Where Angels Prey

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

Thursday, March 10, 2016

Sound Corporate Governance at MFIs: Can it Help Mitigate Political Risk?

Ramesh S Arunachalam

In terms of board functioning, what can MFI boards (themselves) do to improve the practice (emphasis added) of corporate governance in reality? Here are some initial practical suggestions based on experience and this should go a long way in mitigating political risk!

1.      Limit the number of MFI boards on which an (independent) director may sit to not more than three at any given point in time. This will hopefully afford directors the time and space to understand how the MFIs, on whose boards they serve as directors, are actually performing on the ground. During and before the 2010 AP crisis in India, I had personally witnessed directors—who were on multiple MFI boards (often exceeding three)—jumping planes in a literal sense and having very little time to attend to their fiduciary and other responsibilities. Many of them could not even visit the field areas, even before the customary quarterly board review. Some of them who served on subcommittees were even more harassed for time. And let me tell you that the perceptions of the bureaucrats in Andhra Pradesh and elsewhere in India were similar with regard to little time and effort spent by independent directors. Without any doubt, believe me, these perceptions enhanced political risk, when it mattered! Therefore, it appears necessary to ensure that there is a limit—in tune with physical reality—on the number of MFI boards in which a director may sit. And three appears to be a good permissible number but this could vary with context! My larger point is that it makes little sense for independent directors to sit on a large number of boards that they can do little justice towards!

2.      Separate the functions of the chairman of the board of directors and MD (or chief executive officer or equivalent) in MFIs, where they are together and ensure that appropriate outsiders at least occupy one of those posts. This is very critical and should result in dispersed power, especially when the founder promoter is the chairman and/or managing director. Much of the excessive risk taking (in the form of multiple, sequential,  and larger loans being given to subprime-like clients) that occurred during the lead up to 2010 AP microfinance crisis happened primarily because there was no one on the board to seriously question the enthusiastic and entrepreneurial promoters, occupying one or both of these positions. Often, this was because the promoter had, in the first place, appointed these individuals to the board and this had caused a huge conflict of interest. This is again an issue that was brought up in discussions during the 2010 AP crisis, by both bureaucrats and politicians. In my opinion, conflicts of interests were a huge issue that led to the burgeoning and unmanageable growth of Indian microfinance, thereby, enhancing Political Risk!  

3.      Create a transparent board recruitment (or appointment) policy that clearly specifies the duties and profiles of MFI directors, including the chairman. Such a policy must also ensure that directors have adequate skills and experience (apart from the availability of time to do their job). The policy must also ensure that the overall composition of the MFIs’ board of directors is suitably diverse—including more women, youth, clients (or their interest groups), and individuals with the requisite skills (but possibly different backgrounds) in the board is perhaps a way to improve the boards’ overall functioning and effectiveness and also perceptions about its effective functioning and effectiveness (which in turn should reduce Political Risk). The policy must also ensure that conflict of interest issues are taken into account with regard to board appointments so that the independence of the directors is not compromised.  This again is very critical so that people don’t perceive the board to be a rubber stamp board. There were what I call as five star boards at some large MFIs but the functioning and effectiveness of these boards was poor and the perceptions of these five star boards were that they were rubber stamp boards. That enhanced Political Risk considerably.

4.      Ensure that MFI boards develop (on their own) a formal conflict of interest policy and an objective set of compliance procedures and processes for implementing the same. Such a policy should ideally include: (a) an MFI director’s duty to avoid (if possible) all activities and transactions that could either create a conflict of interest or even the appearance of a conflict of interest; (b) a transparent set of processes and procedures for MFI directors to follow before they engage in certain types of activities (such as agreeing to serve on the board of another MFI or that of a lender or an investor etc.) so as to ensure that such activities will not create a conflict of interest; (c) an MFI director’s duty to disclose any activity and issue that may result, or has already resulted, in a conflict of interest; (d) an MFI director’s (voluntary) responsibility to abstain from voting on any matter where the director may have a conflict of interest or where the director’s objectivity/ability to properly fulfill duties to the MFI may be compromised; (e) adequate procedures and clear norms for transactions and activities conducted with related parties on an arms-length basis; and (f) transparent procedures by which the MFI board will deal with the issue of any noncompliance with the (conflict of interest) policy. Ideally, it would be good for the policy to contain specific (conflict of interest policy) examples of where and how conflicts of interest can arise when serving as an MFI board member. This should facilitate greater understanding of conflict of interest issues, with regard to microfinance in general and the MFI in particular. In my humble opinion, this is one aspect that could go a very long way in mitigating Political Risk in microfinance!

