Where Angels Prey

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

Saturday, May 7, 2011

Does India Need a Micro-Finance/Financial Inclusion Policy?

Ramesh S Arunachalam
Rural Finance Practitioner

There has been a lot of talk about microfinance and financial inclusion in India, especially during the last few years. Especially during the last 6 months, the discussions have centered around having an appropriate regulatory framework for microfinance, scaling up financial inclusion, the need for a sole microfinance regulatory and the like.

As before, every one (and this writer included) have been talking about these aspects, often providing their rather divergent and diverse views. But, it seems to be that, we are again running off, without serious thought to:

·        What we see as part of financial inclusion and/or micro-finance in India and why?
·        What has worked on the ground with regard to financial inclusion and/or micro-finance in India and why/why not?
·        Going forward, what is our vision with regard to the various financial inclusion and/or micro-finance services in India?
·        What do we hope to achieve with scaling up financial inclusion and/or micro-finance in 5 years, 10 years, and 20 years and so on?
·        And Other Questions as Appropriate

Unless, we have a clearly defined national micro-finance/financial inclusion policy answering the above and other questions, our responses to delivering/scaling up low-income financial services will continue to be knee jerk and piecemeal. Interim solutions are undoubtedly necessary as life has to go on but we need to critically look at medium and long term issues as well

Therefore, even before we look at building a PERMANENT regulatory architecture for micro-finance/financial inclusion (through some mechanism and/or a bill etc), let us first look towards devising a national policy for micro-finance and financial inclusion - a policy that is holistic, futuristic and yet practical (in terms of satisfying unmet ground level needs of low income and excluded people) and developed through a TRULY bottom up and democratic process with widespread stakeholder input and consultations. The aspect of having a bottom up and democratic process is very critical to create strong ownership for the policy and adherence to its vision during implementation.

Further, such an approach cannot be a mere document – designed in Delhi or Washington (with all due respect) and - produced through field visits by few important consultants/agencies to select field areas. It has to be truly national in character and must be backed by public interactions with low income people in all parts of the country apart from district, state, regional and national level consultations among various stakeholders. It has to be comprehensive enough in terms of bringing together different and competing models with alternative aspirations. And last but not the least, it must be grounded in reality so as to make a SOLID difference to the lives of the people, for whom it is being framed in the first place…In other words, it just cannot be a writing exercise…

It is about time that we follow the lead of many (other and especially, smaller) countries that have genuinely tried to frame appropriate micro-finance/financial inclusion policies through a proper process. That alone can ensure the orderly/sustainable growth of the Indian micro-finance/financial inclusion sector and simultaneously enable low income people to become a REAL part of the inclusive growth story…The key question here is whether we have the commitment and courage to undertake such an important and urgently required task, in a voluntary and selfless manner…Time alone will provide the answers…

Jai Hind!

Have a Nice Day!    


Friday, May 6, 2011

A Comparative Analysis of Two Types of Agent Led Micro-Finance Models in India: Imperative For RBI To Build Safe Guards Into Priority Sector Lending Directions…

Ramesh S Arunachalam

Rural Finance Practitioner

The recent RBI announcement with regard to priority sector being used for Micro-Finance NBFCs is a very welcome one and is much appreciated as I posted the other day. However, safeguards are needed to ensure that agents of MFIs do not misuse priority sector funds. Thus, when coming out with the detailed guidelines, I hope that the RBI takes cognizance of two major agent led models prevalent in the Indian micro-finance sector.

Let me make a few other assertions. While the exact scale of the agent models nationally is perhaps not known with precision, there is enough cause to believe that it is reasonably widespread as it has been observed in several places in AP, Tamilnadu, UP, Orissa, West Bengal, Karnataka and parts of Madhya Pradesh. This again needs to be looked into closely by the RBI, which is best positioned to conduct an objective and neutral national study and assess which kind of MFIs are involved and why and also geographic places where the same is widespread - and this needs to be done before the detailed directions regarding priority sector are promulgated... 

That apart, it is also imperative that the RBI looks closely at these models and builds sufficient safeguards against their use through supervision and other means and using various stakeholders including banks. If this (building safeguards) appears difficult, a more practical approach could be for the RBI to consider streamlining and legalizing the Centre Leader Type Agent Model and building greater accountability into this type of arrangement - especially, if the RBI feels that this model can be fitted under the Business Correspondent regulations. However, the political agent Micro-finance model should be banned without question. All of these are aspects that the proposed RBI committee on priority sector could look into and provide guidance on.

Here are the operational details of two agent led micro-finance models as I have seen it on numerous occasions and also heard from several stakeholders. Read on…

Have A Nice Day!

