Where Angels Prey

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

Tuesday, November 9, 2010

Has Burgeoning Growth Caused Increasing Frauds in Indian Micro-Finance: Do the Regulators and The RBI Sub-Committee Need to Carefully Examine this Relationship?

Ramesh S Arunachalam
Rural Finance Practitioner

If the desire for the ‘burgeoning growth’ in Micro-finance in India resulted in multiple loans to (perhaps helpless) clients and (inadvertently?) caused havoc in some of their lives, this rapid growth also appears to have had another serious impact on Indian micro-finance – increasing operational frauds. This is something that certainly merits the close attention of the RBI and its Board Sub-Committee, which is currently looking at issues related to micro-finance in India
The following exhibits (Figures 1, 2 and 3 - Please click on document below to open a full size document for better readability), which are reproduced from financial statements[i] of few leading and growing MFIs[ii], indicate serious and increasing frauds in MFIs as per their own financial statements.

From the above figures, it is quite clear that ‘non-existent clients’ and ‘misappropriation of client repayments’ are 2 major types of operational frauds that have (increasingly) happened with this turbo charged growth. Other kinds of frauds are highlighted in Figure 4 ((Please click on document below to open a full size document for better readability)

In fact, Dr Thorat and Arunachalam (2005), in their paper presented at the NABARD High Level Policy Conference At New Delhi in May 2005, highlight in section 3.5 of the paper - “The Case of Internal Control Lapses” - a large number of frauds that had already been observed by 2005. Some of these cases are reproduced here below and you can see that the above categories of ‘non-existent clients’ and ‘misappropriation of client repayments’ are also listed here:
Section 3.5: The Case of Internal Control Lapses
“Lack of appropriate internal controls can also cause failures as illustrated by the examples below:
Example Case # 10: Fieldworkers who were collecting repayment from clients, for long withheld the fact that several clients had been making prepayments as well – i.e., higher than required repayments. What happened was that suddenly, the institution discovered significant amounts paid by clients had not been remitted by fieldworkers and there was a huge loss to the MFI. Clients refused to pay up the already paid amounts and while some fieldworkers absconded, others simply said they could not pay back to the institution as they did not have the money. A variant of this observed at another institution is that fieldworkers were often found to classify regular client payments as delinquent and not turn in some or all of the client money. In both cases, apart from loss of money, institutions concerned also suffered loss of reputation, especially with clients and investors
Example Case # 11: Some institutions lend with a norm of a client bringing a fraction of the loan as their margin money/security deposit. In one such institution, field workers utilized this option to their advantage. For example, if clients were required to bring in 10% of the loan amount, and say, brought in Rs.500 for a loan of Rs.5000, there are instances where fieldworkers have added another Rs.500/- to make the margin money or security deposit as Rs.1000/- and enhanced the loan amount to Rs.10,000 and soon. When the loan reaches the client, Rs.5000/- is kept by the client and the balance of Rs.5000/- is taken away by the fieldworkers and utilized for other purposes including lending in the local market at high/usurious rates of interest. Repayment problems have compounded when fieldworkers have left the organization - clients have refused to pay back half of the ‘loan’ that they never received in the first place. This is a classic case of institutional failure of non-repayment induced by an external factor and the concerned institutions have incurred significant losses.
Example Case # 12: An NGO was linking groups to commercial banks. Suddenly, it was found that the Fieldworkers were taking back a significant proportion of the loan [almost 30%] and the groups had kept quiet for some time – by which time a significant amount of money had been collected. However, in field visits by bankers, this came to light and some fieldworkers/NGO were made to return some money but losses were incurred as groups refused to repay. The confidence of the bankers was so dented that even after several years, they do not lend significantly in that area. Apart from loss of money, there was also loss of reputation.
Example Case # 13: Group leaders collected upfront commissions on loans given by NGO-MFI to the groups. Between 20-55% of loan amounts were said to be taken by them. At time of repayment, some of the members defaulted stating that they did not receive the full loan amount in the first place. Here, there are two kinds of institutional failures: 1) failure of differential access; and 2) failure of non-repayment.
Example Case # 14: In another case, in several groups, a small proportion of loans disbursed were actually utilized by members while the remaining was utilized by field officers of a government sponsored program who were later found guilty of lending the same at usurious rates to the local public. This case attracted significant media attention as well.
Example Case # 15:  A financial intermediary lost a large amount of cash kept at the branch due to theft. Neither was the branch insured nor was there adequate safety in terms of a safe/strong room, guards and other required controls including segregation of duties. Another institution lost a large sum of money in transit when cash was transported from head quarters to branches and vice versa.”[iii]

