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  • MicroFinance Network

    MOVING MICROFINANCE FORWARD

    Ownership, Competition, and Controlof Microfinance Institutions

    Edited byCraig F. Churchill

    1998

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    FOREWORD

    The MicroFinance Network is a global association of leading microfinance practitioners. Oneof the primary purposes of the Network is to provide advanced microfinance institutions with aforum to learn from each others experiences. Each year Network members assemble for threedays of presentations and discussions about important issues regarding the operation of theirinstitutions.

    The three themes of this years conferenceOwnership, Competition, and Controlwereidentified by the Network members as important issues. Network members and a handful ofspecial guests provided quality presentations on these topics, which were followed by extensivediscussions. This document presents a summary of the proceedings of the conference to sharethe content with a wider audience. Anyone who is interested in the sustainable provision ofmicrofinancial services will find this document invaluable.

    The 5th Annual Conference of the MicroFinance Network, Moving Microfinance Forward,was one of the Networks most successful conferences. It was held in Alexandria, Egypt andhosted by the Alexandria Business Association (ABA), a founding member of the Network.The Network greatly appreciates the hard work and dedication of Nabil El Shami, theExecutive Director of ABAs Small and Micro Enterprise (SME) Project, and his very capableteam including Ahmad Mokhtar, the Deputy Director, Amani AlAmir, and Taline Artine. TheNetwork would also like to thank Mohamed Ragab, the Chairman of the Alexandria BusinessAssociation for hosting this event.

    During the opening of the conference, we were very fortunate to have two Egyptian Ministersin attendance to initiate our deliberations, as well as other dignitaries. The Network is verygrateful to Dr. Yousef Boutros Ghali, Minister of Economy, and Mrs. Mervat El-Tallawi,Minister of Social Affairs, for their words of wisdom and support. The Network would alsolike to thank Mr. Abdel Salam Mahgoub, Governor of Alexandria, and Mr. John Wesley,USAID Cairo Mission Director, for their attendance and kind words. In addition, the Networkappreciates the eloquent opening address of Juan Pea, the Executive Vice President ofFONCAP, a public sector initiative in Argentina designed to support the development ofmicrofinance institutions.

    On behalf of the Network, I want to welcome four new members to the MicroFinanceNetwork: Association for Social Advancement (Bangladesh), Fundusz Mikro (Poland),CHISPA (Nicaragua) and Centenary Rural Development Bank (Uganda). We look forwardto their participation and contribution to the Network, and to furthering our mutual objective ofincreasing the access of financial services for low-income communities.

    Finally, I want to take this opportunity to thank the supporters of the MicroFinance Network.Calmeadow continues to do an excellent job serving as the institutional sponsor of theMicroFinance Network. David Wright and the Department for International Development(formerly ODA) has contributed greatly to the Networks research agenda. The ConsultativeGroup to Assist the Poorest (CGAP) provides generous assistance that enables the Networkto increase the scope of its activities. Citibank and a private foundation have been helpful bysupporting the Networks special activities, including staff exchanges and our forthcoming

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    research project on corporate governance. I also want to thank Hank Jackelen and the UnitedNations Development Programme for providing resources toward the Networks annualconference. Finally, the Network would like to thank Marguerite Robinson for her ongoinginvolvement with the Network.

    Maria OteroChair, MicroFinance NetworkWashington, DC, USAJanuary 1998

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    TABLE OF CONTENTS

    FOREWORD.................................................................................................................................... i

    TABLE OF CONTENTS ............................................................................................................... iii

    TABLE OF TABLES ......................................................................................................................iv

    LIST OF ABBREVIATIONS...........................................................................................................v

    THEME I: OWNERSHIP...............................................................................................................1

    PRIVATE EQUITY CAPITAL IN THE MICROFINANCE INDUSTRY, Martin Connell...................................1

    TYPES OF OWNERS FOR MICROFINANCE INSTITUTIONS, Maria Otero.................................................3

    PANEL ON OWNERSHIP INNOVATIONS: K-REP, ACP, CITI S&L .........................................................9Ownership of the K-Rep Bank, Janet Mabwa..............................................................................9The Creation of MiBanco, Manuel Montoya .............................................................................13Experience of Citi Savings and Loans Company Ltd., Peter Ocran ...........................................15

    THEME II: COMPETITION .......................................................................................................19

    COMPETITION IN MICROFINANCE: MARKETS, PRODUCTS, AND STAFF, Michael Chu ........................19

    MARKETS......................................................................................................................................23Marketing Strategies in a Competitive Microfinance Environment, Hermann Krutzfeldt...........23Achieving Microfinance Market Penetration, Shafiqual Haque Choudhury...............................26

    PRODUCTS.....................................................................................................................................28New Product Development, Rosalind Copisarow.......................................................................28Small-scale KUPEDES: Product Development at the BRI Units, Jarot Eko Winarno ................31

    STAFF ...........................................................................................................................................33Preliminary Thoughts On How To Retain Good Staff In MFIs, Marguerite S. Robinson ...........33Staff Incentive Schemes, Nabil El Shami ..................................................................................37Private Sector Incentives for Senior Management, Michael Chu ...............................................41

    THEME III: CONTROL ...............................................................................................................44

    OVERVIEW ON MICROFINANCE FRAUD, Liza Valenzuela .................................................................44

    PANEL ON FRAUD AND INTERNAL CONTROL: BRI, K-REP, PRODEM..............................................47Internal Control Procedures at BRIs Unit Division, Suharsono ................................................47The Experience of Fraud at K-Rep, Janet Mabwa .....................................................................52Everything You Wanted to Know about Fraud, Edurardo Bazoberry.....................................54

    AUDITING: THE MISSING DIMENSION IN MICROFINANCE, Hank Jackelen ........................................56

    APPENDICES

    LIST OF CONFERENCE PARTICIPANTS ............................................................................................A-1

    MICROFINANCE NETWORK MEMBER LIST.....................................................................................A-2

    MICROFINANCE NETWORK MEMBER STATISTICS ..........................................................................A-5

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    TABLE OF TABLES

    Table 1: What is at Stake for Microfinance Owners? ..........................................................................5

    Table 2: Ownership/Capital Structure of the K-Rep Bank.................................................................10

    Table 3: Ownership of MiBanco.......................................................................................................14

    Table 4: Evolution of the Bolivian Financial System (1992-1997) ....................................................24

    Table 5: Diversification of the Bolivian Financial System (1992-1997) ............................................24

    Table 6: Changes in the Bolivian Financial System (1992-1997)......................................................25

    Table 7: Market Share: BancoSol and the Competition.....................................................................25

    Table 8: Fundusz Mikro Pilot Program Analysis ..............................................................................29

    Table 9: Freedom of Choice: Guarantors and Interest Rates at Fundusz Mikro .................................30

    Table 10: ABA Incentive Scheme/Portion A.....................................................................................38

    Table 11: ABA Incentive Scheme/Portion B.....................................................................................38

    Table 12: ABAs Incentive Scheme for Back Office Staff .................................................................39

    Table 13: A Sample of MFI Fraud Cases from Around the World ....................................................45