Thursday, May 5, 2011

Inclusive Finance As The Backbone For Inclusive Growth: Some Critical Issues for Policy Makers, Central Bankers, Donors and Other Stakeholders…

Ramesh S Arunachalam
Rural Finance Practitioner

Inclusive growth has always been seen as the imperative for achieving the equity and equality objectives. While that point is well taken, the experience of the last few years and especially during the global financial crisis suggests that inclusive growth is perhaps essential to even sustain the overall growth momentum. There are several good reasons[i] as to why a REAL inclusive growth paradigm will facilitate this in a rapidly emerging economy like India (and other similar environments). Read On…

First, in many of the emerging market economies like India, a huge proportion of the population (over 60% at least) is based in rural areas, where agriculture is the primary source of livelihood. And any further (substantial) increase in demand for manufactured goods and services will have to come primarily from this large rural population[ii], which mainly depends on agriculture and allied sectors. And barring a couple of years (2005/6), by and large, the performance and growth of agriculture has been rather indifferent.

Indeed, what has become more apparent with this kind of skewed growth is the dualistic nature of the Indian economy - where the gaps are indeed deepening and widening across various sections of the society. The classic manifestation of these gaps and the failure of the economy to re-adjust and ensure equitable economic opportunities for wealth creation, especially in relation to the work and inputs, can hardly go unnoticed –one manifestation is suicides by small and marginal farmers, at the grass-roots. That several farmers have committed suicide in the last few years tells us that the causes of these problems are not short-term – they are, mainly due to serious structural weaknesses in livelihoods systems of low-income people that require urgent and systematic attention.

Why is this happening? What are the consequences in a country like India, where over 60% of the population is engaged in agriculture and related activities? The key point to note here is that this case of farmer suicides is neither a cotton specific problem nor a paddy crop germane issue. Rather, it concerns, fundamental problems[iii] associated with one of India’s largest livelihood sectors, agriculture and allied activities – a sector where over 600 million people and a majority of India’s low income and poor[iv] people earn their living. More importantly, it is a sector without whose produce/products, we can neither eat nor survive in the long run. Therefore, without question, agriculture and allied areas as sectors and the low income people dependent on it for their livelihoods must be “included” in the overall growth paradigm. That is an urgent imperative in India today…
Second, as noted above, from the perspective of supply-side management, growth in agriculture is very vital for keeping manufacturing prices under check, ensuring food security and keeping inflation under control. India knows this better from its own experience of the last few years. Price stability is not merely important as an anti poverty measure but also as an instrument to ensure stable and sustained growth. Again, the lessons of the last 5 years should not be forgotten and especially, with regard to prices of essential food items as well as from a food security perspective. That the farmers who grew these commodities hardly got returns/rewards commensurate with their effort, investment and risks taken can hardly go unnoticed and this again point to very fundamental weakness in the structural aspects concerning agriculture and low income livelihood systems.

Third, higher growth in agriculture and rural areas coupled with demographic dividend (i.e. growing proportion of population in the working age group of 15-65) should result in a rise in the savings level, which, in turn, should facilitate financing the increasing level of investments required to maintain the overall momentum with regard to growth. This is again a very crucial aspect and the role of local and small savings should not be discounted in any serious measure. Its potential to support inclusive growth is phenomenal and appropriate incentives must be provided in this regard to encourage local/small savings as a resource alternative in the new growth paradigm

Fourth, the limitations on increasing production and productivity in agriculture are forcing people to migrate to urban areas and this results in increased population pressure in urban areas as well as larger numbers of urban poor. And this burgeoning urbanization has several important consequences for low income people, who tend to migrate and live in slums. As an NSSO survey revealed (a few years ago), nearly 40 per cent of farmers claimed that would like to quit farming, if they have the option to do so. Unfortunately, there is little option for them except moving into urban slums[v].

Thus, in reality, migration to urban areas primarily implies greater growth of urban slums, which hold a lower quality of life for the poor, many of whom have migrated from rural areas in search of better livelihoods. This growth of urban slums, typically, is associated with greater unemployment for the poor living there, harsh living conditions, enhanced crime, greater negative impact on health and several aspects including environmental degradation[vi]. Therefore, the major point to be noted is that the infrastructure in urban areas is simply not enough to cater to the growing needs of these migrants. Huge and appropriate investments are therefore needed in housing, sanitation, water, lighting and power, solid and other waste management, education, health, and so on and so forth. Therefore, we need “inclusive and enabling investment” in the above areas to deal with the huge and increasing numbers of low-income population in urban areas. This also calls for a paradigm shift in urban planning which must also become more inclusive.

Fifth, in countries such as India, the growth process is essentially knowledge-based and primarily services led. These new growth areas that continue to have a lot of potential going forward. Hence, the requirement of skilled labour is rather huge in comparison to the current levels of availability. Therefore, in order to ensure availability of adequate supply of labour skilled to tackle opportunities in new growth areas mentioned above, we also need huge enabling and inclusive investments in areas such as practical education and skill development – so that the vast majority of people who have the latent potential but cannot afford these services – are facilitated to gain access to such practical skills and knowledge, and thereby perform to their potential.

