REGULATION AND AREAS OF POTENTIAL MARKET ...

REGULATION AND AREAS OF POTENTIAL MARKET FAILURE IN MICRO-FINANCE By Y.S.P THORAT1 AND RAMESH S ARUNACHALAM

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Mr Y.S.P Thorat is Managing Director of NABARD and Ramesh S Arunachalam is Consultant, MCG. The views expressed in this paper are individual and do not necessarily represent official views of the institutions that the authors represent

Regulation and Areas of Potential Market Failure in Micro-Finance, Y.S.P Thorat and Ramesh S Arunachalam

TABLE OF CONTENTS SL.NO 1 2 2.1 3 3.1 3.1 3.2 3.3 3.4 3.5 3.6 3.7 4 5 Annex 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 Annex 2 Annex 3 Annex 4

DETAILS Background Strategic Context: Regulation and Market Failure The Financial Market Place for Micro-Finance Existing Legal Forms and Implications for Failure Failures in the Financial Market Place for Micro-Finance The case of public Deposit The Case of Non-Transparent Transactions The Case of MIS and Portfolio Quality

The Case of Product Design The Case of Internal Control Lapses The Case of Political and Religious Factors Summary of Issues and Implications for Addressing Market Failure Regulating the Micro-Finance Sector Annexes Issues to Consider While Establishing A Regulatory Mechanism For MicroFinance Portfolio Management – Credit Risk, MIS and Disclosures – and Regulatory Implications Loan Portfolio Audits and Regulatory Implications Internal Controls Aspects for Micro-Finance and Regulatory Implications Risk Management Issues for Micro-Finance and Regulatory Implications Customer Related Aspects for Micro-Finance including KYC Norms and Regulatory Implications Technology for Micro-Finance and Regulatory Implications Outsourcing in Micro-Finance (Agency Model) and Regulatory Implications Portfolio Quality and Ageing of Past Due Loans Regulatory Challenges Micro-finance in India Supervision and Regulation of MFIs in India - the Present Scenario

PAGE.NO 3 4 5 10 12 12 14 18 19 20 21 23 26 29 29 29 30 31 33 34 35 36 37 59 61

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Regulation and Areas of Potential Market Failure in Micro-Finance, Y.S.P Thorat and Ramesh S Arunachalam 1

Background

Micro finance, as an industry, appears to have arrived in India. The burgeoning growth experienced by the sector, over the last few years, is testimony to the fact that a large number of stakeholders are embracing micro-finance, as a sustainable approach to poverty reduction. This appears to be true, irrespective of whether you consider the NABARD SHG Bank-model, the SIDBI MFI approach, the ICICI partnership model and/or other innovative approaches2 While increased growth and interest in the sector are welcome signs of its current and potential impact, this growth is not without problems. Anecdotal evidences3 from the field indicate that several types of failure in the ‘market place for micro finance’ have either occurred and/or are occurring. While these failures may be isolated and even sporadic incidents, the fact remains that these early warning signals should not and cannot be ignored. Accordingly, this paper analyses the “financial market place for micro finance” and attempts to identify potential sources of failure4 in this market place. Two points deserve specific mention here: (1) In attempting to highlight ‘potential’ areas of market failure, we would like to CLEARLY state that we are not, in any way, implying that such failures are occurring all the time with all institutions5; and (2) Rather, we have systematically tried to learn lessons from the field using past experiences and analyze existing institutional arrangements to identify weakest links (areas) in the micro-finance market place that could witness POTENTIAL failures. The ultimate objectives from this exercise are three fold: a. Enabling provision of financial services for all potential users (low income people) in urban and rural areas, so that they have continued access to financial products and services commensurate to their depth of financial literacy and risk appetite at reasonable and affordable price, b. Developing a competitive, transparent, efficient, stable, and balanced financial system for micro-finance, and c. Fostering fairness and transparency whereby financial institutions follow good corporate governance principles and provide efficient, affordable and market based financial services to poor clients. The remainder of this paper is organized as follows: The next section (Section 2) sets the context and framework for the aforementioned analysis. Section 3 describes potential areas where market failures could occur based on an analysis of existing arrangements, some anecdotal evidence and historical data. Section 4 outlines a framework for action including regulatory and supervisory mechanisms required to safeguard the sector from such market failures. It concludes with a discussion of various measures required to mitigate the occurrence of potential market failures. Section 5 contains several annexes including specific regulatory actions required, guidelines on technical aspects related to “loan portfolio management and MIS” to promote transparency in micro-finance, regulatory challenges in the current micro-finance environment and other issues.

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Excellent summaries of alternative micro-finance models in India, their growth, special characteristics, achievements, innovations and other aspects are already available. Hence, they are not discussed here. 3 Several stakeholders offered to share incidents and experiences in a generalised manner to promote learning for the sector, without reference to specific institutions. This was done on the basis of confidentiality and with the assurance from the authors that the specific context would not be identified under any circumstances 4 The term failure is used synonymously with ‘market failure’, ‘institutional failure’ or ‘systemic failure’. 5 Institutions involved in micro-finance have done commendable work and this analysis is not meant to be a generalisation of the situation in the micro-finance sector; rather, it should be seen as a proactive analysis of potential failures that could occur

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2

Strategic Context: Regulation and Market Failure

A market and/or institutional failure (see Box below) is said to occur when things/events/aspects do not happen as per the ideal. In the case of micro-finance, several types of market/institutional failures are possible but before describing that, a definition of micro-finance seems necessary from the perspective of this paper. Micro-finance is the delivery of credit, savings, insurance and other services (through alternative channels) by various formal and informal institutions to low-income clients in an efficient, affordable and sustainable manner. For example, failure in the market place for micro-finance is said to occur when: • • • • • • • • • • • •

Loans do not reach clients, Clients do not make repayments, Cash in the system is lost in transit, through theft, or other means such as internal control lapses, Information systems provide a different than realistic picture with regard to operations, often shrouding delinquency, Political/religious groups tell clients not to repay seemingly ‘usurious’ micro-finance loans, Governance is not transparent and accountable in institutions, Non-transparent transactions occur between group entities, directly or indirectly related to same promoter, Provisions in the law are overcome through seemingly legal means but such solutions defeat the very purpose for the existence of the law itself, Loan funds are diverted for non micro-finance activities, Coercive methods are used to extract repayment from clients, Clients exist on loan books but not in reality, and Plus several other aspects.

Regulation is establishment of fair rules to conduct the ‘business’ of micro-finance and supervision is ensuring compliance to these above rules. The essence of regulation is to prevent market/institutional failures and ensure stability and soundness of the financial system – in this case the financial market for microfinance system. According to Joseph Stiglitz6 "Regulatory reform requires the elimination of excessive or burdensome regulations, as well as regulations whose sole purpose is to inhibit competition. At the same time, regulations need to promote competition, and prudential behavior, while continuing to ensure that clients are protected.". Others have also endorsed the need for regulation to prevent ‘market failures’. As an international expert in micro-finance argues, “Financial regulation ensures financial self-sufficiency of institutions and also provides protection against institutional failures. While some may argue that regulations could impede the growth of micro-finance institutions, however the fact remains that as … the microfinance sector and institutions grow, risks and chances of failure also increase… Regulation would then become imperative for the microfinance industry.” Remarks a senior banker, “The first purpose (of regulation), which applies in all sectors of the economy, is to ensure that markets work efficiency and competitively. Regulation for this purpose includes rules designed to promote adequate disclosure, prevent fraud or other unfair practices and prohibit anti-competitive behavior such as collusion or monopolization. This type of regulation does not materially alter or prescribe the nature of products or services, but simply aims to ensure that there are fair and efficient markets. Also, there will be no room in a competitive market for non-commercial mispricing. Competitors with high cost structures will also be forced to rationalize their operations in order to remain competitive.” 6

Source: The World Bank, The 1998 WIDER Annual Lecture, Helsinki, Finland, January 7, 1998

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Commenting on this aspect of regulation and market failure, an industry observer states, “While we clearly have to address the potential and real abuses that exist in the system…. we, also need to preserve, encourage and facilitate to the greatest extent possible, clients, continued access to credit and other financial services. This mandates that the system for delivery of financial services has adequate safeguards, checks and balances to prevent failures and foster the development of vibrant institutions that can ensure continued and sustained access to financial services for the poor” 2.1

The Financial Market Place for Micro-Finance

The Indian micro-finance system, as evident from Figure 1, is a complex financial system with an increasing number of stakeholders involved in it - from NGOs, NGO-MFIs, Cooperatives, MFIs, NBFC(s), Commercial Banks, (Public and Private Sector) RRBs, Cooperative Banks, DFIs and others. Explicit legitimacy to the sector is still lacking and as of today, micro-finance is delivered through a complex array of institutions governed by multiple laws7. Regulation8 of micro-finance is also complex, from very passive (for some types of entities) to very active (for others). In fact, some of these laws and hence regulatory/supervisory mechanisms, even have the potential to work at cross-purposes and the potential for conflict of interest also exists. Current trends in the sector are summarized below: 1. Several models exist but there are three key ones: The NABARD SHG Bank Linkage Model and its variants, The Institutional MFI Model supported by SIDBI, ICICI, FWWB, Commercial bankers and other stakeholders and The Partnership Securitization Model of ICICI and other commercial bankers. 2. Most of these models work through a complex array of institutional forms - including not-for-profit entities, mutual benefit organizations and for-profit institutions – that perform social and financial intermediation in different degrees, as per the requirements of the specific model. There is lack of clarity with regard to legal aspects in the Indian environment, both with regard to appropriate form and associated legal compliances 3. Within institutions, financial and social intermediation is typically done by different types of groups – SHGs, Joint Liability Groups, Solidarity Groups and/or Neighborhood Groups. However, some of the institutional models also focus on individuals. Target clients tend to be primarily women, although programs are beginning to serve men as well. Likewise, urban areas are still very much underserved in comparison to rural areas. 4. The states of Andhra Pradesh and Tamilnadu have the maximum coverage under various models. 5. To overcome information asymmetry with regard to the micro-finance portfolio, credit rating is done by specialized agencies but these agencies also tend to be (indirectly) involved in capacity and systems building through group companies. Specialized credit rating agencies are available to rate MFIs as well as SHG federations 6. Associations of micro-finance institutions have also become very active and they provide members with various services including access to information, policy advocacy, capacity building services and the like. One of them (Sa-Dhan) is involved in preparing a Draft Micro-Finance Act along with specific provisions 7. Capacity building services are provided to the sector by a wide range of institutions and individuals. Specialized modules on delinquency, financial analysis, interest rate setting, accounting, MIS, operational risk management, business planning and other areas are also available. 8. MIS is at its infancy, both in terms of computerization as well as manual maintenance of key records and documents. While several vendors did make an attempt to service the sector, the lack of a standard off 7

Please refer to Figure 2 for further details (page 11 of this paper). There are several papers that provide detailed discussion on these topics 8 Please refer to annex 4 for details.

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the shelf software and cost aspects have meant that MIS in the sector is still very nascent. As a result, most institutions are still experimenting with their own specially calibrated non-standard MIS9 9. Interest rates were de-regulated by The Central Bank (Reserve Bank of India) for micro-finance but State level ordinances continue to be an obstacle, although courts have provided some relief 10. There is a prominent viewpoint gaining ground that sustainability is not merely a function of charging appropriate interest rates. Rather, institutions and channels must be efficient and provide need based innovative products and services at affordable cost in a transparent manner – the case of micro-finance being market led 11. In several geographical pockets, micro-finance is witnessing severe competition but channels (in terms of individual intermediaries as well as generic options) are still very limited. However, new options like echoupals, Internet Kiosks, STD booths, post offices, and other such arrangements are being explored 12. E banking initiatives including low cost ATMs are also likely to be introduced in the future 13. Political interference with micro-finance because of its impact on money lenders and other factors, appears to be increasing at the local level 14. Religious groups are also active and pushing MFIs and other institutions towards micro-finance compatible with religious beliefs 15. Several expert committees appointed by The Reserve Bank (Vyas Committee, Ganguly Committee, Vaidyanathan Committee), amidst their regular mandate, have also dwelt on the role of micro-finance in promoting financial services for the poor and SMEs 16. Physical targets in terms of number of SHGs linked, loans disbursed to SHGs, loan outstanding of MFIs and clients reached by MFIs have become synonymous with the performance of the sector. Quality oriented indicators appear far less prominent while discussing the achievements of the sector 17. Large number of lenders and fewer donors. Apart from DFIs, commercial banks (public and private sector) and others are lending to the sector with greater vigor. As a result, the sector currently has unlimited access to collateral free and almost condition less ‘soft’ interest loans including external commercial borrowings. 18. Private investors and equity funds are also on the rise for making appropriate investments in microfinance 19. Intermediary institutions are transforming to become regulated entities but their capacity to comply with regulation is yet to fully tested 20. Governance is at its infancy in the micro-finance and it requires considerable strengthening as strategic and fiduciary aspects are involved. 21. Decentralisation and building up of second line management is necessary as is enhancing staff accountability. Accordingly, professionalism is also required as part of the current growth and to address capacity constraints through induction of professionals. 22. Enhancing staff accountability and job effectiveness/efficiency, especially in view of the burgeoning growth, is also very critical and hence, professionalising personnel administration is a must to attract quality staff and retain them. The Indian micro-finance sector is plagued by high turnovers today

23. Institutions are growing very fast and handling larger portfolios as well as larger volumes of cash. Cash management is therefore a critical aspect and given the nascency in the micro-finance sector in India and 9

MIS is very nascent in India and needs to be attended to ensure greater transparency and accountability and also better management to keep up with the burgeoning growth. MIS is still at its infancy and there is a widespread recognition of the fact that a best practices MIS capable of handling large volumes of clients/records needs to be in place for reasons of accountability and transparency as well as effectively satisfy growth and regulatory requirements. Thus, MIS requires significant up gradation as portfolio is growing rather rapidly and computerisation to help keep pace with this growth is necessary

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the unique challenges of transferring money across rural areas, risk management becomes a very important issue. Growth also enhances several risks such as political risk, fraud risk, operational risks and the like, which need to be immediately addressed.

24. With burgeoning growth, the systems are being severely tested and may have to be re-designed. Also, while general design of systems tend to be good on paper, consistent implementation is poor and needs to be enhanced 25. Several new financial products are also on the anvil, both at the intermediary and client level including remittance services, warehouse receipt loans and the like. 26. Deposit taking is restricted by legal form and voluntary savings, as a product, is used primarily by cooperatives although some societies and trusts are currently accepting recurring deposits. 27. A draft micro-insurance legislation has been discussed and several insurance companies have come up with very innovative products in life and general insurance including crop, health, weather etc. 28. While the agency model of insurance should grow because of its technical soundness, it is yet to have sector wide acceptance from financial intermediaries in micro-finance for various reasons. Many MFIs are still continuing with their informal in-house schemes

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Figure – 1: The Financial Market Place for Micro-Finance in India Reserve Bank of India

Govt Programs/ Private Sector

Commercial Banks – Private/ Public Sector

NABARD

RRBs

Various Channels

Ministry of Finance

DFIs (like SIDBI)

Scheduled Banks MFI as Agents (off Balance Sheet Lending)

Cooperative Banks

Institutional MFIsVarious Legal Forms/Models Not-for-Profit, Mutual Benefit, For-Profit MFIs etc.

SHG Linkages

SHGs/Individual lending

SHGs/Individual lending

JLG/SGs/ SHGs/Individuals

JLG/SGs/ SHGs/Individuals

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To summarise the key trends, with several enthusiastic and well-intentioned lenders/investors vying for the top 20/30 MFIs and commercial banks pushing the target milestones vis-à-vis the SHGs formed/linked, we are in for a phase of burgeoning growth. In fact, in no other industry are such collateral free large sized loans, with almost the characteristics of public deposits, so easily available (please see box below) Features of a Typical loan product Obligation to repay as per stringent terms One/few Lenders Collateral forms a major part of the lending decision Personal guarantees and other conditions apply Market interest rate, which is higher than deposit rate or micro-finance loan rate Cautious approach to lending; loans limited by Debt-Equity and DSC ratios; Insistence on significant promoter’s capital

Features of a Public deposit Obligation to repay when client requires it Multiple people No collateral but rather track record of safety of the institution is the key No conditions Cheapest source of nonsubsidized capital Money given in trust and safety is most important along with liquidity and minimum returns

Features of Loans Given to the micro-finance sector Obligation to repay as per ‘soft terms’ One/few lenders No collateral but track record of the promoter in serving the poor; social credentials No personal guarantees and stringent conditions Soft interest rates, often closer to deposit rates Good national purpose and promoters’ good intentions were prime drivers for loans coming to the sector; Social development loan given to social entrepreneurs on commercial principles; unlimited access

While this kind of a situation is a very welcome sign, it means that commercial banks/financial institutions are ready to take a risk vis-à-vis the sector and the various financial intermediaries are equally willing to handle/absorb larger sums of money, without perhaps the administrative and managerial capacity to manage that growth. This is however a serious aspect that could cause market/institutional failures. Thus, what started as an informal, minuscule and soft sector is now in the process of transforming to a fullfledged industry. Clearly, micro-finance is at cross-roads and any attempt to develop it further must also be accompanied by a commensurate effort to establish fair rules of the game (regulation) and enable compliance to these rules (supervision) on the part of various stakeholders. Lack of willingness to do this could result in withdrawal of key financial services (by the currently enthusiastic lenders) at the first sign of ‘crying wolf’ – i.e., when a serious failure occurs, especially in a large intermediary/institution. If this happens, history would repeat itself and result in the biggest market failure - inability to provide continued access to affordable and high quality financial services to the poorest people. Without question, a trigger, in the form of a crisis, to come up with better and suitable regulation is not the answer. It is clearly time to take up the early warning signals and cues from developments/changes taking place within the sector and come up with suitable regulatory measures as the cost of a large failure could result in loss of access to financial services by the poor - too large a cost that we can hardly afford to be pay. Therefore, it becomes all the more critical to closely analyze developments within the sector for potential areas of failure and attempt to build safeguards against such occurrences. This is what is attempted here.

