Where Angels Prey

Where Angels Prey is a novel by Ramesh S Arunachalam. Please refer to www.whereangelsprey.com for more information

Tuesday, November 30, 2010

The Role of Independent Directors in Enhancing Corporate Governance in Indian MFIs: Specific Issues That Need To Be Examined By The RBI Board Sub-Committee

Ramesh S Arunachalam
Rural Finance Practitioner

A lot has been heard about the role of independent directors in MFIs during the last few months and I will not get into the specifics but there are numerous examples of situations (at MFIs) which could been salvaged, had only the independent directors acted 'independently'. The fact of the matter is that the image of micro-finance did take a beating and could have been avoided, had only the independent directors acted swiftly and appropriately...Never mind and let bygones be bygones…

Given below are several critical issues - with regard to the roles, appointment, compensation and other aspects - pertaining to independent directors. It would be useful if the RBI sub-committee looks closely at these issues and provides some clarity on how best independent directors can be used to enhance/improve governance of MFIs in India. The various specific issues are listed hereafter:

How To Hire The Independent Directors?: First, in many MFIs, the promoter, who is (often) also the CEO, hires the board rather than the desired practice of the board hiring the CEO. That practice needs to be looked at from a corporate governance standpoint. The key question is “how can boards hired by the Promoter/CEO be really independent?” While declarations provided periodically by independent directors could be used to monitor their independence, this is certainly an issue that the RBI sub-committee must ponder about and try to work out a solution.

Who Can Become Independent Directors?: Second, there is a lack of clear cut eligibility requirement for independent directors - in terms of objective criteria such as age, expertise and experience (especially related to micro-finance). The RBI sub-committee could attempt to spell out such criteria including age, experience, knowledge and expertise (in finance, micro-finance etc) and also specify operational standards for these criteria so that the task of identifying independent directors (for MFIs) perhaps becomes more transparent and relatively easier.

Who is An Independent Director?: Third, we need clarity regarding the definition of 'independent directors', especially in line with globally-accepted standards. The RBI sub-committee could try to define the same with regard to MFIs and may be SEBI could also be involved in the process so that the same can be broad based later. Without question, there is an immediate need is to adopt a clearer definition of 'independent director' in line with the criteria recommended by leading governance codes such as those of the New York Stock Exchange, UK's Combined Code and others etc.

Should There Be A Board Nomination Committee With Vesting Powers?: Fourth, whether it would be desirable to have the vesting powers of appointment of new independent and executive directors in specially constituted board nomination committees is something that needs to be examined, in the context of MFIs. These committees would have to follow a process and lay down clear criteria for selecting board members. The nomination committee chaired by an independent director should not only hire independent candidates to the board, but also be made responsible for ensuring the 'real independence' of the proposed appointment. This is another aspect that the RBI sub-committee could look into as part of its mandate and provide suitable recommendations

How Much Time Should Be Spent by Independent Directors on Their Work?: Fifth, should the independent directors be mandated to spend a certain minimum time on work at the MFI? As an industry observer argues, 'independent directors should be required to devote a certain minimum number of hours every quarter or so to understand the business of micro-finance and gain insights of the MFIs in which they are serving as directors. This will enable them to examine the risks being taken and the appetite of their MFI to take such risks as well as understand and provide guidance on other strategic aspects, as may be required.’ This again could be looked into by the RBI sub-committee

How Many MFIs To Serve as an Independent Director?: Sixth, a related aspect is the time spent by independent directors on board meetings of a single MFI, annually. When there are people who have at any one point in time, serve as independent directors on several MFI boards, naturally, the quality of directorship is likely to suffer. It may appropriate for the RBI sub-committee to recommend a threshold level for number of MFIs, in which people (professionals) could serve as independent directors.

Should Peer Appraisal of Independent Directors Be Made Mandatory?: Seventh, peer appraisal of independent directors is an option for enhancing their effectiveness and this needs to be examined from the perspective of MFIs. While such an appraisal process would need to be managed with associated sensitivities, board members should also view this as an opportunity for continuous improvement and enhancing the corporate governance framework. Traditional methods of evaluation (in terms of share prices and strategy initiatives) can be augmented with a formal and objective appraisal of the governance framework. The appraisal should enable identification of gaps, better decision making, improve effectiveness of meetings, etc. This is also an aspect that could be looked at by the RBI sub-committee, in the context of MFIs

Do First Time (Independent) Directors Need Capacity Building?: Eighth, another critical area often ignored is the need for continuous director education programs, especially for the entry or first time (independent) directors. This is very critical for micro-finance and especially, if we want to ensure that the same people do not serve on the boards of too many MFIs. This capacity support could be done through the College of Agricultural Banking or any other appropriate institute. This is a very critical issue and could be examined by the RBI sub-committee

How Should Independent Directors Be Compensated?: Ninth, the compensation of independent directors is a very critical and contentious issue and there have been a lot of controversies in the recent months. The RBI sub-committee must surely set standards for the same and ensure that the independence of the independent directors is not compromised, under any circumstances. One option would be to entrust this to the board nomination committee and ensure that the promoter/CEO do not interfere in setting and implementing norms of compensation for independent directors. While there could be other strategies, I think that this is one of the most important issues that needs to be looked at by the RBI sub-committee.

