Where Angels Prey

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Tuesday, September 4, 2012

Regulation and Supervision of Micro-finance Investment Vehicles (MIVs): A Suggested Practical Framework, Part II

Ramesh S Arunachalam

A previous article (PART I) looked at the issue of regulation/supervision of MIVs using the levels of analysis aspect. In this article, we look at practical questions that regulators/supervisors would need to ask at these various levels to ensure minimum regulation/supervision of MIVs concerned. What is provided here is only a starter’s set[i] and that caveat needs to be stated up front and clearly.

As noted earlier in PART I, there are four levels of analysis as shown below and for reasons outlined in PART I, we restrict our discussion to levels # 1 and 2.

Relationship (s)
Level # 1
Investor – Fund
Level # 2
Fund – Fund Manager (or Fund – Sub-Advisor)
Level # 3
Fund/Fund Manager – MFI
Level # 4
MFI – Clients

OK, let us start with level # 1.

Level # 1: Investor – Fund

At level # 1, the following questions appear to be relevant:

a.    What has the fund promised investors when collecting their money?
b.    Has the fund delivered (at the most basic level) what it has promised to its investors?

Let us take an example. For instance, a fund may claim to be an ethical fund like ASN Novib Fund[ii] and it may have received some tax/other concessions. Investors may also have invested in the fund became of its ethical tag (and associated tax breaks) - which basically come from the fund claiming to make certain kinds of ethical investments and engage in some specified behavior. Taking the ASN Novib – Triple Jump case, I quote from the ASN Novib Fund annual report 2007 (pages 12, 13 and 14). The report notes that:

“Socially Ethical Project Regulations: The Socially Ethical Project Regulations [Regeling Sociaal Ethisch Beleggen], which allows private funds to be used to achieve development aid goals thanks to tax relief, is a major success. ASN Bank anticipates that there will continue to be a widespread interest in socially ethical investments. The market for microfinance institutions which satisfy the ASN-Novib Fund’s strict criteria is moving apace. There is an increase in expertise and experience as well as the number of small businesses which are being reached, and a great deal of growth is still possible. In order to ensure that an optimum dialogue occurs with the Ministries of Development Cooperation and of Finance, which determine what tax relief is available, ASN Bank has assumed the role of chair of the Beraad Sociaal Ethisch Beleggingsfondsen [Socially Ethical Investment Funds Forum] of the Netherlands Bankers Association [Nederlandse Vereniging van Banken]” [iii] (Page No. 12 and 13)

It further notes:

“Socially responsible investment allowance: As of 1 January 2004 additional tax benefits apply to investments in the ASN-Novib Fund following the latter’s acquisition of a socially ethical status. First of all a maximum allowance of EUR 53,421.00 (the amount for 2007) is provided for socially responsible investments under Box 3. Socially responsible investments include green and socially ethical investments, amongst others. In this case the savings amount to 1.2% of capital gains tax on investments of up to EUR 53,421.00. In addition, a deduction is permitted on any income tax owed, which is equivalent to 1.3% of the average value of any tax-exempt investment listed in Box 3. Consequently, the relevant tax benefits can amount to 2.5% (1.2% + 1.3%) of one’s investment. In the case of partners both allowances represent an amount as high as EUR 106,842.00 (the amount for 2007). An indexed tax exempt sum of EUR 54,223.00 has been determined for 2008. The corresponding figure for partners is EUR 108,446.00.” [iv] (Page No 14)

Likewise, the ASN Novib annual report 2008 notes that:

“Socially Responsible Investment Regulation: Because of the socio-ethical status of the ASN Novib Fund, an additional tax benefit applies to investments in the Fund. Investors in the Fund enjoy a Box 3 exemption of no more than € 54,223 (2008) for socially responsible investments, which include green and social/ethical investments. The savings for investors amount to 1.2% of capital gains tax on investments up to € 54,223. In addition, the tax authorities permit a deduction on any income tax due, which is 1.3% of the average value of any tax exempt investment listed in Box 3. Consequently, the relevant tax benefits can amount to 2.5% (1.2%+ 1.3%) of one’s investment. In the case of ‘partners for tax purposes’, both allowances represent an amount as high as € 108,446 (2008). A tax-exempt sum of € 55,145 per person has been indexed for 2009. The corresponding figure for partners is € 110,290.” [v] (Page No. 13)

Now, the regulator needs to be sure that the fund has indeed behaved ethically and made such investments. Given the information in Hugh Sinclair’s book and my previous articles[vi], I am not sure that ASN Novib fund’s investment in LAPO was entirely in line with its ethical objectives.

A related question arises in this regard:

c.   Is the fund legal in its operations in terms of its investments? Is it supporting legal organizations/ activities?