Last but not the least, whenever we talk of rural areas, the sector that comes first to our mind is agriculture. However, there is the (unorganized and informal) non-farm sector which continues to play an increasingly role in absorbing a large numbers of rural people. Make no mistake – taken together, this non-farm sector and value added agriculture enterprises (MSME) sector have huge potential for growth but this again requires investment in “inclusive infrastructure and enabling mechanisms” for ensuring easier/quicker access to assets, skills, appropriate technology, wide range of vulnerability reducing financial services (including credit for post harvest and post production) and fair linkage to various markets and other market development infrastructure (both private sector and government procurement). Without question, such efforts can make these hitherto excluded sectors, an expanding base for wealth creation and generation in a competitive manner in rural areas

Therefore, to reiterate, it is critical to ensure that growth takes place in: (a) agriculture, allied and non-farm sectors as well as secondary and services (enabling) sectors in rural areas; and (b) amongst urban poor so that they have a better quality of life and opportunities for sustainable livelihoods/wealth creation and thereafter, they also serve as a growing market for the goods and services produced by the expanding industrial sector including those produced by various kinds of MSMEs. However, this growth cannot be mere dumping of goods and/or provision of services in rural areas or among the urban poor. It has to be responsible growth and delivered in an ethically sound and transparent manner and this is one of the most important lessons from the present Indian micro-finance crisis/growth story. Otherwise, all the gains will be lost…and we will still be at square one...

To summarise, it is clear that inclusive growth is very necessary for sustainable development and equitable generation of wealth and prosperity. However, achieving this inclusive growth is the biggest challenge in a democratic country like India as it translates to the concern of integrating 600 million people living in rural India and several million living in urban slums into the mainstream economy and facilitating them to create wealth and better quality of life at the grass-roots. And that is a task in which a new paradigm of inclusive finance must take the lead in and show the way forward such that sustainable growth and wealth creation opportunities are available to all excluded sections of the society and in all neglected sectors of the economy and parts of the country.

And this requires that we let go off our narrow conceptualization of inclusive financial services and broaden the paradigm to ensure that financial services play a very vital role in addressing two critical supply-side issues: (i) by creating an effective and fair ecosystem for delivery of a wide range of (financial and related) services to facilitate productive and enabling investment in largely excluded but employment impacting sectors such as agriculture, value added agriculture, MSMEs etc as well as hitherto excluded (geographic) areas and for enabling low income and excluded people (living in rural India and urban slums) to realize their latent untapped potential; and (ii) by driving large scale investment in inclusive infrastructural facilities and enabling mechanisms like watersheds, irrigation, rural/urban reconstruction, social infrastructure such as health care, education and sanitation and the like.

Without question, mere credit[vii] to low-income people can do very little for inclusive growth as has been consistently argued by many proponents of the narrow inclusive finance paradigm. Only a new, braod and enabling paradigm of inclusive finance as mentioned above can help usher in an era of real inclusive growth in India…

Have A Nice Day!

[i] This post draws from several resources including: Inclusive growth – the role of banks in emerging economies by Mrs Usha Thorat and other web based resources as well as papers by this author
[ii] And this issue becomes even more critical when one considers the fact that the average monthly per capita consumption expenditure (MPCE) in urban areas in India is near double that of rural areas. And in some States (like in Central or Eastern India), these disparities are even more glaring.
[iii]  “Farming is both a way of life and the principal means of livelihood to 65 per cent of India's population of 110 crore, Our farm population is increasing annually by 1.84 per cent, The average farm size is becoming smaller each year and the cost-risk-return structure of farming is becoming adverse, with the result that farmers are getting increasingly indebted. Marketing infrastructure is generally poor, particularly in perishable commodities. The support systems needed by farmers, like research, ex-tension, input supply and opportunities for assured and remunerative marketing are in various stages of disarray. Small farmers are forced to borrow money from money-lenders at high rates of interest, since less than 60 per cent of the credit requirements of farmers is met by institutional sources.” (Dr M S Swaminathan, Chairperson, National Commission on Farmers, 2006).
[iv] Despite significant progress made by India during the last decade or so, about 30 – 35% of the total population still lives below the poverty line.
[v] INDIA has always been considered a country that lives in its villages. But increasingly rural Ind1a is moving towards the town and the City. The 2001 Census established that almost one- third of India's population, an estimated 285 million people, lived in urban areas. By 2020, half the country's population is expected to be city-based.
[vi] In fact, as the data suggest, almost 50% of country’s population and a large majority of the poor are likely to reside in urban slums in India by 2020. And Noted environmentalist Chandrasekar confirms the above trends and summarises the issues with rapid urbanisation, “Although on paper all cities have some kind of development plan, the actual development follows no particular pattern except that dictated by expediency, patronage and privilege. As a result, every city in India is the epitome of urban chaos - lacking in adequate water and sanitation, affordable housing, all weather roads, decent public transport and clean air. Cities generate wealth but increasingly Indian cities have become home to the urban poor. Every city is marked by the informal settlements where the poor are forced to live without access to basic services like water and sanitation. City administrations are unable to check the flow of poor people into the city and have failed to build affordable housing where the poor can live. As a result, in some cities like Mumbai, for instance, half the population lives in slums. And in Maharashtra, India's most urbanised State, 61 cities and towns have slum populations that together makeup over 27 per cent of the total urban population and a third of the total population of the State. Indeed, the slum has now become an inescapable part of the Indian urbanscape” (The Hindu,).
[vii] Several factors like market imperfections and other factors (like poor infrastructure and production practices etc) severely constrain these low income people in their efforts to build sustainable livelihoods and enhance their economic security - as a result of fragile livelihoods, they often go through a cycle of being financially included and excluded at various times.  The key point is that, in the absence of other infrastructure and mechanisms, the use of loans by poor and vulnerable people renders them into greater debt.