How to Protect Client Interests on The MFI Board?: The RBI sub-committee could also examine whether there could be specially designated independent directors, representing client interests. This is especially crucial in MFIs that have and use the Mutual Benefit Trust (MBT) structure, which is indeed a client owned body – please recall that there have been many issues with regard to governance of MBTs in the recent past and the extent to which their interests are being protected in the boards of MFIs. The same should be explored by the RBI sub-committee and suitable recommendations provided and like compensation, this is a very important issue in MFI governance.

Finally, while enhancing the quality of independent directors would surely enhance governance, there is also a right mindset aspect that we should not forget. As Mr Kris Gopalakrishnan, (Infosys CEO) says, 'We may not be able to eliminate corporate frauds altogether. No amount of regulation will help to stop frauds. At the end of the day, corporate governance is a mindset issue. We need stricter, stronger and quick enforcement of law by regulatory agencies so that it will act as a deterrent for others.[i]  Other observers agree, “As a baseline, MFIs need to have good governance in case they need to sustain and be profitable in the long run. Governance needs to be lived and practiced by the promoters and senior management at all times – and most importantly, when faced with the most difficult of situations.”

Therefore, while practicing good governance at all times is certainly a mindset issue, the least we can do is to incentivize good governance and perhaps penalize bad governance and do this consistently and without fear or favour. For this, we need a practical guiding framework pertaining to appointment, roles, responsibilities and compensation of independent directors and this is something that the RBI sub-committee could gift to the Indian micro-finance sector…that is perhaps low on its governance quotient...at least at this moment...  

[i] Quoted with Adaptation from The Satyam Saga, Business Standard Publication

Monday, November 29, 2010

Why Did Several Top Indian MFIs Grow Very Rapidly During April 2007 to March 2009: 4 Scenarios for Hypothesis Testing By The Reserve Bank Of India Board Sub-Committee on Micro-Finance!

Ramesh S Arunachalam
Rural Finance Practitioner

I have been wondering about the causes of the burgeoning growth experienced by MFIs in India during the last few years and have had this nagging question, at the back of my mind, for almost 3 to 4 months:

ð   What caused MFIs to grow at such rapid rates?
ð   Specifically, what made them add a very significant proportion (often greater than 2/3rds) of their total end march 2009 client outreach, during the period April 2007 – March 2009?

Please see data in Tables below, which are self-explanatory. They have been compiled from http://www.mixmarket.org/

As seen from the above tables, the following aspects are clear:

·    For the group of top 14 MFIs (ranked on the basis of number of clients added from April 2007 to March 2009 and other parameters), barring two institutions, for all the others, almost 75% (or more) of the total clients (added between April 2005 to March 2009) were done so during the period April 2007 to March 2009.
·    For the two institutions that are exceptions, nearly 2/3rds (or 67%) of the clients added between April 2005 to March 2009, were done so during the fastest growth period – April 2007 to March 2009
·    Further, for these top 14 MFIs, barring three institutions, all of them added a very significant proportion (>2/3rds or 66.67%) of their total end March 2009 client outreach during the 24 months from April 2007 to March 2009. That is phenomenal growth indeed by any standards
·    This clearly establishes this period of April 2007 to March 2009 as the period of most rapid growth (ever perhaps) in Indian micro-finance.

Therefore, in many ways, these two financial years (April 2007 – March 2009) represent a watershed for Indian micro-finance and I believe that the seeds for the present Andhra Pradesh and Indian micro-finance crisis were actually sown then or thereabouts. That this period of phenomenal growth occurred just 1 to 1 1/2 years after the famous KRISHNA Crisis in Andhra Pradesh (2005/6) is indeed interesting and I think the remarks of Mr C S Reddy, CEO, APMAS (quoted from the CGAP Blog) put the various happenings in proper perspective:

“For almost six years, the MFIs have been asked to improve their practices on the ground. However, there is no improvement. After the 2005-06 crisis, the MFIs came up with the voluntary code of conduct. Its implementation is yet to begin. The SHGs and their federations suffered a great deal due to the exponential growth of the MFIs without any regard for the SHGs.

In 2005-06, MFIs made several commitments like reducing the interest rates, not indulging in multiple lending and that the recovery practices would not be coercive. None of those commitments were acted upon. They did not seem to learn any lessons from the previous experiences. MFIs have pushed a lot of credit resulting in many households in a debt trap.

