balance per Deposit accounts

(or it could be divided per Depositors, please give your feedback on that)

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Average deposits balance Total deposits B13 + B14 +B18

per Deposit accounts = Number of Deposit Accounts N5

Why this ratio is important

This indicator provides information on the level of target clientele trust and the efficiency of the range of
savings products in responding to client needs. This ratio gives an indication of the target population that
the MFI reached considering its mission and objectives.

Managers should look closely at the trend of this ratio overtime. This ratio should see a positive trend in
this ratio since the goal of the MFI is to increase the services delivered. However, managers should
analyze the reasons behind a drop of this ratio. It could indicate a loss in confidence from the clients, an
increase in membership, a change in the target population or large deposit withdrawals due to a specific
event.

Each MFI should set its own optimal objective and it should be based on the MFI’s business plan and
mission. If the MFI is growing quickly, managers may want to use period averages for the denominator.
MFIs may also substitute Number of Depositors as a surrogate for Number of Deposit Accounts provided
that they explain the definition of the numerator and denominator.

Effects of adjustments

None of the adjustments proposed in the Framework affect the liquid ratio.

R23 Yield on liquidity and investments

Yield on liquidity and Financial Revenue from investments I5

investments = Average Cash + Average Trade Investments + Average Other Investments B1 ave + B2 ave + B8 ave

Why this ratio is important

This ratio indicates the return that the MFI generates from its average cash and investments during the
period. It measures the efficiency of the institution to manage its liquidity and investments. The objective

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is to maximize the return on investments restricted to respect liquidity standards, to match with the
liabilities and to diminish the various risks involved in the liquidity management. Nevertheless, the
revenue from investment activities should demonstrate some stability and be in accordance with the
budgeting projections. Comparison with market benchmarks can reveal the ability of the institution to get
revenues from its liquidity and investments.

This ratio should be part of a liquidity and investment policy which sets the framework and guidelines
overseeing liquidity activities in MFIs. The policy should at least define liquidity standards and limits in
order to secure deposits of members and answer to the need of funds.

The yield on liquidity and investments depends on the market and will therefore vary by country. In
addition to compare this ratio with market benchmarks, a manager can compare this ratio with the Cost of
Funds (R6). Managers should maintain a sufficient yield on liquidity and investments in regards to the
Cost of Funds of the MFI.

Effects of adjustments

None of the adjustments proposed in the Framework affect the liquid ratio.

R24 Ratio on Savings Liquidity

(This ratio will require some items from the sub-account: restricted cash other than Required Reserves
and Undrawn Portion of committed credit lines.)

Reserves against deposits as required by regulator plus B1 – restricted cash other than required by regulator against
Liquid Assets / Total unrestricted cash + undrawn portion deposits + undrawn portion of committed credit lines
Demand Deposits Total Demand Deposits B13

Why this ratio is important

This indicator provides information on the cash available to meet withdrawals in demand deposits
accounts. Generally the regulator will require a statutory reserve against demand deposits, but if not, the
institution should ensure that an adequate amount of cash is available to cover possible withdrawals.

If cash is not available to meet large-scale withdrawals (possibly either due to seasonality or due to loss of
confidence in the institution), then the institution could run into liquidity problems which could quickly
escalate into insolvency.

R25 Effective financial expense of savings

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Financial Expense of Total interest expense of savings I19

Savings Mobilized Average savings balance Average (B13+B14+B18)

Why this ratio is important

This indicator is important to provide a sense of how the financial expense of the deposit program
compares to borrowing opportunities in the market. Given the complexities of deposit mobilization, an
institution should ensure that it provides the most cost-effective liabilities in its capital structure.

R26 Effective Operating Expense of Savings

Cost per Unit of Direct and Indirect Operating expenses allocated to savings (I17a+I18a+I20a)
Savings Mobilized Average Savings Balance Average (B13+B14+B18)

Why this ratio is important

This ratio is important to ensure that the gain on deposit mobilization (through cost-effective financing)
compensates the institution for the cost of administering the program. If the cost of the program is too
high (i.e. cost per Unit of savings mobilized PLUS effective financial expense of savings > cost of short
term borrowings,) then the institution should consider replacing deposits with cheaper short-term
borrowings

This ratio can also provide a guide to an MFI about how to price its savings products. The effective
financial expense of savings (or average interest rate paid on savings) should be lowered if financial
expense plus operating expense is greater than the cost of other forms of liabilities or equity. From a
profitability perspective, deposits should be the most cost-effective form of liabilities in order to justify
the expense of maintaining the deposit program.

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Summary of SEEP 18 Expanded Ratios (8 new ratios for total 26):

R1 OSS
R2 ROA
R3 ROE
R4 Yield on Gross Portfolio
R5 Portfolio to Assets
R6 COF
R7 D/E
R8 Capital Adequacy (formerly Liquid Ratio)
R9 Uncovered Capital Ratio (formerly PAR)
R10 Foreign Currency Risk (formerly Write Off)
R11 Risk Coverage Ratio
R12 Operating Expense
R13 Cost per Client
R14 Borrower per Loan Officer
R15 Clients per Staff
R16 Turnover
R17 Average Loan Size
R18 Average Disbursement Size
R19 (Shift R8 to starting at R11)
R20 (Shift down)
R21 (Shift down)
R22 Average Deposit Balance per Deposit Account
R23 Yield on Liquidity and Investments
R24 Ratio on Savings Liquidity
R25 Effective Financial Expense of Savings
R26 Effective Operating Expense of Savings

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