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3

Existing Legal Forms and Implications for Failure

Before we discuss specific areas where failure could potentially occur, it seems useful to briefly comment on the existing institutional forms, which can be used in different ways in the various generic models of microfinance – different ways in terms of the extent of social versus financial intermediation carried on by the entities ranging from pure social intermediation and facilitation (SHG Bank Linkage Model) to mixture of social and financial intermediation (MFI Institutional Model and Partnership Model). Currently, there are many legal forms10 (mainly, not-for profits, mutual benefits and for-profits) through which micro-finance is operationalised. The multiplicity of legal forms means that different acts and laws will govern the different legal forms as shown in Figure 2. This has several implications11 for institutional failures: • First, with existence of multiple legal forms for delivering micro-finance services, supervision and regulation are, by default, dispersed across authorities with the result that no single authority oversees the functioning of all legal forms. Hence, uniform regulation is difficult to enforce as some of the features of any legal enactment may not apply or be relevant to some legal forms (for example, capital adequacy is not appropriate for not-for-profit MFIs). • Second, chances of institutional failure abound as different authorities expect each other to regulate and supervise the MFIs in their respective categories and this may result in none of them appropriately supervising/regulating MFIs in their own categories. Lessons from the NBFCs failures clearly illustrate lack of appropriate coordination between several regulators. In fact, this is exactly what has happened in the case of some of the not-for-profit MFIs and they have no serious regulation or supervision as different authorities feel that these entities are the responsibility of the others. Thus, the quality of supervision and regulation across different legal forms is variable, depending on the concerned authority and this again enhances the chance of systemic failure. However, the fact is that, irrespective of legal form, if market failure occurs, it will undoubtedly affect the micro-finance industry as a whole rather than that specific legal form. • Third, dispersion of supervision and regulation also means that learning from ‘early warning’ is not available with one single regulatory/supervisory body and hence, the opportunity to plug all possible loopholes related to systemic failures becomes less likely. This again is similar to the NBFC failures of the 1990s. Without question, regulation attempts to provide for and reduce market failures in functioning of enterprises and when the regulatory authorities are different, a comprehensive knowledge base of likely market failures is not possible as this knowledge could be spread over different regulatory bodies. Hence, regulatory attempts to mitigate the risk of various causes of market failures is likely to be less comprehensive • Fourth, even if The Central Bank were to come out with a common code for regulation of all forms and models of micro-finance, the enforcement of this is difficult as different laws are governed by different authorities who have different historical predispositions and interpretations of the law. Hence, it would be almost next to impossible to enforce legal requirements across all entities. Take the case of interest rate de-regulation circular issued by the RBI with regard to micro-finance in 1999. Despite this, the State Usury Act (for example in Tamilnadu) had12 managed to place ceilings on interest rates for MFIs and this caused a distortion in the market place in that the Central Bank Circular on de-regulation of interest rates has not been respected. • Fifth, consistent application of the regulatory norms is therefore not possible and this is not healthy for the development of an industry, such as micro-finance. For example, standardised norms regarding various operational aspects and/or characteristics of MFIs cannot be uniformly promulgated, as they

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There are several papers that describe the alternative legal forms and their advantages and disadvantages. For example, the SIDBI SA-DHAN Theme Paper (2005), Ramesh S Arunachalam offers a detailed description of this as an annex 11 Extracted and adapted from the SIDBI-SA-DHAN Theme Paper (2005) mentioned above 12 While this state ruling has been challenged, it nonetheless clearly shows that contradictory ordinances can be promulgated, resulting in negating the perceived positive effects of the Central Bank Circular

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•

would not be applicable for certain types of legal forms (e.g., the non-profits). This includes norms for governance, portfolio quality, accounting methods and standards, capital adequacy and other issues. Lastly, institutions can use various laws and create newer entities to overcome specific regulations with regard to micro-finance and this is a dangerous aspect which can result in market failures – legal solutions can be formulated to tackle seemingly ‘stringent’ micro-finance regulations and the prime driver for the legal solution is the presence of alternative legal forms under other laws. The next section explains how this can occur with regard to deposit taking, which MFIs are not allowed to engage in. This example is merely illustrative and there are many aspects in other laws that can be used to formulate legal solutions to various micro-finance regulations. FIGURE 2 - LEGAL FRAMEWORK/LAWS IMPACTING DELIVERY OF FINANCIAL SERVICES FOR LOW INCOME CLIENTS IN INDIA

Ministry of Home Affairs Foreign Contribution Regulation Act FCRA (1976)

Financial Services for Low Income Clients

Ministry of Finance, RBI and NABARD

• • •

BR Act BCA Act NBFC Reg

Registrar at Societies and Trusts Society Registration (Various Acts) and same for Trusts

Different Legal Forms

Insurance Regulatory Development Authority IRDA Act, 1999

Registrar of Cooperatives State/Central - State Cooperative Acts (several) - Multi State Cooperative Act - Parallel Cooperative Acts (Like MACS ACT etc)

Central Board Direct Taxes Registrar at Companies

Income Tax Act, 1961

Companies Act, 1956 Key: BR Act – Banking Regualtion Act, 1949 BCA Act – Banking Companies Acquisition Act, 1970 and 1980 NBFC Regulations – Non-Banking Finance Company (NBFC) Regulations till date RBI – The Reserve Bank of India (RBI) Act (1934) and amendments till date FCRA – Foreign Contribution Regulation Act (FCRA), 1976 and amendments MACS – Mutually Aided Cooperative Societies Act (MACs) and its amendments The above Acts/Regulations and all amendments to date and several other Acts have to be consulted to get a comprehensive understanding of legal issues pertaining to delivery of financial services for low-income clients in India

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3.1

Failures in the Financial Market Place for Micro-Finance

Several types of failures in the financial market for micro-finance can occur and these are highlighted below: 3.1

The Case of Public Deposits

Take the case of public deposits. NBFCs cannot access public deposits as per prevailing regulations, unless they satisfy certain conditions. There are clear ways to overcome this: a. Same group of promoters could create a community institution like a MACs or equivalent (in states of Bihar, Orrisa, J and K, Madhya Pradesh etc) or Multi-state cooperative or MBT to accept voluntary deposits from members. b. The community institution could be directly formed by the same promoters or established through other related persons (Benami Promoters) c. Community institution could lend this money (collected through voluntary deposits from members) to the NBFC, which could then on-lend this money to its (NBFCs) clients or use it for other purposes. d. This is a clear case of overcoming prevailing regulations on deposit taking through use of multiple legal forms. e. The problem is complicated by the fact that different legal forms are regulated/partially regulated by different entities and hence, it would become difficult to keep track of this. f. In fact, as diagrammed in Figure 3 (below), there are three situations portraying the use of the ‘deposit’ money by the NBFC. All of these three situations represent market failure and the implications are indeed serious, as under all of them, the money of depositors could be at risk.

Figure 3: Overcoming Deposit Regulations

Community Institution lends to NBFC (same group, directly or indirectly related)

NBFC

Lends to same clients as community institution

Possible Diversion through Ghost Clients

Investment in other sectors

Lends to other clients

III

I

II

MACs, Multi State Cooperative, MBT, and other forms of Community Institutions

Voluntary Deposits

Members are Users, Owners and Managers

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As shown in Figure 3 (below), in states, where appropriate legal forms are not available in the form of cooperatives, two strategies can be pursued for overcoming the regulation concerning deposit taking well as transfer of surplus to the for profit institution: 1. For example, consider that a Trust/Society, engaged in financial intermediation, decides to transform to an NBFC 2. Accumulated surplus from Trust/Society is routed an unknown/unclear legal form called as Mutual Benefit Trust (MBT) – which is supposed to be community owned 3. MBT invests in the NBFC and in this way, a transfer of capital occurs 4. NBFC begins operations and lends to clients 5. To raise voluntary deposits, same/related promoters of NBFC establish between 100 – 200 groups (SHGs) in a nearby state 6. They then proceed to form a Multi-State cooperative, which can legally accept voluntary deposits from members in both the states. The existing clients of the NBFC also become members of the cooperative and hence, it would become possible for the NBFC to access deposits from its client through an alternative legal form 7. The Multi-State cooperative then lends to the NBFC, which on-lend this money to its clients – as noted before, these clients can be the same for all 3 entities, NBFC, MBT and Multi-State cooperative or they can be different 8. Ghost clients can also be used to divert the ‘member deposits’ of the Multi State Cooperative for other legal/illegal activities 9. Irrespective of whether ghost-clients exist or not, these strategies that help overcome existing regulations represent a failure in the Micro-finance market place. While genuine problems like inability of non-profits to invest in for-profits do exist, the use of alternative and multiple legal forms to overcome existing regulations is a serious aspect that must be addressed by the different authorities. Without question, the existence of several alternative legal forms and associated passive/active regulators and supervisors compounds the problem. Due diligence at the time of registration could be an option as would better coordination and sharing of information between the various stakeholders concerned. Example Case # 1: An NGO-MFI was practicing several models of micro-finance including linkages and SHG lending through federation. Federations were either unregistered or registered as societies/trusts at the local level. In an attempt to collect savings and bring it into the organization, the NGO-MFI started the process of building Mututal Benefit Trusts (MBTs). This move backfired because groups resisted the takeover of savings that they felt were crucial for their internal loaning. This whole process attracted media attention and also that of the district administration. Simultaneously, SHGs also stopped payment of the loans taken from the federation and this institutional failure caused the NGO-MFI to abandon the strategy of MBT formation (to bring in savings). The NGO-MFI has had to rebuild the micro-finance program again.

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Figure 4: Overcoming Deposit Regulations and Transfer of Surplus

7 Multi State Cooperative

6

Loans to NBFC

Investment

4

NBFC

5

Deposits from Members

Loans to clients

Trust or Society MBT

1

2 Surplus Transfer

Financial Intermediation 3.2

3 Surplus Transfer

The Case of Non-Transparent Transactions

Multiple institutions within a promoter group (at the intermediary level) may also result in non-transparent transactions within the group entities. As noted earlier, at the intermediary level, there is a tendency and incentive to have multiple institutions – say, for example, an NBFC, a trust or a society, a Mutual Benefit Trust (MBT), a Mutually Aided Cooperative Society (MACs) or equivalent, a Multi State Cooperative etc. The multiplicity of institutions under one group causes several problems. As an industry observer noted, “The presence of several institutions within one umbrella (equivalent to a group13) results in lack of transparency in transactions – for example, if the trust or society buys out the portfolio of the NBFC at a premium or vice versa, without any valid reason”. He further remarks, “Cash flows between group institutions can become a never ending chain and a prime motive could be diversion of funds. For example, with large number of clients, (it would be impossible to have a head count), lending to ghost clients and/or 13

The main promoter may not be the same but surrogate control can be traced. In some cases, the promoter is the same and can be identified.

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duplication of clients across lenders, could occur and result in diversion of funds to activities other than micro-finance. The key question that arises is should not micro-finance also be subjected to the same KYC norms as other financial intermediaries.” Such diversion of funds, according to a commercial banker, “could occur to businesses-outside of micro-finance – which may be directly/indirectly related sister concerns”. Add an official with a wholesaler, “Holding company (pyramid) structure of many Indian corporations creates strong incentives for diversion of funds among group companies. Many corporates in India are organized in the form of pyramids, with a holding company (or Group) structure being in control over a large number of companies. A promoter owns enough shares to control firm A (say, 26 percent), which in turn, owns controlling shares in firm B, and so on. The promoter, thus, is allowed control over all firms in the pyramid, even the ones in which he/she has no direct ownership. This separation of ownership from control characterizes pyramids and creates strong incentives for the promoter to divert resources between firms. The usual ways are through low interest rate loans, input sales or purchases at artificial prices (under or over invoicing), leasing of assets and guarantees for other companies’ borrowings.” Take the case of portfolio buy outs in micro-finance depicted in Figure (below). Several transactions are depicted in the diagram. Figure 5: Portfolio Buy Outs within a Group of Institutions

Entity E (directly or indirectly related to NBFC)

Money Transfer

Entity D Owned by E

Money Transfer

IV

V

Entity C owned by D

Money Transfer

III

Entity B1 owned by C

Money Transfer

NBFC A

Money flow including premium

II

Ib Trust or Society B

Ia NBFC buys-out portfolio of Trust/Society at a Premium

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Transaction

Entities Involved NBFC A and Trust/Society B

Description NBFC A buys out micro-finance portfolio of trust/society B at premium

NBFC A and Trust /Society B

Money transfer (including premium) to Trust/Society B From NBFC A

Trust/Society B and Entity B1

Appropriation of money, form of transaction dependent on entity B1

Entity B1 and Entity C

Appropriation of money, form of transaction dependent on entity C

Entity C and Entity D

Appropriation of money, form of transaction dependent on entity D

Entity D and Entity E (with some relationship to NBFC or same promoters). Often times, this chain is very long to unearth

Appropriation of money, form of transaction dependent on Entity E; Promoters contribution could also come back this way and not be invested

Entity E and NBFC

Investment in NBFC by Entity E which would be for a profit.

IA IB II III IV

V

VI

Several things can complicate the aforementioned market failure and a major one is whether there were Ghost clients in Trust/Society B’s portfolio that was bought out at a premium by the NBFC. Likewise, Ghost Fieldworkers/Ghost Branches can cause market failures like increase of ‘Ghost Expenses’ thereby reducing profits and/or transfer of money (surplus) to other entities. And a sign of this is a sudden drop/stagnation in efficiency indicators, despite increasing scale of portfolio and clients, which can be justified by claiming expansion to very remote areas. Lastly, if the promoters of the NBFC and Entity E are one and the same, portfolio buyouts represent a way to transfer out the initial investment of money, while still retaining control of the NBFC. This is like a double-edged sword where the promoters benefit in both ways A retired bank official sums up, “Incidentally, many of these were serious issues with the NBFCs in the 1990s and lack of attention to them resulted in serious institutional failures then and it could happen now in micro-finance. Without question, these are systemic loopholes in the law that require to be plugged and appropriate checks and balances created. Without this, the stability and soundness of the micro-finance financial market system, which is slowly getting integrated into the mainstream financial system, could be threatened.” Example Case #2: “A reputed social intermediary becomes a financial intermediary and also acquires significant capital for financial intermediation. The financial institution takes off, and soon other groups join as (shadow) promoters. As the financial institution grows, the shadow promoter coerces ‘social intermediary’ to divert funds to other sectors, as collateral free lending at low rates of interest is not easily available. Ghost clients, field workers, branches are used as a front for this and it would be impossible for law to detect this, especially because of rate of growth of the institution that is supposedly serving clients in interior and far flung rural areas.” – as told by an industry observer

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Example Case # 3: In one institution, where concurrent loans are given to clients, tranches of loans from 2 lenders were to be disbursed to the clients. As per the MIS, books and records, both tranches were disbursed but only one actually reached the clients. The other tranche was apparently used by the institution for some other purpose. A sample portfolio audit resulted in this aspect coming to the attention of lender 1 who then informed lender 2 and both lenders do not support the MFI anymore - this is market failure of client duplication and diversion of micro-finance funds - – as told by an evaluator Example Case # 4: An institution obtained loans from two lenders showing the same set of clients to both of them. This became apparent during a monitoring mission of one lender. It was specifically determined that the loan from the 2nd lender, while being shown in the MIS and books as loans to clients (the same clients were also shown as borrowers to lender 1 with only one loan against their name), was used for other purposes – again a case of market failure of diversion and ghost clients – as told by an evaluator Two key questions arise based on the above discussion: (1) What provisions exist in the law to prevent this diversion, accurately identify the ghost clients (see figure below), branches, and fieldworkers and/or penalize the mission drift from micro-finance? ; and (2) How can this potential market failure of diversion of microfinance funds to other sectors (e.g.) movie making, real estate, investment etc be tackled/prevented? If ensuring access to financial services for the poor is the primary goal of micro-finance, then, is not this potential market failure of ‘diversion of micro-finance funds’ a serious issue that needs checks/ balances against. While we do not imply that this market failure is always happening, we are stating that it could happen. While, admittedly, frequency of occurrence of this market failure may be low, its impact and severity, if it happens, are enormous. Just imagine, what would be the implications for micro-finance, if such were found to be true of a large/reputed institution. Just as prevention is better than cure, it is imperative to address the twin market failures of ‘diversion’ and lack of ‘access’ and have provisions in law that can help prevent it if possible.

Figure 6: Market Failure and Ghost Clients Loans

Exist

Given

Not Given

No Market Failure

Market Failure Due to lack of access to loans (exclusions)

Clients Market Failure Do Not Exist

No market failure

Because clients do not exist but clients appear to have been given loans

Notes: Loans meant to be given to the poor clients do not actually reach them. This could happen because of ghost clients/ghost fieldworkers/ghost branches. Ghost clients are extremely difficult to isolate when there is burgeoning growth, especially, in the absence of comprehensive 3rd party portfolio audits.

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3.3

The Case of MIS and Portfolio Quality

The lack of sound/stable MIS (Manual/Computerised), especially in the wake of burgeoning growth, is another aspect that could result in market/institutional failures. This is in part due to the lack of consistency/standardisation in record keeping, accounting practices, loan portfolio management techniques, methodology for data collection and analysis of micro-finance performance. Therefore, starting from the field level, rationalisation of records and use of appropriate but basic accounting/portfolio management and control practices is very critical. Several institutional failures with regard to MIS are possible Example Case # 5: An institution used a specific short cut (installment method14) to calculate the age of past due loans. When the organisation’s entire portfolio was subjected to rigorous and accurate ageing as per best practices (some time later), real delinquency was much higher than that reported by the installment method used by the MFI. By then, a large number of past due loans had become significantly overdue (beyond the loan term) and perhaps uncollectible whereas the MFI still considered them of age of less than 3-6 months past due. Provisioning was inappropriate, delinquency went out of hand, and there were several other impacts including large-scale write-off of loans and the specific donor has withdrawn from the MFI Example Case # 6: 98% repayment, PAR> 1 day 1 day)=36%. This poor portfolio quality, coupled with loss of income, has left the institution struggling for growth and significant capital is at risk. The market failure here is that the wrong method of repayment appropriation (caused by delinquency) resulted in loss of income for the MFI, which the donors had in fact been subsidizing through grants to cover operating deficits. Example Case # 7: An MFI with a reasonably good MIS was reporting PAR>1 day = 2%. On verification during an evaluation mission, it was discovered that the basis for generating PAR was principal overdue and not interest overdue. Intrigued, the team tried to find conditions where principal overdue = 0 but where there is an interest overdue, and there were several loans that had this condition. Including these loans with principal overdue = 0 and interest overdue>0 to recalculate PAR resulted in PAR>1 day changing from ‘2%’ to “19%”, a significant jump indeed. Several lenders decided to go slow with the institution thereafter. An industry analyst who participated in the example # 4 evaluation exercise, briefly highlights the distorting impact of using wrong methods in portfolio management and MIS and the potential for these to cause failures: “Some MFIs first adjust a client’s repayment towards principal and then towards interest. When this happens and there is delinquency, this triggers a reduced portfolio yield (as compared to effective interest rates) rather than a higher portfolio at risk” He further notes, “likewise when clients make prepayments there is a strong possibility that Principal. Overdue could be ‘0’ while interest overdue could still be there. Take the case of a client making equal installment payments of 100 (Principal.) on reducing interest (18%) for a 10 month period Let us assume that on the due date for the 1st installment, the client pays 215 (units of currency) towards the following - 15 towards interest for 1st installment, 100 towards principal for 1st installment and 100 towards principal for 2nd installment15 (prepayment made for 2nd installment at time of 1st installment). Assume that the client who has prepaid the principal for the 2nd installment (at the 1st installment itself) does not come to pay the interest 14

Please refer to Annex 2 for technicalities pertaining to ageing of past due loans. This is because interest for the 2nd instalment cannot be collected at the time of the 1st instalment as it is not due then and is due only at the time of the 2nd instalment. 15

18


for the 2nd installment (which is due only on the actual due date (of the 2nd installment). When this happens, the client will not have any principal overdue (as principal was prepaid) but will most certainly have interest overdue. Any ageing report will find it difficult to track this because most often loan ageing is based on the principal amounts rather than interest amounts.” Likewise, there are many other aspects that can distort the MIS including loan rescheduling, refinancing, write offs, fresh loan disbursements for which repayment is yet to begin and hence, adjusting the portfolio at risk measure is necessary. Unless aspects like these are followed according to technical and best practices norms, risk assessment and management of a micro-finance portfolio, will, at best, be inaccurate just like when the installment method of ageing is used to classify and manage an MFI’s loan portfolio. The impact of (using) these wrong methods on a large portfolio could be devastating and ultimately, cause institutional failure within the micro-finance system, as evident from the above examples. Argues a senior official of a lender, “the potential for misrepresentation of asset classification and income recognition is quite high. There is increasing evidence that the asset quality of many intermediaries’ portfolios is far worse than is being officially reported.” Example Case # 8: Regular monitoring reports are requested by a lender and in one such instance, the borrowing institution sent a floppy which contained two portfolio reports – one called as ‘portfolio report – lenders’ and another titled as portfolio reports-internal. PAR> 1 day was lower by almost 23% in the former as opposed to the latter. The lender does not take portfolio reports from the institution seriously and has also taken steps to reduce its exposure in the said institution 3.4

The Case of Product Design

Product design can also be used as a shroud for delinquency. Flexibility in repayment schedules can actually be causing/shrouding delinquent behavior and this too can affect the stability and soundness of the microfinance system, ultimately resulting in market/institutional failure. Example Case # 9: Product design can also be used to shroud delinquency, as the following example will illustrate. An MFI had a product where clients had to repay in 46 weekly installments spread over 52 weeks. So, while MFI reported 0% PAR (delinquency), as high as 23% of the clients with outstanding loans had skipped 4/5/6 payments (weekly installments). Until alerted by an audit team, the MFI assumed 0% PAR but when re-adjustments were made as per best practices, the MFI’s provisioning had to change significantly to account for the very high delinquency (PAR > 1 Day exceeded 38% for even 1 installment skipped). Lenders and international investors are wary of giving large loans to the institution and/or investing in it Delinquency can be camouflaged in several other ways including re-scheduling16, re-financing, fresh loans (greening) to delinquent clients, write-offs, staff loans to redress delinquency and the like. All of this will affect the stability and soundness of the micro-finance system and so checks/balances are required to ensure that shrouding of delinquency does not occur.