MFIs have to demonstrate that they “walk the talk”. Those that seem to make comments in support of the MFI practices need to understand the practices on the ground. Responsible microfinance does not exist in practice” - Quoted from CGAP Blog, Crisis or Opportunity.

While it is now an accepted fact that MFIs grew at a scorching unbelievable pace and perhaps did not engage in RESPONSIBLE Micro-Finance as promised by themselves, without question, we need to understand the happenings better in terms of causality. Specifically, we need to better understand their motivation to grow at the rates they (eventually) did and also, on who actually gave them the resources to grow at this pace? There are several possible explanations, which could be explored and this has to be properly researched and understood by The RBI Board Sub-Committee – as only then can proper remedies, to cure the actual causes, be offered. Otherwise, the solutions provided may tackle just the symptom whereas the disease could still be spreading…

Accordingly, the four scenarios for analysis and hypothesis testing are listed below:

1.   Scenario # 1: MFIs Grew So Rapidly Because They Wanted Greater Investment and Better Valuation and Were Keen to Tap Capital Markets: Did the MFIs grow because they wanted to attract more equity at higher than normal valuations and ultimately, tap the capital markets (IPO etc)? For the years in question (April 2007 to March 2009), what is the actual level of equity investment into Indian micro-finance and how does it compare with previous years, both in terms of the volume of the transactions (deals) as well as the valuations paid? Was this flow of equity dominated by certain types of investors? Were they national, international or both?

2.   Scenario # 2: The Financial Inclusion Drive by Policy, Donors and International Agencies Resulted in MFIs Growing At A Scorching Pace: Did MFIs grow because of the (well intentioned) drive by policy and/or specialized donors/international agencies towards financial inclusion? What specific policy/vision pronouncements can be traced to the above/preceeding periods and what is the relative impact of these in accelerating the growth of micro-finance for the period in question? Were there special drives to enhance financial inclusion in the concerned periods and what is the relative impact of these in causing burgeoning MFI growth during the concerned periods?

3.   Scenario # 3: Commercial Banks Pushed MFIs To Grow At A Burgeoning Rate So That They (The Banks) Could Achieve The Mandatory Priority Sector Lending Targets: Did the MFIs grow because the commercial banks, in turn, pushed them (the MFIs) so as to meet/satisfy priority sector lending norms and/or acquire a larger portfolio and get better returns from a captive pro-poor market? Which types of banks have increased their micro-finance portfolio during the concerned years and by how much? Is there a rationale underlying the pattern of increases across the various types of banks? Did policy push the commercial banks to cater more to micro-finance and what can be said about the impact of this on the ground, in terms of increased lending to MFIs, during the specified period?

4.   Scenario # 4: Investors Who Paid a Huge Premium Sought Commensurate Returns ASAP And They Caused MFIs to Grow Very Rapidly: Or was it the investors - who had perhaps paid larger than normal valuations and were eager to get their commensurate returns, ASAP - who made the MFIs grow at a very rapid pace? What can be said about the various equity deals that took place in Indian micro-finance during April 2007 to March 2009? What were the respective valuations and how appropriate were these, in comparison to national and international standards? Who were the main categories of investors that came in? What can be said about their motivation, orientation and vision and its impact in terms of causing the burgeoning growth among MFIs during the concerned years?

Therefore, it becomes critical to analyse the above four scenarios and understand their (relative) causal impacts that (perhaps) drove the Indian micro-finance industry to such a desperate situation and deep crisis. The point of this exercise should not be to witch hunt or blame any stakeholder(s) – that phase is clearly long over and it is about time that we approach the whole crisis in a constructive, scientific and professional manner so that appropriate solutions are put forward (and necessary safeguards created) to prevent such crisis from recurring in future. I sincerely hope that the RBI Board Sub-Committee, looking into the micro-finance, calls for authoritative (emphasized as reliable/valid data[1]) on the above and analyses the same before outlining its prescriptions for regulation of the Indian micro-finance industry…This is another step that will enable the RBI to take greater charge of the ‘orphaned’ Indian micro-finance industry that is desperately and urgently seeking a legitimate regulator…

[1] While the above are all serious possibilities, the lack of reliable and valid data prevents us from making a conclusive argument. For example, I have been struggling, despite my deep-rooted contacts in the Indian micro-finance industry to get reliable data on how bank lending to the micro-finance industry in India grew in the same period. Likewise, it has also been extremely difficult to get accurate information on the various equity deals that happened in Indian micro-finance during the last few years. I am close to finishing this and will post separately on the same, as and when credible data becomes fully available

Sunday, November 28, 2010

Improving The Governance of Compensation in MFIs: Four Practical Strategies Based On The Indian Experience…

