R8 Uncovered Capital Ratio

Why This Ratio Is Important

The Uncovered Capital ratio (R8), also called UCR, is sometimes known in the commercial sector as the Open Exposure ratio, Open Credit Exposure ratio, or Open Loan Exposure ratio. The ratio measures the amount of capital, which may be at an elevated risk of unexpected losses as measured by “un-provisioned” Non-performing Loans as of 30 Days Past-Due. MFIs that do not currently calculate capital levels may substitute equity for total capital in the denominator of the ratio. The equity version of the UCR can provide NGOs and other MFIs not measuring capital with a good sense of the equity base available to support the uncovered deterioration of the non-performing loan portfolio.

UCR indicates how the MFI is managing its level of loan portfolio risk relative to its capital. For this reason, it is recommended as an enhancement to the NPL30 ratio (R14) as a more revealing ratio to assess vulnerability and potential loss. Because the UCR ratio tracks NPL30, it is useful as an MFI’s warning signal of excessive portfolio delinquency relative to the capital base that supports it. An increased focus on the UCR as a measure of capital adequacy may become best practice for the microfinance industry going forward. When considered in conjunction with the CAR, the UCR provides managers with an additional analytical dimension to understand and report on an MFI’s capital adequacy. An MFI should seek to maintain a lower UCR, which signifies that the MFI has a greater capital or equity base to support its risky loan portfolio.

Similar to the requirement for CAR, the amount of capital required for a sustainable UCR level should cover unexpected losses, while its provisions should cover expected losses. This ratio can change quickly as a function of rapid portfolio deterioration, and thus can have an immediate (and sometimes adverse) affect on an MFI's solvency position. This phenomenon is corroborated in a recent Basel document, which notes that, “Microloans manifest deterioration in portfolio quality faster than commercial loans, due to their shorter average duration and more frequent repayments. Also, so-called contagion effects amongst low-income borrowers in the same location can increase delinquencies exponentially.” ^[26] The Basel II framework does not require monitoring and reporting of this ratio, but does require risk rating of loans, assignment of risk weights, and asset disclosures.

Effects of the Adjustments

Indicates how the MFI is managing its level of risk relative to the amount of capital based on adjustments to the Impairment Loss Allowance.

Benchmarks

Microfinance industry benchmarks do not yet exist for this indicator. A UCR ratio such as 25 percent or less indicates that the institution’s capital is at lower risk from potential losses and has better risk management. This may indicate that the MFI is less susceptible to losses above what it has already provisioned. Risk of capital loss increases as the value of the ratio increases. MFI management should set a benchmark for this ratio, and also implement a policy to investigate patterns of NPL30 loans when the institution exceeds the benchmark.

NOTES

^[26] Basel Committee on Banking Supervision. 2010. Consultative Document. Microfinance Activities and the Core Principles for Effective Banking Supervision. Basel, Switzerland: Bank for International Settlements, page 19.

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