    Table 14: Fraud Survey: United States Banks (1993)........................................................................48

    Table 15: Management and Control Function for Financial Institutions ...........................................51

    Table 16: Treasury Risks, Controls, and Auditing Procedures ..........................................................56

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    LIST OF ABBREVIATIONS

    ABA Alexandria Business Association

    ACP Accion Comunitaria del Peru

    AfDB African Development Bank

    ASA Association for Social Advancement

    BDB Bank Dagang Bali

    BIMAS Integrated Mass Guidance

    BRAC Bangladesh Rural Advancement Committee

    BRI Bank Rakyat Indonesia

    CABEI Central American Bank for Economic Integration

    CAF Corporacion Andina de Fomento

    CDC Commonwealth Development Corporation

    CGAP Consultative Group to Assist the Poorest

    DFID Department for International Development

    EDPYME Entidades de Desarrollo para la Pequena y Microempresa

    EO Extension Officer

    ESOP Employee Stock Ownership Plan

    EQI Environmental Quality International

    FFP Fondos Financieros Privados (Private Financial Funds)

    FMO Nederlandse Financierings-Mautschappij Voor Ontwikkelingslanded

    IDB Inter-American Development Bank

    IFC International Finance Corporation

    IFI Instituto de Fomento Industrial

    IIC Inter-American Investment Corporation

    IT Information Technology

    K-Rep Kenya Rural Enterprise Program

    KUPEDES General Rural Credit

    MFI Microfinance Institution

    MIF Multilateral Investment Fund

    MIS Management Information Systems

    NBFI Non-Bank Financial Institution

    NGO Non-Governmental Organization

    ODA Overseas Development Administration

    PRODEM Fundacion para la Promocion y Desarrollo de la Microempresa

    ROSCA Rotating Savings and Credit Associations

    SIDI Societ dInvestissement et de Developpement International

    SME Small and Micro Enterprise

    USAID United States Agency for International Development

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    THEME I: OWNERSHIP

    PRIVATE EQUITY CAPITAL IN THE MICROFINANCE INDUSTRYMartin Connell, President, Calmeadow, Canada

    The leaders of the microfinance industry are committed to delivering sustainable andcommercially viable microfinance services. This is a tremendous challenge, particularly fornon-governmental organizations (NGOs) that establish regulated financial institutions. Forinstitutions that succeed in making this transformation, it will irrevocably change the nature oftheir business and how it is run. One key component of transformation is the raising of privateequity capital.

    As NGOs around the world contemplate transforming into commercial ventures, the level ofinterest in how and where to source private equity capital has risen dramatically. However, theharsh reality is that, with few exceptions, private sector portfolio equity capital is basicallyunavailable. By portfolio investment, one refers to capital from private individuals,corporations, investment funds, and financial institutions, which assume minority positions inmicrofinance institutions purely for profit.

    Alternatively, various forms of social capital are available to the microfinance sector. Thesecapital sources sometimes get confused with private capital because in many respects theymimic it in their expectations and terms. This social capital comes primarily from privatefoundations, certain NGOs, some public institutions, and a handful of wealthy, progressively-minded and sometimes politically-motivated individuals and corporations.

    It is encouraging to witness the successful equity financing and subsequent commercializationof a few institutions, such as BancoSol and Caja Los Andes in Bolivia, ACP in Peru, and K-Rep in Kenya. However, because there are some misconceptions about the availability ofcapital sources, a number of NGOs spend a great deal of time pursuing funds that do not yetexist. Quite simply, because the microfinance industry has not demonstrated its comparativeadvantage as a profitable equity investment opportunity, pure private capital is holding backand waiting for results. Since this is the situation, it is better for microfinance institutions(MFIs) to focus their efforts where the opportunities do lie.

    Sources of Private Capital

    The following is a list of investment capital resources that are keen on the microfinance sectorand have accessible funds, albeit with a current bias towards Latin America:

    Private social capital Private social capital includes a limited number of private foundations,like Ford and Rockefeller; North American NGOs such as ACCIONs Gateway Fund andCalmeadow; and a handful of private individuals and corporations, including The CalvertGroup, Shorebank, and Triodos.

    Public social capital These are public funds working in a private sector manner for socialgood. Examples include the International Finance Corporation (IFC), Corporacion Andina de

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    Fomento (CAF), the Multilateral Investment Fund (MIF) and the Inter-American InvestmentCorporation (IIC) of the Inter-American Development Bank (IDB), FMO from theNetherlands, Central American Bank for Economic Integration (CABEI), BAWI of the SwissGovernment, and the Commonwealth Development Corporation.

    Private investment funds These funds, which specialize in microfinance, are backed bysome of the same private and public institutions listed above. To date, ProFund of Costa Ricais the only private sector investment fund that exists specifically for microfinance. However,Calmeadow is conducting a study to determine the feasibility of creating a similar fund forAfrica, and the Department for International Development (DFID) and the IFC have asked forproposals to prepare a feasibility study for an Asian fund.

    Local private capital sources - These sources are motivated primarily by public relationsconcerns or opportunities, rather than the return on their investment. For example, the originalBolivian bank shareholders of BancoSol fall into this category, as does Citibank (Colombia)and another leading Colombian private bank, which have recently become shareholders inFinansol.

    All of these sources are already committed to the same broad social development objective astheir prospective microfinance investees. The drawback, for the moment at least, is that mostof these investors have a Latin American focus. Hopefully, this will expand as opportunitiescontinue to appear in other regions.

    Attracting Private Capital

    Locating this capital is one thing, attracting it is another. To attract equity capital, MFIs haveto deal with some key elements that will influence the investment decision. These issuesinclude:

    The institutions operational maturity, including expertise and competence Its commitment to transformation and sustainability The existence of a conducive regulatory and political environment, and the institutions

    relationship with the political and regulatory authorities

    The mission and focus of the investee, which must be consistent with investor The financial health and indicators of the institution, such as the number of loans

    outstanding, the average loan size, and the pattern of portfolio growth

    The quality of the portfolio including loan loss ratios and arrears The potential to attract debt capital and deposits The level of profitability, including the institutions comparative operating costs and

    spreads

    Investors will also want to assess the institutions competitive position in the local market.This standing can be assessed through reputable market research that indicates the demand formicrofinance services is compatible with the institutions growth strategy, and an analysis ofthe institutions strengths and weaknesses vis--vis current and potential competitors.

    Depending on whether the investor wants to assume a passive or active role, the institutionsgovernance structure and its openness to potential involvement at the boardroom table mayinfluence the investors level of interest. Another factor influencing investment will be the

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    degree of involvement with local investors and/or donors. The involvement of local investors isusually an advantage, since foreign investors with social objectives consider their role astransitional until purely private capital can be attracted to this market. This leads to the finalpoint: investors want to ensure that there is a realistic exit strategy for their investment. Byway of example, if the company will eventually be listed on the local stock exchange, this willpresent an opportunity for investors to sell their shares.

    Is It Worth It?

    After defining the opportunities, the requirements, and a few of the strategies needed to acquireequity capital, it is necessary to ask if it is worth it? Is the cost of transforming and pursuingthis capital worth the price? The price refers to the legal, financial, and psychological priceof inviting equity investors into a microfinance institution.

