Effective control systems at MIVs: The key to accountable investing and responsible microfinance globally

All microfinance investment vehicles need to introspect and bring in a positive control environment that can encourage accountable and responsible investing. That alone can usher in an era of responsible microfinance on the ground

A previous articlei emphasized the importance of having properly functioning (effective) internal control systemsii at microfinance investment vehicles (MIVs). This article takes a first look at such control systems and provides practical (starter) suggestions to MIVs, policy makers, regulators and other stakeholders on how (best) to structure such systems so as to achieve the goal of accountable investing as well as responsible microfinance.

 

Having said that, let us now move on to substantive issues related to the control system.   

 

The formality of any control system will depend largely on an MIV’s size, the scale and complexity of its operations, its risk profile and so on. Less formal/structured internal control systems at smaller MIVs can be as effective as highly formal/structured internal control systems at larger (and complexly structured) MIVs. But the key is that every MIV should have an internal control system, this system should be commensurate with the size, scale and complexity of its operations and most importantly, the system should actually work on the ground in real time.  

 

Many of the problems with MIVs (recently in the news due to Hugh Sinclair’s recent book and commentary on the sameiii) could have (perhaps) been avoided, if and only if, the concerned MIVs had an effective and appropriate internal control system operational in the first place—one that did not merely exist on paper but was rather implemented in reality. This is something that the concerned MIVs will have to self-assess, with regard to their respective organizations and bring about the necessary changes. Regulators/supervisors and other stakeholders including CGAPiv could also enable these MIVs to assess the qualityv of their control systems and make the necessary changes.

 

That said, what then are the key components of such a system?

 

In my opinion, an effective control system (at any MIV) should have five key elements:

  1. An appropriate control environment,
  2. Supported by a proper risk management system,
  3. With control activities commensurate with the size, scale and complexity of investment/operations,
  4. Aided by a transparent and accurate accounting, information, and communication systems, and
  5. Backed by dispassionate self-assessment/monitoring.

Having set the context, let us now look at what each of these elements mean in reality through a series of articles. And in this first article, I focus on the strategic element of the “appropriate control environment”, an issue that is seldom thought about in practice but one that I believe is very (if not most) crucial to the long-term survival of the MIV.  

 

Why should each and every MIV have an appropriate control environment?

 

This is because the control environment is the foundation on which the MIV’s control system is (to be) built. Basically, it reflects the board’svi (and also senior management’s) commitment to strong and effective internal control at the MIV. In other words, it provides the discipline and structure to the entire (internal) control system. Without this commitment by the board of directors (and senior management) to strong and effective controls, no (internal) control system (however well designed and structured) can actually work on the ground. And this commitment must clearly be visible throughout the MIV—for all staff to see and emulate. Let us be clear on that!

 

And who has to play a crucial role in establishing this at an MIV?

 

At a very basic level, it is an MIV’s board of directors (perhaps along with and through senior management) who must assume responsibility for establishing and maintaining an effective internal control system that: a) meets statutory and regulatory requirements (if any); b) protects the MIV, its assets, operations and investors; and c)  responds to changes in the MIV’s environmental conditions. They need to ensure that the control system operates as it is intended to and is also modified (appropriately) when circumstances so dictate. 

 

And for discharging the above duties, the board of directors must fully understand the risks that the MIV could face, set the acceptable limits for these risks, and ensure that senior management takes the steps necessary to identify, monitor and control these risks. In turn, the senior management must then take the responsibility to implement the strategies approved by the board, to set appropriate internal control process/procedures, and to monitor the effectiveness of these process/procedures. There can be no substitute for this.

 

This makes it quite clear where the main responsibility for control rests and that is fairly and squarely on the strategic shoulders of the MIV’s board of directors (along with the senior management)—not on the compliance and audit departments. However, having said that, everyone in an institution shares the responsibility to some extent and that is where the board (through the senior management) must play a catalytic role in shaping a positive control culture throughout the entire organization.

 

Thus, a key task for the board (through senior management) is to establish the right culture within the MIV—a culture in which the importance of internal controls is stressed, and high ethical and integrity standards are promoted and adhered to.

 

And this culture cannot be determined simply by what the board or top levels of management (merely) say—it will have to be judged more importantly by what they (actually) do?