The regulator also needs to be sure that the fund does not invest in activities or organizations (MFIs etc) that are engaged in and/or support illegal activities. And I think that the definition of legal should be based on laws in the home (parent) country as well as the host country.

Again, let us take the case of ASN Novib, which is classified as an ethical fund and was accorded certain tax benefits in Netherlands. A key question that arises here is: How appropriate was it for the ASN Novib fund to invest in LAPO that, according to public domain material, was involved in illegal collection/ intermediation of savings as well as suffered several other weaknesses? Two specific issues would serve to highlight this better:

A.     Illegal collection/intermediation of savings – evidence in the public domain

MicroRate's 2007 rating report[vii] clearly mentions the following:

“’Client savings intermediation without a license and without an appropriate structure’ as a weakness” (Page No. 1)

"Borrowings are well diversified among a large number of mainly foreign lenders. Approximately one-third of funding is provided by client deposits even though as an NGO, LAPO is not licensed to mobilize savings." (Page No. 5)

"With a cost of only 4%-5%, savings deposits are a much cheaper source of funding than commercial credits. Recognizing this, LAPO has strongly pushed savings mobilization. In MicroRate's opinion, this policy bears a serious risk since as a NGO, LAPO is neither authorized nor adequately equipped to mobilize savings from the public." (Page No. 5)

"LAPO's present policy using savings deposits to fund its operations-besides being illegal-exposes its clients to risks of which they are unaware." (Page No.6)

B.     Unusually high interest rates – evidence in the public domain

And the Planet Finance rating report[viii] of 2009 notes that:

"Since the end of October 2009, all clients pay a 2.5% monthly flat interest rate (from 3% before), disbursement and administration fees, and a 2% risk premium (covering clients in case of fire or death). Earlier in 2009 before that change of pricing, LAPO increased the amount of cash collateral requested as compulsory savings prior to loan disbursement, from 10% to 20% of the loan amount (upfront) and from 50 to 100 NGN at each instalment. Compulsory savings earn interest at a rate of 4% per annum (from 6% before). The decrease in interest rates coupled with the increase in the level of cash collateral, resulted in an increase of the average Effective Interest Rate (EIR) for the clients to 125.9% from 114.3% before." (Page No.6) 

Likewise, the Planet Finance rating report[ix] of 2011 notes that:

"LAPO had its pricing certified by Microfinance Transparency as of December 2010 for its Regular Loan. The average price for a first-time loan with insurance was estimated at 80%, expressed as a nominal APR. Since then, the average APR for Regular Loan decreased to around 76%. However, Microfinance Transparency also noted that as the client remains with LAPO, the APR can reach between 99% and 144% by the third year (depending on the loan amount and increase at each cycle) due to the cost of accumulating weekly savings that cannot be withdrawn." (Page No.7)

Without any doubt, the ratings and other public domain material also pointed to other serious issues and weaknesses in the investee (LAPO) apart from its illegal collection and intermediation of client savings and inordinately high interest rates: a) an illegal loan product (perhaps) because illegal savings collection was a part of it; b) conflict of interest in terms of the auditor being related to the CEO and other such issues; c) high levels of client desertion; d) lack of transparency with regard to data (which led to MicroRate’s subsequent withdrawal of its rating); and e) poor governance among other things.

Given this, it is clear that ASN Novib’s investment in LAPO (via Triple Jump) was supporting illegal activities on the ground. And irrespective of whatever retrospective action is/was taken, the regulator/ supervisor must have a method to determine (in the future especially), whether or not investments being made by MIVs are legal. Otherwise MIVs will claim to be making ethical investments while actually doing things to the contrary.

Another question appears important at this level (level # 1).

d.      Is the fund tapping legal sources of money?

Regulators must be clear that the contributions by investors are indeed from legal sources and this is especially difficult, especially when web based and related mechanisms are used. But this is an important question indeed and it is dealt with in a separate article.

Ok, let us now move on to level # 2

Level # 2: Fund – Fund Manager (or Fund – Sub-Advisor)

The following questions appear relevant here (at level # 2):

e.   Is the fund taking adequate steps to protect its investors?
f.    Does the fund have minimum standards/systems to ensure that investments made by the fund manager are in line with what has been promised by the fund to its investors?
g.   Does the fund have sufficient supervisory mechanisms to ensure that the fund manager (sub-advisor) safeguards the interests of the fund and its investors?
h.   Does the fund have independent access to information about the investees in which the fund manager (sub-advisor) proposes to invest and/or has invested?