Wednesday, May 4, 2011

RBI Acceptance of Malegam Committee Recommendations: Great Beginning But Miles To Go Before We Can Sleep…

Ramesh S Arunachalam
Rural Finance Practitioner

The RBI has finally given its view on the Malegam Committee Recommendations (MCR) and it is on the lines expected. In this post, I broadly compare the MCR recommendations with RBI statements in the monetary policy and then comment on what is unfinished with regard to the Micro-Finance regulation agenda in India

I quote from the Monetary Policy document of the RBI, which is re-produced below (http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=6376&Mode=0)

92. “In the wake of the Andhra Pradesh micro finance crisis in 2010, concerns were expressed by various stakeholders and the need was felt for more rigorous regulation of non-banking financial companies (NBFCs) functioning as micro finance institutions (MFIs). As indicated in the Second Quarter Review of November 2010, a Sub-Committee of the Central Board of the Reserve Bank (Chairman: Shri Y. H. Malegam) was constituted to study issues and concerns in the MFI sector. The Committee submitted its report in January 2011, which was placed in public domain.
The Committee, inter alia, recommended (i) creation of a separate category of NBFC-MFIs; (ii) a margin cap and an interest rate cap on individual loans; (iii) transparency in interest charges; (iv) lending by not more than two MFIs to individual borrowers; (v) creation of one or more credit information bureaus; (vi) establishment of a proper system of grievance redressal procedure by MFIs; (vii) creation of one or more “social capital funds”; and (viii) continuation of categorisation of bank loans to MFIs, complying with the regulation laid down for NBFC-MFIs, under the priority sector. The recommendations of the Committee were discussed with all stakeholders, including the Government of India, select State Governments, major NBFCs working as MFIs, industry associations of MFIs working in the country, other smaller MFIs, and major banks.

In the light of the feedback received, it has been decided:
·         to accept the broad framework of regulations recommended by the Committee;
·         that bank loans to all MFIs, including NBFCs working as MFIs on or after April 1, 2011, will be eligible for classification as priority sector loans under respective category of indirect finance only if the prescribed percentage of their total assets are in the nature of "qualifying assets" and they adhere to the "pricing of interest" guidelines to be issued in this regard;
·         that a “qualifying asset’’ is required to satisfy the criteria of (i) loan disbursed by an MFI to a borrower with a rural household annual income not exceeding ` 60,000 or urban and semi-urban household income not exceeding ` 1,20,000; (ii) loan amount not to exceed ` 35,000 in the first cycle and ` 50,000 in subsequent cycles; (iii) total indebtedness of the borrower not to exceed ` 50,000; (iv) tenure of loan not to be less than 24 months for loan amount in excess of ` 15,000 without prepayment penalty; (iv) loan to be extended without collateral; (v) aggregate amount of loan, given for income generation, not to be less than 75 per cent of the total loans given by the MFIs; and (vi) loan to be repayable by weekly, fortnightly or monthly instalments at the choice of the borrower;
·         that banks should ensure a margin cap of 12 per cent and an interest rate cap of 26 per cent for their lending to be eligible to be classified as priority sector loans;
·         that loans by MFIs can also be extended to individuals outside the self-help group (SHG)/joint liability group (JLG) mechanism; and
·         that bank loans to other NBFCs would not be reckoned as priority sector loans with effect from April 1, 2011.

93. Detailed guidelines in this regard will be issued separately.”

What does all of this mean for Indian micro-finance?

First of all, it is great for the micro-finance industry that the broad framework of The Malegam Committee Report (MCR) recommendations have been accepted - as this provides the much needed legitimacy to the sector. That the RBI has recognized loans to low income people as part of priority sector is excellent news and that it has given first cut (but explicit) guidelines regarding the same is very welcome.

As I have been reading the MCR more and more, I am now convinced that the framework of report (forgetting the nitty gritty recommendations and value for different criteria) has a lot of merit because it has used regulation by principles, rules and incentives in appropriate balance. This will be elaborated in a separate post

Second, what is really interesting from the RBI pronouncement is the fact that priority sector is being used as an incentive to shape the behavior of MFIs and provide direction for the orderly growth of the Micro-finance industry. In this regard while the aspect of enhancing overall indebtedness to Rs 50000 is a very pragmatic one, the decision to shift the loan ceiling for the 1st loan from 25,000 to Rs 35,000 needs careful consideration. I do hope that to be appointed committee on priority sector looks at this and other aspects carefully…Here are some my suggestions with regard to the priority sector… Read On..

http://microfinance-in-india.blogspot.com/search/label/Priority%20Sector%20Lending and


Third, the Malegam Committee Report (MCR) provided a large number of excellent recommendations regarding several others aspects including minimum systems for MFIs, supervision, client protection, corporate governance and the like and the real time implementation of these aspects on the ground. Please see summary of MCR recommendations here (http://microfinance-in-india.blogspot.com/2011/01/rbi-sub-committee-report-my-summary-of.html).