 

For example, do the MIV’s policies (remuneration, etc) reward risk-taking at the expense of accountable and responsible investing? The pressure (at MIVs) to disburse more and more loans as well as make rapid equity investments have been known to be associated with remuneration policies that reward (immense) risk taking by MIVs—in turn, this pressure appears to have come from the practical imperative to (immediately) invest (all) the monies available with the MIVs so that there is maximum utilization of the MIV’s resources/assets. Of course, all these are driven by the desire of wanting to have better operational results, attract more capital for deployment and also provide better returns to the primary investors and shareholders of the MIV. In a way, this is a cyclical process indeed. Readers may want to recall that many of the large (NBFC) MFIs themselves emulated and replicated the above process at a retail level (kept on disbursing, ignoring the risks at hand) in Andhra Pradesh (during 2005 -2010) which perhaps resulted in multiple, over and ghost lending and finally, led to the 2010 Andhra Pradesh microfinance crisis. And of course, remuneration policies (including bonuses and stock options) were clearly tied to faster disbursement, all along the financial sector value chain! 

 

Likewise, another relevant issue here is the question of whether the board/senior management displays a casual attitude towards breaches of limits? Do they encourage the right attitude towards regulatory compliance? Is there backing and respect at board/senior management levels for the internal audit and compliance functions?

 

The response of the board/senior management levels of the MIV to these kinds of issues will clearly determine how other staff at the MIV actually behaves in practice, including their attitude to control issues and the overall control environment. This point needs emphasis here!

 

Table 1 below provides specific examples (not exhaustive) of the differences between policy and implementation (i.e. between what is said and what is actually done) for the benefit of various stakeholders. One aspect needs clarification here—I am not arguing that this is happening at every MIV and always so. I am merely providing an illustration of what could happen in terms of differences between policy statements and actual implementation with regard to controls and the implications that this would have in building a positive control culture at the MIV. Just wanted to be clear on that!
The aspect of intended (i.e. existing merely on paper as policy) versus realized (i.e. as seen during implementation) in an “internal control system” is a very critical issue. Problems occur when there is a huge gap between the intended “internal control system” and the realized “internal control system”. Therefore, it is the duty of the board (through guidance to the senior managementvii to ensure that there is a close (if not complete) fit between the intended “internal control system” and realized “internal control system”. The corollary follows that where the fit between ‘internal control system’ and realized ‘internal control system’ is low, the board will have to step in (and get the senior management) to bring about necessary changes. This would be a critical duty of the board in shaping the control environment.

 

Therefore, it would certainly be appropriate to expert the board/management of MIVs—involved in the LAPO caseviii as well as those MIVs who were part of the burgeoning growth of the Indian microfinance sectorix during 2008 to 2010—to try and answer the above questions.

 

All these MIVs surely need to introspect with integrity and bring in a positive control environment that can encourage accountable and responsible investing. That alone can usher in an era of responsible microfinance on the ground. And, last but not the least, regulators/supervisors would also need to emphasize the importance of having such a positive and appropriate control environment at MIVs—as part of their overall regulatory framework…

 

(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.)
 


i Regulation and supervision of microfinance investment vehicles: A suggested practical framework—Part I; and Regulation and supervision of microfinance investment vehicles: A suggested practical framework— Part II;

ii The term control system is used synonymously with the word internal control system

iii Please see - Confessions Of A Microfinance Heretic: How Microlending Lost Its Way And Betrayed the Poor by Hugh Sinclair (http://www.microfinancetransparency.com/). Please also refer to the following articles: Why not regulate and supervise microfinance investment vehicles in their country of incorporation?; Triple Jump’s Response to Hugh Sinclair’s Book: Does It Raise More Questions than Provide Credible Answers?; Why blame the MFIs alone?; Should not microfinance investment vehicles be judged by the same standards set for retail MFIs?; and Does Sinclair’s Open Challenge (to the Global Micro-Finance Industry) Make His Claims True

ivConsultative Group to Assist the Poor (http://www.cgap.org/p/site/c/)

v Judging the quality will require not merely the examination of whether or not an appropriate internal control system exists on paper but rather studying if indeed what is said on paper actually works on the ground. That is the key to making inferences about quality.

vi Board = Board of Directors or Equivalent as may be as per the legal form of the MIV as per the relevant laws in the country of incorporation.

vii I am not suggesting micro management by the board under key circumstances.

viii The MIVs are well known and I do not want to name them

ix The MIVs are well known and I do not want to name them

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    COMMENTS

    S.S.A.Zaidi

    7 years ago

    A vrery well -articulated article-Taking a cue from this I am tempted to write an article on how laxity in internal control systems led to the collapse of many institutions
    Zaidi

    S.S.A.Zaidi

    7 years ago

    A vrery well -articulated article-Taking a cue from this I am tempted to write an article on how laxity in internal control systems led to the collapse of many institutions
    Zaidi

    Banks: Penalty for failing to pass education loans

    From now on, education loan applicants will now why their applications got rejected

     
    To make sure that education loans are not denied to eligible students, finance minister P Chidambaram has announced that bank officers rejecting applications without sufficient reasons would be penalised.  
     
