Where Angels Prey

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

Thursday, October 25, 2012

Rajat Gupta’s crime and conviction: Power gone wrong or breach of trust?

Ramesh S Arunachalam and Sushruthi Ramesh

Rajat Gupta’s case is the tale of a prosperous environment gone terribly wrong and a stark wake up call to correct it, if indeed we are to make an attempt to revive the faltering world economy at all
 
When the ball finally dropped on Rajat Gupta, it would seem it wasn’t as severe as anticipated at all. Two years imprisonment, a $5 million fine for charges of being compliant to insider trading. 

Please Click Here to Read More

Wednesday, September 12, 2012

Hugh Sinclair replies to my posts on regulation/supervision of MIVs


Given BELOW is Hugh Sinclair's Response to my earlier posts - Regulation and Supervision of Micro-finance Investment Vehicles (MIVs): A Suggested Practical Framework, Part I, Part II and Effective Control Systems at Micro-Finance Investment Vehicles (MIVs): The Key to Accountable Investing and Responsible Micro-finance Globally!



Hugh Sinclair's Response:

 
First of all, I would like to thank Mr Arunachalam for the work he is doing in this regard. I am pleased my book has helped place these issues on the table. MIV regulation is long overdue.

I produce this current text in response to Mr Arunachalam’s three recent posts on the topic of MIV regulation:  Regulation and supervision of microfinance investment vehicles - Part I and  Part II; and Effective Control Systems at Micro-Finance Investment Vehicles (MIVs).

I think two points need to be raised here. First, the focus on ASN Bank and Triple Jump should not distract from the fact that there may be other MIVs/banks that are equally guilty; and second, the implied ignorance of ASN Bank as to the underlying truth regarding LAPO may not necessarily be accurate.

ASN Bank invested in LAPO via Triple jump alongside Oxfam Novib. The ASN Novib fund, the first ever retail microfinance fund in fact, stood at €181 million at the end of 2011. However, let us not forget the other investors in LAPO: Deutsche Bank, Citi, Grameen Foundation, Calvert Foundation, BlueOrchard, responsAbility, Incofin etc. Each, to a greater or lesser extent, may be as guilty of the charges made in these documents as those investors explicitly mentioned. Kiva also pumped in approximately $5m, but is not a mainstream MIV. What is interesting is that most of these players knew precisely what they were doing either at the point of investing (had they bothered to read the rating reports as part of their due diligence) or shortly afterwards (when I pointed this out to most of them, as described in the book). They chose to do nothing until the New York Times began questioning them. In the case of BlueOrchard and responsAblity this is clearest, as they invested after the NYT article, by which point there was no excuse for ignorance.

However, the comment "The [ASN Novib] fund perhaps took at face value, the information that was provided by the fund manager [Triple Jump] and assumed it to be ‘correct’ and hence, did not do its own checks with regard to the reliability/validity of information" could lead a reader to assume that ASN Novib were somehow deceived by Triple Jump, and were thus largely innocent, or guilty only of failing to scrutinize Triple Jump sufficiently. This may not paint the complete picture.

Consider first of all that some (not all) information regarding the questionable nature of LAPO was in fact given to ASN Novib, and other information was publicly available. However, even after I raised the issue extremely openly with Triple Jump; after I directed a specific complaint to Ab Engelsman (Chairman of the board of Triple Jump, Chairman of the Netherlands Platform for Microfinance, multiple other positions including with ASN Bank and Oikocredit); and after I had explained the situation in some detail to Bruno Molijn of Oxfam Novib, they still managed to invite the LAPO CEO as their guest speaker to their AGM that year. When a rather embarrassing question about LAPO's interest rates exceeding 100% was asked publicly in the meeting (footnote 8), they failed to answer the question and in their next Spaarmotief newsletter, published by ASN Bank (not Triple Jump) they reassured their investors of interest rates charged to the poor of 25-30% (page 10). Although ASN Bank did eventually stop financing LAPO, to suggest that they were simply duped by Triple Jump may not be entirely accurate.