    Most NGOs are in control of the management of their enterprise. The managing director or theexecutive team runs the business, develops the strategies, and maintains the mission. Theboard is generally supportive and compliant. This is a fairly comfortable situation.

    Entering into a relationship with outside investors can irrevocably change the nature of theinstitution. It usually requires a radical reorganization of the governance structure, raises thelevel of expectations, creates intensive and often intrusive involvement from governmentregulators, and exposes the institution to the dictates of a market that requires a permanentcommitment to increasing growth and profitability. Management becomes accountable forresults and vulnerable to job insecurity.

    The decision to pursue private equity capital is a difficult one. The institution has to have astrong enough desire to accept the challenges and requirements of becoming a fully regulatedfinancial institution. Management needs to be prepared to deal with outside shareholders whodemand a say in the business and in their employment.

    On the plus side, equity is permanent capital. In a regulated context, equity can leveragedeposits and borrowed capital, allowing the institution to increase its scale significantly. Forexample, BancoSol with an original equity of US$6 million now has total assets of US$50million. Only equity can make serious growth possible, and it replaces the tedious process offorever chasing after grants. Depending on the types of investors the institution attracts,shareholders can bring valuable expertise and guidance to the institution, and their financialstake in the institution heightens their commitment to provide these resources. In addition, bybecoming a regulated financial institution, an MFI can offer an increased variety of financialservices, including savings, which provides better service to its customers.

    In sum, transformation is a big step. Once committed, there is no going back. NGOs willwant to consider it carefully.

    TYPES OF OWNERS FOR MICROFINANCE INSTITUTIONSMaria Otero, Executive Vice President, ACCION International, USA

    Ownership of microfinance institutions has recently become an issue of consideration, and it isquickly becoming an important one. Its importance emerges as more and more NGOmicrofinance institutions are creating regulated financial institutions in order to access

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    commercial sources of funds and expand the outreach of their operations. In addition, NGOsare recognizing the benefits, to the clients and to the institution, of offering full financialservices, including savings deposits. Both factors require that NGOs become some type ofregulated financial institutionbe it commercial bank, non-bank financial institution (NBFIs),or credit union. The process of transformation places ownership in the forefront of themicrofinance discussions.

    The mission of most microfinance institutions, whether regulated or not, encompasses a socialobjectiveto provide financial services to as many low income or poor entrepreneurs aspossibleand therefore raises an additional challenge to the discussion of ownership.Regulated MFIs generally aim to incorporate the lowest sectors of the productive labor forceinto the formal financial system and thereby expand the financial sector reach. Therefore,while MFIs are becoming commercial institutions, and are concerned with the bottom linereturn on investment, level of earnings, and other measures of profitabilitythey neverthelessmaintain a combination of social and commercial objectives that are unlikely to be found inother commercial ventures.

    Because of its roots in the development field and its social mission, microfinance launched itsfirst programs over twenty years ago with subsidized funds from various sources. As the fieldhas become more commercial in its orientation, it has attracted investors who, unlikefoundations or multilateral donors, are seeking a return for their investment. Today,microfinance institutions have owners who are motivated by different priorities and interests,emerging from their emphasis on social development or profit concerns. This combination ofowners seldom exists in most private businesses. As a result, microfinance institutions need toconsider the combination of different types of owners that comprise the institutions ownership,their various motivations, and how they relate to the long-term survival of the institution.

    This discussion of ownership of microfinance institutions has two objectives: 1) to understandwith greater clarity the various perspectives of different types of owners; and 2) to explore howthese characteristics affect the institution.

    Ownership and Governance

    Different types of owners bring different attributes to a microfinance institution. Thecharacteristics of microfinance owners are manifested in the roles they play. One of the keyroles is in the area of governance. Owners comprise or elect the governing body of theinstitution. Governance refers to the ability to create accountability for the institution. Thisrequires owners, through their agents on the board, to hold management accountable, tomeasure their performance, and to compare their achievements with targets to whichmanagement and the board have established.

    Good governance requires two elements: duty to loyalty and duty to care. Duty to loyaltymeans the members of a governing body operate in good faith, in the best interests of theinstitution. Their decisions are not influenced by priorities or concerns that relate to otherprofessional or personal issues. Duty to care is the expectation that members of a governingbody make a responsible effort to be fully informed about the institutions activities, financesand plans, which in turn allows them to make good decisions. In addition to enforcingmanagement accountability, owners of an institution need to align themselves to these twoelements of governance.

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    Types of Owners

    We have established that microfinance institutions have various types of owners. To comparethe merits of each type, it is useful to measure the role of different owners against thisdefinition of governance. To do so, it is necessary to establish what the different owners ofmicrofinance institutions have at stake. In other words, what is in it for them? Why are theyinvesting and playing this governance role? Table 1 outlines what is at stake for differenttypes of investors involved in microfinance, assuming responsible deployment of their role asowners.

    NGO Private Investors Public Entities Specialized EquityFunds

    Moral responsibility Return on investment Political concern Return on investmentInstitutional mission Capital preserved Entering the field Institutional missionReturn on investment Social sense of responsibility Return on investment Long-term concernLong-term concern Good projectInstitutionalcredibility or image

    Each of the owner types are concerned with a return on their investment, however there are twoimportant differences. First, typically the return on the investment is primary concern forprivate investors and equity funds, whereas NGOs and public entities may have otherpriorities. Second, NGOs and some public entities may measure the return on investmentdifferently than other types of owners. Instead of, or in addition to, the financial return on theinvestment, social investors may be concerned with a social return, such as the depth (howpoor are the clients?) and breadth (how many clients?) of outreach.

    The first column in Table 1 refers to NGOs that are investors in microfinance institutions, suchas PRODEM which currently owns 35% of BancoSol, or K-Rep Holdings which will own25% of the K-Rep Bank (as discussed in more detail below). NGOs have a sense of moralauthority and their institutional mission at stake when they assume an ownership role in a for-profit financial institution. Their investment serves as a means for the NGO to further itsmission. Therefore, their role is to ensure that the MFI does not lose sight of the social agendaof its NGO owner. In addition to expecting a social and financial return on their investment,NGO owners have a long-term concern for the institution. Since the NGO continues to workin the microenterprise development field in some capacity, it is committed to this investmentfor the long-term.

    Private investors are concerned that their return be enhanced and that their capital bepreserved. But as discussed above, considering the level of maturity of the microfinance field,pure private investors are rare or non-existent. To date, the majority of private investment inmicrofinance has some sense of social responsibility.

    There are other considerations for public entities. These owners have political concerns atstake, in the broadest sense of the word political. Public investments in microfinance areoften the result of a directive from above. Consequently, these owners may be less concernedabout their financial return than with the mere fact that they have entered this market. TheWorld Bank serves as an example. The interest of the IFC in microfinance has increased asthe World Bank President highlights the importance of microfinance and instructs the agency

    Table 1: What is at Stake for Microfinance Owners?

