Evaluating MFI Internal Control Systems: Some Strategies for Regulators and Supervisors

Ramesh S Arunachalam

Rural Financial Practitioner

Regulators/Supervisors, in evaluating the internal control systems of financial intermediaries in micro-finance should choose to direct special attention to activities or situations that historically have been associated with internal control breakdowns leading to substantial losses.

Certain changes environment should be the subject of special consideration to see whether accompanying revisions are needed in the internal control system. These changes include: (1) a changed operating environment; (2) new personnel; (3) new or revamped information systems; (4) areas/activities experiencing rapid growth; (5) new technology; (6) new lines, products, activities (particularly complex ones); (7) portfolio restructurings, buy outs etc; and (8) expansion of operations.

To evaluate the quality of internal controls, Regulators/Supervisors can and must take a number of approaches.

First, they can evaluate the work of the internal audit department through review of its work papers, including the methodology used to identify, measure, monitor and control risk. If satisfied with the quality of the internal audit department’s work, supervisors can use the reports of internal auditors as a primary mechanism for identifying control problems, or for identifying areas of potential risk that the auditors have not recently reviewed.

Second, Regulators/Supervisors may also require periodic external audits of key areas, where they define the scope.

Third, Regulators/Supervisors may also conduct on-site examinations and a review of internal controls should be an integral part of such examinations. An on-site review could include both a review of the business process and a reasonable level of transaction testing in order to obtain an independent verification of the financial intermediaries own internal control processes. This appropriate level of transaction testing should be performed to verify the:

·         Adequacy of, and adherence to, internal policies, procedures and limits;

·         Accuracy and completeness of management reports and financial records; and

·         Reliability (i.e., whether it functions as management intends) of specific controls identified as key to the internal control element being assessed.

Further, in order to evaluate the effectiveness of the five internal control elements of financial intermediaries in micro-finance (or a unit/activity thereof) Regulators/Supervisors should:

·         Identify the internal control objectives that are relevant to the MFI and its unit or activities under review (e.g., lending, accounting etc);

·         Evaluate the effectiveness of the internal control elements, not just by reviewing policies and procedures, but also by reviewing documentation, discussing operations with various levels of personnel, observing the operating environment, and testing transactions, especially at the ground level;

·         Share their concerns about internal controls and recommendations for their improvement with the board of directors and management on a timely basis, and;

·         Determine that, where deficiencies are noted, corrective action is indeed taken in a timely manner.