Ramesh S Arunachalam
Rural Finance Practitioner

There has been so much of controversy regarding the governance of compensation in MFIs, especially during the last few months. I had posted my observations - a few days ago - with regard to remuneration issues at various MFIs in India. In this post, I try and look at how the governance of compensation at MFIs can (perhaps) be improved in practice…This is something that we stakeholders (bankers, investors, technical support personnel, raters and others including MFI associations and regulators perhaps) - in the Indian micro-finance industry - could look towards achieving…in our own little ways…as part of our work with MFIs. Here are some practical things that we could try and implement on the ground…to ensure that the process in governance of compensation at MFIs becomes transparent and is perceived to be fair…

1.   Boards Must Play Proactive Role in Governance of Compensation at MFIs and Compensation System Must Not Be In Grip Of The CEO/Senior Management: First, boards of MFIs can and must play a proactive role in establishing proper governance of remuneration and that is where the buck actually stops…It naturally follows that the board must also ensure that this compensation system is not primarily controlled by the chief executive officer and/or other members of the senior management team (chief operating officer, chief finance officer etc).

In fact, the above has been a major problem with some of the MFIs in India – here, the compensation system, which was firmly in the grip of the CEO and/or senior management team, witnessed non-transparent actions, related party transactions and whimsical payouts to CEO/Senior Management, without sufficient rationale or justification. In fact, I see these happenings as a major catalyst for the present micro-finance crisis in Andhra Pradesh and India as, at the concerned MFIs, many of the (compensation) decisions were laden with significant conflict of interest…and they are really questionable from a legal as well ethical standpoint…

Key Questions (Not exhaustive) For Various Stakeholders: Therefore, it is in our interest, as an industry stakeholder to ask relevant questions as part of our day-to-day work in the micro-finance industry and some of the key questions are given below:

  1. Are the board of directors effectively taking overall responsibility for the MFI compensation system, including by participating directly in the design and operation of this system?
  2. Has the board ensured that the CEO and/or senior management team at the MFI are NOT in control of the compensation system?
  3. Is the compensation policy aligned with the risk management framework of the MFI?
  4. Have the board of directors at the MFI approved and periodically reviewed the compensation policy?
  5. Has the board ensured that the compensation policy at the MFI does NOT provide incentives for excessive risk-taking?

2.   MFIs Boards Must Have Members with Requisite Compensation Experience and Real Independence So That They Can Effectively Participate in Governance of Compensation: This takes us to second aspect – i.e., therefore, it becomes crucial for the MFI to have board members with relevant expertise in compensation and perhaps risk management. More importantly, these members must have complete independence in dealing with the (design and operation) MFI’s compensation system. In a way, this is the fulcrum of having a fair compensation system at the MFI and the board members not only need to have the requisite experience but also must be able to use it in an independent and objective manner. This in turn implies that the boards of the MFIs should not be filled with friends, relatives and nodders as Mr Damodaran, the former SEBI chairman has argued. Again, in the present crisis, in few cases, nominee directors and other independent directors seem to have been silenced and their independence appear to have been compromised (on several occasions) with regard to matters of compensation and remuneration. This again, has left a very bad taste with the general public about the micro-finance industry in India.

Key Questions (Not exhaustive) For Various Stakeholders: The relevant key questions are given below:

  1. Is the board composed of independent, non-executive members, without any conflict of interest?
  2. Does the board have sufficient expertise (in terms of members) to assess risk management issues related to compensation?
  3. Does the board have (members with) the skills and experience to reach an independent judgment on the compensation policy?
  4. Are the relatives of the CEO and/or senior management on the board of the MFI? Are there close former associates and/or friends of the CEO/Senior Management, who are on the board of the MFI?
  5. Can the appointment of the above members to the board of the MFI be justified in terms of their professional expertise? Or are these relatives/former associates/friends there on the board primarily because of their (personal) relationship to the CEO/senior management?

3.   Independent Board Remuneration Committee Must Be Established At MFIs to Oversee Design and Operation of Compensation System: While the above two points define the role and responsibility of the board of directors, a key question that arises here is how can the MFI board best accomplish this? Neither can all members of the board spend their entire time on this nor can individual members of the board work on this in an adhoc manner.

In other words, there is a critical “how to” with regard to the discharging of the above roles and responsibilities by the MFI board – i.e., the establishment of an appropriate independent remuneration committee[i] and the defining of its mandate to function. And it is through this committee, that the MFI’s board of directors, can design, monitor and review[ii] the compensation system to ensure the system operates as intended.