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    to address it as part of its portfolio of investments. Public entities also have an interest inbeing involved in good projects. The return on investment may not be as important as theassurance that the investor will gain (or at least not lose) something in terms of its publicimage by investing in a particular institution. This suggests that what is at stake for publicinvestors is quite different from the objectives of other investors.

    Specialized equity funds for this sector, such as ProFund in Latin America, are concernedabout their return first and foremost. They are concerned not just about the return on capital,but also assurance that the risks for the fund are properly managed, and that the investmentsmeet the criteria outlined by the funds charter. But these owners also have an institutionalmission at stake. Like NGOs, they are concerned about the long-term success of this field.

    The Impact of Ownership Characteristics on MFIs

    The perspectives and nature of the various institutional types have a significant impact on theinvestors. All investors want to make sure they can withdraw their money at some point. Butsome investors are driven by short-term earnings, and will pull their money out if there is a dipin the earnings. Others are willing to stay in for the long term. Given the immaturity of themicrofinance industry, and the fact that a change in the ownership composition can bedisruptive, at this point MFIs generally prefer patient, long-term investors.

    Owners may assume an active or passive role. An active owner is involved in the governanceof the institution, and has the capacity to play an active role. This requires that owners havethe skills to participate actively, and can carry out their duty of care effectively. An activeowner is able to spend the time, to take the trips, and to make the effort, and has the resourcesnecessary to fulfill its governance role. Each owner brings a different set of skills to assist theinstitution to maintain quality and grow. Their effectiveness depends not just on their skills,but also their capability to deploy that expertise so that it is available when it is required.

    Another characteristic of owners is their continued access to capital, particularly equitycapital. This is important for two reasons. First, under certain conditions, such as thefinancial crisis at Finansol where recapitalization was required, access to additional capital inan expedient manner is critical. Second, access to additional capital is relevant when there is asale of shares. Existing owners have the right to first refusal, and they may or may not havecapital to purchase additional shares. If the institution wants to grow and existing owners donot have additional capital, their stake and voice will become diluted in the process of issuingnew shares.

    Ownership Patterns

    There are some patterns that emerge in the relationship between ownership types and thefeatures of ownership. However, it is hard to generalize about any type of owner and makeassertions that the owner will have certain characteristics because there are many differentfactors involved. Under certain circumstances NGO owners can benefit the institution by theway they execute their governance responsibilities. The same is true of many private investors.Public entities, however, are the least likely to provide effective governance because theirpolitical stake in the institution is usually not a sufficient incentive for them to play an activerole. Given other responsibilities and internal award systems, serving effectively on a board isnot a priority. Even though specialized equity funds are funded by public sector funds,because of their stake in the development of the microenterprise field in general, they tend tocombine some of the best characteristics of the NGOs and private investors. There is a

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    compelling and interesting argument for the way equity funds can function in the ownershipposition, even though they are still channeling public funds.

    Another pattern is that a microfinance institution should try to strike a balance in itsshareholder composition to have an ownership structure that will bring the strengths of thevarious types of owners to the table. For MFIs that serve a social and a commercial mission, itis beneficial for the ownership composition, through the motivation of individual owners, tocombine these dimensions.

    Discussion

    BancoSol. Even though the bank has been operational for five years, ownership at BancoSolcontinues to evolve. Ownership is a very important issue for microfinance practitionersbecause owners appoint the directors, and the directors guide and approve (or reject) thestrategy of the institution. Consequently, the directors have the authority to ensure that theinstitution is pursuing its mission, whether it is social or otherwise.

    The main change that has occurred in the ownership structure of BancoSol in the past year wasthe sale of the shares of IIC (approximately 20 percent) to three existing shareholders. Therewas an agreement among the original shareholders for the right of first refusal. If existingshareholders had been unwilling or unable to purchase the shares, it is unclear what wouldhave happened. The market for variable income securities in Bolivia is still in its infant stage.

    In Bolivia, there are two main aspects that the Superintendency of Banks considers beforegranting a license: management skills and ownership. The Superintendency wants to see thatowners have something at stake. This issue is exemplified by a Bolivian NGO that has beenwaiting for the Superintendencys approval for the past 18 months. The delay stems from thefact that the proposed owners of the new institution consist solely of other NGOs, which inturn do not have owners.

    If owners and their directors do not have a common vision of the institution, it makes itdifficult for them to give management an explicit mandate to lead these companies. Theobjectives may be social or profitable, but if they are not clearly established from thebeginning, it is very difficult to adopt them along the way. Consequently, the transformation ofan NGO into a regulated financial institution requires long-term vision and foresight on thepart of the founders.

    Owners and directors play a variety of roles. Some are active, others are not. But in the end,they have to deliver. They cannot just give speeches. The microfinance field, which is stillgrappling with this issue of ownership, needs strong and involved owners that can serve as rolemodels for prospective owners of other transforming institutions. A role model owner is astrategic ally, who is involved and ready to lead the organization through an evolution. Astime passes, the corporation goes through different stages of development, which requires anevolution of institutional strategies. A role model owner is a strategic ally who is involved andready to lead the organization through this evolution.

    Social Ownership. Many leading MFIs, particularly NGOs, are concerned about an ownershipperspective that requires the involvement of external private capital. These institutions aremore interested in social ownership than attracting investors. Ownership does not just connotean economic definition. It also has a social or psychological aspect. The ownership

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    relationship between the founders of an NGO and their organization is akin to a fatherowning his son.

    In some circles, there may be a contradiction between microfinance and private investors.Many MFIs, particularly in Asia, have not developed to the point where they are an attractiveinvestment for external shareholders. Successful microfinance institutions in Bangladeshgenerate a 3 to 4 percent surplus at the most, but this return is not sufficient to attractinvestors. Private sector investors look for profits, whereas microfinance institutions are moreconcerned about working for the good of others.

    The commitment of the management and staff of MFIs, who strive every day to work for thegood of others, should also be considered a form of ownership. These people labor andsacrifice to build sustainable institutions. Through this effort, microfinance practitionersinvest a different type of equitysweat equity.

    In addition to the social ownership of MFIs through the labors of staff and management, theseinstitutions consider their clients as owners. But one cannot get a large amount of funds fromthis type of owner. This necessitates searching for other sources for funding, but notnecessarily equity investors. If the microfinance industry suddenly adopts real financialownership by private sector shareholders, the whole sector may encounter problems becausethe motivations of private investors are likely to be contradictory to the institutions mission.

    On the other hand, the issue of ownership is not about shareholders making a profit on thebacks of low income borrowers. If an MFI avoids having owners because it is worried thatthey will hijack the institutions mission, it will miss out on the benefits that investors bring tothe institution, in the form of sustainability over time, good governance, and bettermanagement, which will ultimately benefit more people and have a greater social impact.

    The issue of ownership implies control. And control raises the issue of governance. Noownership structure is perfect. This discussion helps to outline the link between ownership,control, and governance. If we protect the social mission of the institution, perhaps throughownership by borrowers, this has implications in terms of governance. How can two millionborrowers exert governance in an institution? With this ownership structure, great emphasis isplaced on the governance exercised by management. Some managers will be great, but otherswill be prone to the temptations of having relatively unsupervised control. At the otherextreme, in a situation with private investors, there is the possibility that they will hijack thesocial mission of the institution to achieve a greater return on their investment. No solution,including sweat equity, is perfect. The challenge for the microfinance communityowners,directors, and managers alikeis to craft the best solution possible, and this may involvecombining various types of owners to reflect the social and commercial missions of MFIs.