    “No application should be turned down by the officer who is receiving it. It can only be turned down by one level higher. They will now penalise branch managers who turn down, say, 5/10 deserving applications which are overturned by a superior officer,” Mr Chidambaram told reporters. The Indian Bank Association (IBA) would come out with a new circular on education loans in the next few days, he said.  
     
    “Bank loan is the right of every student who meets the parameters. No bank can turn away an applicant. Every application for a bank loan must be received and acknowledged and every deserving candidate must be given the loan if the student meets the parameters,” Mr Chidambaram said.
     
     Education loans are granted to Indian nationals for pursuing higher studies in India or abroad. As per its website, the State Bank of India (SBI) gives loans up to Rs10 lakh for studies in India and Rs30 lakh for education abroad. Such loans are usually extended to candidates pursuing professional courses from approved universities or from autonomous institutions like IITs and IIMs, among others.
     
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    Ajit Misquitta

    8 years ago

    Another new scam being perpetrated by the HDFC bank among others is to force loan takers to purchase an insurance policy at their own cost even though they may have other insurances before giving out personal loans. This practice smells of misselling and I believe the RBI should initiate an investigation and refund all such payments taken under this ruse to unsuspecting customers.

    Finance Ministry says no to Iranian bank's plan to open branch in India

    Earlier, Ministry of Home Affairs had also denied security clearance to applications by Parsian Bank and two other Iranian banks fearing threat of money laundering and terror financing in banking transactions

     
    New Delhi: The Finance Ministry has declined permission to Iran's Parsian Bank to open a branch in India apparently due to security concerns and threat of money laundering, reports PTI.
     
    Iran had been pressing New Delhi for allowing Parsian Bank to open a branch to settle oil and other trade with India.
     
    The matter was examined by Reserve Bank of India (RBI), and subsequently, based on RBI's report, a decision was taken by the Finance Ministry not to agree to Parsian Bank's application, sources privy to the development said.
     
    Earlier, the Ministry of Home Affairs (MHA) had denied security clearance to applications by Parsian Bank and two other Iranian banks fearing threat of money laundering and terror financing in banking transactions as cautioned by the Financial Action Task Force (FATF).
     
    India became a member of Paris-based FATF in 2010 and is required to follow standards prescribed by FATF to check money laundering and terror-financing activities.
     
    Sources said since RBI in December 2010 scrapped a long-standing mechanism of settling payments through the Asian Clearing Union mechanism; India pays 55% of the value of oil its imports from Iran in euro payments through Turkey's Turkiye Halk Bankasia. The balances 45% of crude payments are made in rupees through UCO Bank.
     
    Under the rupee payment mechanism, 45% of the payments made by Indian oil companies for their imports from Iran are credited in rupees in the accounts of Iranian Banks maintained with UCO Bank.
     
    These rupee resources are being used for making payments for Indian exports, including project exports, to Iran.
     
    Besides opening a branch, Tehran also wants the rupee balance in the UCO Bank accounts to be permitted to finance third country imports by Iran.
     
    The operational modalities have to be discussed and agreed between the two sides, sources said.
     
    India imported 17.44-18 million tonnes of crude oil from Iran -- 10.5% of the nation's total oil imports in 2011-12. This year, imports from Iran are likely to dip to 14-16 million tonnes or 8.4% of 190 million tonnes of planned crude oil imports.
     
    Bilateral trade between the two nations is skewed in favour of Iran. In 2011-12, the total trade between India and Iran was around $15.94 billion. While India's exports were around $2.4 billion, India's imports from Iran were around $13.5 billion. India's imports exceed that of its exports by $11.14 billion.
     
    Sources said while India's gross exports to the world increased by more than 21% during 2011-12 as compared to previous year, India's exports to Iran declined by 3.8%.
     
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