Therefore, as noted above, it is critical that MFIs have a board remuneration committee as an integral part of their governance structure and organisation to oversee the compensation system’s design and operation on behalf of the board of directors. The following are important issues here:

·    The remuneration committee should be constituted in a way that enables it to exercise competent and independent judgment[iii] on compensation policies/practices and the incentives created (at the MFI) for managing risk, capital, liquidity and customer satisfaction.
·    In addition, the committee should carefully evaluate practices by which compensation is paid for potential future revenues whose timing and likelihood remain uncertain. This is a very critical lesson from the recent global financial crisis as also the current micro-finance crisis in Andhra Pradesh.
·    And while doing so, the committee should demonstrate that its decisions are consistent with an assessment of the MFI’s true financial condition and future prospects.
·    Further, to that end, the remuneration committee must work closely with the MFI’s risk committee in the evaluation of the incentives created by the compensation system, and 
·    It should also ensure that the MFI’s compensation policy is in compliance with Global Good Practices and Standards as well as respective rules of the national regulatory authorities

Key Questions (Not exhaustive) For Various Stakeholders: The relevant key questions are given below:

a.   Are there controls in place to regularly oversee the compliance of the compensation system? What are these and how sufficient are these controls? Is one of key controls, the independent board remuneration committee?
b.   In order that the MFI board remuneration committee is able to operate independently from the senior executives, is it composed, at a minimum, of a majority of independent, non-executive (board) members, without any conflict of interest[iv]?
c.   Does the MFI’s board remuneration committee have (members with) the skills and experience to reach an independent judgment on the compensation policy?
d.   Do the charter/ terms of reference of the board remuneration committee suggest that it has sufficient powers (mandate) to perform its functions independently?
e.   Is the board remuneration committee at the MFI responsible for the preparation of recommendations to the board regarding compensation, including those which have implications for the risk and risk management?
f.    Has the board remuneration committee at the MFI made recommendations to the board on the compensation to be paid to the highest paid employees, based on a pre-determined materiality threshold?
g.   Does the board remuneration committee at the MFI have access to advice, either internal or external, that is independent of advice provided to senior management? What has been the process used for commissioning external advisers to advise the board on compensation policy? Do these advisers report directly to the board remuneration committee? 
h.   Does the board remuneration committee at the MFI have unfettered access to information and analyses from risk and control function personnel (e.g., risk management, finance, compliance, internal audit and human resources etc)?
i.    Does the board remuneration committee at the MFI engage appropriate control function personnel in its deliberations on compensation policy? Do control functions at the MFI have input in the structure and determination of compensation?

4.   MFI Board Remuneration Committees Must Ensure An Annual External Compensation Review: Last but not least, the remuneration committee should facilitate an annual compensation review at the MFI and get it externally done. This review should be independent of any CEO/senior management interference and it should be submitted to the remuneration committee, board of directors and regulator. It should also be disclosed publicly. And it goes without saying that such a review should, among other things, assess (legal) compliances with the applicable rules and standards promulgated by the relevant regulatory authority.

Key Questions (Not exhaustive) For Various Stakeholders: The relevant key questions are given below:

  1. Is there an external annual compensation review at the MFI?
  2. What is the process developed for conducting the annual compensation review? Is it an objective and fair process without conflicts of interest?
  3. Does the annual compensation review assess the compensation policy’s compliance with the global principles/standards in the micro-finance industry, as well as standards (if any) promulgated by national supervisors?
  4. Does this include ensuring that all material compensation plans/programs (including those for executives and employees whose actions have a material impact on the risk exposure of the MFI) are covered?
  5. Does this include assessing the appropriateness of the plans/programs relative to organisational goals, objectives and risk profile of the MFI?

Without question, irrational and adhoc compensation practices (at some MFIs) appear to be a major factor that seem to have contributed (in some measure) to the present micro-finance crisis in Andhra Pradesh and India. Therefore, it is imperative that the micro-finance industry undertakes immediate and suitable action to address (such) unsound compensation systems, prevalent at many MFIs. And this action …must be speedy, determined, coherent and transparent… for the micro-finance industry in India to gain back its credibility and past glory. I also hope that the RBI sub-committee focuses on this aspect as part of its Micro-finance regulatory exercise…

[i] Some times the board may have people with requisite skills and experience and also independence. They however need to be appointed to the MFI compensation committee and there are cases, where this has not happened as the CEO/senior management have desired otherwise.
[ii] Two issues are relevant here and one is the fact that the compensation system will need to have controls to ensure compliance and in some ways, the committee itself is the main control available. Thus, the committee will have to also review the practical operation of the compensation system regularly for compliance with design policies and procedures. Compensation outcomes, risk measurements, and risk outcomes should also be regularly reviewed for consistency with intentions. That is very critical
[iii] Same as i above
[iv] Same as i above

Saturday, November 27, 2010

The Proposed Credit Bureau for Micro-Finance in India: A Great Idea But Let It Not Be Baptism by Fire!