I do sincerely hope that the detailed guidelines of the RBI do touch upon these aspects in serious measure. Otherwise, priority sector could be misused again… and there are numerous examples in the public domain for the RBI and various stakeholders on how priority sector could be misused (e.g., huge loan to promoter to buy shares in the same MFI as highlighted by Prof Sriram in one case in his EPW article) if the accompanying facets of the Malegam Committee Report (MCR) including Corporate Governance aspects are not considered, while drawing up detailed guidelines…

Hope the RBI ensures that other facets concerning minimum systems, corporate governance, supervision and all other important issues, as mentioned in the Malegam Committee Report, are duly considered and appropriately implemented

Have A Nice Day!

Monday, May 2, 2011

Risk Assessment and Risk-based Auditing At Systemically Important and Large MFIs: Some Practical Guidelines…

Ramesh S Arunachalam
Rural Finance Practitioner  

Risk assessment and risk-based auditing are very critical mechanisms and need to be undertaken at large and systemically important MFIs and this post provides some practical suggestions in this regard…

Risk assessment is a process by which an auditor identifies and evaluates the quantity of the MFIs risks and the quality of its controls over those risks. Through risk-based auditing, the board and auditors use the results of the risk assessments to focus on the areas of greatest risk and to set priorities for audit work. That however does not mean that the audit department can lose sight of or ignore areas that are rated low-risk. An effective risk-based auditing program will ensure adequate audit coverage for all of an MFI’s auditable activities. The frequency and depth of each area’s audit should vary according to the auditor’s risk assessment.

Program Design: Properly designed risk-based audit programs increase audit efficiency and effectiveness. The sophistication and formality of audit approaches will vary for individual MFIs depending on the MFIs’ size, complexity, scope of activities, staff capabilities, quality of control functions, geographic diversity, and technology used. All risk-based audit programs should:
·         Identify all of the MFI’s operations, product lines, services, and functions (i.e., the audit universe).
·         Identify the activities and compliance issues within those operations, product lines, services, and functions that the MFI should audit (i.e., auditable entities).
·         Include profiles of significant operational units, departments, and products that identify business and control risks and document the structure of risk management and internal control systems.
·         Use a measurement or scoring system to rank and evaluate business and control risks of significant operational units, departments, and products.
·         Include board or audit committee approval of risk assessments or the aggregate result thereof and annual risk-based audit plans (that establish internal and external audit schedules, audit cycles, work program scope, and resource allocation for each area to be audited).
·         Implement the audit plan through planning, execution, reporting, and follow-up.
·         Have systems that monitor risk assessments regularly and update them at least annually for all significant operational units (regions or branches), departments, and products.

Risk Matrix and Guidelines: An effective scoring system is critical to a successful risk-based audit program. In establishing a scoring system, directors and management must consider all relevant risk factors so that the system minimizes subjectivity, is understood, and is meaningful. Major risk factors commonly used in scoring systems include:
·         The nature of transactions (e.g., volume, size, liquidity);
·         The nature of the operating environment (e.g., compliance with laws and regulations, complexity of transactions, changes in volume, degree of system and reporting centralization, economic and regulatory environment);
·         Internal controls, security, and MIS;
·         Human resources (e.g., experience of management and staff, turnover, competence, degree of delegation); and
·         Senior management oversight of the audit process.

Auditors or risk managers should develop written guidelines on the use of risk assessment tools and risk factors and review the guidelines with the audit or risk committee. The sophistication and formality of guidelines will vary for individual MFIs depending on their size, complexity, scope of activities, geographic diversity, and technology used. Auditors will use the guidelines to grade or assess major risk areas. These guidelines generally define the basis for assigning risk grades, risk weights, or risk scores (e.g., the basis could be normal industry practices or the MFI’s own historical experiences). They also would define the range of scores or assessments (e.g., low, medium, and high, or a numerical sequence, for example, 1 through 5). The written guidelines should specify:
·         The length of the audit cycles based on the scores or assessments. Audit cycles should not be open-ended. For example, some MFIs set audit cycles at 12 months or less for high-risk areas, 24 months or less for medium-risk areas, and 36 months or less for low-risk areas. However, individual judgment and circumstances at each MFI will determine the length of its audit cycles.
·         Guidelines for overriding risk assessments. The guidelines should specify who could override the assessments, the approval process for such overrides, and the reporting process for overrides. The override process should involve the board or its audit committee, perhaps through final approval authority or through timely notification procedures. Overrides of risk assessments should be more the exception than the rule.
·         Timing of risk assessments for each department or activity. Normally, risks are assessed annually, but they may need to be assessed more often if the MFI or a specific product experiences excessive growth (as between April 2007 – 2009), if MFI staff or activities change significantly, or changes to or new laws and regulations occur.
·         Minimum documentation requirements to support scoring or assessment decisions.