16

Rescheduling/refinancing /written offs could be legitimate under certain situation like calamity etc.

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3.5

The Case of Internal Control Lapses

Lack of appropriate internal controls can also case 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 market 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 market failures: 1) market failure of differential access; and 2) market 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. The above and other types of control breakdowns, resulting in failures typically seen in problem cases (above and others) can be grouped into five categories:

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•

•

• •

•

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. 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. 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. 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.. 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.

3.6 The Case of Political and Religious Factors Government sponsored micro-finance programs, local politicians and others have tendered to set wrong public opinions/trends that MFIs and micro-finance programs/models are expected to follow and this could result in institutional failure. This especially concerns the interest rate aspect-time and again, comparisons with heavily subsidized government programs make the other micro-finance programs appear costly and even usurious. Example Case # 16: In case of one federated MFI, propaganda by local vested interest groups (money lenders) and politicians, resulted in public opinion being formed against the “legitimate” service charges being levied. The local politicians further gave a call for non-repayment of loans by SHGs – which some SHGs followed (voluntarily as well as under coercion) – resulting in significant delinquency. While the MFI continues to work in the area, paying off loans from its surplus/donor funds, it has adopted a very cautious approach and perhaps will not reach originally envisaged scale. Institutional failure occurred as loans in 2 districts had to be almost written off. Example Case # 17: Religious groups gave a strong call to clients to not repay loans as even basic ‘interest’ was against the religious beliefs. The result is that MFIs are suffering due to reduced repayment and blockage of money in the specific area - losses that they may have to meet from their hard earned surpluses and/or other sources Example Case 18: Politicians (supported by money lenders) at local level gave a call to clients to not repay to an MFI, which in their opinion was charging usurious rate of interest. The result is that the MFI has had artificial brakes on its growth and has had to tackle this problem using various means including community

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support. The real fate and implications of this action by politicians at the local level will perhaps be only known after some time. In fact, political/religious risk to micro-finance is extremely high as the industry grows and gathers momentum. There are no provisions in the law to counter the public propaganda by politicians (at local level) who have made, and could continue to make public statements to the poor to not repay seemingly ‘usurious’ micro-finance loans. The same applies to religious leaders issuing a ‘Fatwa’ to clients to not repay ‘microfinance’ loans. The key question that arises here is whether this is fair and legal? Is this not tantamount to encouraging ‘reneging’ of a micro-finance loan contract? How can well meaning micro-finance programs/MFIs create and sustain a culture of credit discipline when so-called responsible public people instigate such violations? All of these may seem as minor irritants but if left unchecked, they can spread and strike at the very heart of the micro-finance movement. This can happen to any institution and result in market/institutional failure. Therefore, we need provisions in the law to take care of such ‘political/religious positions’ that could destroy the sprit and discipline of micro-finance and ultimately, the industry itself. Thus, several possible areas exist where failures could occur in the market place for micro-finance and such failures could happen when: • • • • • • • • • • • • • •

Loans do not reach clients, Clients do not make repayments, Cash in the system is lost in transit, through theft, fraud or other means such as internal control lapses, Information systems provide a different than realistic picture with regard to operations, often shrouding delinquency, Political/religious groups tell clients not to repay seemingly ‘usurious’ micro-finance loans, Governance is not transparent and accountable in financial intermediaries; non-transparent transactions occur between group entities, directly or indirectly related to same promoter, Provisions in the law are overcome through seemingly legal means but such solutions defeat the very purpose for the existence of the law itself, Diversion of collateral free, (unlimited access) low cost funds to non micro – finance activities which could be (legal / or not-legal) Coercive methods are used to extract repayment from clients, Clients exist on loan books but not in reality - Ghost clients, field workers, and branches Duplication of clients in terms of same clients being shown for different lenders Creation of organizational forms without clear legal status like MBTs Surplus reduction and transfers of profits through non-transparent transactions between related entities (Ghost branches and Ghost field workers), and Several other aspects.

Some practical situations indicative of market failure are given in the box next page

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Practical Situations Indicative of Market Failure • • • • • • • • • • • • • • • • • • • • • • • • • • 3.7

Loan disbursement to clients does not occur or is not as per the contract Repayments schedule does not exist or is not proper/consistent Principal amounts actually collected from clients are different from contractual amounts Principal prepayments by clients are not recorded and/or deposited Interest/service/other charges actually collected from clients are different from contractual amounts Over due amounts are not calculated properly Appropriation of client repayments is not properly done Loans administration is contrary to credit policy Loan terms are different from set policy limits for various aspects including nominal and effective interest rates/fees, size of the loan, repayment period, installment frequency, grace period for the loan, service and other charges and size of the installment (principal/interest) MFI records with regard to loans are neither proper nor consistent with one another/client records Loan documentation is incomplete MFI has delinquency, which it is attempting to shroud through an improper MIS, re-scheduling, refinancing, write-offs etc. Loan tracking systems are inadequate – i.e. insufficient systems to track over dues exist Method of age calculation for overdue loans is incorrect All overdue amounts are not taken into account for generating “risky” loans and calculating the portfolio at risk (omission of interest overdue) Ageing of past due loans and provisioning do not match the loan repayment frequency Loan loss provisioning and write-offs are not as per best practices and/or as required by regulation Delinquency indicators are not as per best practices norms Loans disbursed to clients (as per MFI records) are actually used by others such as staff/outsiders Loan repayments (cash collections) from clients have been appropriated by staff/others Pre-numbered receipts and vouchers are not used for loan administration There is a mismatch between loan disbursement records and transaction records (vouchers/DPN’s) in terms of amounts/dates Reconciliation of loan related receipts/payments is not done at all levels Reconciliation of loan repayment receipts at various levels for the same day shows inconsistency both within themselves and also with cash/other records Overall, MFIs internal controls over the lending activity are not adequate There is inconsistency between loan portfolio data and financial statements/external audit data Summary of Issues and Implications for Addressing Market Failure

The burgeoning growth of the micro-finance sector means that financial intermediaries may not have the administrative and managerial capacity (systems and human resources required) to handle increasingly larger and rapidly growing portfolios. This in turn has implications for risk management and portfolio quality management, which, in turn, have implications for market and institutional failures. There are several specific issues in this regard and they are highlighted below: 1. Institutions are growing and are handling larger portfolios – be it clients, groups or loans. This in turn means that they are handling larger volumes of cash and larger number of people, both as organisations and as individuals working within such organisations. Cash management is therefore a critical aspect and given its nascency in the micro-finance sector in India and the unique challenges of transferring money across rural areas, risk management becomes a very important issue. Growth also enhances several risks such as political risk, fraud risk, operational risks and the like, which need to be immediately addressed. Hence, risk management within MFIs is a critical aspect that regulation needs to focus on and help with

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2.

3.

4.

5.

6.

protecting institutions from system/market failure. This can be addressed through the enforcement of (design/implementation of) standardised and appropriate risk management and internal control systems. Now, with a variety of legal forms, each regulated and supervised by different authorities, this is clearly not at all possible. Also, given the nature of the regulatory and supervisory authorities and their quality of supervision and regulation, especially in the case of Trusts, Societies, Mutual Benefit Trusts and Traditional cooperatives, it is unlikely that stringent and appropriate norms can be enforced by anyone, including the Central Bank. This calls for the need to have a single regulatory authority for all models and forms of micro-finance. This will also help overcome the problem of using alternative legal forms to overcome micro-finance regulations. The increasing profit orientation of the micro-finance industry has even attracted private investors and overall, the suppliers of finance to the industry have grown significantly, both in terms of volume of money available as well as the diverse stakeholders doing it (NABARD and SIDBI, Private and Public Sector Commercial Banks, Private Investors, Semi Wholesalers and many others). Now, with increasing flow of funds to the sector and with all of them targeting17 the available 20-30 larger/medium MFIs, there is a serious risk of rapid/burgeoning growth fuelled by the supply (wholesaler) side and not backed by appropriate growth in MFI systems and administrative capacity to manage that growth – this could result in portfolio quality problems within the sector. With burgeoning growth, the systems are being severely tested and may have to be re-designed. Also, while general design of systems tend to be good on paper, implementation in terms of consistency needs to be enhanced. In many ways, systems and procedures are non-negotiables and minimum requirements for MIS, Internal Control, Internal Audit, Human Resources and other systems need to be prescribed, adhered to and also verified through loan portfolio and system audits by third party auditors. Burgeoning growth also requires good corporate governance and especially, with transparency and accountability. However, governance is at its infancy in the micro-finance and it requires considerable strengthening. Here again, it would be useful to help institutions practice better governance by incentivising the process and having regulatory guidelines and enabling enforcement. A related aspect is professionalism – this is also required as part of the current growth and institutions need to address capacity constraints through induction of professionals at various levels including at Board, Senior Management and Operational levels. Lastly, enhancing staff accountability and job effectiveness/efficiency, is also very critical and hence, professionalising personnel administration is a must to attract quality staff and retain them18. The issue of rapidly growing client numbers and use of outsourcing (agents) to expand outreach is another aspect that requires attention. With this high growth in clients, it is imperative that, the sector begins to implement KYC (Know Your Customer) norms such that there are appropriate means of identification for the clients beings served and also scope for physical verification through loan portfolio audits. This is the only way to reduce institutional failure due to ghost clients, ghost branches and ghost field workers and also prevent diversion of funds from micro-finance, and Last but not the least, experience from around the world indicates that poor credit quality coupled with weak credit risk management practices continues to be a dominant factor in failures and financial crises. Therefore, it is clear that information on credit risk profiles, including the quality of the credit exposures and the adequacy of the credit risk management processes is in the assessment of the financial intermediaries condition, performance and ability to survive in the long-run. Such information is also

17

There are several reasons for this limited targeting: (1) The nature of suppliers have changed as compared to the past and donors have given way to a pool of suppliers including DFIs, commercial banks, private investors and others with a for profit orientation for whom equity investments (and returns) are likely to be more important; (2) Also, because of seemingly high entry barriers (minimum capitalisation requirements and other aspects) associated with regard to registering as a for profit NBFC MFI, smaller MFIs registered as trusts and societies are not able to access funds and as a result, most of the suppliers are concentrating on the few available larger for profit MFIs and facilitating them to grow, albeit at a pace that is not accompanied by commensurate development of systems, policies and procedures; and (3) Another reason is essentially regulatory for the inability of promising NGO MFIs to become for profit NBFC. This pertains to the aspect of investing the accumulated surplus of NGO MFIs in the new for profit ventures. All of these have resulted in limited number of for profit players available to service the micro-finance industry 18 The Indian micro-finance sector is plagued by high turnovers today

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important in assessments of the overall safety and soundness in micro-finance financial system. This must be made mandatory as part of any regulation To summarise, a lot of goodwill and hardwork has been invested in bringing micro-finance to its current state of burgeoning growth. Social activists, NGOs, MFIs, Bankers, DFIs, Regulators, Govt, and others like service providers to the sector have worked really hard and lobbied to influence the financial system to lend to the poor and also accept deposits from the poor. This good work cannot be frittered away. Clearly, there are several factors such as those given earlier that require effective regulation and supervision of the microfinance sector in India. There is clearly a need to step back and objectively assess this complex situation and evolve pragmatic solutions that would result not only in effective regulation and supervision but also contribute to building a vibrant, healthy and competitive19 micro-finance sector with sufficient choices for the poor and appropriate safe guards against potential market failures. As an industry analyst notes, three aspects make it imperative to regulate the micro-finance sector now: “(1) Significant proportion of loan funds to the sector are coming from commercial banks – in ways, these are indeed ‘public’ deposits being on-lent and the sector virtually has unlimited access to ‘condition less’ collateral free loans at ‘soft’ interest rates; (2) The sector has grown considerably and should continue to grow even more and perhaps at a more scorching pace. The volume of money invested in the sector and institutions (individuals) is therefore by no means small by any standards; and (3) There are some striking similarities to the “NBFC” failure scenario of 1990s and the early warning signals available point to several potential areas where ‘market’ failure could indeed occur. “ NBFC Situation of the 1990s Explosive growth Group companies present Funds diverted to group companies No serious regulator and lack of coordination among regulators Ghost plantations were a major phenomenon that caused failure Same plantations were sold to many investors NBFCs had weak governance, poor MIS and controls and very little risk management ‘Cheap’ and unlimited public deposits NBFCs failed, loss of money for depositers, and loss of faith in the NBFC system among bankers, public and others.

Micro-Finance Situation Today Burgeoning growth Several entities under a promoter group Possibility of non-transparent transactions between group entities not ruled out No single serious regulator – multiple regulators with different levels of supervision and no serious coordination among regulators and supervisors Ghost clients are possible here along with Ghost branches and Ghost fieldworkers Same clients are shown as borrowers for loans from multiple lenders Financial intermediaries in micro-finance also tend to have weak governance, MIS and controls and perhaps, very weak risk management functions By and large, collateral free, soft interest, condition less (no personnel guarantee) loans – virtually unlimited scale today ?????????????????????????????????????????

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There is a tendency for proponents of one or the other models to dismiss the alternative routes by saying that regulating the alternative models are difficult and hence, they should be discouraged from financial intermediation. Any such action that would prevent pluralism in micro-finance runs the serious risk of reducing access of financial services to poor people. As the global experience has indeed shown, there is a critical need for alternative routes to serve diverse and distinct segments of the market and this pluralism, should, at no cost be reduced to a monopolistic approach to delivering financial services. At the same time, it must be recognised that while diversity of approaches has its advantages in terms of enhancing access and promoting outreach, it will present a regulatory challenge that the industry as a whole must objectively analyse and address. Competition is the driving force in an industry and attempts to reduce competition, will at best, reduce options and choices for the poor – this in turn will turn the clock back in an industry that has the potential to contribute to economic development in an emerging developing market like India, where millions of poor people are still languishing without access to basic financial services

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4

Regulating the Micro-Finance Sector

As micro-finance moves from its ‘pilot-testing’ phase to the ‘large scale rollout’ stage, it becomes imperative to establish fair rules for conducting micro-finance and also to ensure compliance for two basic reasons. Firstly, because the micro-finance sector is now intermediating significant financial resources and assuming greater risks, it would have to contend with higher regulatory standards. Second, the rapid changes taking place in the more aggressive segments of the sector underscore the critical need for stricter regulation to protect the loan funds (which are indeed public deposits) and more generally to help in maintaining the soundness of the financial system and prevent market/institutional failures that could result in drying up of support for the sector. Inability and/or willingness to do so is tantamount to promoting the biggest market failure-‘withdrawal of financial services to the poor’ in terms of lenders not providing loans to them and bankers not accepting deposits from them. This will and could happen as long as micro-finance, is not GUIDED through its growth phase, a largely uncharted terrain towards expanding outreach, enhancing sustainability and creating impact. The case to regulate micro-finance has never been stronger- so, let us work out mechanisms to do it now. While the spirit to regulate is important, the form is equally or more critical and the specific aspects that would need to be considered for such regulation are briefly highlighted below, with details given in Annex1. In clear terms, any solution to this complex aspect of potential market failures and related regulation requires the following basic measures: 1. Bringing activities of all institutions and models of micro-finance under a single regulatory regime. To start with, it would be a special cell/unit in The Reserve Bank of India and it could then be moved to a separate regulatory authority, if required. The functions of this single regulatory regime could be as described in Table (below) Role of Single Regulatory Regime

Market Legitimization

Market Regulation and Supervision

Market Protection

Specific Aspects ; Accreditation and registration of institutions for delivery of basic financial services to low income clients ; Granting licenses for deposit taking financial services, when institutions meet the existing standards ; Both of the above could be based on internal as well as 3rd party assessments of institutions on several aspects ; Appropriate prudential regulation ; Supervising both basic and deposit taking institutions in terms of ensuring minimum standards of portfolio quality, cost of operations and the like. Use of third party auditors for portfolio audits, systems audits etc ; Imposition of market discipline and ensuring legal compliances and enforcement of other statutory requirements ; Mitigating the impact of scale economies and informational incompleteness (asymmetry) through minimum systems and practices on several aspects including MIS, portfolio management, internal control, risk management, governance, KYC norms etc ; Facilitating education of micro-finance clients in terms of their rights as consumers, ; Taking action on complaints from clients in terms of violations by service providers ; Protection of institutions from various State Level Usury interest ordinances

S. Srinivasan, M sidbi, 3rd Idbi towers 5-9-89/1 &2, chapel road, hyd – 500001

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040-23234454 2. Requiring all institutions to follow standards of corporate Governance20 including specific disclosure norms. The following practices should be viewed as critical elements of any governance process: ; Establishing strategic objectives and a set of corporate values that are communicated throughout the organisation. ; Setting and enforcing clear lines of responsibility and accountability throughout the organisation. ; Ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to undue influence from management or outside concerns. ; Ensuring that there is appropriate oversight by senior management. ; Effectively utilising the work conducted by internal and external auditors, in recognition of the important control function they provide. ; Ensuring that compensation approaches are consistent with the institutions ethical values, objectives, strategy and control environment. ; Conducting corporate governance in a transparent manner. Transparency can reinforce sound corporate governance. Therefore, public disclosure is desirable in the following areas: a. Board structure (size, membership, qualifications and committees); b. Senior management structure (responsibilities, reporting lines, qualifications and experience); c. Basic organisational structure (line of business structure, legal entity structure); d. Information about the incentive structure (remuneration policies, executive compensation, bonuses, stock options) etc; e. Nature and extent of transactions with affiliates and related parties21 3. Establishing standards for certain non-negotiables in terms of minimum system requirements22 such as MIS, risk management and internal controls, internal audits, portfolio management guidelines including assets classification and income recognition, accounting standards, capital adequacy and the like. Some of these would have to be verified through on-site supervision and special audits and institutions must be given reasonable time to comply. 4. Ensuring quarterly portfolio audits23, conducted on a required scale and with sufficient scope. Minimum standards to be met and standardized best practices audit methodology to be defined and adhered to 5. Implementation of KYC Norms in a rigorous manner by all concerned institutions. This calls for, among others, the following: ; Customer acceptance, customer identification and record keeping standards should be implemented with consistent policies and procedures throughout the organization. ; Each branch office should maintain and monitor information on its accounts and transactions. This local monitoring should be complemented by a robust process of information sharing between the head office and its branches and regarding accounts and activity that may represent heightened risk.

20

Governance is an aspect that is lacking among financial intermediaries in India and can be regarded as the key factor that could result ultimately in failures. 21 For example, the International Accounting Standards Committee defines related parties as “those able to control or exercise significant influence. Such relationships include: (1) parent-subsidiary relationships; (2) entities under common control; (3) associates; (4) individuals who, through ownership, have significant influence over the enterprise and close members of their families; and (5) key management personnel". The IASC expects that disclosures in this area should include. (a) the nature of relationships where control exists, even if there were no transactions between the related parties; and (b) the nature and amount of transactions with related parties, grouped as appropriate. (IASC International Accounting Standard No. 24, Related Party Disclosures). 22 Please refer to Annex 1 for details 23 Please refer to Annex 1 for details

27


; Internal auditors should verify that appropriate internal controls for KYC are in place and that financial intermediaries are in compliance with supervisory and regulatory guidance. The audit process should include not only a review of policies and procedures but also a review of customer documentation and their records along with sampling of a significant number of random accounts. ; The role of audit is particularly important in the evaluation of adherence to KYC standards on a consolidated basis and supervisors should ensure that appropriate frequency, resources and procedures are established in this regard and that they have full access to any relevant reports and documents prepared through the audit process. ; Many MFIs now have multiple institutions. Customer due diligence here poses issues that may not be present for single entity. Thus, there should be systems and processes in place to monitor and share information on the identity of customers and account activity of the entire group, and to be alert to customers that use their services through different institutions. ; “The Basel Committee believes similar guidance needs to be followed for all non-bank financial institutions and professional intermediaries of financial services including MFIs/Others”.