Ramesh S Arunachalam and Bhalchander Vishwanath[i]

The last time around we had a similar but not so severe micro-finance crisis (2005/6) in Andhra Pradesh – and some industry well wishers argued for the (Sa-Dhan) code of conduct, so well intentioned but not implemented adequately on the ground. Fast forward to the Kolar micro-finance crisis (2009) and industry observers argue that the situation had a different association but similar strategy and result – MFIN and its code of conduct, again well intentioned but not well implemented. Come to the present and there is the current Andhra Pradesh crisis (September 2010 onwards) and industry experts say that this time around, one of the solutions could really be ‘high tech’ - i.e., the proposed credit bureau to be set up by The Micro-Finance Institutions Network (MFIN). Could the proposed credit bureau (indeed) be a solution to the present crisis? Read on…

First, despite the most sophisticated credit bureaus, the sub-prime crisis in the US could not be avoided and therefore, no credit bureau - irrespective of the manner in which it is designed and implemented - is likely to be a foolproof strategy with regard to avoiding such crisis. Make no mistake about this please! Believing that a credit bureau could indeed prevent such a crisis from recurring would be as naive as one could get. There can no replacement what-so-ever for sound lending, based on an objective assessment of a client’s (likely) cash flows and his/her loan absorption capacity. Further, there can also be no substitute for the relationship banking that most of us get and without question, micro-finance clients deserve the same as well.

Second, when we talk of micro-finance clients, there is so much information asymmetry with regard to their loans and lives and we are not sure that the proposed credit bureau would be able to acquire such information.  We do not have access to any reliable and valid information on informal sources of finance and getting them at the scale required for the proposed credit bureau, should be next to impossible in the Indian context.  We cannot also easily track the lending that an SHG does to its members – it could become cumbersome to do so and very difficult task from a record and data management perspective

Third, when many MFIs (including the large ones) have not been able to set up and run appropriately designed and aggregated management information systems (MIS) across geographies, products, states etc at their own individual MFI level, how can we expect them (and their association) to accomplish a more difficult task with significant complexity and scale? There are serious issues with record keeping, portfolio management, internal control and finance/accounting systems in many MFIs and the integrity of the ground level data is very questionable. Therefore, expecting the MFI association to do something that is much, much more advanced, when the basic foundations of record keeping and data management are itself very weak is going to be a stretch.

Fourth, establishing a credit bureau even with limited functionalities takes an enormously long time. In India with multiple models of microfinance - MFIs, Banks, RRBs, SHGs, Cooperatives - lending to clients, integrating information from all these entities and making them available with a reasonable degree of reliability will be an enormously complex project requiring significant investments. Please note that huge investment in terms of money and effort would be required to build the central credit bureau and also implement it at the individual MFI level.

Fifth, studies on efficacy of credit bureaus indicate that they do have risks of financial exclusion of the poorest clients. That needs to be noted and before embarking on such an initiative, we need to mitigate the risks of financial exclusion due to new techniques that focus on impersonal means of making credit decisions.

"The results therefore bring both good news and a cautionary note. They are positive in that they show that credit bureau information allows MFIs to more effectively service the poor. Yet, they highlight that a number of poor individuals are initially screened out as credit bureau information is utilized. It is important that we understand which poor individuals are no longer offered loans.

If they are indeed bad clients, in the sense that they are likely to default because they refuse to pay even though they have sufficient resources or because they make overly-risky investments, then there is little cause for alarm. However, if those who are screened out are individuals whose bad repayment record is a result of idiosyncratic shocks and not moral hazard, then MFIs must be careful in using credit bureau information.”[ii]

Sixth, there are also significant investment and operational costs involved in setting up a credit bureau. These include:
a.   Cost of setting up and maintaining the credit bureau
b.   Cost of capturing additional information for credit bureau purposes and making changes to the MIS systems of participating organizations, which may have differing designs and standards (thereby, posing numerous problems for integration as well)
c.   Cost of training the staff
d.   Cost of client education: Clients who are mostly poor should be able to get their credit status and report for free. They should be entitled to this information, as it is theirs alone.  They should also be educated on what a credit report means and what they need to do to improve their credit (rating or score). There should be also an independently monitored appeal process at no cost to the client so that clients are not inadvertently excluded due to improper credit approval systems.

A robust financial model that takes all of these into account should be built so that it does not lead to additional costs for the client or handling fees for the MFI.

Seventh, the efficacy of setting up specialized microfinance credit bureaus has also been questioned in a few studies in Latin America. It perhaps makes more sense to set up a general credit bureau through the main banking system (for the middle class and upper middle class) and extend the same to lower middle class and the poor. With CIBIL operational, the same could be done in India and that would also not burden the poor with bearing the costs of setting up the infrastructure of a credit bureau.

"The country case studies reviewed in this chapter lead to the preliminary conclusion that it is unwise to develop very specialized credit bureaus that by their nature fragment the credit information market. Whether in El Salvador or Bolivia, the specialized sectorial bureaus do cater to their institutional subscribers, but their databases miss a wealth of information on clients who have not yet fallen under the purview of that particular sector. Efforts to create specialized MFI credit bureaus have been based on the assumption that the market niche of MFIs is completely separate from the market niche of other lenders. This assumption is proving to be false, at least in many Latin American countries, where microfinance clients access a variety of sources of financing, including the corner store.