    K-Rep. In K-Reps short experience with prospective owners it has come to realize that thecharacteristics of microfinance ownership by public entities depends largely on the individualswho represent these organizations. It can be advantageous to the MFI if the representative ofthe public entity is capable and committed, but if the individual is an uninformed bureaucrat,he or she can create problems. During the time K-Rep has negotiated with various publicinvestors, the responsible personnel have changed with some regularity, which significantlyalters the focus and characteristics of the prospective owner. This has the tendency to prolongthe negotiation process.

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    Another tension, which remains unresolved, is the potential involvement of individual privateinvestors whose motive is purely profit. There were a few individuals who wanted to invest inK-Rep Bank, but through early discussions it became clear that their motivation would haveundermined the development focus of the bank. They were looking for an opportunity only tomake money, so K-Rep excluded them. In the future, when K-Rep Bank goes public, theinstitution needs to resolve how to maintain its mission without unnecessarily interfering in themarket for its shares.

    While social ownership is an admirable objective, it is challenging to implement. K-Reps firststep toward social ownership is an employee stock option program (ESOP), the details ofwhich are discussed below. Ultimately, K-Rep intends to transfer the ownership of the bank toits clients by going public. One of the negotiation points with all the current investors is thatthey must divest in five years to allow this to take place. This solution resolves the investorsconcern regarding an exit strategy, and it guarantees that the bank will have patient investorsfor a specific period to establish a track record.

    Conclusion. From an historical perspective, this discussion of microfinance ownership isinteresting because it completes the circle. The persons who originally supplied financialservices to this market, the moneylenders, are private individuals. The relationship betweenthese original lenders and the market is one of high profitability. Subsequent entrants into thisfield were non-profit lenders, the NGOs which operated, and continue to operate, with publicresources. But public resources are finite. In the long run, for microfinance institutions toachieve their social mission by providing financial services on a large scale, they will need toattract private investment. What will make it attractive for private money to get to thismarket? Growth and profitability, which reflect the twin mission of MFIs.

    In some markets, particularly in Bolivia and to a lesser extent elsewhere, private capital isentering this market purely for commercial reasons. This is likely to change the nature of thisbusiness. In the near future, the microfinance community will see how the involvement ofprofit-driven capital affects institutions that are trying to balance social and commercialobjectives. The challenge for leading MFIs is to demonstrate that there does not have to be aconflict between their social mission and private investment.

    PANEL ON OWNERSHIP INNOVATIONS: K-REP, ACP, CITI S&L

    Ownership of the K-Rep Bank

    Janet Mabwa, Finance and Administration Manager, K-Rep, Kenya

    K-Rep Bank was incorporated in June 1997. The official launch of the bank was originallyscheduled to take place between August 1997 and February 1998, but it was postponedbecause of the political situation in Kenya toward the end of 1997. K-Rep is concerned thatthe bank may be perceived as partisan if it is launched during the general election period,therefore the launch will be postponed until 1998.

    The ownership profile of the K-Rep Bank is outlined in Table 2. Originally, K-Rep intended tobe the majority shareholder with over 51 percent of the shares. However, Kenyan bankingregulations limit the ownership percentage of an investor to a maximum of 25 percent if theshareholder is not a commercial bank. Consequently, K-Rep needed to bring other investors to

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    the table even though its asset base was large enough to meet the minimum capitalrequirements for a bank.

    Besides K-Rep Holdings, the only local investor is Kwa Multipurpose Co-operative Society,which is a vehicle for employee ownership of the bank. Because of the 25 percent ownershiprestriction, K-Rep brought in its assets (including loan receivables) into the bank throughconvertible income notes that serve as quasi equity worth some US$4 million in the bank. Thislong term debt resembles equity: it does not have a fixed return and it is retired only when thecapital structure is changed, such as when the company goes public. The income notes earnreturns only when dividends are declared, however they appreciate through retained profits.

    The few local prospective investors that were interested did not have the corresponding socialmission that K-Rep required. K-Reps board was concerned about the possible influence thatthese investors might have and decided to exclude them from the ownership structure. Sincelocal investors were either not interested or not appropriate, K-Rep turned to foreign investorswho currently own 65 percent of the shares. They have agreed to exit through a sale of sharesto local investors in five years.

    Shorebanks investment consists of two pieces. Half of the investment is a grant from FordFoundation to Shorebank to invest in K-Rep, and the other half comes from its own resources.Of the foreign investors, Shorebank was allowed to hold the largest percentage of sharesbecause it has a decidedly development focus. This arrangement allowed the investors with thestrongest social missionK-Rep, Kwa, and Shorebankto control 53 percent of the shares.K-Rep has an agreement with Shorebank that when it divests its interests, the portion thatcame from Ford Foundation will be placed at K-Reps disposal.

    The ownership percentage of the other shareholders was determined based on the amount theywere willing to invest and the remaining available shares. K-Rep believes that all of its foreignowners will bring strong financial and commercial discipline to the bank.

    Governance

    The bank will be governed by a seven-person board of directors consisting of individualsselected by the shareholders. Shareholders with a minimum of 10 percent of the shares can

    Table 2: Ownership/Capital Structure of the K-Rep Bank

    Investor OwnershipPercentage

    Amount Invested(US$)

    K-Rep Holdings Ltd. 25.0 1,496,000Kwa Multipurpose Co-operative Society Ltd. 10.0 598,000Shorebank Corporation 18.0 1,077,000International Finance Corporation 16.7 1,000,000African Development Bank 16.7 1,000,000Triodos Bank 8.6 513,000FMO 5.0 299,000

    Total Equity 100.0 5,982,000

    K-Rep Income Notes (quasi equity) 4,000,000Ford Foundation long-term loan 1,000,000

    Total Capital Base 10,082,000

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    appoint one representative, and two or more shareholders may combine their shares to qualifyto appoint a director. However, Kwa shares are a special class which does not carry votingrights, and therefore Kwa does not have a board seat. This was established to ensure that thethree organs of the bankthe board, management, and stafffunction semi-independently ofeach other.

    The banks board will consist of representatives of the following institutions: two from K-RepHoldings Ltd., one each from Shorebank, the IFC, the AfDB, and from FMO/Triodos, and oneexternal director.

    Process of Identifying Investors

    The organizations first step in identifying investors was to turn to its previous sources ofcapital, namely donors such as USAID, Ford Foundation, and ODA (now DFID), as well asinformed individuals. They provided contacts and suggestions, some of which materialized,such as Ford facilitating the relationship with Shorebank.

    K-Rep prepared a business plan, which it sent to prospective investors. The plan wasaccompanied by a request asking them to express interest, in terms of mode and percentage ofinvestment. The initial response to this request was not particularly promising. It took almostone year to identify equity in sufficient amounts.