6. Outsourcing guide lines for correspondents/agents with regard to micro-finance24, and lastly 7. Ensuring compliance on all of the above aspects within a reasonable time frame through a mandatory compliance function at institutions. ; Financial intermediaries in micro-finance need a compliance function and it can be defined as follows: “An independent function that identifies, assesses, advises on, monitors and reports on the institutions compliance risk, that is, the risk of legal or regulatory sanctions, financial loss, or loss to reputation an financial intermediaries may suffer as a result of its failure to comply with all applicable laws, regulations, codes of conduct and standards of good practice (together “laws, rules and standards”)”. ; The applicable laws, rules and standards are likely to have various sources, including primary legislation, rules and standards issued by supervisors, market conventions, codes of practice promoted by industry associations, and internal codes of conduct applicable to the staff members of the financial intermediaries. They are likely to go beyond what is legally binding and embrace broader norms of integrity and fair dealing. ; The purpose of the compliance function is to assist the financial intermediaries in managing its compliance risk. Compliance risk is sometimes also referred to as integrity risk, because a financial intermediaries reputation is closely connected with its adherence to principles of integrity and fair dealing. Supervisors must be satisfied that effective compliance policies and procedures are followed and that management takes appropriate corrective action when breaches of laws, rules and standards are identified. ; Compliance with laws, rules and standards helps to maintain the financial intermediaries’ reputation with, and thus meet the expectations of, its customers, the markets and society as a whole. Although compliance with laws, rules and standards has always been important, compliance risk management has become more formalized within the past few years and has emerged as a distinct risk management discipline.

24

Please refer to Annex 1 for details

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5

Annexes Annex 1: Issues to Consider While Establishing A Regulatory Mechanism25 For Micro-Finance

1.1

Portfolio Management – Credit Risk, MIS and Disclosures – and Regulatory Implications

The following areas are critical for institutions engaged in micro-finance and regulation must encourage institutions to: (1) Establish an appropriate credit risk environment; (2) operate under a sound credit granting process; (3) maintain an appropriate credit administration, measurement and monitoring process; and (4) ensure adequate controls over credit risk. In addition, information from MIS, of financial intermediaries engaged in micro-finance, should be: • Relevant and timely. Information should be provided with sufficient frequency and timeliness to give a meaningful picture of the institution’s financial position and prospects. • Accurate. Information should reflect reality on the ground and also be reliable. • Comparable. Information needs to be compared across institutions and over time. Hence, standardized procedures must be used to develop the MIS and standard definitions of indicators and standard methods for calculating the same must be rigorously followed. This does not imply loss of flexibility but rather suggests standard use of best practices oriented indicators and methods for portfolio quality measurement. • Comprehensive. To enable users of information to make meaningful evaluations, information should be comprehensive. This often implies the aggregation, consolidation and assessment of information across a number of activities and legal entities. Financial intermediaries in micro-finance should also provide more detailed disclosures with regard to the following areas: • Accounting policies and practices; • Risk management including controls • Exposures across regions/sectors • Asset quality including methods for determining it and indicators • Earnings in relation to effective interest rates. While specific disclosures will vary in scope and content according to level and type of activities, all financial intermediaries should provide sufficient, timely and detailed information so as to allow stakeholders/regulators to develop a full and accurate picture of the true financial condition. Further, the disclosures should be consistent with the information that the financial intermediary generates and uses internally to measure, manage and monitor its portfolio and other risks. As management information systems and management reporting continue to evolve and improve, the timeliness and extent of such disclosures should also correspondingly improve. Finally, any financial intermediary in micro-finance should also discuss the techniques it uses to monitor and manage past due or impaired assets/credit relationships, including its procedures for credit quality classifications and its practices and procedures for evaluating the adequacy of credit loss provisions and credit loss allowances26.

25

Several resources including working papers from BASEL, RBI circulars and publications and several other country Central Bank publications/notifications were used to extract key issues mentioned in this annex. They would be properly cited while updating references after the NABARD conference 26 Some accountants consider the use of the terms “provision” and “reserve” inappropriate when referring to accumulated value adjustments of loan assets and prefer other descriptions, e.g., “allowance”. For instance, the International Accounting Standards Committee defines a provision as a type of liability, while a reserve is defined as a component of equity (IASC Framework for the Preparation and Presentation of Financial Statements).

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1.2

Loan Portfolio Audits27 and Regulatory Implications

The loan portfolio is the primary income-generating asset for an micro-finance and it is most commonly subject to material misstatements. Most institutional failures stem from the deterioration in the quality of the loan portfolio. An assessment of the risks and inadequacies inherent in micro-finance portfolio therefore assumes tremendous importance and this is the most important objective of a ‘loan portfolio audit’. MFI credit (lending) operations have unique characteristics that portfolio auditors must first understand. Several aspects that need attention include: • Difficulty in maintaining portfolio information - MFIs grant a large number of small loans, and process a very large number of (repetitive) tiny payments. Their operations are often tend to be dispersed over a wide geographic area. As a result, MFIs utilize streamlined and decentralized operating structures in order to be efficient. These factors make it a challenge to maintain effective portfolio information and management systems. Lack of portfolio information is a serious aspect which could result in lower portfolio quality - ‘bad’ loans not being identified and followed up. • Decentralization could cause deviation from prescribed credit policy and result in fraud, error or manipulation - Decentralization implies that relatively few staff members are involved in approving, disbursing, monitoring, and collecting each loan. This structure increases the opportunity for deviation from approved policies, and for fraud, as well as increases the risk of error or manipulation when branches transfer information to headquarters. • Mandate of efficiency may result in lesser controls/procedures/information/supervision - To handle small and repetitive transactions efficiently, MFIs come under great pressure to cut costs, sometimes, even at the expense of adequate portfolio controls and information, as well as sufficient supervision of clients and loan officers, which, in turn, could affect portfolio quality. • Burgeoning growth of portfolio could result in failures of established systems - Many MFI portfolios are growing rapidly. First, this growth puts pressure on systems and can camouflage repayment problems – this can happen especially when growth exceeds the administrative capacity to manage that growth. Second, a rapidly growing portfolio has a larger percentage of loans in the early stages of repayment. Delinquency problems often occur in the later stages of the repayment cycle. Receiving large grants, and the pressure from donor agencies to report impact places pressure on managers to disburse loans quickly and sometimes, even without demand – this is clearly a recipe for disaster. This pressure has created an environment for fraud in several cases as well. • Restructuring (rescheduling and refinancing) of delinquent loans is an often-used strategy to camouflage portfolio quality - MFIs generally dislike provisioning for problem loans or writing them off. They want to maintain a good image in the eyes of outsiders, especially donors. This sometimes leads to restructuring or refinancing as a tool to hide delinquency. Other strategies for shrouding delinquency include write-offs and repeated fresh loan disbursements. • Weak information systems may not even permit MFIs to recognize delinquency - MFI information systems are often weak and thus systems for operational loan tracking are seldom integrated with their accounting systems. The lack of appropriate systems may mean that MFIs may not even recognize delinquency in their portfolio, which can be tackled in the first place only if MFIs are aware of it. These issues, among others, make the loan portfolio audit a very crucial but rather complicated and time consuming exercise. Auditors will need to allocate significant effort in the review of the loan portfolio and to carry out field visits. The audit of loan assets (micro-finance portfolio), would include an audit of the systems and procedures and associated lending internal controls as well. Thus, it will not only provide essential feedback with a view to safeguard the institution’s primary asset - the loans to its clients – but more importantly, it should also enable stakeholders to understand the risks inherent in the loan portfolio and systems/ procedures used to mitigate this risk. This information could prove useful in two other ways: (1) facilitate prudent decisions regarding investing in the MFI (either directly or indirectly); and more importantly, (2) help isolate specific areas for capacity building and technical assistance for enhancing the portfolio management by the MFI. The loan portfolio audit is relevant for all models of micro-finance. 27

Extracted and adapted from MicroSave Loan Portfolio Audit Toolkit (2004)

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1.3

Internal Controls Aspects for Micro-Finance and Regulatory Implications

The main elements of the sort of control systems needed are: (1) management oversight and the control culture; (2) risk assessment; (3) control activities; (4) information and communication; and (5) monitoring activities. 1) Management oversight and the control culture: The starting point is that the Board of Directors need to understand the risks run by the institution, to set the acceptable limits on these risks, and to ensure that senior management takes the steps necessary to identify, monitor and control these risks. Senior management must then take the responsibility to implement the strategies approved by the Board, to set appropriate internal control procedures, and to monitor the effectiveness of these procedures. This makes it quite clear where the main responsibility for controls rests - and that is fairly and squarely on the shoulders of the institution’s Board of Directors and its senior management, not just on its compliance and audit departments. However, having said that, everyone in an institution shares the responsibility to some extent. A key task for the Board and senior management is to establish the right culture within the institution, a culture in which the importance of internal controls is stressed, and high ethical and integrity standards are promoted. This culture will be determined not simply by what the top levels of management say but what they do. For example, do the institution’s remuneration policies reward risk-taking at the expense of prudence? Does senior management display a casual attitude towards breaches of limits? Do they encourage the right attitude towards regulatory compliance? Is there backing and respect at senior levels for the internal audit and compliance functions? The response of the senior levels of the organisation to these kind of issues will determine how personnel lower down actually behave in practice, including their attitude to control issues. 2) Risk assessment: The important thing is to identify and evaluate every factor that could adversely affect the achievement of the institution’s objectives. This means not just the familiar risks of credit risk and liquidity risk, but also risks such as operational risk, legal risk and reputational risk. And this needs to be an ongoing process, continually re-evaluating the risks and reviewing the control systems to address these risks. 3) Control Activities: Control activities need to be an integral part of the daily operations of an institution. Examples of this include: top level reviews of performance and risk exposure; appropriate activity controls that monitor performance and exceptions at the departmental or branch level; segregation of duties; physical controls on access to assets; periodic checking for compliance on various aspects; a system of approvals and authorisations for transactions over certain limits; and a system of verification and reconciliation of transaction details and activities. The objective should be to ensure that all areas of the institution are continually in compliance with established policies and procedures. 4) Information and communication: An effective internal control system requires that there are adequate and comprehensive internal financial, operational and compliance data, as well as external market information about events and conditions that are relevant to decision making. Information should be reliable, timely, accessible, and provided in a consistent format. These systems, including those that hold and use data in an electronic form, must be secure, monitored independently and supported by adequate contingency arrangements. But having the information is only the first step. Equally important is the second step, that the information should get to the right people at the right time. Third, accuracy and transparency of information are critical. 5) Monitoring: Monitoring of the effectiveness of an institution’s internal controls should be a continual and ongoing process, and that monitoring of key risks should be an integral part of the daily operations of the institution. Effective and independent internal audit and compliance functions have an important role to play here. This requires these functions to have direct access to senior levels of the organisation so that potential criticisms of systems or transactions cannot be blocked by the line management concerned.

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Supervisors, in evaluating the internal control systems of financial intermediaries of micro-finance may choose to direct special attention to activities or situations that historically have been associated with internal control breakdowns leading to substantial losses. Certain changes environment should be the subject of special consideration to see whether accompanying revisions are needed in the internal control system. These changes include: (1) a changed operating environment; (2) new personnel; (3) new or revamped information systems; (4) areas/activities experiencing rapid growth; (5) new technology; (6) new lines, products, activities (particularly complex ones); (7) portfolio restructurings, buy outs etc; and (8) expansion of operations. To evaluate the quality of internal controls, supervisors can take a number of approaches. Supervisors can evaluate the work of the internal audit department through review of its work papers, including the methodology used to identify, measure, monitor and control risk. If satisfied with the quality of the internal audit department’s work, supervisors can use the reports of internal auditors as a primary mechanism for identifying control problems, or for identifying areas of potential risk that the auditors have not recently reviewed. Supervisors may also require periodic external audits of key areas, where the supervisor defines the scope. Supervisors may also conduct on-site examinations and a review of internal controls is an integral part of such examinations. An on-site review could include both a review of the business process and a reasonable level of transaction testing in order to obtain an independent verification of the financial intermediaries own internal control processes. An appropriate level of transaction testing should be performed to verify the: • Adequacy of, and adherence to, internal policies, procedures and limits; • Accuracy and completeness of management reports and financial records; and • Reliability (i.e., whether it functions as management intends) of specific controls identified as key to the internal control element being assessed. In order to evaluate the effectiveness of the five internal control elements of financial intermediaries in micro-finance organization (or a unit/activity thereof) supervisors should: • Identify the internal control objectives that are relevant to the organisation, unit or activity under review (e.g., lending, investing, accounting); • Evaluate the effectiveness of the internal control elements, not just by reviewing policies and procedures, but also by reviewing documentation, discussing operations with various levels of personnel, observing the operating environment, and testing transactions; • Share supervisory concerns about internal controls and recommendations for their improvement with the board of directors and management on a timely basis, and; • Determine that, where deficiencies are noted, corrective action is taken in a timely manner.

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1.4

Risk Management Issues for Micro-Finance and Regulatory Implications

Risk Assessment and Corporate Governance 1. Sound corporate governance is an essential element of a strong risk management process. Governance involves many players, each with specific assigned responsibilities to ensure that the system as a whole is sufficient to support the business strategy and ensure the effectiveness of the systems of internal control. 2. Directors are not expected to understand every nuance of every line of business or to oversee every transaction. They can look to management for that. They do, however, have the responsibility to set the tone regarding their institutions risk-taking and to oversee the internal control processes so that they can reasonably expect that their directives will be followed. They also have the responsibility to hire individuals who they believe have integrity and can exercise a high level of judgment and competence. Risk Management and Internal Controls 3. Boards of directors are responsible for ensuring that their organizations have an effective audit process and that internal controls are adequate for the nature and scope of their businesses. The reporting lines of the internal audit function should be such that the information that directors receive is impartial and not unduly influenced by management. Internal audit is a key element of management's responsibility to validate the strength of internal controls. 4. Internal controls are the responsibility of line management. Line managers must determine the level of risks they need to accept to run their businesses and to assure themselves that the combination of earnings, capital, and internal controls is sufficient to compensate for the risk exposures. 5. In many of the recent failures that have received public attention, basic tenets of internal control, particularly those pertaining to operating risks, were not followed. 6. Internal controls and sound governance become even more important when firms' operations move into higher-risk areas. Indeed, when changes are happening, control failures often increase significantly. Rapid growth, introduction of new products and delivery channels are examples of situations that put stress on the control environment. 7. When these types of changes occur, "people risks" rise. These are risks that are related to training employees in new products and processes. Employees who join the organization need to learn the culture of the company and the control environment. Employees unfamiliar with their new responsibilities--the systems they use, the services they provide customers, the oversight expected by supervisors and members of internal control functions--are all more likely to create control breaks. 8. Rapid growth and change also modify the relative risks to an organization. Further, the pressure to beat a competitor to market with new products may shortcut the design-review process and omit an important control. 9. Many of the companies that have been the center of recent governance failures demonstrate some similar characteristics. They were lead by hard-charging entrepreneurs whose ability to think outside the box pioneered advances in new lines of business. But the personalities of these individuals, in many cases, led to a focus on growth and support and inadequate time spent building the control infrastructure. 10. Another form of people risk is internal fraud. When expectations of the market and supervisors, or pressures of personal life become overwhelming key staff may step over the ethical and legal boundaries and cover up errors or purposely commit fraud. 11. Although risk management has become much more quantitative, considerable management judgement must be applied to the risk management process. Frequent, small losses can generally be absorbed in the operating margin of the product or service. It is the low-probability, large losses that provide the greatest challenge. And, it is just such risks--the ones that can severely damage, if not kill, an organization--that too many institutions do not formally take into consideration.

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Operational risk event types that have been identified as having the potential to result in substantial losses and failures include: • • • • • • •

1.5

Internal fraud. For example, intentional misreporting of data/portfolio, employee theft, etc External fraud. For example, robbery, forgery, and damage from computer hacking. Employment practices and workplace safety. For example, workers compensation claims, violation of employee health and safety rules, organised labour activities, discrimination claims, and general liability. Clients, products and business practices. For example, fiduciary breaches, misuse of confidential customer information, improper activities using the financial intermediaries account, money laundering, and sale of unauthorised products. Damage to physical assets. For example, terrorism, vandalism, earthquakes, fires and floods. Business disruption and system failures. For example, hardware and software failures, telecommunication problems, and utility outages. Execution, delivery and process management. For example, data entry errors, collateral management failures, incomplete legal documentation, unapproved access given to client accounts, etc. Customer Related Aspects for Micro-Finance including KYC Norms and Regulatory Implications

; There is increasingly recognising of the importance of ensuring that financial intermediaries have adequate controls and procedures in place so that they know the customers with whom they are dealing. ; Adequate due diligence on new and existing customers is a key part of these controls. Without this due diligence, financial intermediaries can become subject to reputational, operational, legal and concentration risks, which can result in significant financial cost. ; So, regulators would need to examine the KYC procedures currently in place and also draw up recommended standards applicable to financial intermediaries in micro-finance. ; Sound KYC policies and procedures are critical in protecting the safety and soundness of financial intermediaries in micro-finance and the integrity of systems within financial intermediaries in microfinance. ; Sound KYC procedures must be seen as a critical element in the effective management of various potential failures in financial intermediaries in micro-finance. ; KYC safeguards go beyond simple record-keeping and require institutions to formulate a customer acceptance policy and a tiered customer identification programme that involves more extensive due diligence and proactive monitoring. ; The need for rigorous customer due diligence standards is not restricted to financial intermediaries alone. “The Basel Committee believes similar guidance needs to be followed for all non-bank financial institutions and professional intermediaries of financial services including MFIs/Others”.

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1.6

Technology for Micro-Finance and Regulatory Implications

With the technology options that are now becoming available, the delivery models are likely to undergo drastic changes and this again, could have an impact on supervision and regulation, especially in relation to E Banking. Security aspects with regard to physical movement of cash and internet/mobile banking require good understanding of the subject and appropriate regulations. This fact gets compounded by the fact that communication technology is at a stage where by newer technology leap frogs older technology (by passes at least one generation of technology) and any regulation to deal with such rapidly changing technology must also keep in mind the likely future direction in the structure and application of the technology. Without question, internet kiosk banking, e choupals, Mobile/SMS banking, various types of electronic cards and other such applications of technology to reduce transactions and operational cost will undoubtedly require special regulatory expertise not only in the technology domain but also in the micro-finance domain. And effective regulation of such eclectic forms of micro-finance services would be possible only if it is approached from the perspective of addressing market failures related to the technology, micro-finance and their interactive effects Suggested supervisory action in this regard would include: 1. A regular programme of independent tests of security and control procedures by inspectors, auditors or consultants should be implemented with regard to technology. 2. Such a programme should be capable of identifying lapses in control before they put operations seriously at risk. 3. The frequency and depth of audit tests conducted in any area should reflect the level of risk to the institution if the security and control procedures in that area should fail. 4. From the supervisory standpoint, there is a need both to evaluate the adequacy of an institution’s EDP technology and the efficiency of its system of EDP/technology internal control and auditing. 5. In such a specialized field it would be particularly helpful for the supervisor to take advantage of the expertise of the third party system auditors. 6. They should periodically assess the soundness of the EDP processes which are vital to the institution’s operations and the effectiveness of the internal EDP controls. 7. They should also be asked to report any shortcomings and imperfections, which have come to their attention, to the management and supervisor. 8. Where the supervisors discharge their responsibilities mainly through on-site inspections, it is normal procedure for inspectors to include interviews, documentary inspections and sample checks in this area. 9. Certainly it is now essential that inspectorates include EDP specialists whose training matches the level of EDP sophistication of the institutions under inspection. 10. Both inspectors and auditors normally use, in their work in the EDP area, check-lists or examination guides prepared by supervisory authorities with the assistance of specialized institutions and these represent an extremely useful supervisory tool. This can be prepared exclusively for dealing with finance intermediaries in micro-finance.

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1.7

Outsourcing in Micro-Finance (Agency Model) and Regulatory Implications

Outsourcing is defined as a regulated entity’s use of a third party (either an affiliated entity within a corporate group or an entity that is external to the corporate group) to perform activities on a continuing basis that would normally be undertaken by the regulated entity, now or in the future. Outsourcing can be the initial transfer of an activity (or a part of that activity) from a regulated entity to a third party or the further transfer of an activity (or a part thereof) from one third-party service provider to another, sometimes referred to as “subcontracting.” In some jurisdictions, the initial outsourcing is also referred to as subcontracting. 1. Financial services businesses throughout the world are increasingly using third parties to carry out activities that the businesses themselves would normally have undertaken. Industry research and surveys by regulators show financial firms outsourcing significant parts of their regulated and unregulated activities. These outsourcing arrangement are also becoming increasingly complex. 2. Outsourcing has the potential to transfer risk, management and compliance to third parties who may not be regulated, like in micro-finance. 3. In these situations, how can financial service businesses remain confident that they remain in charge of their own business and in control of their business risks? How do they know they are complying with their regulatory responsibilities? How can these businesses demonstrate that they are doing so when regulators ask? Most importantly, now can they assure themselves that their agents, 3rd parties are not engaging in practices that could contribute to institution failure. Some suggestions28 I.

