A long list of instances of failures of microfinance institutions holds several important lessons for the RBI and the finance ministry on the regulation and supervision of the sector

SKS Microfinance was in the news recently and this concerned cash embezzlements and frauds for the financial year 2011. As Microfinance Focus notes, "According to auditors, SKS Microfinance recorded 408 cases of cash embezzlements and frauds in the financial year 2011….Company's annual report shows 156 cases of cash embezzlements by the employees, aggregating Rs16,018,106 during 2011. …There were 205 cases of loans given out to non-existent borrowers on the basis of fictitious documentation created by the employees of the company, aggregating Rs45,177,531. Further, 47 cases of loans taken by borrowers under fake identity, aggregating Rs13,786,130, were reported during the year. The Company is pursuing the borrowers to repay the money. The outstanding loan balance (net of recovery) aggregating Rs6,386,267 has been written off.ⁱ

Here are some more examples from MFI financial statements and many more can be found at http://microfinance-in-india.blogspot.com/2010/11/has-burgeoning-growth-caused-increasing.html:

 "(xxi) Based upon the audit procedures performed for the purpose of reporting the true and fair view of the financial statements and as per the information and explanations given by the management, we report that no material frauds on or by the Company were noticed/reported during the year although there were some instances of frauds on the Company by its employees as given below:

(a)    Thirty-three cases of cash embezzlements by the employees of the Company aggregating to Rs.7,079,683 were reported during the year. The services of all such employees involved have been terminated and the Company is in the process of taking legal actions. We have been informed that nine of these employees are absconding. The outstanding loan balance (net of recovery) aggregating to Rs.5, 377,428 has been written off;

(b)    Eighteen cases of loans given to non-existent borrowers on the basis of fictitious documentation created by the employees of the Company aggregating to Rs.5,645,657 were reported during the year. The services of all such employees involved have been terminated and the Company is in the process of taking legal actions. The outstanding loan balance (net of recovery) aggregating to Rs.4,253,379 has been written off; and

(c)    One case of fraud by an employee of the Company in collusion with vendors has been reported during the year. The aggregate value of transactions is Rs.9,610,755 (including Rs.3,051,510 in respect of the previous year). The services of the said employee and the arrangements with the said vendors have been terminated. The Company has initiated legal action and criminal proceedings against such employee. The financial effect of the loss incurred by the Company is not currently quantifiable."

In fact, even as I write this, I am aware that there is a special committee of the RBI headed by former Deputy Governor, Mrs. Usha Thorat, which is looking into issues related to NBFC supervision and the recommendations of this committee are very critical given that the NBFC MFIs are among the largest MFIs in India, both in terms of number of clients serviced as gross loan portfolio outstanding. It is also pertinent to remember that, the 6 large AP headquartered MFIs who added about US $ 2.076 billion and 9.76 million clients during April 2008 - March 2010, did not attract the supervisory attention of the department of non-bank supervision, RBI, which was supposed to look closely and scan (systemically important) NBFCs with loan assets greater than Rs 100 Crores. Please note that in numerical terms, the above figures are equivalent to each of these (6) MFIs adding Rs 78 Crores every month for 24 months. This apart, we are all aware that the RBI is preparing detailed guidelines for MFIs based on the Malegam Committee Report (MCR) and the Union Ministry of Finance is has recently put out a draft bill for regulation of MFIs. The latter is especially note worthy because it brings greater focus on savings/thrift and perhaps, in the long term it could also facilitate MFIs to offer savings services to the poor. While the need for ensuring that the poor have access to savings is indeed welcome, enabling MFIs to offer thrift is fundamentally unsound because of the several reasons including weak internal controls.

Therefore, I would like to use this opportunity to make a humble submission on what I think are some of the key internal control issues that caused the on-going micro-finance crisis in India. I sincerely hope that these are taken into account and addressed appropriately while formulating the Usha Thorat committee recommendations, preparing the detailed guidelines based on the Malegam committee report and finalizing the draft micro-finance bill, currently on the website of the Union Ministry of Finance.

As given above, 'non-existent clients' and 'borrowers with fake identity' are two very common types of operational frauds that have been (increasingly) occurring due to the turbo charged growth in the Indian micro-finance industry  and the commensurate lack of quality internal controls. It must also be noted that there are several other kinds of frauds  ('misappropriation of client repayments' and the like) prevalent in Indian micro-finance and all of these are highlighted below:

The loan disbursement related frauds typically include: (a) Loan officer  issues loans to "ghost" or non -existent clients; (b) Loan officer issues 2nd or 3rd loan to delinquent clients to facilitate repayment (top-up or greening of loans and this is very evident from cases of clients with multiple loans); (c) Loan officer provides bulk money to agents for onward disbursement and has no serious means to check their actual disbursement to clients. In many cases, these loans are used for non-micro-finance activities; (d) Staff/ cashier/accountant makes loans to themselves and show fictitious names or clients with false identities; (e) Loan officer charges clients an unofficial "fee" (BAKSHISH) from clients to enable them to access a loan from an MFI; (e) Loan officer, staff, accountant, cashier issue larger loans to clients and use some portion of the loan for their own consumption. They however do not repay and expect the client to repay and this is an important reason for delinquency; and (f) Several other aspects.

The loan repayment related frauds normally include: (a) Loan officer collects payment, issues receipt, but does not deposit the money repaid (by the client) with the MFI. This could happen with client prepayments or regular payments; (b) Agents collect loan payments and do not deposit them in a timely manner with the concerned MFI. Agents, who have not lent money to clients but rather used loan amounts from MFI, do not repay the MFI at all; (c) Staff/loan officer charges unofficial delinquency fees to manage delinquency; (d) Loan officer/others collect payments on loans that have been officially written off and keep it themselves; and (e) Several other aspects

Other kinds of frauds that have been witnessed are: (a) Insurance payments do not reach the client nominees, who in course of time forget to ask for them; (b) Insurance premiums are not deposited at the branch; and (c) Higher than required insurance payments are collected in the guise of administrative charges (please do recall that IRDA recently initiated an enquiry against a large Indian MFI)

The most relevant question here is why have these (increasing) frauds occurred and what are the lessons for regulation and supervision? And the answer is very simple: MFIs that have faced burgeoning growth in the last few years have not had commensurate capacity and (internal control and other) systems to manage their turbo-charged growth. Further, as a result of the strong decentralized (agent) model that some of these MFIs have used and are continuing to use, they are increasingly vulnerable to frauds (especially, when their growth is rapid). OK, it is one thing to acknowledge the frauds and isolate reasons for their existence but, given the fact that they have been increasing in Indian micro-finance since 2005 , we cannot afford to let this go on. We need to learn from these internal control lapses and surely, these lessons must be dovetailed into regulation and supervision. This is attempted here below:

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