Corporate governance: What boards of large NBFC MFIs can do on the ground? (Part II)

Corporate governance is the collective responsibility of the directors. While we can have impressive norms for corporate governance, they cannot be effectively enforced through regulation alone

While the previous Moneylife article (How to make the boards of large NBFC MFIs implement corporate governance norms in practice? (Part I) discussed critical issues with regard to corporate governance in large NBFC MFIs, this article explores what MFI (microfinance institution) boards can (themselves) do to improve the practice of corporate governance in reality. Here are some initial practical suggestions based on experience:   

1.    Limit the number of MFI boards on which a director may sit to not more than three at any given point in time. This will hopefully afford directors the time and space to understand how the MFIs-on whose boards they serve as directors-are actually performing on the ground. During and before the crisis in India, I had personally witnessed directors-who were on multiple MFI boards (often exceeding three)-jumping planes in a literal sense and having very little time to attend to their fiduciary and other responsibilities. Many of them could not even visit the field areas, even before the customary quarterly board review. Some of them who served on sub-committees were even more harassed for time. Therefore, it appears necessary to ensure that there is a limit-in tune with physical reality-on the number of MFI boards in which a director may sit. And three appears to be a good permissible number.

2.    Separate the functions of the chairman of the board of directors and MD (or chief executive officer or equivalent) in MFIs, where they are together and ensure that appropriate outsiders at least occupy one of those posts. This is very critical and should result in dispersed power, especially when the founder promoter is the chairman and/or managing director. Much of the excessive risk taking (in the form of multiple and larger loans being given to sub-prime like clients) that occurred during the lead up to 2010 Andhra Pradesh (AP) microfinance crisis happened primarily because there was no one on the board to seriously question the enthusiastic and entrepreneurial promoters, occupying one or both of these positions. Often, this was because the promoter had in the first place, appointed these individuals to the board and this caused a conflict of interest  

3.    Create a transparent board recruitment (or appointment) policy that clearly specifies the duties and profile of MFI directors, including the chairman. Such a policy must also ensure that directors have adequate skills and experience (apart from the availability of time to do their job). The policy must also ensure that the overall composition of the MFI's board of directors is suitably diverse-including more women, youth, clients (or their interest groups) and individuals with the requisite skills (but possibly different backgrounds) in the board is perhaps a way to improve the boards' overall functioning and effectiveness. The policy must also ensure that conflict of interest issues are taken into account with regard to board appointments so that the independence of the directors is not compromised.  

4.    Ensure that MFI boards develop (on their own) a formal conflict of interest policy and an objective set of compliance procedures and processes for implementing the same. Such a policy should ideally include: (a) an MFI director's duty to avoid (if possible), all activities and transactions that could either create a conflict of interest or even the appearance of a conflict of interest; (b) a transparent set of processes and procedures for MFI directors to follow before they engage in certain types of activities (such as agreeing to serve on the board of another MFI or that of a lender or an investor etc) so as to ensure that such activities will not create a conflict of interest; (c) an MFI director's duty to disclose any activity and issue that may result, or has already resulted, in a conflict of interest; (d) an MFI director's (voluntary) responsibility to abstain from voting on any matter where the director may have a conflict of interest or where the director's objectivity/ability to properly fulfil duties to the MFI may be compromised; (e) adequate procedures and clear norms for transactions and activities conducted with related parties on an arms-length basis; and (f) transparent procedures by which the MFI board will deal with the issue of any non-compliance with the (conflict of interest) policy. Ideally speaking, it would be good for the policy to contain specific (conflict of interest policy) examples of where and how conflicts of interest can arise when serving as an MFI board member.

5.    Have a compulsory formal evaluation of the functioning of the MFI's board of directors by an external independent evaluator. This is a very critical issue and the results of this evaluation should be made available to shareholders and supervisory authorities-officially publishing this evaluation (on their website) is an aspect that could also be considered by the MFIs concerned. Such a formal evaluation of the board should preferably be done in the absence of the CEO or managing director, so as to ensure that the exercise is a free, fair and independent one. The services of independent evaluators-individuals and/or institutions who have not had (or do not have) a material relationship (as defined in common parlance) with the MFI-could be taken in this regard. Management institutes (like IIMs and others like College of Agricultural Banking, etc) could also be actively involved in these (evaluation) processes.

6.    Suitably compensate MFI board members for their time but do not incentivize their working on the basis of stock options or other such mechanisms that invariably encourage undue or excessive 'risk' taking as was witnessed during the 2010 AP microfinance crisis. Even if the law permits, it seems prudent not to remunerate board members through stock options and the like as then the independence of directors may be seriously compromised. Again, the happenings in India in the run up to the 2010 AP microfinance crisis clearly demonstrates the fact that independent directors who have been so compensated have Not performed their fiduciary and other duties appropriately. The key issue to note here is much of the 2010 crisis occurred because board members and senior management were compensated heavily (in the short-term) whereas the risks of their strategies could be known only in the medium/long-term. This mismatch created a huge incentive for excessive risk taking, which, in turn, led to the 2010 AP microfinance crisis.

7.    Make it mandatory for MFI boards to set up a risk committee and establish clear rules regarding the composition and functioning of this committee. Additionally, make it compulsory for one or more members of the audit committee to be a part of the risk committee and vice versa. Further, the chairman of the risk committee should always report to the AGM and outline the role that directors have played in shaping the MFI's risk profile and strategy. Also, the risk committee should frame a 'risk control declaration' which should also be published so as to ensure its wider dissemination and use - both within and outside the organization.

8.    And last but not the least, create an obligation for a specific duty ('duty of care') to be established for the board of directors so that they take into explicit account the interests of various stakeholders (mainly, clients) during the decision-making procedure. This is especially critical and much of the 2010 AP microfinance crisis would not have occurred if only boards of MFIs had exercised such a duty of care that explicitly looked after the interest of clients who were constantly over-indebted. The desire for better operating performance at many MFIs meant that the board of directors at these MFIs just did not bother about the impact of their turbo charged growth on clients and their well being. Therefore, there is an explicit need to incorporate a duty of care-especially with regard to clients-among MFI boards.

To summarise, for the microfinance sector that has undergone deep crisis in India, corporate governance has never been more important than now. Corporate governance is not just the responsibility of an individual MFI. Rather, it is the collective responsibility of all individuals who become directors on the boards of an MFI and serve together. While we can have great sounding norms and guidelines for corporate governance, unfortunately, they cannot be effectively enforced through regulation alone. They need to be practiced at all times (including difficult circumstances as is currently the case in Indian microfinance) and that is where the individual initiative of directors (serving on MFI boards) does really matter. And I sincerely hope that directors on MFI boards do ensure that this happens in real time on the ground… by enabling and facilitating their boards to re-orient their functioning in the light of the suggestions made above... If this happens, many of the ills plaguing the Indian microfinance sector and MFIs will slowly but surely start to vanish.

(Ramesh S Arunachalam has over two decades of strong grass-roots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural and urban development and urban poverty alleviation across Asia, Africa, North America and Europe. He has worked with national and state governments and multilateral agencies. His book-Indian Microfinance, The Way Forward-is the first authentic compendium on the history of microfinance in India and its possible future.)

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