II.

III. IV. V.

VI. VII.

VIII. IX. X.

28

A regulated entity seeking to outsource activities in micro-finance should have in place a comprehensive policy to guide the assessment of whether and how those micro-finance activities can be appropriately outsourced. The regulated entity should establish a comprehensive outsourcing risk management program to address the outsourced micro-finance activities and the relationship with the service provider (MFI/FI). The regulated entity should ensure that outsourcing arrangements neither diminishes its ability to fulfill its obligations to customers and regulators, nor impede effective supervision by regulators. The regulated entity should conduct appropriate due diligence in selecting third party service providers (MFI/FI). Outsourcing relationships should be governed by written contracts that clearly describe all material aspects of the outsourcing arrangement, including the rights, responsibilities and expectations of all parties including MFI/FI The regulated entity and its service providers should establish and maintain contingency plans, including a plan for sudden events and problems that may occur including political risk. The regulated entity should take appropriate steps to require that service providers protect confidential information of both the regulated entity and its clients from intentional or inadvertent disclosure to unauthorized persons. Regulators should take into account outsourcing activities as an integral part of their ongoing assessment of the regulated entity. Regulators should assure themselves by appropriate means that any outsourcing arrangements do not hamper the ability of a regulated entity to meet its regulatory requirements. Regulators should be aware of the potential risks posed where the outsourced activities of multiple regulated entities are concentrated within a limited number of service providers as in micro-finance.

Source: Extracted and adapted from the Basel Committee working paper on outsourcing.

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Annex 2.Portpolio Quality and Ageing of Past Due Loans1 2.1 WHY SHOULD THE INSTALLMENT METHOD OF AGEING NOT BE USED? Example 1 Assumptions for Example 1 Loan Amount to Client A Disbursement Date Number of Installments Frequency of Installment Interest Months in a Year Method of Interest Calculation

1000 31/07/2002 10 Monthly 18% 12 Declining Balance

⇒ 1000 units of currency were disbursed to Client A on 31/07/2002 (July 31st 2002) ⇒ The loan amount (Principal or Prin.) is payable in 10 monthly equal installments along with interest levied at 18% on the declining loan balance, calculated on a monthly basis. ⇒ However, interest is calculated on a daily basis when payments for installments are made a few days late to account for the late days. ⇒ The 1st installment falls due on the last day of the succeeding month – here the loan was disbursed on 31st of July 2002 and thus, the 1st installment falls due on 31st of August 2002. Subsequent installments fall due on the last day of succeeding months ⇒ Accordingly, Client A’s Loan Installment Schedule is as shown in Table 1 below I Installment Number 1 2 3 4 5 6 7 8 9 10 All 10 Installments

Table – 2.1 Client A’s Loan Installment Schedule II III IV Prin Due as Per Date Due Int Due as Per Schedule Schedule 31/08/2002 100 15.00 30/09/2002 100 13.50 31/10/2002 100 12.00 30/11/2002 100 10.50 31/12/2002 100 9.00 31/01/2003 100 7.50 28/02/2003 100 6.00 31/03/2003 100 4.50 30/04/2003 100 3.00 31/05/2003 100 1.50 NA 1000 82.50

1 This section draws heavily from: (1).MIS for Micro-finance, Ramesh S Arunachalam (2003), and (2) MicroSave MCG Loan Portfolio Audit Toolkit (2004)

37

Transactions Made by Client A is Given in Table 1B Below Table – 2.2 S No of Installment Amount Paid 1 115.00 2 113.50 3 112.00 4 110.50 5 109.00 6 107.50 7 onwards No Payment Please Note: Some MFIs charge interest from day 1 but this depends on the orientation and policy of the MFI. Please note that this is merely an assumption, which can be changed as also repayment schedules and modes. What needs to be emphasized is the fact that this will apply equally to all situations wherein different assumptions are used.

38

Now, as given above, assume that Client A makes a 1st payment of 115 (units of currency) on 31/08/2002, that is on the due date of the 1st installment. First, 15 (units of currency) will go towards interest amount due as per schedule while 100 will go towards prin. amount due as per schedule. I

II

III

IV

V

Installment Number

Date Due

Prin Due

Int Due as Per Schedule

Date Paid

1

31/08/2002

100

15.00

31/08/2002

Interest due as per payment date is same as interest due as per instalment schedule because due and payment dates are same. If payment were made 1 day later than 31st of August 2002, then interest due would be higher. If Client A had made repayment on 1st of Sept. 2002, then interest payable would be approximately 15.50. This is a crucial aspect which should not and cannot be ignored.

VI Int Due as per payment date 15.0

VII

VIII

IX

X

XI

XII

Amount Paid

Int Paid

Prin Paid

Cum Prin Paid

Prin. Prepaid

Prin Outstanding

115.00

15.0

100.00

100.00

0

900.00

Interest Paid of 15 units of currency

Prin Paid of 100 units of currency

What does the earlier Table show us? 1) If Paid Total Amount – Due Total Amount = 0, and 2) If Paid Date – Due Date = 0 Then, we safely conclude that the client has no over dues and also made 100% on-time repayment. If either of these conditions is not true, then, it would be safe to conclude that the client has not made 100% on-time repayment. An analysis of the over dues would make it clearer. This is done hereafter in the explanations of the various columns in the Loan repayment tables: Table 2 below and Table 3 (page after that).

Column Column I Column II

Column III Column IV Column V Column VI Column VII Column VIII Column IX Column X Column XI

Table 2.3 - Columns and Explanations Explanation Installment number, which is from 1 to 10, as the loan is given for 10 installments Date on which installment is due, which is the last date of the month as per credit policy. For 1st installment alone, as per credit policy, the due date is the last day of the month succeeding the month of loan disbursement. Here, the loan was disbursed in July 2002 and hence, due date for 1st installment is 31st August 2002 Prin. Due per installment, which is 1000 units of currency (loan disbursed) divided by 10 equal monthly installments for repayment, which is 100 Interest due if the client pays as per schedule, which is (1000 x 18)/(100 x12) = 180/12 = 15 for 1st installment; (900 x 18)/(100x 12) = 13.50 and so on Actual date when client makes (made) payment This is the interest due as per payment date. If the client pays 1 day later than the due date, the interest to be paid would be 15.50 for the 1st installment Total amount actually paid by client, which will first go towards interest and the remaining will go towards prin. amounts and these are given in Column’s VIII and IX Actual Interest Paid Actual Prin. Paid Cumulative Prin. Paid, which is sum of Prin. amounts, paid so far. Prin. Prepaid or any excess amount paid over and above the due (and overdue) amounts

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Column Column XII Column XIII Overdue Definition2

Column XIV Column XV Column XVI

Table 2.3 - Columns and Explanations Explanation Prin. Outstanding, which is loan disbursed – cum prin. paid. At end of 1st installment, this is 1000 – 100 = 900 Gives the OD processing date. In the case of the 1st installment, all amounts are due by 31/08/2002 and if not paid by that day, they become ‘overdue amounts’, the next day which is 1/09/2002 – this date is also called as the OD processing date. If there were an overdue for installment 1, then on 1/09/2002, the age of this over due would have been 1 day = 1/09/2002 – 31/08/2002 = 1 day. Please refer to Installment 7, where overdues exist as client does not make payments by the due date, which is 28/02/2003. Thus, on 1/03/2003, the over dues have an age of 1 day. For installment 7, on 1/03/2003, the interest OD is 6 which is arrived by subtracting interest due ‘6’ from interest paid ‘0’ = 6 – 0 =6 Likewise , for installment 7, on 1/03/2003, the prin. OD is 100 which is arrived by subtracting prin. due ‘100’ – prin. paid ‘0’ = 100 – 0 = 100 The actual age of the over dues after installment 7, specifically on 1/03/2003 is one day, which is arrived by subtracting 1/03/2003 (reference date for taking age) from 28/02/2003 (due date). At the end of installment 8, specifically on 1/04/2003, the actual age of the over dues are 1/04/2003 – 28/02/2003, which is 32 days because, interest of 6 and prin. 100 from installment 7 are still unpaid.

Column XVII

Column XVIII Column XIX

Also, additionally, interest of 6 and prin. 100 from 8th installment has also become overdue with age of 1 day. However, while calculating the age of the loan, we will have to take the EARLIEST UNPAID OVERDUE into account, which occurred because the 7th installment was not paid on 28th February 2003 and which has still remained unpaid even on 1/04/2003 Shows whether the overdue has been settled or not. This, also helps to ensure that when the clients make payments, the money first goes towards interest overdue (1st), then interest due (if interest is due on that date as per schedule), then prin. over due and last towards prin due. In this case, even after the end of installment 10, specifically on 1/06/2003, it is clear that interest and prin. over dues from installment 7 are yet to be settled Shows prin overdue that was paid Shows interest overdue that was paid

Thus, the loan repayment schedule can be filled out for all installments as per explanations and columns given earlier

2

Definition of Overdues is also crucial. When does a loan become overdue or pastdue is an aspect that must be clearly specified. It is suggested that the day after an amount is due, the amount if not paid becomes overdue. If on 30th April, 2003, an amount of Rs 100 is due and it is not paid, then, on 1st May 2003, this amount is in arrears or overdue

40

41

42

2.2 Summary - Calculating the correct age is the basis for all portfolio quality indicators and the key to having a good MIS in micro-finance

To calculate the correct age of an overdue loan, the following steps are suggested Step 1

Using business rules and credit policy prepare the loan repayment format (given in Table 3 earlier) in an accurate manner.

Step 2

For this proper and timely maintaining of adequate records is a must. Among other things the following are the minimum documents required:

⇒ Individual Loan Ledger ⇒ Aggregated Loan Ledger Step 3

Also clearly state the loan terms especially with regard to:

(a)

Loan Disbursed Amount

(b)

Disbursement Date/Schedule

(c)

Loan Term in Number of Installments – 10, 20, 30 etc

(d)

Frequency of Repayment of Installment – Weekly, Monthly or otherwise

(e)

Due Date for 1st Installment – exactly 1 week or month from disbursement. Mention upfront any grace or moratorium period. Also, clarify in case of monthly repayment schedules, whether month end is considered as the due date

(f)

Disclose moratorium (Grace Period), if any. For example, many MFIs are using the following method. All loans disbursed in the previous months, will have their 1st installment due on the last day of the next month. That is, loans disbursed on 1st January 2002 and 21st January 2002 will have their first installment due on the last date of February 2002. This again must be clarified and specified as it has a significant impact on all calculations including ageing, portfolio quality, ratios and sustainability

(g)

Interest Rate and Method of Interest Calculation including fines, penal interest etc

(h)

Sequence of Payment – Which is to be taken first including interest overdues, interest, principal overdues and principal etc. The suggested sequence is Fines, Interest Overdues, Interest Due, Principal overdues and Principal

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Step 4

Definition of Overdues is also crucial. When does a loan become overdue or pastdue is an aspect that must be clearly specified. It is suggested that the day after an amount is due the amount if not paid becomes overdue. If on 30th April 2003 an amount of Rs 100 is due and it is not paid then on 1st May 2003 this amount is in arrears or overdue (or past due)

Step 5

When overdues from several past installments exist while calculating age of the overdue it is important to take the date on which the earliest installment (among these several installments) first fell overdue.

Step 6

But this must be done only if amounts from that installment are still unpaid.

Step 7

If amounts from that installment have been paid then the next earliest installment for which unpaid overdues exist must be taken as the basis for calculating age.

Thus, the generic formula for calculating the age of an overdue loan as on any date is as follows

Reference Date of Calculation (Today or As On Date) - (Minus) Date of Earliest Installment with Unpaid Over Dues = “Y” Number of Days of Age

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Example 2 Let us consider another example. ⇒ Let us assume that 1032 (Prin. alone) has not been paid by a client and part of it is overdue from August 1st 2001 ⇒ The loan term ends on 31st January 2002 ⇒ The value per (monthly) installment is 180 (Prin. alone) ⇒ The age of the overdue loan is often calculated as per formula below

Formula for Calculating the Age of the Overdue Loan Prin. Overdue Amount Age of Overdue Loan = Installment Amount As per the above formula, the age, as at 1st February 2002, for the above loan is

Age of Overdue Loan (1st February 2002) =

Prin. Overdue Amount

1032 =

= Prin. Installment Amount

5.96 Months

180

This is absolutely correct, as 6 months intervene between 1st August 2001 and February 1st 2002 – August 2001

Further Assumptions ⇒ Now, let us now assume that we are on July 1st 2002. ⇒ Let us also assume that no further repayments have been made by the client – that is, not a single unit of currency has been paid back by the client

2.3 Recalculating the Age of the Overdue Loan as on July 1st 2002 The age of this overdue loan, as per the (installment) above method of ageing calculation, is still 6 months – i.e., prin. overdue amount divided by value of installment (prin.) which is 1032/180 = 5.96 months = 6 months

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But the actual (correct) age is 6 months till loan term end (Aug 01, Sept 01, Oct 01, Nov 01, Dec 01 and Jan 02) + 5 months from February 1st 02 till July 1st 02 (Feb 02, Mar 02, Apr 02, May 02, and June 02) or 11 months in all So what is considered 180 days past due is actually 330 days past due, as shown above. Thus, the incorrect method of ageing has an impact on the REAL ability of the MFI to actually collect money [the further the borrower is in terms of actual age of the overdue, the less likely for an MFI to get it back]. Also, it distorts provisioning, income and finally, sustainability. In fact, after a loan is past its scheduled loan term, if this incorrect method of ageing is used, Portfolio at Risk (PAR) by Age will always be under reported2. 2.4 Implications Consider that there are several loans that are actually more than 330 days past due. While individually they may constitute a small percentage and contribute accordingly to PAR, cumulatively, as a large number of such loans exist, their impact on PAR would be significant. And this becomes even more serious when their age is distorted and PAR by age is used as a standard. This aspect is highlighted sequentially.

2

The converse is also true – for loans within the loan term, the installment method of ageing would always over report age. Only at the end of the loan term (near about), would the installment method of ageing give the correct (accurate) age. In our example, this is age as at Jan 31st 2002 where the actual age is the same as the age as calculated through the installment method of ageing.

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Example 3 Consider another example… ) The loan term finishes on January 31st 2002 ) The amount of prin overdue is 400 (part of which is overdue since December 1st 2001) ) The prin amount per (monthly) installment is 200 ) The age as per the installment method, as at February 1st 2002 is = 400 divided by 200 = 2.0 months As noted earlier, this is correct. ) Now, assume that we are on June 1st 2002. ) The age as per the installment ageing formula is still 2 months (assuming that the client has not paid back any further amounts ) This age of 2 months is however not correct as demonstrated earlier and also as shown in the discussion hereafter The actual age is 2 months from Dec 1st 01 till end of loan term (31st of Jan 2003) + Whole of February 02 + Whole of March 02 + Whole of April 02 + Whole of May 02 = 6 months Now, assume that PAR > 60 Days is used as a standard or a benchmark. Thus, if the ageing done by the MFI is based on the installment (incorrect) method, such loans as the one above, which are actually 6 months past due WILL never come into the fold of PAR > 60 Days. And if there are a large number of such loans, because of the erroneous method of ageing, the reported PAR values will also portray an incorrect picture and hence, the standard of using PAR based on age would also become ineffective. This has implications for provisioning, income recognition and sustainability apart from mere portfolio management. These aspects are highlighted below in sequential fashion.

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Example 4 2.5Using data from the examples I, II and III, let us assume the following about a small MFIs portfolio ⇒ We are at s specific date and would like to age the MFI’s portfolio as on this date ⇒ There are 122 outstanding loans of which 72 are current (with no overdues). ⇒ Of the remaining 50 loans, as per the accurate method of ageing, 10 are like in the category of example 1 whereby they are actually 551 days past due whereas the incorrect installment method says that they are only 120 days past due ⇒ Likewise, 10 loans are in the category of example 3, whereby they are actually 330 days past due whereas according to the erroneous installment method of ageing they are only 180 days past due ⇒ The last 30 loans are like in example 3, whereby they are actually 6 months past due whereas the incorrect installment shows them to be just 60 days past due ⇒ Let us assume that we are using PAR > 60 days or PAR > 90 days or PAR > 120 days or PAR > 180 days as a standard and would like to compare the aged Portfolio with that of other MFIs Table 2.6 - Data for use in Example 4 Example 1 Example 2 Example 3 Number of Loans 10 10 30 Loan Outstanding per loan 400 1032 400 Principal Over Due per loan 400 1032 400 Actual Age of over due for 551 days 330 days 180 days each loan Age of over due for each loan 120 days 180 days 60 days as per Installment Method All the Overdue Loans are past their loan term. For the sake of convenience, we are assuming the same values for overdues and other aspects, exactly as given in the 3 examples.

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2.6 Impact on Provisioning, Write-offs, Income Recognition and Sustainability See below the ageing tables as per the accurate method of ageing and installment method of ageing Table 2.7 - Loan Loss Provision Based on Accurate Ageing Amount in Unpaid Principal Arrears (Currency Balance Portfolio Provisioning (CU) at Risk Rate Description of Loans No. of Loans Units) Current 72 0 100000 0.00% 0% 1 - 30 Days Past due 0 0 0 0.00% 10% 31 - 60 Days Past due 0 0 0 0.00% 25% 61 - 90 Days Past due 0 0 0 0.00% 50% 91 - 120 Days Past due 0 0 0 0.00% 75% 121-180 Days Past due 30 12000 12000 9.50% 90% 181 – 365 Days Past due 10 10320 10320 8.17% 100% above 365 Days Past due 10 4000 4000 3.17% 100% Total 122 26320 126320 20.84% NA

Loan Loss Provision (CU) 0 0 0 0 0 10800 10320 4000 25120

Table 2.8 - Loan Loss Provision Based on Inaccurate Installment Method of Ageing Amount in Unpaid Arrears Principal Loan Loss (Currency Balance Portfolio Provisioning Provision Units) (CU) Description of Loans No. of Loans at Risk Rate (CU) Current 72 0 100000 0.00% 0% 0 1 - 30 Days Past due 0 0 0 0.00% 10% 0 31 - 60 Days Past due 30 12000 12000 9.50% 25% 3000 61 - 90 Days Past due 0 0 0 0.00% 50% 0 91 - 120 Days Past due 10 4000 4000 3.17% 75% 3000 121-180 Days Past due 10 10320 10320 8.17% 90% 9288 181 - 365 Days Past due 0 0 0 0.00% 100% 0 above 365 Days Past due 0 0 0 0.00% 100% 0 Total 122 26320 126320 20.84% NA 15288

Indicators PAR Arrears Rate PAR > 30 Days PAR > 60 Days PAR > 90 Days PAR > 120 Days PAR > 180 Days PAR > 365 Days Loan Loss Provision Rate

Table1 2.9 – Comparative Analysis of Ageing and Provisioning Data Using the 2 methods of Ageing Accurate Instalment Difference Method of Method of between 2 Ageing Ageing methods 20.84% 20.84% 0.00% 20.84% 20.84% 0.00% 20.84% 20.84% 0.00% 20.84% 11.34% 9.50% 20.84% 11.34% 9.50% 20.84% 8.17% 12.67% 11.34% 0.00% 11.34% 3.17% 0.00% 3.17% 19.89% 12.10% 7.79%

Instalment Method understates Risk by extent below 0.00% 0.00% 0.00% 9.50% 9.50% 12.67% 11.34% 3.17% 7.79%

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AGED PAR CATEGORIES TYPICALLY INCLUDE THE FOLLOWING… PAR > = 1 Day PAR > 30 Days PAR > 60 Days PAR > 90 Days PAR > 180 Days PAR > 365 Days (1 Year)

= Sum of PAR 1-30 Days+31-60 Days+…PAR > 365 Days = Sum of PAR 31-60 Days+61-90 Days+ …PAR > 365 Days = Sum of PAR 61-90 Days+91-120 Days+ …PAR > 365 Days = Sum of PAR 91-120 Days+121-180 Days+ ...PAR >365 Days = Sum of PAR 181-365 Days+ PAR >365 Days = Sum of PAR > 365 Days

⇒ Thus, as shown in the previous Tables, the instalment method of ageing, grossly understates the risk whether we use PAR >60 days or PAR >90 Days or PAR >120 Days or PAR > 180 Days as a standard - when the portfolio has overdue loans past their loan term ⇒ When MFIs use the instalment method of ageing, very risky assets (especially, those past the loan term most unlikely to be collected) are shown as collectable or somewhat collectable assets ⇒ Specifically, take the case of PAR > 60 days, which is a commonly used standard in micro-finance. As much as 9.50% of risky assets are omitted from this category when the instalment method of aging is used. ⇒ Likewise, for PAR > 120 days, as much as 12.67% of risky assets are crucially overseen ⇒ While the actual proportion of risky assets shrouded while using the installment method depends on the actual composition of the portfolio, the key point here is that: 1) it understates risk, when overdue loans are past their loan term and 2) it over states risk when the overdue loans are within the loan term ⇒ Similarly, provisioning is also affected as shown by the specific example; using the installment method of ageing results in the portfolio being under provisioned by almost 7.79%, when the over due loans are past their loan term. Impact of Installment Method of Ageing on Loan Loss Provisioning Example 1 loans, which are actually 551 days past due are under provisioned by 1000 units of currency. This is because, using the accurate method of ageing, they come into the category of loans > 365 past due, thereby having a 100% provision rate which makes the provision amount as 4000 (4000 Outstanding X 100%). However, as per the installment method of ageing, they come into the category of loans between 91 – 120 days past due, which carries a provision rate of 75%, making the provision amount as 3000 (4000 X 75%). Likewise, under provisioning for example 2 loans is 1032 and for example 3 loans, it is 7800.