A broadly similar pattern took place with Kiva and Calvert Foundation. I document conversations (email and audio, both reproduced on the book website) which demonstrate prior knowledge of the specific activities of LAPO, but were ignored. Only when the NYT contacted Calvert/MicroPlace did they withdraw LAPO and shortly afterwards Kiva followed suit, but they had demonstrably known about this for some time and consciously failed to take corrective action. Calvert continues working with Triple Jump to this day.

Take the case of BlueOrchard, for example. When confronted about their investment in LAPO following this scandal, they issued a press release of questionable integrity which I analyse in the book and reproduce in full on the website. The CEO of BlueOrchard was replaced recently.

Thus we could potentially have an even more serious case on our hands. Not only are the fund managers not behaving entirely ethically, but even when the funds detect this, they chose not to act.

While I applaud Mr Arunachalam’s work, and believe this is a vital first step in regulating the MIVs, he is perhaps being generous with the actual integrity of some MIVs!

Even when they KNOW things are going wrong, they continue to invest if this is a profitable investment opportunity, and they are willing to present knowingly flawed information to their own investors in the meantime. This could be considered criminal in some sectors, in the microfinance sector it is "best practice". Indeed, one recent book review used precisely this term. And let's not underestimate the magnitude of the charges: the list of implicated parties includes many of the largest MIVs on the planet. This is, in short, a total disgrace.

But, be warned: were any sensible regulator to hold these MIVs accountable to anything like the standards expected of regular investment funds, we may indeed see a number of MIVs close. Their deviation from legal, best or ethical practice, is so far off the mark that one wonders if it is indeed possible to fix such errant institutions. The question of whether or not MIVs need to be regulated is, in my opinion, so blindingly obvious that it is an indictment on the entire sector that the issue is only now being raised. They absolutely need to be regulated immediately and with genuine scrutiny. The more interesting question is whether or not some of these MIVs should be allowed to operate at all, particularly when taking government funding or money from the general public.

One can anticipate precisely where the most vehement resistance to MIV regulation will emerge from: the MIVs themselves. They are delighted to have rating agencies examine their MFIs (although they don't necessarily take note of any inconvenient findings, as the LAPO case demonstrates), but who does the ratings of the MIVs? There is none in practice (LuxFlag is largely ineffective rubber-stamping). Transparency when it suits them, opaqueness the rest of the time. Damian von Stauffenberg summarised the majority of MIVs succinctly to the House of Representatives in 2010: “not terribly transparent”.

Allow me to suggest a possible solution: as with the independent rating agencies (I would exclude only Planet Rating from this category not for any question regarding its integrity, but because it is part of the larger Planet Group, who engage in investment activities, and thus it may not be considered entirely independent), why don’t we establish a genuine, in-depth ratings for MIVs? This would have to go beyond the current superficial analyses and actually scrutinise the processes, interest rates, due diligence activities, monitoring, social performance etc. of the MIV and its investees. As long as this was a profound rating, and not a window-dressing exercise, then investors could decide whether or not to entrust their money to an MIV based on such information. This is, essentially, precisely what the MIVs supposedly do with rating reports of MFIs, after all.

Regulators could then insist that any tax-payer funding or capital raised from the general public must go through an MIV that has achieved a certain minimum rating. Naturally the MIVs will not support such a rating service, and would be hesitant to fund it or encourage its use, for fear of what the ratings would uncover (look at the information we can gather about their integrity from publicly available information!). However, if this became a condition for the MIVs to access capital from state or general public purses, this could be a step in the right direction. An MIV would be free to continue operating without such external scrutiny, but would be unable to tap public funding. Those with nothing to hide will jump at the chance, and gain access to substantial sums of capital. Others would have to rely on purely private investors, some of whom may wonder why the MIV failed to obtain such a rating. Transparency at its best.

The advantage of this structure is that it would not have to be self-initiated within the microfinance sector, which has a tendency to select its own acolytes. As long as a number of important capital providers and countries initiated such a move and provided the initial funding, this could quickly achieve critical mass and become best practice within the sector, as MFI ratings did. The countries to consider are, obviously, Holland, Luxembourg, the US, Switzerland and perhaps the UK. The All Party Political Group for microfinance is specifically examining the issue of microfinance regulation in both developing and developed countries. Indeed, such a measure could possibly persuade the Norwegian government back into the microfinance sector following their recent departure.