The above given frauds and control breakdowns, resulting in failures typically seen in the exhibits and problem cases (given above) can be grouped into five clear categories:
1.    Lack of adequate management oversight and accountability, and failure to develop a strong control culture within the institution. Without exception, cases of loss reflect management inattention to, and laxity in, the control culture of the institution, insufficient guidance and oversight by boards of directors and senior management, and a lack of clear management accountability through the assignment of roles and responsibilities. These cases also reflect a lack of appropriate incentives for management to carry out strong line supervision and maintain a high level of control consciousness across the organisation.
2.    Inadequate recognition and assessment of the risk of certain activities, whether on- or off-balance sheet. Many organisations that have suffered losses neglected to recognise and assess the risks of new products and activities, or update their risk assessments when significant changes occurred in the environment or business conditions including growth. Many recent cases highlight the fact that control systems that function well for traditional or simple products are unable to handle more sophisticated or complex products, especially in burgeoning growth.
3.    The absence or failure of key control structures and activities, such as segregation of duties, approvals, verifications, reconciliations, and reviews of operating performance. Lack of segregation of duties in particular has played a major role in the losses that have occurred.
4.    Inadequate communication of information between levels of management within the institution, especially in the upward communication of problems. To be effective, policies and procedures need to be effectively communicated to all personnel involved in an activity. Some losses occurred because relevant personnel were not aware of or did not understand the policies. In several instances, information about inappropriate activities that should have been reported upward through organizational levels was not communicated to the board of directors or senior management until the problems became severe. In other instances, information in management reports was not complete or accurate, creating a falsely favourable impression of a business (portfolio) situation..
5.    Inadequate or ineffective audit programs and monitoring activities. In many cases, internal audits were not sufficiently rigorous to identify and report the control weaknesses. In other cases, even though auditors reported problems, no mechanism was in place to ensure that management corrected the deficiencies.
And the simple and key point for the RBI Sub-Committee is this: Many MFIs that have faced burgeoning growth in the last few years have not had commensurate capacity and systems to manage their turbo charged growth. Further, as a result of the strong decentralised model that many of these MFIs have used and are continuing to use, they are increasingly vulnerable to frauds (especially, when their growth is rapid). Some of the common conditions that make these MFIs vulnerable to frauds are given below:
  • They are experiencing very rapid growth
  • Their MIS and accounting systems are weak
  • Their systems are constantly undergoing change (eternal innovation or pilot testing?)
  • Their internal control systems are inadequate and constantly being stressed and sheared
  • Their employee turnover is high
  • Their loan officers handle excessive and increasing amounts of cash[iv]
  • Their policies and systems are not followed because of their decentralised model and internal audits are either weak or are almost non-existent
  • Their governance is weak and non-transparent, with significant related party transactions

Therefore, the RBI Sub-Committee needs to look closely into the kind of (obvious and non-obvious) (operational and other) frauds that are occurring in micro-finance and help foster adoption (through enabling regulation/supervision) of good practices that can mitigate the ever increasing frauds and clean the industry of its bad practices. The time has REALLY come for the RBI to take charge of Indian Micro-finance and provide on-course corrections so that the industry does not fade away into oblivion…

[i] These MFIs, from whose financial statements, the frauds listing have been taken, are perhaps among the more transparent MFIs in India.
[ii] The idea here is not to target any individual MFI and that is why their names have been withheld
[iii] Thorat, Y S P and Ramesh S Arunachalam (2005), “REGULATION AND AREAS OF POTENTIAL MARKET FAILURE IN MICRO-FINANCE”, Paper presented at the NABARD High level policy conference in New Delhi
[iv] Mix market data seems to indicate that and I will discuss this in a separate post


  1. Hi Ramesh! Great to see that you finally found how to blog and as usual, very interesting postings.

    SKS script got hammered today, 4%. It is now below its listed price

    Micro-Finance to Face Slow Painful Death. SKS Share to enter Free Fall. Sell, Sell, Sell!

  2. MFIs in India has fallen in their self created trap that could happen due to unbridled growth they could pursue for quite sometime. These institutions should have self regulatory model and should be empowered by some the state or institutions to share the risks that are beyond the means and management of the poor borrowers either due to lack of knowledge or arising from hazards due to natural calamities. In this regard the recent step tken to insure the risks of business of SMEs is worth emulating. --DR.S.N.GHOSAL