    From the positive responses it received within a specific time frame, K-Rep selected strategicpartners based on investors that would:

    bring knowledge and expertise governing similar institutions give the bank a strong public image have resources for additional investments if necessary protect the K-Rep Bank from political interference have clout to influence Kenyan authorities

    The strategic partners also needed to share K-Reps vision and aspirations, and be willing todivest in five years. Ultimately, K-Rep chose only institutional rather than individual investorsbecause their motivations were more transparent.

    These shareholders follow the pattern of public entities, as described above, in that theirprimary motivation seems to be the image that accompanies their investment in a goodproject in microfinance. For these institutions, ownership in K-Rep Bank requires a politicalrather than a financial investment. This is exemplified by the fact that the return they expecton their investment is linked with the local savings deposits rather than real earnings withcommercial investments.

    Besides excluding individual investors, there were several institutional investors that wereeventually excluded from the ownership composition of the K-Rep Bank. Timing is one factorthat led to exclusion. Calmeadow did not make the list because it was not able to commit whenit was time to make the final decision. It requested to reserve the right to buy shares at apremium in one year. The other shareholders however were not in a position to accept thisproposal because they had no basis to determine the future value of the shares. Secondly, theywere reluctant to have their stakes diluted at that point. K-Rep also excluded the EcumenicalDevelopment Cooperative Society because it proposed a mixture of debt and equity, and K-

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    Rep believed this would represent a conflict of interests. The Commonwealth DevelopmentCorporation (CDC) was also approached but it declined the invitation.

    Kwa: The Employee Stock Ownership Plan

    Kwa Multipurpose Co-operative Society was established to administer the K-Rep employeestock ownership plan. As a private company, K-Rep Bank cannot have more than fiftyshareholders. Therefore the society was a necessary vehicle to involve staff in the ownershipof the bank. The membership of the society includes the staff, management, and boardmembers of the K-Rep Group.1 The society is run by a management committee that is electedby all members once a year.

    Ten percent of the banks shares have been allotted to Kwa, which it will purchase with aUS$700,00 grant from CGAP and hold in trust for Kwa members.2 Kwa will assign sharerights to individual staff based on a formula that combines the persons rank in theorganization and their length of service. These rights allow staff to participate in dividendsfrom the bank proportionate to the rights they hold, and will allow them to own the sharesdirectly when the bank goes public. Staff will also benefit if the value of the sharesappreciates. Staff are free to trade their rights among Kwa members. Kwa will arrange forannual valuation of shares and charge a small brokerage fee for facilitating this trading.

    To qualify for the assigned rights, Kwa members must be an employee or board member of theK-Rep Group, and have served K-Rep for at least three years uninterrupted. Eligible staffhave to agree to purchase one right for every three rights of the banks shares that areapportioned as a bonus. To purchase their rights, staff can borrow from Kwa at 9% p.a. forfive years. This requires staff to demonstrate some degree of commitment and have somethingat stake, so that their ownership of the bank is not just a gift that they do not take seriously.Staff forfeit their rights if they leave K-Rep voluntarily before completing three years. Noindividual can hold more than 5 percent of the assigned rights.

    While it is expected that most, if not all, employees will be members of Kwa and participate inthe stock option scheme, it is entirely voluntary. K-Rep will not compel anyone to join.Participants must be aware that, like any investment, the banks shares carry a risk element,and K-Rep advises Kwa members to conduct their own due diligence.

    Kwas allotment of rights consist of 67,000 units of the banks shares. Of these units, 20,000will be allotted to staff up front (15,000 as a bonus and 5,000 sold at a discounted rate). Therights to the balance are retained in the Kwa treasury to be allocated during the five yearperiod before the bank goes public. Kwa will issue the balance as a bonus to current staffmembers and to new staff once they have met the three year eligibility requirement. Kwa willretain the portion of dividends for undistributed rights. When the bank goes public, staff willhave direct ownership corresponding to the rights they hold. 1 The K-Rep Group is a conglomerate of for-profit and non-profit development organizations that wasestablished by K-Rep in pursuit of its development mission. Presently the conglomerate consists of threeorganizations, K-Rep Holdings, Ltd. (KHL), K-Rep Development Agency (the NGO), and the K-Rep Bank. Inthe future, KHL hopes to establish other development companies such as a micro-insurance company, a micro-mortgage finance company, micro-assets management company (investment funds), and a developmentconsulting company.2 Of this grant, US$598,000 will be used to purchase shares, and the balance will cover related development,valuation, administration, legal, and trusteeship expenses, and local and international technical assistance costsrelated to the development of the ESOP.

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    The Creation of MiBanco

    Manuel Montoya, Managing Director, ACP, Peru

    In 1996, Accion Comunitaria del Peru (ACP) announced its intention to create an EDPYME, acategory of non-bank financial institution recently established by the Banking Superintendencyto serve the micro market.3 While ACP had intended to create a commercial bank in the long-term, it considered the EDPYME framework an appropriate initial step as well as a learningstructure, for bank regulators and for itself.

    At the Micro Credit Summit in February 1997, President Fujimori of Peru announced that hewanted to facilitate the creation of a commercial bank dedicated to providing financial servicesto microentrepreneurs, along the lines of BancoSol. The President even named the bankMiBanco. His invitation encouraged ACP to leap into the ocean of formal finance as acommercial bank rather than just dipping in its toe to test the waters as an EDPYME.

    MiBanco Investors

    Originally, the investors in ACPs proposed EDPYME included the NGO as well as ACCIONInternationals Gateway Fund and ProFund. However, when ACP decided to create a full-fledged bank, it believed that it would benefit from the experience of strategic partners from thePeruvian banking sector. With the governments support, two commercial banks, Banco deCredito de Peru and Banco Wiese, were invited to be shareholders to provide that experience.ACP also believed that these shareholders would help convince the clients of the bank that thiswas a private initiative, since it assumed that clients would not repay their loans if theybelieved these originated from public funds.

    ACP accepted the Presidents invitation on two conditions. The first condition is that thisinstitution would be capitalized solely with private resources. The second condition is that theboard and management would be determined by Accion Comunitaria. This arrangement wasacceptable to the government as long as ACP created a commercial bank named MiBanco andallowed the government to have a non-voting representative on the board for the first two yearsof the bank.

    The target capitalization for MiBanco is US$16 million, although the bank will be launchedwith approximately US$7 million. The logic behind incremental increases in equity is to avoidovercapitalization, which leads to zero leverage and therefore a low return on shareholdersequity. Since the current assets of the bank are approximately US$7 million, the debt to equityratio is about 1:1, far below a preferred target for MFIs of 5:1. As the assets of the bankincrease (i.e., as the loan portfolio expands), the board will call for additional injections ofequity to fuel the banks growth.

    The ownership structure of MiBanco is outlined in Table 3. Once the bank reaches its targetcapitalization, ACP will have invested US$10 million. These resources come not from donorgrants, but rather from retained earnings that it has accumulated over the past seven years.ACP is investing this sizable sum because it wants to maintain control of the banksoperations.