Pursuing quick-fix solutions, such as endowing an MFI association with equipment, software, technical assistance, and operating expenses to run a small MFI credit bureau, is tempting for donors. As has been illustrated by the cases of INFORED and FINRURAL, however, setting up a credit bureau is not a simple matter. It requires superior technology, business marketing sophistication, and the ability to attract as subscribers large and multiple clients. With a large subscriber base, a bureau can have something useful to offer, in addition to securing its financial sustainability.[iii]"

Eighth, currently micro-finance (or rather micro-credit) is going through a phase of limited relationship building with the client. A credit bureau will perhaps depersonalize the client-loan officer relationship even more. What is needed at this time is deeper involvement and knowledge of the client's life and business and stronger relationship building with clients. A credit bureau may end up doing the reverse and thereby increase the risks to the micro-finance sector.

Ninth, such a bureau should be mainstreamed and housed with CIBIL or any other independent body, and MFIN should (perhaps) limit itself to playing the much needed facilitating/coordinating role. This alone will enable the credit bureau to be viewed as a reliable and valid data source with regard to low income people. It will also allay concerns of poaching of bank clients by MFIs and vice-versa.

Therefore while a credit bureau is a good medium to long-term solution, it is certainly not an immediate solution for the current set of issues. It has and will continue to have operational challenges for several years, if not decades in the context of a country like India that has a huge variety and complexity of financial services. Let us not overburden it with unrealistic expectations – that would surely be a recipe for disaster. A credit bureau is a great idea by itself and it should be made to succeed. Let us incubate it in a favourable environment and not let it face baptism by fire at its very birth…

[i] Mr Bhalchander Viswanath is CEO of United Prosperity.Org and the views expressed are purely personal. Ramesh S Arunachalam is an India based Rural Finance Practitioner.
[iii] Refer: Credit Bureaus: A Necessity for Microfinance? by Anita Campion and Liza Valenzuela. http://www.microlinks.org/ev_en.php?ID=7445_201&ID2=DO_TOPIC, page 22'

Friday, November 26, 2010

The Governance of Risk Management in MFIs: Lessons from The Andhra Pradesh and Indian Experience

Ramesh S Arunachalam
Rural Finance Practitioner

One of the most important fallouts of the recent crisis has been the apparent lack of and/or failure of risk management at many MFIs. There are several observations I have here and these are articulated below, not in any order of importance:

Internal Controls for Financial Reporting Vs Risk Management: In many MFIs, the (sole) focus on internal controls was mainly for the purpose of financial reporting. This resulted in risk management getting divorced from strategy and its implementation. Also, in several MFIs, the basic tenets of internal control, particularly those pertaining to operating risks, were not followed.

Risk Handled in Piecemeal Fashion: In a few cases, the enterprise (or MFI) as a whole was not considered and risk was handled in a piece meal fashion – so much so that even the boards were completely out of touch with the (risk management) systems in place. Thus, a holistic and comprehensive perspective on risk was lacking

Risk Management Mistaken with Risk Elimination: In one MFI, effective risk management was seen as eliminating risk taking and that is perhaps an inappropriate view of things. MFIs and other stakeholders must understand that RISK is a fundamental driving force in any activity including the business and entrepreneurship of micro-finance. Therefore risk elimination is perhaps strictly not possible. The aim must be to ensure that risks are understood, managed and, where appropriate, communicated throughout the organization, so that the whole MFI can be ready for it, as and when it becomes significant.

Inability to Seriously Anticipate and Properly Manage Political Risk: In several MFIs, the present political risk was neither (seriously) anticipated nor managed on an institution wide basis. People (initially) looking at this risk were perhaps either far too junior or lacked the requisite contextual experience and often, there seemed to be no serious guidance from senior management/board. Most importantly, boards were, in a number of cases, ignorant of the key (political and other key) risks facing their MFIs and came into the picture, much later than required

Lack of Board Involvement in Establishing/Overseeing Risk Management Structure: Without question, the effective implementation of risk management requires involving the Board in both establishing and overseeing the risk management structure. This did not happen and in many MFIs, the Board neither reviewed nor provided guidance about the alignment of overall (Corporate and Micro-Finance) strategy with risk-appetite and the internal risk management structure.

Lack of Independence of Risk Management and Control Functions: To assist the Board in its work, risk management and control functions need to be independent, reporting directly to the Board. However, this was seldom the case and as a result, risk perceptions often got altered by line management (and other staff) and were perhaps not fair representations of the true risk confronting the MFI (A situation akin to not wanting any bad news, often, without realizing that timely bad news affords a great chance to have appropriate on-course corrections). Sometimes, a true picture of the risks perhaps never reached the board, which was left high and dry when the same affected the organisation

So, how then can the Governance of Risk Management be improved in MFIs?