Again, let us take the ASN Novib case. The ASN Novib Fund annual report[x] of 2007 notes that:

LAPO, Nigeria: In February the ASN-Novib Fund approved a loan of EUR 1 million to LAPO in Nigeria. LAPO is the second microfinance institution in Africa to which the ANF has provided a loan. Various studies have revealed that Nigeria is one of the poorest countries in the world. For more than 30 years Nigeria has been rocked by unrest and military regimes, with the result that the country has barely developed. The majority of the people have had to rely on income from their own small-scale activities which lend themselves exceedingly well to micro-funding. Although micro-credit is still in its infancy in Nigeria, with a loan portfolio of USD 7.5 million and 84,000 customers LAPO is the absolute epitome of micro-lending in that country. LAPO has made the leap from receiving a loan from the Oxfam Novib fund for less developed organisations to one from the ASN-Novib Fund for more mature organisations. LAPO services the poorest population groups in Nigeria. LAPO’s internal surveys of its customers have revealed that their circumstances have improved by 80% compared with the situation prevailing before they had received a loan from it. In conclusion LAPO is actively involved in the development of Nigeria’s national regulations governing microfinance institutions, which will provide legal protection for any savings which poor people hold with such organizations”. (Page No. 8 and 9)

This statement about LAPO in the ASN Novib Fund annual report of 2007 runs counter to available public domain information. Clearly, LAPO was involved with illegal collection and intermediation of client savings apart from having several other weaknesses. Yet, the ASN Novib Fund called LAPO as the ‘absolute epitome of micro-lending’. This clearly shows that the ASN Novib Fund lacked the systems needed to safe guard the interests of its investors as well as gauge/collect ‘objectively correct’ information pertaining to investments made by the fund manager. The fund perhaps took at face value, the information that was provided by the fund manager and assumed it to be ‘correct’ and hence, did not do its own checks with regard to the reliability/validity of information. The fund needs to revisit these aspects for its own good as well as that of its investors.

And herein lies an important lesson for all stakeholders including MIVs (and/or investors) who use fund managers/sub-advisors:

Lesson # 1: Irrespective of any circumstances, it is the paramount duty of funds to actively supervise their fund managers/sub-advisors (so as to safeguard their own and investor funds). And the regulator needs to ensure that such effective and timely supervision of the fund manager (sub-advisor) by the fund happens on the ground in a continuous manner.        

From a regulatory standpoint, this is indeed a serious issue because when a fund makes investments through fund managers/sub-advisors, it does so (for and) on behalf of its investors. And therefore, the regulator must be sure that the fund has a strong mechanism/method (system) to ensure that the investments made (by the fund manager/sub-advisor) have been done with required care and are in the best interests of the investor. The mechanism could range from mere inspection (by the fund) of a fund manager/sub-advisors’ due diligence records to even actual due diligence (on a random basis) of the investees covered. And specially, the regulator also needs to be sure that funds INDEED have the requisite systems and processes to do this in real time. Therefore, it would be useful for the regulator/supervisor to randomly and selectively test the strength of internal control and other such systems at the level of the fund, fund managers and sub-advisors.

Another question is relevant at this juncture:

i.    Does the fund manager have minimum standards of governance, management and systems to ensure that investments made are in line with what has been promised by to the investors?

Take for example, what Hugh Sinclair notes in his book[xi]: 

“The Calvert document was largely copied and pasted from the ASN Novib document. The same myths about the smoothly operating IT system, the same low interest rates, even large chunks of text explaining the political environment of Nigeria, were simply lifted from ASN Novib’s document into the Calvert proposal—even though they was known, without doubt, to be false. The author was even thoughtful enough to copy some spelling mistakes. In the discussion of interest rates the word “flat” had been removed, obscuring this questionable practice from Calvert, although it had been mentioned in the original document presented to ASN-Novib. In another bizarre twist, at one point the document referred to LAPO as “PRIDE,” which was another MFI that Triple Jump had lent to in Africa that also charged high interest rates to the poor, and in which Calvert had also coincidentally invested in. A copy-and-paste error I suspect, albeit one that no one had detected. (Page No. 116 and 117)

The author of the document was none other than Inge, the same girl who prepared the ASN-Novib document and who had recently left on maternity leave. She and I had discussed LAPO at length, including the high interest rates charged to the poor. She was entirely aware of the reality at LAPO—we had explicitly discussed the second mission to Nigeria. How could she have written this proposal, knowing that it misrepresented LAPO’s operations? Inge’s relative lack of interest in microfinance certainly did not suggest to me that she would deliberately fabricate evidence—she had nothing to gain, and given the controversy surrounding LAPO, surely such inconsistencies would be detected….I drew up a third column in the sheet that I had prepared for Oxfam Novib and filled in the information presented to Calvert. In most cases the same fabrications, or errors, that had been presented to ASN-Novib were also presented to Calvert. This was potentially serious, and there was no defense of this was the best information we had available at the time, as there had been with ASN-Novib. (Page No. 117)