5.      Have a compulsory formal evaluation of the functioning of the MFI’s board of directors by an external independent evaluator. This is a critical issue and the results of this evaluation should be made available to shareholders and supervisory authorities —officially publishing this evaluation (on their website) is an aspect that could also be considered by the MFIs concerned. Such a formal evaluation of the board should preferably be done in the absence of the CEO or managing director or promoter (as applicable), so as to ensure that the exercise is a free, fair, and independent one. The services of independent evaluators—individuals and/or institutions who have not had (or do not have) a material relationship (as defined in common parlance) with the MFI—could be taken in this regard. In India, premier management institutes (such as IIMs) and others (like the College of Agricultural Banking, etc.) could be actively involved in these (evaluation) processes and likewise, similar institutions could be involved in other contexts. Again, this should serve to enhance the perception that boards are indeed independent and are not likely to encourage excessive sub-prime like risk taking by the CEO or the promoters. This again should reduce Political Risk!

6.      Suitably compensate MFI board members for their time but do not incentivize their working on the basis of stock options or other such mechanisms that invariably encourage undue or excessive “risk” taking as was witnessed during the 2010 AP microfinance crisis. Even if the law permits, it seems prudent not to remunerate board members through stock options and the like as the independence of (independent) directors may be seriously compromised. Again, the happenings, in India, in the run-up to the 2010 AP microfinance crisis clearly demonstrate the fact that independent directors who had been so compensated had not performed their fiduciary and other duties appropriately. The key issue to note here is that much of the 2010 crisis occurred because board members and senior management were compensated heavily (in the short term), whereas the risks of their strategies could be known only in the medium/long term. This mismatch created a huge incentive for excessive risk taking, which, in turn, led to the 2010 AP microfinance crisis. The parallels with the US subprime can hardly go unnoticed. Thus, proper incentivisation of MFI board members and transparency in this process should go a long way in mitigating Political Risk. Much of the crisis in Andhra Pradesh 2010 emanated after an economic times article touched on the actual bonus and kind of compensation that had been provided (5 months earlier) to the now out of favour sacked CEO, who had led the MFI through a spectacular IPO. That was not all! Other articles highlighted that independent directors were compensated with (huge) stock options even as the promoter gave himself a HUGE (as per the context) interest free loan from the MFI’s coffers. Again, let us understand that, whether it is right or not, Political Risk stems from perceptions about institutions, people and their actions and the larger point here is that let us do things in a transparent manner and without conflicts of interest!

7.      Make it mandatory for MFI boards to set up a risk committee and establish clear rules regarding the composition and functioning of this committee. In addition, make it compulsory for one or more members of the audit committee to be a part of the risk committee and vice versa. Further, the chairman of the risk committee should always report to the AGM and outline the role that directors have played in shaping the MFI’s risk profile and strategy. Also, the risk committee should frame a “risk control declaration,” which should also be published so as to ensure its wider dissemination and use—both within and outside the organization. This again, will go a long way in mitigating Political Risk!

8.      And last but not the least, create an obligation for a specific duty (“duty of care”) to be established for the board of directors so that they take into explicit account the interests of various stakeholders (mainly, clients) during the decision-making procedure. This is especially critical and the 2010 AP microfinance crisis would (perhaps) not have occurred, if only boards of MFIs had exercised such a duty of care that explicitly looked after the interest of clients who were constantly over-indebted. The desire for better operating performance at many MFIs meant that the board of directors at these MFIs just did not bother about the impact of their turbocharged growth on clients and their well-being. Therefore, there is an explicit need to incorporate a duty of care—especially with regard to clients—among MFI boards. This again, should go a long way in mitigating Political Risk!

To summarize, for the microfinance sector that has undergone a deep crisis in India, corporate governance has never been more important than now and good governance can alter perceptions and mitigate political risk! Corporate governance is not just the responsibility of an individual MFI. Rather, it is the collective responsibility of all individuals who become directors on the boards of an MFI and serve together. While we can have great sounding norms and guidelines for corporate governance, unfortunately, they cannot be effectively enforced through regulation alone. They need to be practiced at all times (including difficult circumstances) and that is where the individual initiative of directors (serving on MFI boards) does really matter. And I sincerely hope that directors on MFI boards do ensure that this happens in real time on the ground—by enabling and facilitating their boards to reorient their functioning in the light of some of the suggestions made. If this happens, many of the ills plaguing the (Indian) microfinance sector and MFIs will slowly but surely start to vanish as also the Political Risk associated with Microfinance!

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