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⇒ The converse (over provisioning) can also be shown to be true whereby the installment method of ageing results in over provisioning - when an MFI’s portfolio has all overdue loans within the loan term ⇒ Likewise, this also impacts write-offs: specifically, when MFIs use the installment method of ageing (and all over due loans are past their loan term), they will not write-off loans that actually need to be written off. ⇒ The corollary here is that MFIs may thus continue accruing interest for such loans when they actually should not be doing so. ⇒ In other words, the installment method of ageing also has an impact on income (or loss) recognition and de-recognition and in both cases (when loans are past their loan term as well as within it), these tend to get distorted as well ⇒ Thus, all of the above also distort the financial statements and are likely to present an inaccurate picture of the true financial situation of the MFI in question ⇒ Therefore, this approximate and inaccurate method of ageing is better avoided ⇒ One may also be tempted to argue that if an MFI has overdue loans within the loan term and also passed the loan term and if it uses the installment method of ageing, the negative effects will balance out each other – such an argument is dangerous and tantamount to saying that 2 mistakes will even out. ⇒ In conclusion, all stakeholders involved in micro-finance should try and ensure that this inaccurate installment method of ageing is not used by MFIs and other stakeholders to age the loan portfolio. This is very crucial to building reliable and valid indicators to assess micro-finance performance as the process is as important as the outcomes. The overall impact of using the installment method of ageing is summarized in Table 2.10 and diagrammed in Figures 2.1 Box 1: Impact of Ageing Method on Loan Write-Offs and Interest Reversals As per the accurate method of ageing, 10 loans (with total Principal Overdue of 4000 units of currency and total Principle Outstanding of 4000 units of currency) would have to be written off (as age of overdue loans is > 551 days) whereas as per the installment method of ageing, they would not be written off (as age would be just 120 days) Taking same values for Interest Overdue as given in example 1, the total accrued interest for these 10 loans, which would have to be reversed, would be 1140 units of currency (UC) {114 per loan x 10 loans} and this reversal should have taken place as actual age of each of these 10 loans is 551 days. But, it will not happen if age is calculated using installment method, as then the age would just be 120 days (for each loan).

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Table 2.10- Summary Impact of Using Incorrect Installment Method of Ageing 1) Impact on Portfolio Quality Parameter/Activity When Installment Method of Ageing is used and all loans are When Installment Method of Ageing is beyond the loan term used and all loans are within the loan term PAR (not aged) ⇒ Not affected ⇒ Not Affected Arrears Rate (not aged) ⇒ Not affected ⇒ Not Affected Aged Portfolio at Risk ⇒ Age is understated ⇒ Age is over stated Loan Loss Provision ⇒ Results in Under Provisioning ⇒ Results in Over Provisioning Write-offs ⇒ Loans with older age over dues that need to be written-off are ⇒ Loans that need not be written-off could be written off due to age being actually not written-off. Hence, most risky assets continue to overstated exist on the portfolio Income Recognition ⇒ As loans with older age over dues that need to be written-off ⇒ Accrued interest could be de-recognized and Reversal are actually not written-off, interest (not likely to be got) is because age is over stated still being accrued and this is not a correct practice. 2) Impact on Financial Statements Financial Statement When Installment Method of Ageing is used and all loans are When Installment Method of Ageing is beyond the loan term used and all loans are within the loan term Portfolio Report ⇒ Understates Risk ⇒ Overstates Risk Balance Sheet ⇒ Inaccurate as interest accrued will never be reversed as age is ⇒ Inaccurate as interest accrued could be reversed because age is over stated, under stated, especially if rules for reversal are based on age especially if rules for reversal are based ⇒ Loan loss reserve is understated because of lower provisions on age ⇒ Loan loss reserve is overstated because of higher provisions Income Statement ⇒ Understates provision expenses and over states income when ⇒ Overstates provision expenses the accrual method of accounting is used.

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Table 2.10- Summary Impact of Using Incorrect Installment Method of Ageing ⇒ Distorts true picture of profitability and ⇒ Distorts true picture of profitability and sustainability and sustainability overstates profitability and sustainability by understating provision expenses and accruing income on loans that need to be written-off 3) Implications for Different Stakeholders Stakeholders When Installment Method of Ageing is used and all loans are When Installment Method of Ageing is beyond the loan term used and all loans are within the loan term Micro-Finance ⇒ MFIs classifying their less risky assets ⇒ MFIs classifying their riskiest assets as less risky Institutions as more risky ⇒ Under provisioning when actually a higher provisioning is required ⇒ Over provisioning when actually a low ⇒ MFIs showing higher than actual income, profitability and provisioning is enough sustainability ⇒ Showing lower than actual income, ⇒ Accrual of interest on loans that need to be written-off and profitability and sustainability for whom already accrued interest perhaps needs to be ⇒ Reversal of accrued interest when reversed perhaps not necessary Donors, Wholesalers ⇒ An inaccurate picture of an MFI’s ⇒ An inaccurate picture of an MFI’s portfolio quality – most and Investors portfolio quality risky assets can never be discerned as they have a lower reported age in comparison to actual age ⇒ An inaccurate picture of an MFI’s financial situation as reflected by The ⇒ An inaccurate picture of an MFI’s financial situation as Income Statement and Balance Sheet reflected by The Income Statement and Balance Sheet – Overstatement of Income, Profitability and Sustainability and inaccurate portrayal of asset quality Regulators ⇒ MFIs not conforming to prudential norms and regulations ⇒ MFIs not conforming to prudential established by authorities norms and regulations established by authorities

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Table 2.10- Summary Impact of Using Incorrect Installment Method of Ageing Credit Rating Agencies

⇒ Inaccurate assessment of an MFIs true credit worthiness as also the risks involved in transacting business with the MFIs concerned

MIS Developers

⇒ MIS using wrong logic of determining age of over due loans and also resultant inaccurate outputs and reports

Clients

⇒ An inaccurate picture of an MFI’s financial situation

⇒ Inaccurate assessment of an MFIs true credit worthiness as also the risks involved in transacting business with the MFIs concerned ⇒ MIS using wrong logic of determining age of over loans and also resultant inaccurate outputs and reports ⇒ An inaccurate picture of an MFI’s financial situation

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FIGURE 2.1 WHY THE INSTALLMENT METHOD OF AGEING SHOULD NOT BE USED BY THE MICRO-FINANCE SECTOR?

Installment Method of Ageing, if used…

When all Loans are past the Loan term Has the following Impact …

1. Understates age of past due loans 2. Shrouds the risk in an MFI’s portfolio while it is actually higher 3. Results in lower than prudentially required provisioning 4. Causes interest to be accrued when it should not 5. Prevents write-offs of loans that need to be written off 6. Portrays higher than actual profitability and sustainability 7. Causes severe income (or loss) recognition and de-recognition problems 8. Presents inaccurate financial situation of an MFI 9. Leads to inaccurate assessments with regard to credit risk PLUS MANY OTHER NEGATIVE IMPACTS

When all Loans are within the Loan term Has the following Impact …

1. Overstates age of past due loans 2. Overstates the risk in an MFI’s portfolio while it is actually lower 3. Results in higher than prudentially required provisioning 4. Could result in accrued interest being reversed when not necessary 5. Could result in write-offs of loans that need not be written off 6. Portrays lower than actual profitability and sustainability 7. Causes severe income (or loss) recognition and de-recognition problems 8. Presents inaccurate financial situation of an MFI 9. Leads to inaccurate assessments with regard to credit risk PLUS MANY OTHER NEGATIVE IMPACTS

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2.7 Discussion To calculate the correct age of an overdue loan, we suggest the following steps Step 1


Step 2




(i)


(j)


(k)


(l)


(m) Due Date for 1st Installment – exactly 1 week or month from disbursement. Mention upfront any grace or moratorium period. Also, clarify in case of monthly repayment schedules, whether month end is considered as the due date (n)

Disclose moratorium (Grace Period), if any. For example, many MFIs are using the following method. All loans disbursed in the previous months, will have their 1st installment due on the last day of the next month. That is, loans disbursed on 1st January 2002 and 21st January 2002 will have their first

(o)

installment due on the last date of February 2002. This again must be clarified and specified as it has a significant impact on all calculations including ageing, portfolio quality, ratios and sustainability

(p)


(q)


56

Step 4


Step 5


Step 6


Step 8


Step 9

Thus the generic formula for calculating the age of an overdue loan as on any date is as follows


57

2.8 Other Issues of Importance This annex briefly highlights the distorting impact of using the installment method of ageing in portfolio management. Many other technical issues are equally important for loan portfolio management in micro-finance and some of these are identified below. The MIS analyst must be careful of such aspects when making the reports and keep these issues in mind. 1

What happens when MFIs use a different sequence for client repayments? Some MFIs first adjust a client’s repayment towards principal and then towards interest. When this happens and there is delinquency this triggers a reduced portfolio yield (as compared to effective interest rates) rather than a higher portfolio at risk.

2

Likewise when clients make prepayments there is a strong possibility that Prin. Overdue could be ‘0’ while interest overdue could still be there. Take the case of a client making equal installment payments of 100 (Prin.) on reducing interest (18%) for a 10 month period Let us assume that on the due date for the 1st installment the client pays 215 (units of currency) towards the following - 15 towards interest for 1st installment100 towards prin for 1st installment and 100 towards prin for 2nd installment3 (prepayment made for 2nd installment during 1st installment). Assume that the client who has prepaid the prin for the 2nd installment (at the 1st installment itself) does not come to pay the interest for the 2nd installment (which is due only on the actual due date (of the 2nd installment). When this happens, the client will not have any prin overdue (as prin was prepaid) but will most certainly have interest overdue. Any ageing report will find it difficult to track this because most often loan ageing is based on the prin amounts rather than interest amounts. The key question is how should MFIs treat this issue and what should portfolio managers do?

3

Likewise, there are many other aspects like adjusting the portfolio at risk measure for rescheduling, refinancing, write offs, fresh loan disbursements for which repayment is yet to begin and the like. Unless aspects like these are followed according to technical best practices norms, managing an MFI’s portfolio, will, at best, be inaccurate and inefficient just like when the installment method of ageing is used to classify and manage an MFI’s loan portfolio.

3 This is because interest for the 2nd instalment cannot be collected at the time of the 1st instalment as it is not due then and is due only at the time of the 2nd instalment.

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Annex 3: Regulatory challenges to Micro-Finance in India The primary regulatory challenge is the lack of an appropriate legal form, specific to micro-finance. MFIs can critically incorporate themselves as either not-for-profits or mutual benefit organisations or forprofit entities. While micro-finance is being carried on by these different legal entities, each form has its own unique share of challenges and constraints. Some of the key regulatory challenges1 include (but are not limited to the) following: Challenges Legal form and incorporation aspects: Legality of financial intermediation for non-profits:

Descriptions lack of an appropriate legal form to deliver all of the financial services required by the poor – credit, savings, insurance and other such services inability of not-for-profit MFIs to: (1) engage in financial intermediation in a strict legal sense without contradicting various other laws (IT ACT, 1961 etc) of the land in India, (2) borrow from commercial banks and related stakeholders, and (3) secure external commercial borrowings (ECB loan funds) from outside of India

Transformation and taxation issues for non-profits:

lack of an enabling provision and easy mechanism to transfer the assets and liabilities of the not-for-profits to the alternative structures, if required. This becomes a critical issue as many of the not-for-profit MFIs are desirous of transforming to become regulated institutions. A related issue is the lack of appropriate mechanisms for building of reserves for future growth and transformation, which is of course limited and impacted by taxation requirements ; the large geographic (multi-state) territorial dispersion required for becoming a cooperative under the Multi-State Cooperative Act (Central or National Cooperative) ; the various problems associated with the traditional cooperative institutional arrangement – both with regard to the undemocratic behavior permissible under the law (superseding of the boards, no elections etc) and also governance issues like vitiated management’s that may not ensure exclusive focus on the poor clients, and ; the lack of appropriate and enabling progressive cooperative legislations (like the MACS parallel law in AP and some other states) which result in suppression by the Govt which results in loss of ownership and control of micro-finance activities

Incorporation and management of cooperatives:

Capitalisation requirements for regulated MFIs:

high capital requirement for setting up of for-profit NBFCs, LABs and UBCs (Urban Cooperative Banks), which many of the not-for-profits may not be able to afford or alternatively, even if they have accumulated surplus, may not be able to invest into the regulated entity because of legal restrictions (given in point 3 above)

Regulation and supervision norms for regulated MFIs:

somewhat stringent regulation requirements associated with for-profit NBFCs2, LABs and UBCs in terms of the products and services they can offer, norms for provisioning and the like

1

Extracted and adopted from the SIDBI Sa-Dhan Theme Paper, for 2005 SIDBI-SADHAN conference on regulation, written by Ramesh S Arunachalam and Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India. This MCG background paper was used extensively to develop section 3 in the above mentioned SIDBI - SADHAN Theme paper. 2 As per currently standing instructions of RBI, no NBFC with minimum net owned funds (NOF) of less than Rs.25 lakh is eligible to accept public deposits. Such companies have to stop acceptance of deposits forthwith. Earlier, in January 1997, the RBI had asked all NBFCs to compulsorily register with RBI by 08 July 1997. Such NBFCs were allowed to carry on their business unless registration was denied to them. Further, these NBFCs are now required to file returns to the RBI in prescribed formats on quarterly basis indicating their reserve position and maintenance of liquid assets irrespective of whether NBFCs hold public deposits or not. For-profit NBFCs undertaking microfinance activities also have to comply with a large number of statutory requirements to carry on their business as NBFCs. These compliance’s embrace, besides equity, a lot of other areas of regulation involving liquid assets, rating requirements and prudential norms. Sometime ago, for the new NBFCs, the RBI has enhanced the NOF requirement to Rs. 2 crore.

59

As the SIDBI – SADHAN theme paper notes, “problems are exacerbated due to the fact that majority of the MFIs in India today are presently incorporated as not-for-profit institutions. In fact, as a study by MCRIL3 reveals, there is a continued dominance of not-for-profit institutions (nearly 80%) in the provision of microfinance services through the MFI institutional channel. Chart 1 - Distribution of MFIs by Legal Forms4

70% 60% 50% 40% 30% 20% 10% 0% Societies

Trusts

Cooperatives

Companies/Banks

Registration

Societies and Trusts are Non-Profit in Nature Hence, it is clear that, at present there is no legal enactment that can take care of the special requirements for registration, regulation and supervision and/or transformation of not-for-profit institutions that are involved in micro-finance. The RBI Act, 1934 does not explicitly recognise the financial activities of the not-for-profit institutions. Also, The Banking Regulation Act, 1949 does not have specific mention about microfinance and MFIs/CDFIs. Not-for-Profit institutions therefore face diverse organisational, legal and other procedural constraints, which have arisen mainly due to their legal (non-profit) status, voluntary character and innate difficulties in combining social development and financial intermediation. Specifically, there are many issues pertaining to the regulation of not-for-profit MFIs and these are briefly highlighted below:” Key Issues Pertaining to Legality of Financial Intermediation by Not-for-Profit Institutions5 Legal Form and Financial Intermediation 1. Even if societies and trusts are serving the poor, can they carry on financial intermediation (credit, savings and insurance) in a legal sense? 2. When their bye-laws6 and objects do not have lending, savings mobilization and insurance (risk fund) provision clauses, can they carry on such activities? 3. Can they receive loans from wholesalers for on-lending to poor clients, even if their objects and bye-laws do not have a borrowing clause? Methodology Adopted for Financial Intermediation 1. Can Informal (unregistered) MFI Federations (of SHGs) carry on such financial intermediation activities? 2. Can Informal SHGs carry on such financial intermediation activities, despite the official recognition from NABARD and RBI? Receipt of Foreign Funds for Financial Intermediation 1. When such entities lend their foreign grant funds, are they violating Foreign Contribution Regulation Act (FCRA)? 2. How can such not-for-profit MFIs become eligible to utilise external commercial borrowings? Alternatively, what do such not-for-profits do when they have already received ECBs under the automatic route but have to respect the changes in regulation of not accessing loan funds through ECBs? Packaging of Products and Financial Intermediation 1. Does financial intermediation by these MFIs (especially lending) violate exemptions provided under section 3

M-Cril Microfinance Review 2003, M-Cril Data Source: M-Cril Microfinance Review 2003 5 Extracted and adopted from the SIDBI Sa-Dhan Theme Paper, for 2005 SIDBI-SADHAN conference on regulation, written by Ramesh S Arunachalam and Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India. This MCG background paper was used extensively to develop section 3 in the above mentioned SIDBI - SADHAN Theme paper. 6 Not-for-profit MFIs face severe constraints in amending their bye-laws to enable them to deliver financial services. Typically, registrar of societies create a major problem when these MFIs attempt to amend their bye-laws so that they can borrow money from wholesalers and others 4

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Key Issues Pertaining to Legality of Financial Intermediation by Not-for-Profit Institutions5 12 A of the Income Tax Act? 2. Does the charging of interest by such federations prevent their financial intermediation (loaning) activities from being classified as either relief for the poor or object of general public utility as per definitions under Section 2 (15) of the Income Tax Act? 3. Considering the effective rates of interest charged by such institutions, are they violating the Usurious Loan Act and the State Level Money Lending Acts? 4. Can they mobilize savings from clients despite it being akin to collection of public deposits? Is this problem compounded when no interest or return is provided to clients? 5. Is the provision of insurance and related services violative of the amended insurance regulations? 6. Can they provide in-house insurance and risk fund services to poor clients, despite the fact that there could a serious credit risk in making payouts to clients (especially, if all of them have a claim simultaneously)? 7. Is the provision of linkages to external insurance schemes permitted? Regulation and Supervision and Transformation to Regulated Entities 1. Why are they not regulated and supervised? 2. If these not-for-profit MFIs desire to transform to regulation institutions, what are the legal options and what are the practical problems likely to be faced during transformation?