Management Responsibilities: Day-to-day management of the risk-based audit program rests with the internal auditor or internal audit manager, who monitors the audit scope and risk assessments to ensure that audit coverage remains adequate. The internal auditor or audit manager also prepares reports showing the risk rating, planned scope, and audit cycle for each area. The audit manager should confirm the risk assessment system’s reliability at least annually or whenever significant changes occur within a department or function.

Line department managers and auditors should work together in evaluating the risk in all departments and functions. Auditors and line department managers should discuss risk assessments to determine whether they are reasonable. However, the auditors, with concurrence of the board, audit committee or risk committee, should have ultimate responsibility for setting the final risk assessment. Auditors should periodically review the results of internal control processes and analyze financial or operational data for any effect on a risk assessment or weighting. Accordingly, MFI management should keep auditors current on all major changes in departments or functions, such as the introduction of a new product, implementation of a new system, changes in laws or regulations, or changes in organization or staff.

I hope that systemically important MFIs including large NBFCs wake up to have serious internal audits as part of their institutions…this alone can help prevent the kind of institutional lapses that led to the present day crisis…

Have a Nice Day!

Designing The Internal Audit Function At MFIs: Some Critical Issues…

Ramesh S Arunachalam
Rural Finance Practitioner  

Internal auditors play a very critical role in any organization and the same applies to micro-finance.

Role of Internal Auditors: The primary role of internal auditors is to independently and objectively review and evaluate an MFIs activities to maintain or improve the efficiency and effectiveness of risk management, internal controls, and corporate governance. They do this by:
·         Evaluating the reliability, adequacy, and effectiveness of accounting, operating, and administrative controls.
·         Ensuring that MFI internal controls result in prompt and accurate recording of transactions and proper safeguarding of assets.
·         Determining whether an MFI complies with laws and regulations and adheres to established policies.
·         Determining whether management is taking appropriate steps to address current and prior control deficiencies and audit report recommendations.

Internal auditors must understand an MFIs strategic direction, objectives, products, services, processes as well as clients to conduct these activities and make a judgement on the above. The auditors then communicate findings to the board of directors or its audit committee, who then will brief and discuss with senior management.

In addition, internal auditors often have a role in transformation activities. This role may include such duties as helping the board and management evaluate safeguards and controls, including appropriate documentation and audit trails, during the transformation process at the MFI – this is a very critical issue as many MFIs transform to become for profits from non-profits

Oversight and Structure: MFIs should conduct their internal audit activities according to existing professional standards and guidance. But how the internal audit function is accomplished depends on the MFI’s size, complexity, scope of activities, and risk profile, as well as the responsibilities assigned to the internal auditor by the board of directors.

In larger MFIs, a chief auditor and a full-time internal audit staff may accomplish the internal audit function. In other MFIs, the internal audit function may be accomplished by one or two employees or a holding company or even by an outside vendor. In many small MFIs, the officer or employee designated as a part-time auditor may also have operational responsibilities. In any case, to maintain independence, the person responsible for accomplishing the internal audit function should be independent of whatever area is being audited and should report findings directly to the board or its audit committee.

The audit committee should position the internal audit function in the institution’s organizational structure such that the function will perform its duties with impartiality and not be unduly influenced by managers of day-to-day operations. The ideal organizational arrangement is having the internal audit function report directly and solely to the audit committee regarding both internal audit issues and administrative matters, e.g., resources, budget, and compensation.

Some MFIs place the manager of internal audit under a dual reporting arrangement: functionally accountable to the audit committee for matters such as the design of audit plans and the review of audit scope and audit findings, while reporting to a senior executive on administrative matters. Such an arrangement potentially limits the internal audit manager’s independence and objectivity when auditing the senior executive’s lines of business. Thus, chief financial officer, controller, or other similar positions should generally be excluded from overseeing the internal audit activities even in a dual role. In structuring the reporting hierarchy, the audit committee should weigh this risk of diminished independence against the benefit of reduced administrative burden in adopting a dual reporting organizational structure. Under a dual reporting arrangement, the internal audit function’s objectivity and organizational stature is best served when the internal audit manager reports administratively to the chief executive officer.

That said, the best option of course is to ensure that the internal audit departmental head reports directly to the board or audit committee of the MFI, to ensure that all potential and real conflicts of interests are negated…

Have A Nice Day!

