The Journey of Indian Micro-Finance: Lessons For The Future

The book, "The Journey of Indian Micro-Finance: Lessons For the Future" can be ordered on the web from Aapti Publications from July 22nd 2011 at and it will also be available at stores in major metros in India by end July/early August, 2011. If interested, please read a review of the book by Ms Sucheta Dalal, Managing Editor, Money Life, at or

Friday, April 15, 2011

Internal Control Issues in The Present Indian Micro-Finance Crisis: Lessons For NBFC Supervision and Business Correspondent Regulations

Ramesh S Arunachalam
Rural Finance Practitioner

Even as I write this post, I am aware that there is a special committee of the RBI headed by former Deputy Governor, Mrs Usha Thorat, that is looking into issues related to NBFC supervision. I am also aware that RBI is looking closely into aspects of Business Correspondents. I would like to make a humble submission of what I think are some of the key internal control issues that caused the on-going micro-finance crisis in India. I sincerely hope that these are taken into account while formulating the recommendations of the above committees as well as acting on the recommendations of the Malegam Committee. Read on…

1.       Weakened Internal Audit Function in Many MFIs: Boards of directors are responsible for ensuring that their MFIs have an effective audit process and that internal controls are adequate for the nature and scope of their businesses. The reporting lines of the internal audit function should be such that the information that directors receive is impartial and not unduly influenced by management. Internal audit is a key element of the overall responsibility to validate the strength of internal controls. This sadly did not happen in many MFIs and especially, at the large AP headquartered MFIs. The same weakness continues in many large and fast growing MFIs located in other parts of India

2.       Disregard for Internal Controls by Many Line Managers: Internal controls are the responsibility of line management. Line managers must determine the level of risks they need to accept to run their businesses and to assure themselves that the combination of earnings, capital, and internal controls is sufficient to compensate for the risk exposures. It is clear from the Indian micro-finance crisis that basic tenets of internal control, particularly those pertaining to operating and related risks, were not followed – in fact, from my posts on agents, it is apparent that the line managers in major fast growing MFIs had disregard for even the most basic controls.

3.       Enhanced People Risks Also Causing Failure of Internal Controls: Internal controls and sound governance become even more important when firms' operations move into higher-risk areas. Indeed, when changes are happening, control failures often increase significantly. Rapid growth (as happened during April 2007 – March 2009), introduction of new products and delivery channels (including business correspondents) are examples of situations that put stress on the control environment. When these types of changes occur, "people risks" rise. These are risks that are related to training employees in new products and processes. Employees who join the organization need to learn the culture of the company and the control environment. Employees unfamiliar with their new responsibilities--the systems they use, the services they provide customers, the oversight expected by supervisors and members of internal control functions--are all more likely to create control breaks.

This is what is happening in Indian micro-finance and I have met a number of stakeholders at the grass-roots who state that all and sundry, including those with local criminal records have been brought in as staff, to meet the burgeoning growth requirements. I am 6 foot and three inches tall (and well built) and let me tell you that I was personally intimidated (and petrified) by the kind of staff and agents that I met during the present field visit in various places. They appear to be local toughies often used by local political masters and have no idea of the micro-finance spirit and mission – they just know to quickly disburse and recover money as tough money lenders do and most importantly, have zero tolerance in performing their duties. Much of this is captured on video tape as well. With many staff/agents who are not necessarily attuned to the vision and spirit of micro-finance, I am not at all sure that the current on-going efforts to integrate social performance, client protection and the like will happen on the ground, UNLESS some real fundamental changes are made to the MFI delivery model (I will be making a separate post on this aspect based on my field experiences)

4.       Drive for Efficiency Causing Omission of Key Controls: Rapid growth and change also modify the relative risks to an organization. Further, the pressure to beat competitors to the market with new/old products may also result in adoption of shortcuts (in the process) and important controls. This has happened consistently and today, the drive for efficiency and more standardized process is such that no time is being invested in building the client level relationship, which incidentally was the key feature in the early success of micro-finance. The proliferation of agents and shortest lead time to disburse loans as an incentive criterion are as a result of this efficiency drive and these again, have resulted in omission of key controls in many MFIs.

5.       Irrational Expectations and Internal Frauds: Another form of people risk is internal fraud. When expectations of the market and supervisors, or pressures of personal life become overwhelming key staff may step over the ethical and legal boundaries and cover up errors or purposely commit fraud. This is what has happened in several cases and please see the following post:

6.       Greater Focus on Quantitative Versus Qualitative Risks: Frequent, small losses can generally be absorbed in the operating margin of the product or service and MFIs have tended to focus more on such risks and problems. 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 organization--that too many MFIS have not formally take into consideration. And that, in many ways, has resulted in many problems on the ground in the present day Indian micro-finance crisis

7.       Entrepreneurial Drive Results in Lack of Control Infrastructure: Last but not the least, many of the Indian MFIs, which have been at the center of recent governance failures, demonstrate some similar characteristics. They are lead by hard-charging entrepreneurs whose ability to think outside the box (in all fairness) pioneered growth, advances and innovation in micro-finance. But the personalities of these individuals, in many cases, led to a single-minded focus on growth, profits, equity investments and share valuations and this perhaps resulted in very little time being spent on building the control infrastructure so vital for the micro-finance  

I hope that the relevant committees look at these and other issues related to internal controls in the crisis affected Indian micro-finance industry. That is also one area where some rebuilding can and must start ASAP…to put the Indian micro-finance sector back on the rails…

Have A Nice Day!

1 comment:

  1. Ramesh

    Good message. Internal audit will not bring out entire episode, so internal inspection which will bring out both Financial and Physical related matters which affect the branch

    Hiring local male goonda will do his goodas work only. u cant expect him to do socialwork.
    It is a clear violation of the management mission drift of recritment policy