    3 Entidades de Desarrollo para la Pequea y Microempresa or Development Entities Serving Small and MicroBusinesses.

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    In two years, ACP expects that MiBanco will initiate a citizen participation plan by sellingUS$1 million of shares to clients and staff. The organization feels that it is necessary todemonstrate the performance of the institution first before it makes shares publicly available.As an exit strategy, ProFund and ACCIONs Gateway Fund have an option to sell their sharesin seven years, and the shares will be valued either through the stock exchange or negotiated asa put option.

    Private Shareholders

    As a facilitator, the government used its influence to encourage the private banks to invest inMiBanco. It is unclear whether the banks would have deemed a US$1 million investmentworthy of the time and trouble if it were not for the governments involvement. In fact, ACPhad to encourage the government not to solicit more investments for MiBanco since this wouldhave compounded the problem of being under-leveraged.

    Another reason the banks may be interested in this investment, despite the small size and theextra work, is to learn more about operating in the microenterprise market. ACP has not madeany arrangements with its two bank investors regarding competition. MiBanco must rely onthe honesty of the members of the board to not pass on competitive information. ACP is notpreventing them from taking expertise and know-how from MiBanco and then entering themarket themselves because it believes that the market is big enough for everyone. Whilemicrofinance is not the cornerstone of either banks strategy, MiBanco must increase itsefficiency and marketing ability to prepare for this type of competition.

    Transformation Challenges

    One of the challenges of transformation is determining what the NGO will do after the bank iscreated and most of the staff and assets are transferred to the new institution. Possibilitiesinclude offering training services for the banks clients or developing new financial products.It is clear, however, that the NGO will not provide services that will ultimately compete withthe bank. In the long-term, the NGO needs to determine what it will do with money it receivesfrom selling the loan portfolio. There are not many alternative investment options where it canreceive the same levels of return that it gets from the microenterprise portfolio.

    From ACPs brief experience to date, it has learned that the costs of transformation should notbe underestimated. Conversion to a bank requires significant investments in security, cashierfunctions, and MIS, all of which must comply with banking regulations. In addition, theweaknesses of an institution become magnified in the transformation process. Since the bulk

    Table 3: Ownership of MiBanco

    Shareholder OwnershipPercentage

    ACP 60.00%

    ProFund 19.68%

    ACCION International 7.00%

    Banco de Credito de Peru 6.66%

    Banco Wiese 6.66%

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    of the NGOs capital came from retained earnings, it was not accountable to donors orshareholders. The banks investors, however, are expecting significant improvements inefficiency and productivity. Ultimately, the clients will benefit from changes demanded byshareholders in the form of improved service and lower interest rates.

    The bank will be governed by a nine member board consisting of five ACP directors and onedirector from each of the other four shareholders. The process of selecting directors reveals aninteresting transformation issue. Directors of NGOs have little legal responsibility, but thedirectors of a bank become liable for the institutions assets. This increased responsibility maycause some desirable directors to decline their nomination.

    Operations of the bank will commence in early 1998 and it is expected to reach 100,000borrowers by the year 2000, up from 30,000 clients in 1997. MiBanco will initially focus onproviding services in Lima and Callao where there is the highest concentration of unmetdemand for microcredit, but it expects to receive some political pressure to enter secondarycities in the near future. The bank does not intend to offer savings services immediately for acouple of reasons. There is significantly more competition for savings services than for microcredit. In addition, MiBanco wants its lending activities to be operating in full compliancewith banking regulations before it ventures in to the challenging world of mobilizing voluntarydeposits from low-income persons.

    Experience of Citi Savings and Loans Company Ltd.

    Peter Ocran, Citi S & L, Ghana

    While the public sector has an interest in promoting microfinance to serve a social or politicalagenda, private investors typically do not have the social mission to operate in the microfinancemarket. Citi Savings & Loans (Citi) is an exception. It is capitalized with funds from threeindividual shareholders. In order to gain insights into the potential role that private capital canplay in the microfinance field, it is useful to understand the motivation of the investors of Citi.

    Background

    Citi was incorporated in July 1992 and licensed under the Non-Bank Financial Institutions(NBFI) Act. As an NBFI, Citi can provide three financial services: 1) mobilize deposits fromthe general public, 2) extend loans, and 3) offer hire-purchase (leasing) services. Citi isgoverned by a four-person board comprising the three shareholders and an external director, allof whom are experienced bankers with a good knowledge of the financial sector.

    Citi was capitalized with US$500,000, in the following proportions: 66 percent, 27 percent,and 7 percent. This arrangement creates an obvious dominance of one person in theownership, governance, and daily operations of the company. This could be perceived as aweakness, but it can also be a strength. Since the owners are also the managers, theseindividuals have a stake in the operations and a commitment to ensure that it operatesefficiently. It should be pointed out, however, that the existing shareholders regard thisownership arrangement as temporary; they are actively seeking new shareholders in an effort tobroaden the ownership structure and to increase the institutions capital base substantially.

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    Vision and Results

    The vision of the original shareholders is to become the leader in the microfinance market inGhana by providing innovative, viable, and sustainable financial services to the informal sectorand to bring microentrepreneurs into the mainstream of commercial activities. The main focusis to deliver profitable and sustainable financial services to microenterprises, serving primarilywomen and the urban poor who do not have access to a formal financial intermediary. Citisthree branches are located in market centers dominated by female entrepreneurs, who constitutethe bulk of the countrys economic activity. Private sector development does not just mean bigcorporations. In Ghana, the vast majority of private sector activity occurs in themarketplacethe market that Citi was created to serve.

    So far, Citi has mobilized approximately US$1.6 million in deposits (13,000 savings accounts)and has an outstanding loan portfolio of US$1.2 million (2,500 active borrowers). This israther small compared to the size of the market, but Citi has experienced a rapid learning curveduring its first four years of operations. It has recently undergone an organizational andfinancial restructuring with the assistance of K-Rep, a relationship that was facilitated by theirmutual involvement in the MicroFinance Network.

    Shareholders Motivation

    Why did the shareholders leave their banking jobs to invest in an NBFC serving the micromarket? As entrepreneurs themselves, they identified a gap in the market which they thoughtthey could serve efficiently and profitably. The globalization of the financial sector is cuttingthe spreads for traditional commercial lending and forcing bankers to look for new markets andnew opportunities. In the informal sector, there is a massive demand for financial services,creating an obvious opportunity for anyone willing and capable of serving that market.However, it was not long before the shareholders realized that they could not divorce the socialand developmental perspectives from the purely private sector motives.

    Another reason why these investors, and presumably other private investors, would want toserve this market is because of the resulting satisfaction. The owners of Citi enjoy the fact thattheir investment is benefiting others, although this motivation is not typically emphasized inbusiness school or banking seminars. Citis shareholders have staked their reputation andresources to make an impact in the financial sector of the economy. They receive enormousjob satisfaction from the knowledge that they are providing a valuable service that benefits notonly informal businesses, but the family members of the entrepreneurs as well as the nationaleconomy.

    Stakeholders

    The current stakeholders in Citis ownership structure, in addition to the shareholders, are itsstaff members, clients, and regulators. When considering the ownership of the institution, therelationship between the shareholders and the stakeholders is of paramount importance. Theissues of ownership and governance are so inter-linked that it becomes impossible to separatethem. At Citi, the shareholders and the board are the same people, who perform the followingfunctions on behalf of the other stakeholders:

    They ensure that management maximizes the use of its assets to produce a good return oninvestments to keep both staff and shareholders fulfilled.