Here are some ideas…for what they are worth and what they are not…

Risk Assessment and Corporate Governance
1.  Sound corporate governance at MFIs can enhance the quality of risk management including the processes adopted. As Governance involves many stakeholders, each with specific assigned responsibilities, they need to ensure that the system as a whole is geared to support the overall corporate and business strategy and ensure the effectiveness of the internal control mechanisms.
2.  While board of directors is certainly not expected to understand every nuance of the micro-finance business or to oversee every micro-finance transaction, they surely need to ensure that management does that using an organized hierarchy of responsibilities. The board, however, does have the responsibility to set the tone regarding their MFIs risk-taking (preferences) and to oversee the internal control processes so that they can reasonably expect that their directives will be actually followed during implementation. They also have the responsibility to hire individuals who they believe have integrity and can exercise a high level of judgment and competence.

Risk Management and Internal Controls
3.  Boards of directors also need to be responsible for ensuring that their MFIs have an effective audit process and that internal controls are adequate for the nature, scope and scale of their micro-finance business. The reporting lines of the internal audit function should be such that the information that board (of directors) receives is impartial and not unduly influenced by (line and other) management. Internal audit is a key element of management's responsibility to validate the strength of internal controls. This aspect should not be underestimated.
4.  Internal controls are the responsibility of line management and line managers must clearly determine the level of risks they need to accept to run their micro-finance business (in accordance with the board’s overall risk appetite) and to assure themselves that the combination of earnings, capital, and internal controls is sufficient to compensate for the risk exposures. This again is a very critical issue.

Risk Management, Growth and Corporate Governance

5.  Internal controls and sound governance become even more important when the MFIs’ operations move into higher-risk areas – like the kind of growth that MFIs experienced during 2007 - 2009. Indeed, when changes are happening as they have in the last three years in Andhra Pradesh, control failures will increase significantly. Rapid growth, introduction of new (adapted) products and delivery channels (use of agents for example) are examples of situations that put stress on the control environment.
6.  When these types of changes occur, "people risks" escalate. These are risks that are related to training employees in new products and processes. Employees who join the MFIs need to learn the culture of the company and the control environment. Employees unfamiliar with their new responsibilities--the systems they use, their changing client profile, the services they provide customers, the oversight expected by their own supervisors and members of internal control functions--are all more likely to create control breaks. As a result, MFIs need to be wary of and manage people risks appropriately and in timely fashion, through a good human resources function.
7.  Rapid growth and change also modify the relative risks to an MFI. For example, the pressure to beat a competitor to market with new/same products (as has been the case in Andhra Pradesh in the last three years) may shortcut the design-review process and omit an important control. In fact, significant controls that were there in the original Grameen (or even India Adapted Grameen) have perhaps been forgotten and that is why we hear of unsound lending and coercive recovery practices, with regard to MFIs today. It is time that MFIs revisit their original model and bring back features that facilitated borrower preparation (so significant in the original Grameen and other models), client protection and client dignity. That would be a very useful strategy to minimize and counter political risk…
8.   Many of the MFIs that have been the center of the recent AP crisis also demonstrate some similar characteristics. Barring a few exceptions, they are mostly led by hard-charging entrepreneurs whose ability to think outside the box pioneered advances in the business of micro-finance. But the personalities of these individuals, in many cases, led to a focus on (perhaps even unmanageable) growth and as a result, inadequate time was spent on building the control infrastructure, much required in such an environment
9.   Another form of people risk is internal fraud. When expectations of the market and supervisors, or pressures of professional/personal life become overwhelming, key staff may step over the ethical and legal boundaries and cover up errors or purposely commit fraud. There is good enough reason to believe that this may have been the case with several of the staff who have been found to be involved in recent frauds in Indian micro-finance. Again, the human resources function must take the driver’s seat and try and reduce (or if possible eliminate) unrealistic expectations and ease work time pressures – so that the staff are not forced to cross the line (or LAKSHMAN REKHA), with regard to ethical behavior on the job. An important aspect here is to ensure that there should be NO disconnect between strategy and risk management on the one hand, and incentives on the other. By incentives is meant not just remuneration but also other aspects such as promotion. That would also help in reducing ‘people risks’

To summarise, although risk management has become much more quantitative, considerable management judgment must be applied to the risk management process and this is what MFIs need to get their boards to facilitate. Frequent, small losses can generally be absorbed in the operating margin of the product or service. It is the low-probability, large losses that provide the greatest challenge. And, it is just such risks--the ones that can severely damage, if not kill, an MFI--that too many institutions do not formally take into consideration. Sometimes, I wonder whether MFIs thought lightly about the risk of political action (because the industry was after all widely regarded as the HOLY Cow of financial inclusion) and this gross underestimation is perhaps one of the main reasons as to why they were completely taken aback when this risk actually became a reality…in Andhra Pradesh…in October 2010…