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
[iii] Please see - Confessions Of A Microfinance Heretic: How Microlending Lost Its Way And
Betrayed the Poor by Hugh Sinclair (http://www.microfinancetransparency.com/). Please also refer to the following articles: Why not regulate and supervise microfinance investment
vehicles in their country of incorporation?; Triple Jump’s Response to Hugh Sinclair’s Book: Does It
Raise More Questions than Provide Credible Answers?; Why blame the MFIs alone?; Should not microfinance investment vehicles be judged
by the same standards set for retail MFIs?; and Does Sinclair’s Open Challenge (to the Global
Micro-Finance Industry) Make His Claims True?
[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
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