Sunday, May 1, 2011

Assessing The Quality of Internal Control at MFIs: Guidelines for Regulators and Supervisors…

Ramesh S Arunachalam
Rural Finance Practitioner

Monitoring the quality of internal control at (NBFC) MFIs would become a key task, if the Malegam Committee Report is accepted. And an earlier post already provided a draft suggested questionnaire by which supervisors and examiners can collect basic information on the internal control system at MFIs (http://microfinance-in-india.blogspot.com/2011/04/monitoring-quality-of-internal-control.html)

While that post would enable collection of general information, supervisors/examiners should use appropriate mechanisms/tools to judge the adequacy of internal controls at MFIs and this must be done for each of the components (see post: http://microfinance-in-india.blogspot.com/2011/04/critical-internal-control-components-in.html) of the internal control system given below. This post attempts to provide some practical guidance in this regard:

A) Control Environment

Supervisory Objective: Determine whether the institution’s (MFI’s) control environment embodies the principles of strong internal control. For this, supervisors and examiners need to closely look at:

1.      Assess the effectiveness of the control environment. For this, they should look at:
  • The integrity, ethics, and competence of personnel at the MFI
  • The organizational structure of the institution and its reporting structure
  • Management’s philosophy and operating style and especially that of senior and line management
  • External influences affecting operations and practices including the lending and equity environment
  • Personnel policies and practices and the entire HR system with the kinds of incentives provided
  • The attention and direction provided by the board of directors and its committees, especially the audit or risk management committees.

2.      Determine whether the board periodically reviews policies and procedures to ensure that proper risk assessment and control processes have been instituted at the MFI.

3.      Determine whether there is an audit or other control system in place at the MFI to periodically test and monitor compliance with internal control policies/procedures and to report to the board instances of noncompliance.
  • Does the board review the qualifications and independence of internal and external auditors?
  • Do auditors report their findings directly to the board or its audit committee?
  • Does the board take appropriate follow-up action when instances of noncompliance are reported?

4.      Determine whether management provides the board and its representatives complete access to bank records and this is a critical issue

5.      Determine whether board decisions are made collectively or whether dominant individuals control those decisions. This again is crucial 

6.      Determine whether management information systems provide the board with accurate and reliable information that they need to make informed and timely decisions.

7.      Determine whether the board receives adequate information about the MFI’s own (internal) risk assessment process and this would applicable for systemically important and large MFIs

8.      Determine whether the board and/or management communicate policies regarding the importance of internal control and appropriate conduct to all MFI employees.

9.      Determine whether codes of conduct or ethics policies exist at the MFI. This could even by the regulators’ suggested code (like that of RBI) or the codes provided by the various associations (Sa-Dhan or MFIN)
·         Do audit or other control systems exist to periodically test for compliance with codes of conduct or ethics policies?
·         Do audit or other control system personnel routinely review policies and training regarding ethics or codes of conduct?

B) Risk Assessment[i]

Supervisory Objective: Determine whether the MFI’s risk assessment system allows the board and management to plan for and respond to existing and emerging (including political) risks in the MFI’s activities. For this, supervisors and examiners need to:

1.      Determine whether the board and management of the MFI involve audit personnel or other internal control experts in the risk assessment and risk evaluation process.

2.      Determine whether the risk assessment/evaluation process involves sufficient staff members who are competent, knowledgeable, and provided with adequate resources.

3.      Determine whether the board and management at the MFI discuss and appropriately evaluate risks and consider control issues during the preplanning stages for new products and activities.

4.      Determine whether audit personnel or other internal control experts are involved when the MFI is developing new products and activities.

5.      Determine whether the board and management of the MFI consider and appropriately address technology issues including for new product development and introduction

C) Control Activities

Supervisory Objective: Determine whether the board and senior management at the MFI have established effective control activities in all lines of business. For this, supervisors and examiners need to: 

1.      Determine whether policies and procedures exist at the MFI to ensure that decisions are made with appropriate approvals and authorizations for transactions and activities.

2.      Determine whether processes exist at MFI to ensure that
  • The performance and integrity of each function are independently checked and verified using an appropriate sample of transactions.
  • Accounts are reconciled continually, independently, and in a timely manner and that outstanding items, both on- and off-balance-sheet, are resolved and cleared.
  • Policy overrides are minimal and exceptions are reported to management.
  • Employees in sensitive positions or risk-taking activities do not have absolute control over areas. For example,
Ø      Is there segregation or rotation of duties to ensure that the same employee does not originate a transaction, process it, and reconcile it to the general ledger account?
Ø      Is there periodic unannounced rotation of duties for employees or vacation requirements that ensure their absence for at least a two-week period?
Ø      Are safeguards in place for access to and use of sensitive assets and records?
Ø      Is there dual control or joint custody over access to assets (e.g., cash, negotiable collateral, official checks etc)?

3.      Determine whether reporting lines within a business unit (branch or regional or state headquarters) or functional area at the MFI provide sufficient independence of the control function.
  • Is separation of duties emphasized in the organizational structure?
  • Are systems in place to ensure that personnel abide by separation of duty requirements?
  • Is there an internal review of employee accounts and expense reports?
  • Are personnel accountable for the actions they take and the responsibilities/authorities given to them?

4.      Determine whether operating practices at the MFI conflict with established areas of responsibility and control. Examiners should
  • Interview line and management personnel.
  • Review policies delineating responsibilities.
  • Review reconciliations and transaction origination.
  • Reviews internal audit work papers.
  • Review external audit reports.

5.      Determine whether the MFI internal audit or other control review functions are sufficiently independent. Consider:
  • Where the function reports, administratively, within the organization.
  • To whom, or to what level, the function reports the results of work performed.
  • Whether practices conform to established standards.
  • Whether management unduly influences the timeliness of risk analysis and control processes.

