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.