Ramesh S Arunachalam
Rural Finance Practitioner
If the desire for the ‘burgeoning growth’ in Micro-finance in India resulted in multiple loans to (perhaps helpless) clients and (inadvertently?) caused havoc in some of their lives, this rapid growth also appears to have had another serious impact on Indian micro-finance – increasing operational frauds. This is something that certainly merits the close attention of the RBI and its Board Sub-Committee, which is currently looking at issues related to micro-finance in India
The following exhibits (Figures 1, 2 and 3 - Please click on document below to open a full size document for better readability), which are reproduced from financial statements[i] of few leading and growing MFIs[ii], indicate serious and increasing frauds in MFIs as per their own financial statements.
From the above figures, it is quite clear that ‘non-existent clients’ and ‘misappropriation of client repayments’ are 2 major types of operational frauds that have (increasingly) happened with this turbo charged growth. Other kinds of frauds are highlighted in Figure 4 ((Please click on document below to open a full size document for better readability)
In fact, Dr Thorat and Arunachalam (2005), in their paper presented at the NABARD High Level Policy Conference At New Delhi in May 2005, highlight in section 3.5 of the paper - “The Case of Internal Control Lapses” - a large number of frauds that had already been observed by 2005. Some of these cases are reproduced here below and you can see that the above categories of ‘non-existent clients’ and ‘misappropriation of client repayments’ are also listed here:
The above given frauds and control breakdowns, resulting in failures typically seen in the exhibits and problem cases (given above) can be grouped into five clear categories:
1. Lack of adequate management oversight and accountability, and failure to develop a strong control culture within the institution. Without exception, cases of loss reflect management inattention to, and laxity in, the control culture of the institution, insufficient guidance and oversight by boards of directors and senior management, and a lack of clear management accountability through the assignment of roles and responsibilities. These cases also reflect a lack of appropriate incentives for management to carry out strong line supervision and maintain a high level of control consciousness across the organisation.
2. Inadequate recognition and assessment of the risk of certain activities, whether on- or off-balance sheet. Many organisations that have suffered losses neglected to recognise and assess the risks of new products and activities, or update their risk assessments when significant changes occurred in the environment or business conditions including growth. Many recent cases highlight the fact that control systems that function well for traditional or simple products are unable to handle more sophisticated or complex products, especially in burgeoning growth.
3. The absence or failure of key control structures and activities, such as segregation of duties, approvals, verifications, reconciliations, and reviews of operating performance. Lack of segregation of duties in particular has played a major role in the losses that have occurred.
4. Inadequate communication of information between levels of management within the institution, especially in the upward communication of problems. To be effective, policies and procedures need to be effectively communicated to all personnel involved in an activity. Some losses occurred because relevant personnel were not aware of or did not understand the policies. In several instances, information about inappropriate activities that should have been reported upward through organizational levels was not communicated to the board of directors or senior management until the problems became severe. In other instances, information in management reports was not complete or accurate, creating a falsely favourable impression of a business (portfolio) situation..
5. Inadequate or ineffective audit programs and monitoring activities. In many cases, internal audits were not sufficiently rigorous to identify and report the control weaknesses. In other cases, even though auditors reported problems, no mechanism was in place to ensure that management corrected the deficiencies.
And the simple and key point for the RBI Sub-Committee is this: Many MFIs that have faced burgeoning growth in the last few years have not had commensurate capacity and systems to manage their turbo charged growth. Further, as a result of the strong decentralised model that many of these MFIs have used and are continuing to use, they are increasingly vulnerable to frauds (especially, when their growth is rapid). Some of the common conditions that make these MFIs vulnerable to frauds are given below:
- They are experiencing very rapid growth
- Their MIS and accounting systems are weak
- Their systems are constantly undergoing change (eternal innovation or pilot testing?)
- Their internal control systems are inadequate and constantly being stressed and sheared
- Their employee turnover is high
- Their loan officers handle excessive and increasing amounts of cash[iv]
- Their policies and systems are not followed because of their decentralised model and internal audits are either weak or are almost non-existent
- Their governance is weak and non-transparent, with significant related party transactions
Therefore, the RBI Sub-Committee needs to look closely into the kind of (obvious and non-obvious) (operational and other) frauds that are occurring in micro-finance and help foster adoption (through enabling regulation/supervision) of good practices that can mitigate the ever increasing frauds and clean the industry of its bad practices. The time has REALLY come for the RBI to take charge of Indian Micro-finance and provide on-course corrections so that the industry does not fade away into oblivion…
[i] These MFIs, from whose financial statements, the frauds listing have been taken, are perhaps among the more transparent MFIs in India.
[ii] The idea here is not to target any individual MFI and that is why their names have been withheld
[iii] Thorat, Y S P and Ramesh S Arunachalam (2005), “REGULATION AND AREAS OF POTENTIAL MARKET FAILURE IN MICRO-FINANCE”, Paper presented at the NABARD High level policy conference in New Delhi
[iv] Mix market data seems to indicate that and I will discuss this in a separate post