6.      Determine whether the board and senior management at the MFI has established adequate procedures for ensuring compliance with applicable laws and regulations. Examiners should
  • Determine the frequency of testing and reporting for compliance with laws and regulations by reviewing:
Ø      Audit schedules, scopes, and reports.
Ø      Minutes of senior management and board committees.
Ø      The payment of any fines or liabilities arising from litigation against the institution or its employees. There have been some such cases with regard to some of the MFIs in India in the past
  • Determine whether appropriate attention and follow-up are given to violations of laws and regulations. Consider:
Ø      The significance and frequency of the violations.
Ø      The willingness and ability to prevent reoccurrence.

D) Accounting, Information, and Communication Systems

Supervisory Objective: Determine whether the MFI’s accounting, information, and communication systems ensure that risk-taking activities are within policy guidelines and that the systems are adequately tested and reviewed. For this, supervisors and examiners need to:

1.      Assess the adequacy of accounting systems by determining whether
  • The systems properly identify, assemble, analyze, classify, record, and report the institution’s transactions in accordance with national and international standards.
  • The systems account for all assets and liabilities involved in transactions.

2.      Assess the adequacy of information systems by determining
  • The type, number, and depth of reports generated for operational, financial, managerial, and compliance-related activities.
  • Whether reports are based on accurate and timely data and sufficient to properly run and control the MFI.
  • Whether access to information systems is properly restricted.

3.      Assess the adequacy of communication systems by determining whether
  • Significant information is imparted throughout the MFI (from the top down and from the bottom up in the organizational chain), ensuring that personnel understand:
Ø      Their roles in the control system.
Ø      How their activities relate to others.
Ø      Their accountability for the activities they conduct.
  • Significant information is imparted to external parties such as regulators, shareholders, customers, lenders, investors and others.

4.      Assess how frequently and thoroughly the accounting, information, and communication systems are verified. Consider:
  • The frequency of testing given the level of risk and sophistication of the systems.
  • The sufficiency of ongoing reviews of the systems’ accuracy.
  • The competency, knowledge, and independence of the personnel doing the testing.
  • The sufficiency of contingency planning.

E) Self-assessment and Monitoring

Supervisory Objective: Determine whether senior management and the board of the MFI properly oversee internal control, control reviews, and audit findings. For this, supervisors and examiners need to:

1.      Determine whether the MFI board or a designated board committee has reviewed management’s actions to deal with material control weaknesses and verified that corrective actions are objective and adequate. Consider:
  • Minutes of appropriate board and committee meetings.
  • Audit or other control review reports and follow-up reports.

2.      Determine the frequency and comprehensiveness of reports to the MFI board or board committee and senior management:
  • Review the minutes of appropriate board or committee meetings.
  • Determine whether the reports are sufficiently detailed.
  • Determine whether reports are presented in a timely manner to allow for resolution and appropriate action.

3.      Determine the adequacy of the board’s or board committee’s review of audit and other control functions. Consider whether the MFI board or its committee
  • Reviewed the qualifications and independence of personnel evaluating controls (e.g., external auditors, internal auditors, or line managers).
  • Approved the overall scope of control review activities (e.g., audit, loan review, etc.).
  • Reviewed the results of control evaluations.
  • Approved the system of internal control.
  • Periodically reviews the adequacy of audit or other control systems.

4.      Assess the adequacy and independence of the audit or other control review function. Consider:
  • Results of audit’s or other control review function’s control evaluation and supporting work papers.
  • The function’s organizational structure and reporting lines.
  • The scope and frequency of audits or reviews for all activities across the organisation.
  • Audit or control review reports, management responses, and follow-up reports.

5.      Determine whether MFI management responses to audit or other control review findings are fully documented and tracked for adequate follow-up. Consider whether
·         Documentation detailing the coverage, findings, and follow-up of control weaknesses is adequate.
·         Management gives appropriate and timely attention to material control weaknesses once identified.
·         Line management is held accountable for unsatisfactorily or ineffectively following up on control weaknesses. This is very critical indeed.

When after the above, substantive supervisory concerns about the adequacy of internal control or the integrity of financial reporting controls still exist, supervisors/examiners should consider performing more detailed and additional examination procedures, for those areas of concern. If, after completing those additional procedures, examiners still remain concerned about internal control adequacy or financial reporting control integrity, they should perform appropriate verification procedures to confirm the existence and description of assets.

As an alternative, examiners may require the MFI to expand its own verification program to include the areas of weakness or deficiency; however, this alternative will be used only if management has demonstrated a capacity and willingness to address regulatory problems, if there are no concerns about management’s integrity, and if management has initiated timely corrective action in the past. Use of this alternative must result in timely resolution of each identified supervisory problem. If examiners use this alternative, supervisory follow-up must include a review of work papers in areas where the MFI’s verification program was expanded.

The above aspects should be taken as a starter set and supervisors/examiners, will need to build on these using the day-to-day experience in supervising MFIs…

Have A Nice Day!

[i] While this will apply to all kinds of MFIs, it will be more applicable to large and systemically important MFIs