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?
[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