Annex 4: Supervision and Regulation of MFIs in India – The Present Scenario7 If the nature of incorporation of MFIs (especially, the not-for-profits) and their transformation to regulated MFIs has raised specific legal constraints, the aspect of regulation and supervision of different types of MFIs has also presented critical challenges: ; The For-Profit MFIs are highly regulated and supervised, and the norms are very stringent as compared to other forms of MFIs ; The Mutual Benefit MFIs are somewhat regulated and supervised, although the effectiveness and quality of such supervision varies according to the specific form and context ; In the not-for-profit legal form, only Section 25 NBFCs are somewhat regulated and supervised. With regard to other non-profit forms like societies or trusts (many institutions in the country belong to this category), they are neither supervised nor regulated for the financial intermediation activities. Apart from filing annual financial statements and reports to authorities under the Acts of their registration, these MFIs are not under any statutory compulsion to provide information with regard to their financial intermediation activities including delivery of credit, savings and insurance. ; Thus, the presence of multiple legal forms deters the availability of a level playing field in that for profit MFIs are highly regulated and hence, cannot take deposits while, ironically, on the contrary, many of the unregulated not-for-profit MFIs are actually doing so. Further, aspects such applicability of interest rate ceilings to some legal forms (especially, non profit MFIs) and the exclusion of for profit MFIs from the purview of such legislations is again symbolic of the lack of a uniform playing field backed by consistent and standard ground rules. ; So, clearly, in terms of regulation and supervision, there are significant differences across legal forms, both in terms of quality and quantity of supervision and regulation and this lack of a level playing field could prove detrimental to the development of the industry. As outlined above, the challenges of incorporation and transformation as well as constraints related to supervision and regulation of different legal forms for micro-finance indeed make regulation and supervision of the delivery of financial services for low-income people a very difficult, challenging and complex proposition today. There are several reasons8 for this and these are briefly highlighted below:

7

Extracted and adopted from the SIDBI Sa-Dhan Theme Paper, for 2005 SIDBI-SADHAN conference on regulation, written by Ramesh S Arunachalam and Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India. This MCG background paper was used extensively to develop section 3 in the above mentioned SIDBI - SADHAN Theme paper. 8 Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India, 2004

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Annex 2.Portpolio Quality and Ageing of Past Due Loans1 2.1 WHY SHOULD THE INSTALLMENT METHOD OF AGEING NOT BE USED? Example 1 Assumptions for Example 1 Loan Amount to Client A Disbursement Date Number of Installments Frequency of Installment Interest Months in a Year Method of Interest Calculation

1000 31/07/2002 10 Monthly 18% 12 Declining Balance

⇒ 1000 units of currency were disbursed to Client A on 31/07/2002 (July 31st 2002) ⇒ The loan amount (Principal or Prin.) is payable in 10 monthly equal installments along with interest levied at 18% on the declining loan balance, calculated on a monthly basis. ⇒ However, interest is calculated on a daily basis when payments for installments are made a few days late to account for the late days. ⇒ The 1st installment falls due on the last day of the succeeding month – here the loan was disbursed on 31st of July 2002 and thus, the 1st installment falls due on 31st of August 2002. Subsequent installments fall due on the last day of succeeding months ⇒ Accordingly, Client A’s Loan Installment Schedule is as shown in Table 1 below I Installment Number 1 2 3 4 5 6 7 8 9 10 All 10 Installments

Table – 2.1 Client A’s Loan Installment Schedule II III IV Prin Due as Per Date Due Int Due as Per Schedule Schedule 31/08/2002 100 15.00 30/09/2002 100 13.50 31/10/2002 100 12.00 30/11/2002 100 10.50 31/12/2002 100 9.00 31/01/2003 100 7.50 28/02/2003 100 6.00 31/03/2003 100 4.50 30/04/2003 100 3.00 31/05/2003 100 1.50 NA 1000 82.50

1

This section draws heavily from: (1).MIS for Micro-finance, Ramesh S Arunachalam (2003), and (2) MicroSave MCG Loan Portfolio Audit Toolkit (2004)

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Transactions Made by Client A is Given in Table 1B Below Table – 2.2 S No of Installment Amount Paid 1 115.00 2 113.50 3 112.00 4 110.50 5 109.00 6 107.50 7 onwards No Payment Please Note: Some MFIs charge interest from day 1 but this depends on the orientation and policy of the MFI. Please note that this is merely an assumption, which can be changed as also repayment schedules and modes. What needs to be emphasized is the fact that this will apply equally to all situations wherein different assumptions are used.

38

Now, as given above, assume that Client A makes a 1st payment of 115 (units of currency) on 31/08/2002, that is on the due date of the 1st installment. First, 15 (units of currency) will go towards interest amount due as per schedule while 100 will go towards prin. amount due as per schedule. I

II

III

IV

V

Installment Number

Date Due

Prin Due

Int Due as Per Schedule

Date Paid

1

31/08/2002

100

15.00

31/08/2002

Interest due as per payment date is same as interest due as per instalment schedule because due and payment dates are same. If payment were made 1 day later than 31st of August 2002, then interest due would be higher. If Client A had made repayment on 1st of Sept. 2002, then interest payable would be approximately 15.50. This is a crucial aspect which should not and cannot be ignored.

VI Int Due as per payment date 15.0

VII

VIII

IX

X

XI

XII

Amount Paid

Int Paid

Prin Paid

Cum Prin Paid

Prin. Prepaid

Prin Outstanding

115.00

15.0

100.00

100.00

0

900.00

Interest Paid of 15 units of currency

Prin Paid of 100 units of currency

What does the earlier Table show us? 1) If Paid Total Amount – Due Total Amount = 0, and 2) If Paid Date – Due Date = 0 Then, we safely conclude that the client has no over dues and also made 100% on-time repayment. If either of these conditions is not true, then, it would be safe to conclude that the client has not made 100% on-time repayment. An analysis of the over dues would make it clearer. This is done hereafter in the explanations of the various columns in the Loan repayment tables: Table 2 below and Table 3 (page after that).

Column Column I Column II

Column III Column IV Column V Column VI Column VII Column VIII Column IX Column X Column XI

Table 2.3 - Columns and Explanations Explanation Installment number, which is from 1 to 10, as the loan is given for 10 installments Date on which installment is due, which is the last date of the month as per credit policy. For 1st installment alone, as per credit policy, the due date is the last day of the month succeeding the month of loan disbursement. Here, the loan was disbursed in July 2002 and hence, due date for 1st installment is 31st August 2002 Prin. Due per installment, which is 1000 units of currency (loan disbursed) divided by 10 equal monthly installments for repayment, which is 100 Interest due if the client pays as per schedule, which is (1000 x 18)/(100 x12) = 180/12 = 15 for 1st installment; (900 x 18)/(100x 12) = 13.50 and so on Actual date when client makes (made) payment This is the interest due as per payment date. If the client pays 1 day later than the due date, the interest to be paid would be 15.50 for the 1st installment Total amount actually paid by client, which will first go towards interest and the remaining will go towards prin. amounts and these are given in Column’s VIII and IX Actual Interest Paid Actual Prin. Paid Cumulative Prin. Paid, which is sum of Prin. amounts, paid so far. Prin. Prepaid or any excess amount paid over and above the due (and overdue) amounts

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Column Column XII Column XIII Overdue Definition2

Column XIV Column XV Column XVI

Table 2.3 - Columns and Explanations Explanation Prin. Outstanding, which is loan disbursed – cum prin. paid. At end of 1st installment, this is 1000 – 100 = 900 Gives the OD processing date. In the case of the 1st installment, all amounts are due by 31/08/2002 and if not paid by that day, they become ‘overdue amounts’, the next day which is 1/09/2002 – this date is also called as the OD processing date. If there were an overdue for installment 1, then on 1/09/2002, the age of this over due would have been 1 day = 1/09/2002 – 31/08/2002 = 1 day. Please refer to Installment 7, where overdues exist as client does not make payments by the due date, which is 28/02/2003. Thus, on 1/03/2003, the over dues have an age of 1 day. For installment 7, on 1/03/2003, the interest OD is 6 which is arrived by subtracting interest due ‘6’ from interest paid ‘0’ = 6 – 0 =6 Likewise , for installment 7, on 1/03/2003, the prin. OD is 100 which is arrived by subtracting prin. due ‘100’ – prin. paid ‘0’ = 100 – 0 = 100 The actual age of the over dues after installment 7, specifically on 1/03/2003 is one day, which is arrived by subtracting 1/03/2003 (reference date for taking age) from 28/02/2003 (due date). At the end of installment 8, specifically on 1/04/2003, the actual age of the over dues are 1/04/2003 – 28/02/2003, which is 32 days because, interest of 6 and prin. 100 from installment 7 are still unpaid.

Column XVII

Column XVIII Column XIX

Also, additionally, interest of 6 and prin. 100 from 8th installment has also become overdue with age of 1 day. However, while calculating the age of the loan, we will have to take the EARLIEST UNPAID OVERDUE into account, which occurred because the 7th installment was not paid on 28th February 2003 and which has still remained unpaid even on 1/04/2003 Shows whether the overdue has been settled or not. This, also helps to ensure that when the clients make payments, the money first goes towards interest overdue (1st), then interest due (if interest is due on that date as per schedule), then prin. over due and last towards prin due. In this case, even after the end of installment 10, specifically on 1/06/2003, it is clear that interest and prin. over dues from installment 7 are yet to be settled Shows prin overdue that was paid Shows interest overdue that was paid

Thus, the loan repayment schedule can be filled out for all installments as per explanations and columns given earlier

2

Definition of Overdues is also crucial. When does a loan become overdue or pastdue is an aspect that must be clearly specified. It is suggested that the day after an amount is due, the amount if not paid becomes overdue. If on 30th April, 2003, an amount of Rs 100 is due and it is not paid, then, on 1st May 2003, this amount is in arrears or overdue

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41

42

2.2 Summary - Calculating the correct age is the basis for all portfolio quality indicators and the key to having a good MIS in micro-finance

To calculate the correct age of an overdue loan, the following steps are suggested Step 1


Step 2




(a)


(b)


(c)


(d)


(e)

Due Date for 1st Installment – exactly 1 week or month from disbursement. Mention upfront any grace or moratorium period. Also, clarify in case of monthly repayment schedules, whether month end is considered as the due date

(f)

Disclose moratorium (Grace Period), if any. For example, many MFIs are using the following method. All loans disbursed in the previous months, will have their 1st installment due on the last day of the next month. That is, loans disbursed on 1st January 2002 and 21st January 2002 will have their first installment due on the last date of February 2002. This again must be clarified and specified as it has a significant impact on all calculations including ageing, portfolio quality, ratios and sustainability

(g)


(h)


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Step 4


Step 5


Step 6


Step 7


Thus, the generic formula for calculating the age of an overdue loan as on any date is as follows


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Example 2 Let us consider another example. ⇒ Let us assume that 1032 (Prin. alone) has not been paid by a client and part of it is overdue from August 1st 2001 ⇒ The loan term ends on 31st January 2002 ⇒ The value per (monthly) installment is 180 (Prin. alone) ⇒ The age of the overdue loan is often calculated as per formula below

Formula for Calculating the Age of the Overdue Loan Prin. Overdue Amount Age of Overdue Loan = Installment Amount As per the above formula, the age, as at 1st February 2002, for the above loan is

Age of Overdue Loan (1st February 2002) =

Prin. Overdue Amount

1032 =

Prin. Installment Amount

=

5.96 Months

180

This is absolutely correct, as 6 months intervene between 1st August 2001 and February 1st 2002 – August 2001

Further Assumptions ⇒ Now, let us now assume that we are on July 1st 2002. ⇒ Let us also assume that no further repayments have been made by the client – that is, not a single unit of currency has been paid back by the client

2.3 Recalculating the Age of the Overdue Loan as on July 1st 2002 The age of this overdue loan, as per the (installment) above method of ageing calculation, is still 6 months – i.e., prin. overdue amount divided by value of installment (prin.) which is 1032/180 = 5.96 months = 6 months

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But the actual (correct) age is 6 months till loan term end (Aug 01, Sept 01, Oct 01, Nov 01, Dec 01 and Jan 02) + 5 months from February 1st 02 till July 1st 02 (Feb 02, Mar 02, Apr 02, May 02, and June 02) or 11 months in all So what is considered 180 days past due is actually 330 days past due, as shown above. Thus, the incorrect method of ageing has an impact on the REAL ability of the MFI to actually collect money [the further the borrower is in terms of actual age of the overdue, the less likely for an MFI to get it back]. Also, it distorts provisioning, income and finally, sustainability. In fact, after a loan is past its scheduled loan term, if this incorrect method of ageing is used, Portfolio at Risk (PAR) by Age will always be under reported2. 2.4 Implications Consider that there are several loans that are actually more than 330 days past due. While individually they may constitute a small percentage and contribute accordingly to PAR, cumulatively, as a large number of such loans exist, their impact on PAR would be significant. And this becomes even more serious when their age is distorted and PAR by age is used as a standard. This aspect is highlighted sequentially.

2

The converse is also true – for loans within the loan term, the installment method of ageing would always over report age. Only at the end of the loan term (near about), would the installment method of ageing give the correct (accurate) age. In our example, this is age as at Jan 31st 2002 where the actual age is the same as the age as calculated through the installment method of ageing.

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Example 3 Consider another example… The loan term finishes on January 31st 2002 The amount of prin overdue is 400 (part of which is overdue since December 1st 2001) The prin amount per (monthly) installment is 200 The age as per the installment method, as at February 1st 2002 is = 400 divided by 200 = 2.0 months As noted earlier, this is correct. Now, assume that we are on June 1st 2002. The age as per the installment ageing formula is still 2 months (assuming that the client has not paid back any further amounts This age of 2 months is however not correct as demonstrated earlier and also as shown in the discussion hereafter The actual age is 2 months from Dec 1st 01 till end of loan term (31st of Jan 2003) + Whole of February 02 + Whole of March 02 + Whole of April 02 + Whole of May 02 = 6 months Now, assume that PAR > 60 Days is used as a standard or a benchmark. Thus, if the ageing done by the MFI is based on the installment (incorrect) method, such loans as the one above, which are actually 6 months past due WILL never come into the fold of PAR > 60 Days. And if there are a large number of such loans, because of the erroneous method of ageing, the reported PAR values will also portray an incorrect picture and hence, the standard of using PAR based on age would also become ineffective. This has implications for provisioning, income recognition and sustainability apart from mere portfolio management. These aspects are highlighted below in sequential fashion.

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Example 4 2.5Using data from the examples I, II and III, let us assume the following about a small MFIs portfolio ⇒ We are at s specific date and would like to age the MFI’s portfolio as on this date ⇒ There are 122 outstanding loans of which 72 are current (with no overdues). ⇒ Of the remaining 50 loans, as per the accurate method of ageing, 10 are like in the category of example 1 whereby they are actually 551 days past due whereas the incorrect installment method says that they are only 120 days past due ⇒ Likewise, 10 loans are in the category of example 3, whereby they are actually 330 days past due whereas according to the erroneous installment method of ageing they are only 180 days past due ⇒ The last 30 loans are like in example 3, whereby they are actually 6 months past due whereas the incorrect installment shows them to be just 60 days past due ⇒ Let us assume that we are using PAR > 60 days or PAR > 90 days or PAR > 120 days or PAR > 180 days as a standard and would like to compare the aged Portfolio with that of other MFIs Table 2.6 - Data for use in Example 4 Example 1 Example 2 Example 3 Number of Loans 10 10 30 Loan Outstanding per loan 400 1032 400 Principal Over Due per loan 400 1032 400 Actual Age of over due for 551 days 330 days 180 days each loan Age of over due for each loan 120 days 180 days 60 days as per Installment Method All the Overdue Loans are past their loan term. For the sake of convenience, we are assuming the same values for overdues and other aspects, exactly as given in the 3 examples.

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2.6 Impact on Provisioning, Write-offs, Income Recognition and Sustainability See below the ageing tables as per the accurate method of ageing and installment method of ageing Table 2.7 - Loan Loss Provision Based on Accurate Ageing Amount in Unpaid Principal Arrears (Currency Balance Portfolio Provisioning (CU) at Risk Rate Description of Loans No. of Loans Units) Current 72 0 100000 0.00% 0% 1 - 30 Days Past due 0 0 0 0.00% 10% 31 - 60 Days Past due 0 0 0 0.00% 25% 61 - 90 Days Past due 0 0 0 0.00% 50% 91 - 120 Days Past due 0 0 0 0.00% 75% 121-180 Days Past due 30 12000 12000 9.50% 90% 181 – 365 Days Past due 10 10320 10320 8.17% 100% above 365 Days Past due 10 4000 4000 3.17% 100% Total 122 26320 126320 20.84% NA

Loan Loss Provision (CU) 0 0 0 0 0 10800 10320 4000 25120

Table 2.8 - Loan Loss Provision Based on Inaccurate Installment Method of Ageing Amount in Unpaid Arrears Principal Loan Loss (Currency Balance Portfolio Provisioning Provision Units) (CU) Description of Loans No. of Loans at Risk Rate (CU) Current 72 0 100000 0.00% 0% 0 1 - 30 Days Past due 0 0 0 0.00% 10% 0 31 - 60 Days Past due 30 12000 12000 9.50% 25% 3000 61 - 90 Days Past due 0 0 0 0.00% 50% 0 91 - 120 Days Past due 10 4000 4000 3.17% 75% 3000 121-180 Days Past due 10 10320 10320 8.17% 90% 9288 181 - 365 Days Past due 0 0 0 0.00% 100% 0 above 365 Days Past due 0 0 0 0.00% 100% 0 Total 122 26320 126320 20.84% NA 15288

Indicators PAR Arrears Rate PAR > 30 Days PAR > 60 Days PAR > 90 Days PAR > 120 Days PAR > 180 Days PAR > 365 Days Loan Loss Provision Rate

Table1 2.9 – Comparative Analysis of Ageing and Provisioning Data Using the 2 methods of Ageing Accurate Instalment Difference Method of Method of between 2 Ageing Ageing methods 20.84% 20.84% 0.00% 20.84% 20.84% 0.00% 20.84% 20.84% 0.00% 20.84% 11.34% 9.50% 20.84% 11.34% 9.50% 20.84% 8.17% 12.67% 11.34% 0.00% 11.34% 3.17% 0.00% 3.17% 19.89% 12.10% 7.79%

Instalment Method understates Risk by extent below 0.00% 0.00% 0.00% 9.50% 9.50% 12.67% 11.34% 3.17% 7.79%

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AGED PAR CATEGORIES TYPICALLY INCLUDE THE FOLLOWING… PAR > = 1 Day PAR > 30 Days PAR > 60 Days PAR > 90 Days PAR > 180 Days PAR > 365 Days (1 Year)

= Sum of PAR 1-30 Days+31-60 Days+…PAR > 365 Days = Sum of PAR 31-60 Days+61-90 Days+ …PAR > 365 Days = Sum of PAR 61-90 Days+91-120 Days+ …PAR > 365 Days = Sum of PAR 91-120 Days+121-180 Days+ ...PAR >365 Days = Sum of PAR 181-365 Days+ PAR >365 Days = Sum of PAR > 365 Days

⇒ Thus, as shown in the previous Tables, the instalment method of ageing, grossly understates the risk whether we use PAR >60 days or PAR >90 Days or PAR >120 Days or PAR > 180 Days as a standard - when the portfolio has overdue loans past their loan term ⇒ When MFIs use the instalment method of ageing, very risky assets (especially, those past the loan term most unlikely to be collected) are shown as collectable or somewhat collectable assets ⇒ Specifically, take the case of PAR > 60 days, which is a commonly used standard in micro-finance. As much as 9.50% of risky assets are omitted from this category when the instalment method of aging is used. ⇒ Likewise, for PAR > 120 days, as much as 12.67% of risky assets are crucially overseen ⇒ While the actual proportion of risky assets shrouded while using the installment method depends on the actual composition of the portfolio, the key point here is that: 1) it understates risk, when overdue loans are past their loan term and 2) it over states risk when the overdue loans are within the loan term ⇒ Similarly, provisioning is also affected as shown by the specific example; using the installment method of ageing results in the portfolio being under provisioned by almost 7.79%, when the over due loans are past their loan term. Impact of Installment Method of Ageing on Loan Loss Provisioning Example 1 loans, which are actually 551 days past due are under provisioned by 1000 units of currency. This is because, using the accurate method of ageing, they come into the category of loans > 365 past due, thereby having a 100% provision rate which makes the provision amount as 4000 (4000 Outstanding X 100%). However, as per the installment method of ageing, they come into the category of loans between 91 – 120 days past due, which carries a provision rate of 75%, making the provision amount as 3000 (4000 X 75%). Likewise, under provisioning for example 2 loans is 1032 and for example 3 loans, it is 7800.