Local regulators in developing countries could also use this service. For example, the Indian regulator could insist on a rating above a pre-determined level in order for an MIV to invest in India. Indeed, this could become a powerful tool: if a country believed its microfinance sector was over-heating (Peru, Mexico etc.), they could increase the threshold correspondingly to reduce the number of MIVs able to invest, and raising the quality of those MIVs in the process. This would be a powerful tool in the hands of regulators. One possible danger is that the less scrupulous MIVs would then be driven to the countries with the least stringent regulations and rating criteria. However, developed country governments could restrict such MIVs from raising funds in their countries. Dodgy, unethical MIVs raising capital from unscrupulous investors and incorporated in shady tax-havens investing in desperately vulnerable developing countries with zero regulations would slip through the net, but no regulation is perfect!

This could largely circumvent the problem of off-shore funds. Obviously if Luxembourg tightened its regulations the funds could simply move to the Cayman Islands or some less-regulated jurisdiction (regulatory arbitrage), but an MIV rating would be applicable for any MIV in any regulatory state, and the US/UK/Dutch regulator would determine, in part based on the rating, whether it would invest its own funds or allow funds from its general public to be invested in this vehicle. For example, MicroPlace allows funding ONLY from US investors. Countries such as India would grant permission to MIVs to operate in their jurisdictions based partly on the rating report, regardless of the legal jurisdiction of the MIV.

Of critical importance in such a policy is that the rating agency is both entirely independent, entirely free to perform any analysis it deems required, and equally free to publish such findings openly. No “private ratings” should be allowed. And the staff of such an institution would have to be carefully selected, to not only have excellent microfinance and MIV experience, but retain an arms-length relationship to those being rated. The MIVs would have huge vested interests to place their own loyal supporters within such an institution. Who would finance the rating agency? Initially this would require two key factors: an initial subsidy (not from an MIV) and a handful of confirmed clients, most likely public sector funding bodies (DFID, NORAD, Dutch government etc). NORAD could be particularly suitable for this, as it already places public funds in microfinance through MIVs, via the Norwegian Microfinance Initiative. OPIC invests US tax-payer funds through Triple Jump, as does the Dutch government via Oxfam Novib.

A final consideration is that an MIV rating would have to be affordable for all MIVs, and thus should be priced according to the size and complexity of the MIV. Otherwise a danger is that smaller MIVs may be excluded from obtaining such a rating, enabling only the “mega-MIVs” entry to the club. Also, some may be sceptical of the role of rating agencies in general, particularly in light of the recent financial crisis. While I do not wish to debate the merits of rating agencies in general here (and I share some of these concerns), I state a personal opinion that the specialised rating agencies are actually surprisingly effective, as described in the book.

This suggestion is but one of many possible means to reign in the unscrupulous practices of some MIVs, it is not perfect, but the current situation of zero practical regulation is clearly sub-optimal, and this may be a step in the right direction. It may restore some faith in the sector amongst investors, and may lead to a greater positive impact on the poor.

To bring this back to the original point of ASN Novib and Triple Jump, it is worth pointing out that the Dutch television station KRO is broadcasting a documentary precisely on this topic later this month. The press release is in Dutch, but it is likely that the pressure will rise yet further in the beleaguered Dutch MIV sector.

Monday, September 10, 2012

Effective Control Systems at Micro-Finance Investment Vehicles (MIVs): The Key to Accountable Investing and Responsible Micro-finance Globally!

Ramesh S Arunachalam

A previous article[i] emphasized the importance of having properly functioning (effective) internal control systems[ii] at micro-finance 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 micro-finance.

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 same[iii]) 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 CGAP[iv] could also enable these MIVs to assess the quality[v] 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’s[vi] (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, 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 MIV’s) 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 micro-finance 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 display 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 kind of issues will clearly determine how other staff at the MIV actually behave in practice, including their attitude to control issues and the overall control environment. This point needs emphasis here!

And 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 management[vii]) 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 case[viii] as well as those MIVs who were part of the burgeoning growth of the Indian micro-finance sector[ix] 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 micro-finance 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….



[ii] The term control system is used synonymously with the word internal control system
[iv] Consultative 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