Unfortunately an almost identical document, containing the same material “inaccuracies,” was presented to Calvert Foundation for a loan to LAPO some nine months later (October 8th, to be precise). By this point full information about LAPO was known by all involved, and yet this information was entirely absent from the appraisal sent to Calvert, making many of the same claims, indeed, copied and pasted from the original Oxfam Novib/ANF document which you sent me. Given that this was done with full knowledge of the real situation at LAPO, indeed, after the biggest and most expensive intervention ever under taken by TJAS to resolve these matters, the document presented an undeniably inaccurate picture of the company. This is a much more serious situation than the original document, as I am sure you appreciate. We can no longer claim ‘negligence’, or ‘inadequate information at the time.’” (Page No. 119)

Clearly, if true, the above does not auger well for the kind of governance, management and systems prevalent with fund managers like Triple Jump.

And herein lies another important lesson for the regulator:

Lesson # 2: Irrespective of the circumstances, regulators must ensure that fund managers (sub-advisors) adhere to prescribed minimum standards of governance, management and systems.

While the tendency of the micro-finance industry is to prefer voluntary codes (or self-regulation), regulators must ensure that ‘uniform’ codes exist and that these codes are ‘consistently’ implemented on the ground. Readers may be well versed with the problems associated with such (well-intentioned) voluntary codes. More often than not, such codes do not get implemented as past experience has shown in the case of retail MFIs, especially in India. Therefore, even if voluntary codes are to be used for fund managers (or even for the funds themselves), it would be important to have some regulatory oversight (in real time) into the actual implementation of these voluntary codes.

One final set of questions are very relevant to the operations of the funds/fund managers and the regulators ought to be interested in aspects like these:

a.   Does the fund/fund manager have appropriate internal control and independent internal audit systems vital for making prudent investments?
b.   What about the extent and quality of due diligence prior to investment?
c.   What about the extent and quality of monitoring post investment?

The various problems mentioned by Hugh Sinclair in his book and analyzed in previous articles[xii], also appear to represent serious control breakdowns that can be grouped into categories shown below:

·     Lack of adequate management oversight and accountability, and failure to develop a strong control culture within the institution, from top to bottom
·     Inadequate recognition and assessment of the risk of certain activities, whether on- or off-balance sheet and especially in relation to the organization’s strategic objectives
·     The absence or failure of key control structures and activities, such as segregation of duties, due diligence and approvals for strategic investments and other activities, verifications, reconciliations, and reviews of operating and other performance and the like
·     Inadequate communication of information between levels of management within the institution, causing significant opacity and
·     Lack of independent and effective (internal and external) audit programs and monitoring activities.

To summarise, while all of the above aspects are important from a regulatory/supervisory standpoint with regard to MIVs (and fund-managers/sub-advisors), two crucial areas are important from an internal organization as well as regulatory (external) standpoint: a) the extent and adequacy of internal control systems at the fund/fund manager level; and b) the presence of independent and effective internal audits. Without question, both of these can provide a good basis for ensuring prudent investment by MIVs in the long run. And indeed many of the problems mentioned earlier could have (perhaps) been mitigated (if not completely avoided) if only the MIVs (concerned) had been required (by regulators) to institute well functioning and appropriate internal control systems and also ensure effective independent internal audits of the same. Anyway, while the past provides good learning, we also need to move forward…and so, each of these critical aspects are dealt sequentially in a series of articles with some further ideas on the kinds of specific questions that regulators/supervisors would have to ask…to ensure the above…

[i] At the outset, let me state that these are not exhaustive and/or comprehensive by any means. They are intended to be a starter set only.
[ii] The ASN Novib Fund is also referred to as ASN Novib and they denote the same entity.
[iii] Source: Quoted from ASN - Novib Fund Annual Report 2007 (http://www.asnbank.nl/blob.asp?id=14214)
[iv] Source: Quoted from ASN - Novib Fund Annual Report 2007 (http://www.asnbank.nl/blob.asp?id=14214)
[v] Source: Quoted from ASN - Novib Fund Annual Report 2008 (http://www.asnbank.nl/blob.asp?id=15900)
[vii] Source: Lift Above Poverty Organization (LAPO) Rating Report by MicroRate, December 2007
[viii] Source: Lift Above Poverty Organization (LAPO) Rating Report by Planet Rating, December 2009
[ix] Source: Lift Above Poverty Organization (LAPO) Rating Report by Planet Rating, December 2011
[x] ASN - Novib Fund Annual Report 2007 (http://www.asnbank.nl/blob.asp?id=14214)
[xi] Source: Quoted from Confessions Of A Microfinance Heretic: How Microlending Lost Its Way And Betrayed the Poor by Hugh Sinclair (http://www.microfinancetransparency.com/)

1 comment:

  1. Excellent article !! I totally agree with the points on tax benefits and the investment regulations