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⇒ The converse (over provisioning) can also be shown to be true whereby the installment method of ageing results in over provisioning - when an MFI’s portfolio has all overdue loans within the loan term ⇒ Likewise, this also impacts write-offs: specifically, when MFIs use the installment method of ageing (and all over due loans are past their loan term), they will not write-off loans that actually need to be written off. ⇒ The corollary here is that MFIs may thus continue accruing interest for such loans when they actually should not be doing so. ⇒ In other words, the installment method of ageing also has an impact on income (or loss) recognition and de-recognition and in both cases (when loans are past their loan term as well as within it), these tend to get distorted as well ⇒ Thus, all of the above also distort the financial statements and are likely to present an inaccurate picture of the true financial situation of the MFI in question ⇒ Therefore, this approximate and inaccurate method of ageing is better avoided ⇒ One may also be tempted to argue that if an MFI has overdue loans within the loan term and also passed the loan term and if it uses the installment method of ageing, the negative effects will balance out each other – such an argument is dangerous and tantamount to saying that 2 mistakes will even out. ⇒ In conclusion, all stakeholders involved in micro-finance should try and ensure that this inaccurate installment method of ageing is not used by MFIs and other stakeholders to age the loan portfolio. This is very crucial to building reliable and valid indicators to assess micro-finance performance as the process is as important as the outcomes. The overall impact of using the installment method of ageing is summarized in Table 2.10 and diagrammed in Figures 2.1 Box 1: Impact of Ageing Method on Loan Write-Offs and Interest Reversals As per the accurate method of ageing, 10 loans (with total Principal Overdue of 4000 units of currency and total Principle Outstanding of 4000 units of currency) would have to be written off (as age of overdue loans is > 551 days) whereas as per the installment method of ageing, they would not be written off (as age would be just 120 days) Taking same values for Interest Overdue as given in example 1, the total accrued interest for these 10 loans, which would have to be reversed, would be 1140 units of currency (UC) {114 per loan x 10 loans} and this reversal should have taken place as actual age of each of these 10 loans is 551 days. But, it will not happen if age is calculated using installment method, as then the age would just be 120 days (for each loan).

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Table 2.10- Summary Impact of Using Incorrect Installment Method of Ageing 1) Impact on Portfolio Quality Parameter/Activity When Installment Method of Ageing is used and all loans are When Installment Method of Ageing is beyond the loan term used and all loans are within the loan term PAR (not aged) ⇒ Not affected ⇒ Not Affected Arrears Rate (not aged) ⇒ Not affected ⇒ Not Affected Aged Portfolio at Risk ⇒ Age is understated ⇒ Age is over stated Loan Loss Provision ⇒ Results in Under Provisioning ⇒ Results in Over Provisioning Write-offs ⇒ Loans with older age over dues that need to be written-off are ⇒ Loans that need not be written-off could actually not written-off. Hence, most risky assets continue to be written off due to age being exist on the portfolio overstated Income Recognition ⇒ As loans with older age over dues that need to be written-off ⇒ Accrued interest could be de-recognized and Reversal because age is over stated are actually not written-off, interest (not likely to be got) is still being accrued and this is not a correct practice. 2) Impact on Financial Statements Financial Statement When Installment Method of Ageing is used and all loans are When Installment Method of Ageing is beyond the loan term used and all loans are within the loan term Portfolio Report ⇒ Understates Risk ⇒ Overstates Risk Balance Sheet ⇒ Inaccurate as interest accrued will never be reversed as age is ⇒ Inaccurate as interest accrued could be under stated, especially if rules for reversal are based on age reversed because age is over stated, especially if rules for reversal are based ⇒ Loan loss reserve is understated because of lower provisions on age ⇒ Loan loss reserve is overstated because of higher provisions Income Statement ⇒ Understates provision expenses and over states income when ⇒ Overstates provision expenses the accrual method of accounting is used.

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Table 2.10- Summary Impact of Using Incorrect Installment Method of Ageing ⇒ Distorts true picture of profitability and ⇒ Distorts true picture of profitability and sustainability and sustainability overstates profitability and sustainability by understating provision expenses and accruing income on loans that need to be written-off 3) Implications for Different Stakeholders Stakeholders When Installment Method of Ageing is used and all loans are When Installment Method of Ageing is beyond the loan term used and all loans are within the loan term Micro-Finance ⇒ MFIs classifying their riskiest assets as less risky ⇒ MFIs classifying their less risky assets Institutions as more risky ⇒ Under provisioning when actually a higher provisioning is required ⇒ Over provisioning when actually a low ⇒ MFIs showing higher than actual income, profitability and provisioning is enough sustainability ⇒ Showing lower than actual income, ⇒ Accrual of interest on loans that need to be written-off and profitability and sustainability for whom already accrued interest perhaps needs to be reversed ⇒ Reversal of accrued interest when perhaps not necessary Donors, Wholesalers ⇒ An inaccurate picture of an MFI’s ⇒ An inaccurate picture of an MFI’s portfolio quality – most and Investors portfolio quality risky assets can never be discerned as they have a lower reported age in comparison to actual age ⇒ An inaccurate picture of an MFI’s financial situation as reflected by The ⇒ An inaccurate picture of an MFI’s financial situation as Income Statement and Balance Sheet reflected by The Income Statement and Balance Sheet – Overstatement of Income, Profitability and Sustainability and inaccurate portrayal of asset quality Regulators ⇒ MFIs not conforming to prudential norms and regulations ⇒ MFIs not conforming to prudential established by authorities norms and regulations established by authorities

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Table 2.10- Summary Impact of Using Incorrect Installment Method of Ageing Credit Rating Agencies

⇒ Inaccurate assessment of an MFIs true credit worthiness as also the risks involved in transacting business with the MFIs concerned

MIS Developers

⇒ MIS using wrong logic of determining age of over due loans and also resultant inaccurate outputs and reports

Clients

⇒ An inaccurate picture of an MFI’s financial situation

⇒ Inaccurate assessment of an MFIs true credit worthiness as also the risks involved in transacting business with the MFIs concerned ⇒ MIS using wrong logic of determining age of over loans and also resultant inaccurate outputs and reports ⇒ An inaccurate picture of an MFI’s financial situation

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FIGURE 2.1 WHY THE INSTALLMENT METHOD OF AGEING SHOULD NOT BE USED BY THE MICRO-FINANCE SECTOR?

Installment Method of Ageing, if used…

When all Loans are past the Loan term Has the following Impact …

1. Understates age of past due loans 2. Shrouds the risk in an MFI’s portfolio while it is actually higher 3. Results in lower than prudentially required provisioning 4. Causes interest to be accrued when it should not 5. Prevents write-offs of loans that need to be written off 6. Portrays higher than actual profitability and sustainability 7. Causes severe income (or loss) recognition and de-recognition problems 8. Presents inaccurate financial situation of an MFI 9. Leads to inaccurate assessments with regard to credit risk PLUS MANY OTHER NEGATIVE IMPACTS

When all Loans are within the Loan term Has the following Impact …

1. Overstates age of past due loans 2. Overstates the risk in an MFI’s portfolio while it is actually lower 3. Results in higher than prudentially required provisioning 4. Could result in accrued interest being reversed when not necessary 5. Could result in write-offs of loans that need not be written off 6. Portrays lower than actual profitability and sustainability 7. Causes severe income (or loss) recognition and de-recognition problems 8. Presents inaccurate financial situation of an MFI 9. Leads to inaccurate assessments with regard to credit risk PLUS MANY OTHER NEGATIVE IMPACTS

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2.7 Discussion To calculate the correct age of an overdue loan, we suggest the following steps Step 1


Step 2




(i)


(j)


(k)


(l)


(m) Due Date for 1st Installment – exactly 1 week or month from disbursement. Mention upfront any grace or moratorium period. Also, clarify in case of monthly repayment schedules, whether month end is considered as the due date (n)

Disclose moratorium (Grace Period), if any. For example, many MFIs are using the following method. All loans disbursed in the previous months, will have their 1st installment due on the last day of the next month. That is, loans disbursed on 1st January 2002 and 21st January 2002 will have their first

(o)

installment due on the last date of February 2002. This again must be clarified and specified as it has a significant impact on all calculations including ageing, portfolio quality, ratios and sustainability

(p)


(q)


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Step 4


Step 5


Step 6


Step 8


Step 9

Thus the generic formula for calculating the age of an overdue loan as on any date is as follows


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2.8 Other Issues of Importance This annex briefly highlights the distorting impact of using the installment method of ageing in portfolio management. Many other technical issues are equally important for loan portfolio management in micro-finance and some of these are identified below. The MIS analyst must be careful of such aspects when making the reports and keep these issues in mind. 1

What happens when MFIs use a different sequence for client repayments? Some MFIs first adjust a client’s repayment towards principal and then towards interest. When this happens and there is delinquency this triggers a reduced portfolio yield (as compared to effective interest rates) rather than a higher portfolio at risk.

2

Likewise when clients make prepayments there is a strong possibility that Prin. Overdue could be ‘0’ while interest overdue could still be there. Take the case of a client making equal installment payments of 100 (Prin.) on reducing interest (18%) for a 10 month period Let us assume that on the due date for the 1st installment the client pays 215 (units of currency) towards the following - 15 towards interest for 1st installment100 towards prin for 1st installment and 100 towards prin for 2nd installment3 (prepayment made for 2nd installment during 1st installment). Assume that the client who has prepaid the prin for the 2nd installment (at the 1st installment itself) does not come to pay the interest for the 2nd installment (which is due only on the actual due date (of the 2nd installment). When this happens, the client will not have any prin overdue (as prin was prepaid) but will most certainly have interest overdue. Any ageing report will find it difficult to track this because most often loan ageing is based on the prin amounts rather than interest amounts. The key question is how should MFIs treat this issue and what should portfolio managers do?

3

Likewise, there are many other aspects like adjusting the portfolio at risk measure for rescheduling, refinancing, write offs, fresh loan disbursements for which repayment is yet to begin and the like. Unless aspects like these are followed according to technical best practices norms, managing an MFI’s portfolio, will, at best, be inaccurate and inefficient just like when the installment method of ageing is used to classify and manage an MFI’s loan portfolio.

3

This is because interest for the 2nd instalment cannot be collected at the time of the 1st instalment as it is not due then and is due only at the time of the 2nd instalment.

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Annex 3: Regulatory challenges to Micro-Finance in India The primary regulatory challenge is the lack of an appropriate legal form, specific to micro-finance. MFIs can critically incorporate themselves as either not-for-profits or mutual benefit organisations or forprofit entities. While micro-finance is being carried on by these different legal entities, each form has its own unique share of challenges and constraints. Some of the key regulatory challenges1 include (but are not limited to the) following: Challenges Legal form and incorporation aspects: Legality of financial intermediation for non-profits:

Descriptions lack of an appropriate legal form to deliver all of the financial services required by the poor – credit, savings, insurance and other such services inability of not-for-profit MFIs to: (1) engage in financial intermediation in a strict legal sense without contradicting various other laws (IT ACT, 1961 etc) of the land in India, (2) borrow from commercial banks and related stakeholders, and (3) secure external commercial borrowings (ECB loan funds) from outside of India

Transformation and taxation issues for non-profits:

lack of an enabling provision and easy mechanism to transfer the assets and liabilities of the not-for-profits to the alternative structures, if required. This becomes a critical issue as many of the not-for-profit MFIs are desirous of transforming to become regulated institutions. A related issue is the lack of appropriate mechanisms for building of reserves for future growth and transformation, which is of course limited and impacted by taxation requirements the large geographic (multi-state) territorial dispersion required for becoming a cooperative under the Multi-State Cooperative Act (Central or National Cooperative) the various problems associated with the traditional cooperative institutional arrangement – both with regard to the undemocratic behavior permissible under the law (superseding of the boards, no elections etc) and also governance issues like vitiated management’s that may not ensure exclusive focus on the poor clients, and the lack of appropriate and enabling progressive cooperative legislations (like the MACS parallel law in AP and some other states) which result in suppression by the Govt which results in loss of ownership and control of micro-finance activities

Incorporation and management of cooperatives:

Capitalisation requirements for regulated MFIs:

high capital requirement for setting up of for-profit NBFCs, LABs and UBCs (Urban Cooperative Banks), which many of the not-for-profits may not be able to afford or alternatively, even if they have accumulated surplus, may not be able to invest into the regulated entity because of legal restrictions (given in point 3 above)

Regulation and supervision norms for regulated MFIs:

somewhat stringent regulation requirements associated with for-profit NBFCs2, LABs and UBCs in terms of the products and services they can offer, norms for provisioning and the like

1 Extracted and adopted from the SIDBI Sa-Dhan Theme Paper, for 2005 SIDBI-SADHAN conference on regulation, written by Ramesh S Arunachalam and Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India. This MCG background paper was used extensively to develop section 3 in the above mentioned SIDBI - SADHAN Theme paper. 2 As per currently standing instructions of RBI, no NBFC with minimum net owned funds (NOF) of less than Rs.25 lakh is eligible to accept public deposits. Such companies have to stop acceptance of deposits forthwith. Earlier, in January 1997, the RBI had asked all NBFCs to compulsorily register with RBI by 08 July 1997. Such NBFCs were allowed to carry on their business unless registration was denied to them. Further, these NBFCs are now required to file returns to the RBI in prescribed formats on quarterly basis indicating their reserve position and maintenance of liquid assets irrespective of whether NBFCs hold public deposits or not. For-profit NBFCs undertaking microfinance activities also have to comply with a large number of statutory requirements to carry on their business as NBFCs. These compliance’s embrace, besides equity, a lot of other areas of regulation involving liquid assets, rating requirements and prudential norms. Sometime ago, for the new NBFCs, the RBI has enhanced the NOF requirement to Rs. 2 crore.

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As the SIDBI – SADHAN theme paper notes, “problems are exacerbated due to the fact that majority of the MFIs in India today are presently incorporated as not-for-profit institutions. In fact, as a study by MCRIL3 reveals, there is a continued dominance of not-for-profit institutions (nearly 80%) in the provision of microfinance services through the MFI institutional channel. Chart 1 - Distribution of MFIs by Legal Forms4

70% 60% 50% 40% 30% 20% 10% 0% Societies

Trusts

Cooperatives

Companies/Banks

Registration

Societies and Trusts are Non-Profit in Nature Hence, it is clear that, at present there is no legal enactment that can take care of the special requirements for registration, regulation and supervision and/or transformation of not-for-profit institutions that are involved in micro-finance. The RBI Act, 1934 does not explicitly recognise the financial activities of the not-for-profit institutions. Also, The Banking Regulation Act, 1949 does not have specific mention about microfinance and MFIs/CDFIs. Not-for-Profit institutions therefore face diverse organisational, legal and other procedural constraints, which have arisen mainly due to their legal (non-profit) status, voluntary character and innate difficulties in combining social development and financial intermediation. Specifically, there are many issues pertaining to the regulation of not-for-profit MFIs and these are briefly highlighted below:” Key Issues Pertaining to Legality of Financial Intermediation by Not-for-Profit Institutions5 Legal Form and Financial Intermediation 1. Even if societies and trusts are serving the poor, can they carry on financial intermediation (credit, savings and insurance) in a legal sense? 2. When their bye-laws6 and objects do not have lending, savings mobilization and insurance (risk fund) provision clauses, can they carry on such activities? 3. Can they receive loans from wholesalers for on-lending to poor clients, even if their objects and bye-laws do not have a borrowing clause? Methodology Adopted for Financial Intermediation 1. Can Informal (unregistered) MFI Federations (of SHGs) carry on such financial intermediation activities? 2. Can Informal SHGs carry on such financial intermediation activities, despite the official recognition from NABARD and RBI? Receipt of Foreign Funds for Financial Intermediation 1. When such entities lend their foreign grant funds, are they violating Foreign Contribution Regulation Act (FCRA)? 2. How can such not-for-profit MFIs become eligible to utilise external commercial borrowings? Alternatively, what do such not-for-profits do when they have already received ECBs under the automatic route but have to respect the changes in regulation of not accessing loan funds through ECBs? Packaging of Products and Financial Intermediation 1. Does financial intermediation by these MFIs (especially lending) violate exemptions provided under section 3

M-Cril Microfinance Review 2003, M-Cril Data Source: M-Cril Microfinance Review 2003 5 Extracted and adopted from the SIDBI Sa-Dhan Theme Paper, for 2005 SIDBI-SADHAN conference on regulation, written by Ramesh S Arunachalam and Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India. This MCG background paper was used extensively to develop section 3 in the above mentioned SIDBI - SADHAN Theme paper. 6 Not-for-profit MFIs face severe constraints in amending their bye-laws to enable them to deliver financial services. Typically, registrar of societies create a major problem when these MFIs attempt to amend their bye-laws so that they can borrow money from wholesalers and others 4

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Key Issues Pertaining to Legality of Financial Intermediation by Not-for-Profit Institutions5 12 A of the Income Tax Act? 2. Does the charging of interest by such federations prevent their financial intermediation (loaning) activities from being classified as either relief for the poor or object of general public utility as per definitions under Section 2 (15) of the Income Tax Act? 3. Considering the effective rates of interest charged by such institutions, are they violating the Usurious Loan Act and the State Level Money Lending Acts? 4. Can they mobilize savings from clients despite it being akin to collection of public deposits? Is this problem compounded when no interest or return is provided to clients? 5. Is the provision of insurance and related services violative of the amended insurance regulations? 6. Can they provide in-house insurance and risk fund services to poor clients, despite the fact that there could a serious credit risk in making payouts to clients (especially, if all of them have a claim simultaneously)? 7. Is the provision of linkages to external insurance schemes permitted? Regulation and Supervision and Transformation to Regulated Entities 1. Why are they not regulated and supervised? 2. If these not-for-profit MFIs desire to transform to regulation institutions, what are the legal options and what are the practical problems likely to be faced during transformation?

Annex 4: Supervision and Regulation of MFIs in India – The Present Scenario7 If the nature of incorporation of MFIs (especially, the not-for-profits) and their transformation to regulated MFIs has raised specific legal constraints, the aspect of regulation and supervision of different types of MFIs has also presented critical challenges: The For-Profit MFIs are highly regulated and supervised, and the norms are very stringent as compared to other forms of MFIs The Mutual Benefit MFIs are somewhat regulated and supervised, although the effectiveness and quality of such supervision varies according to the specific form and context In the not-for-profit legal form, only Section 25 NBFCs are somewhat regulated and supervised. With regard to other non-profit forms like societies or trusts (many institutions in the country belong to this category), they are neither supervised nor regulated for the financial intermediation activities. Apart from filing annual financial statements and reports to authorities under the Acts of their registration, these MFIs are not under any statutory compulsion to provide information with regard to their financial intermediation activities including delivery of credit, savings and insurance. Thus, the presence of multiple legal forms deters the availability of a level playing field in that for profit MFIs are highly regulated and hence, cannot take deposits while, ironically, on the contrary, many of the unregulated not-for-profit MFIs are actually doing so. Further, aspects such applicability of interest rate ceilings to some legal forms (especially, non profit MFIs) and the exclusion of for profit MFIs from the purview of such legislations is again symbolic of the lack of a uniform playing field backed by consistent and standard ground rules. So, clearly, in terms of regulation and supervision, there are significant differences across legal forms, both in terms of quality and quantity of supervision and regulation and this lack of a level playing field could prove detrimental to the development of the industry. As outlined above, the challenges of incorporation and transformation as well as constraints related to supervision and regulation of different legal forms for micro-finance indeed make regulation and supervision of the delivery of financial services for low-income people a very difficult, challenging and complex proposition today. There are several reasons8 for this and these are briefly highlighted below:

7 Extracted and adopted from the SIDBI Sa-Dhan Theme Paper, for 2005 SIDBI-SADHAN conference on regulation, written by Ramesh S Arunachalam and Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India. This MCG background paper was used extensively to develop section 3 in the above mentioned SIDBI - SADHAN Theme paper. 8 Legal challenges in Micro-Finance, Working Paper, Micro-Finance Consulting Group (MCG), India, 2004

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