The document discusses an Early Warning System (EWS) for supervising credit and financial institutions (CFIs). It outlines the functions and features of the EWS, including using it as a supervisory tool to identify unsound CFIs, locate problem areas, and address root causes. The EWS monitors additional areas beyond CAMEL and avoids over reliance on weighted composite ratings. Setting benchmarks involves an ongoing process of discussion and review between local supervisors and regulators.

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

2. 1. Functions, Features and Use of the EWS
1. The Role of EWS in Supervision
1. Functions of the EWS
2. Development of the EWS
3. EWS as a supervisory tool
2. General Features of the EWS
1. Idiosyncrasies of CFI and CFI
2. Areas of the EWS and their linkages
3. Validation calculations prove the necessity of expanding CAMEL
4. Core features of the new EWS: renouncement of weighing, database and benchmarks
3. The Analysis Process
1. General framework for the analysis process
2. 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
t
Latent risk occurs Risk identified Financial
consequences in
case of idleness
Time to act!
Strategic crisis
Profitability
crisis
Liquidity
crisis
EWS other visible without
tool assessment tools tool

6. Four general questions to be answered by the EWS
1. ...whether the CFI is in a sound and healthy condition,
2. and if not, from what kind of illness the CFI suffers,
3. which medicine is the right one and
4. 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?
EWS
Indicate jeopardizing developments
even if they show up within these
borders
Experience of the driver
Capture negative developments
before they resolve into violations of
regulatory norms
Economical reality
Addressing the root cause of
deviations from desired threshold-
values
Measures adopted to individual
circumstances of CFI
Regulatory Norm
Ultimate borders of the risk appetite
Speed limit
Violation of norms as negative signal
Political decision
Sanctioning of deviations from desired
threshold-values
Equal treatment of CFI

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

15. 1. What constitutes an EWS?
1. Who is the doctor?
2. Who is the patient?
3. What areas are checked?
4. What diagnostic method is used?
5.

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
1. Risk 3. Reserves
2. Profitability
5. Operating Efficiency
4. Competitiveness
2 3
1
5
4 7
8
6
9

20. Information areas CAMEL vs. EWS
Area Subarea
1. Risk
1.1 Credit Default Risk
1.2 Credit Concentration Risk
1.3 Structural Liquidity Risk
1.4 Interest Rate Risk
2. Profitability and Growth
2.1 Profitability
2.1.a Miscellaneous Income
2.2 Growth
3. Reserves (Buffers)
3.1 Capitalisation
3.2 Provisioning
3.3 Liquidity Reserves
(4. Competitiveness)
4.1 Interest on Loans
4.2 Interest on Deposits
4.3 Dividends
5. Idle Assets,
Operating Cost
5.1 Idle Assets
5.2 Operating Expenses
Insufficiently monitored Not monitored
Treatment of respective EWS-Subarea in CAMEL: Monitored
Different Approach

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
A Asset Quality
M Management
E Earnings
L Liquidity
S Security
C Capital
Composite
Rating Score
Fixed
Weights

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
t
Proposal of preliminary
benchmarks, based on
common sense, prudential
principles and international
experience
Local supervisors are requested to give
reasons for deviating as well as for not
changing preliminary benchmarks
Investigate sectors prone to sector risk!
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
1. The Role of EWS in Supervision
1. Functions of the EWS
2. Development of the EWS
3. EWS as a supervisory tool
2. General Features of the EWS
1. Idiosyncrasies of CFI and CFI
2. Areas of the EWS and their linkages
3. Validation calculations prove the necessity of expanding CAMEL
4. Core features of the new EWS: renouncement of weighing, database and benchmarks
3. The Analysis Process
1. General framework for the analysis process
2. Addressing the root cause: the role of policies, instruments and internal control

28. Stages of the analysis process
1. Description of the CFI as reflected in the EWS
1. Is the data reliable? Entry error? Defect of the accounting system?
2. Trends of a ratio? Benchmarks?
2. Addressing the root cause of deficiencies reflected by the EWS
3. 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
1. Does the CFI maintain appropriate policies and instruments to control the
area? Do these instruments reflect the state of the art of CFI?
2.Are these policies and instruments embedded into an effective and
appropriately formalised organisational structure?
3.Are policies, instruments and other formal structures actually practiced in
daily business and form part of the corporate culture of a CFI?
4.Do the procedures that are actually practised show any internal control
gaps? Are they prone to operational risks, especially fraud risk?
5.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
1. Management oversight and control culture
2. Risk recognition and assessment
3. Control activities and segregation of duties
4. Information and communication
5. 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. 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
Thank you for your attention!