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    They ensure transparency and accountability to regulators, and meet regulators policy andprudential requirements.

    They establish institutional legitimacy to ensure that Citi has an appropriate place in themarket and that it offers products which meet the needs of its clients.

    They strive to uphold industry performance standards to ensure the sustainability of theinstitution.

    In addition, these functions are intended to produce results that will attract the interest of otherinvestors. This is in recognition of the need to increase capital to serve more clients and tomeet regulators liquidity requirements.

    Prospective Investors

    After four years, Citi has learned many lessons, which are being incorporated into its newcorporate strategy. Regarding ownership, the organization intends to invite new shareholders.This will broaden the ownership base and minimize the ownership and governance risk. Localfinancial institutions and foreign development agencies will be invited to participate in theequity of the company. Citi also wants to incorporate members of staff and local partnerintermediaries, such as susu clubs and collectors, as shareholders.

    Susu clubs would be appropriate investors because their mission closely parallels theinstitutions objectives. In Ghana, women constitute 70 percent of the informal sector and areimportant sources of livelihood for many low income families. With no access to formalcredit, they have established susu clubs to use rotational savings mechanisms to mobilize andcirculate surplus funds. Citi works with these groups by offering them bridging loans. Susucollectors form an important linkage in the mobilization of deposits. As Citi works with thesegroups of people, it is becoming apparent that they can be valuable business partners. Thispartnership will ensure that these important stakeholders share in the fortunes of the company,and in return they would give it their loyalty and ensure continued access to credit to the nichemarket.

    By incorporating staff into the ownership of the institution, Citi will be nourishing its mostvaluable asset: its human resources. If staff members are also shareholders, it will improvetheir sense of loyalty to the institution, it will instill a sense of belonging and commitment, andit will enable them to reap the benefits of their labors.

    Discussion

    Credit Unions. Mutual ownership, or client ownership, is the missing piece in thesepresentations. In French-speaking West Africa, there is a recent trend for credit unions toevolve into privately owned banks. This offers a very different picture from the examplesdescribed above because credit unions are client-owned. At this moment, there is a tendencyfor credit unions to open their capital to other investors, but they also try to preserve controlfor member owners.

    There are three reasons why credit unions become banks. First, the size of operations isgrowing and they need to access the capital markets to fuel their expansion. Second, a supply-driven situation exists where investors are looking for opportunities and encouraging thetransformation of credit unions into banks. Third, major credit unions are entering into a crisis

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    of control between members and staff, and they believe that opening the ownership will helpresolve this issue.

    Church Ownership. Another type of ownership that was not addressed explicitly by thepresentations above includes the church or other religious institution. Churches perhapsrepresent a sub-category of the socially responsible investors, but they tend to act more likepublic rather than private entities because, in a sense, they have a constituency to serve. Twomembers of the MicroFinance Network, Centenary Bank and Banco del Desarrollo, includechurch ownership.

    Centenary Rural Development Bank is basically owned by the Catholic church in Uganda.Centenary has three groups of shareholders: 1) the 18 Catholic dioceses own about 41 percentof the bank; 2) the Catholic Secretariat owns 50 percent of the shares; and 3) SIDI, a Frenchinvestment company, owns 9 percent. Centenary intends to go public in the next five yearsthrough the stock exchange that has recently been established in that country.

    Banco del Desarrollo in Chile is a commercial bank with a microfinance subsidiary. As ofOctober 1997, the parent bank had an equity base of US$143 million, with four principalowners: a) Fundacin para el Desarrollo, a development foundation linked with the CatholicChurch (13.9%); b) Inversiones Norte Sur S.A., an investment company related to themanagers and workers of the bank (14.0%); c) Caisse Nationale Credit Agricole, a largeFrench bank (18.1%); and d) San Paolo Bank, a large and old Italian bank (16.4%). Inaddition to these four main shareholders, FMO has a 5% stake, and the remaining 35% isowned by 3,500 individual shareholders, most of whom are clients of the bank.

    Banco del Desarrollo believes that a key issue that defines its owners is a concurrence inapproach and values related to business. At Banco del Desarrollo, the four principalshareholders have the same perspective on issues such as the value of work, people, the family,local community, and the importance of medium and small enterprises in the development of acountry. This common vision is very important when the bank has to make strategic decisions.

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    THEME II: COMPETITION

    COMPETITION IN MICROFINANCE: MARKETS, PRODUCTS, AND STAFFMichael Chu, President and CEO, ACCION International, USA

    Competition can be defined as the fight for the preference and loyalty of the users of a givenproduct or service. It follows that the level of competition is tied to the number of players inthe market. In recent years, the microfinance industry is beginning to experience heightenedlevels of competition, driven in part by the increase in new MFIs.

    Sources of Competition

    One of the reasons for the rise in practitioners comes as a result of a troublesome aspect of thefact that microfinance is currently in fashion in the field of development economics. This hasmeant an increase in new donor money available for microlending activities, which in turn hasled to replicating the conditions that have often caused disasters in financial marketsmoneyin hot pursuit of transactions.

    While this has lured new entrants into the field, these start-ups are often the most harmful typeof competition. Because their source of capital being transient, they cannot guarantee apermanent or reliable access of funds for their clients. Being donor- rather than client-driven,they are not a guarantee of good service. And, worst of all, by believing that microcredit issocial assistance, their subsidized pricing can seriously damage institutions that view thisindustry as a long-term, serious financial activity. The present situation in Nicaragua providesjust such an example. Well-intentioned donors often view microfinance a form of transferringpayments from the rich north to the poor south. Their initiatives have spawned a plethora ofsubstandard MFIs whose indiscriminate competition for clients, often those already beingserved, may in the long run undermine the success of the serious microfinance community.

    The other major source of competition are those institutions that are coming to the industryspurred by the example of MFIs that have achieved economic viability. These are thecommercial entrants who see this market as a valid and attractive economic opportunity. Thisis already occurring in parts of Latin America, where institutions from the conventionalfinancial sector, including consumer finance companies, are reaching down to serve the lowincome market. In addition, new microfinance institutions are being created on a commercialbasis from the outset. Both are the result of the success of well-known high profile pioneerslike BancoSol of Bolivia and BRI of Indonesia.

    Yet the number of MFIs by itself does not produce competition. Indeed, in the early days of amicrofinance market, before anybody has achieved economic viability, scale is actually anenemyone additional client only increases the absolute size of the total deficit. In thisenvironment, it is natural for practitioners to collaborate. For example, Fundusz Mikro inPoland has provided material assistance to other participants in its market in order to poolexperiences so that they all can traverse the learning curve more rapidly. As institutions searchfor the key to economic viability, everyone is an ally and a partner in the quest. However, once

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    viability is achieved, scale becomes a friendone additional client beyond break-evenincreases the surplus at the disposal of the institution. From that moment on, who has theclient becomes important. Market penetration, client retention, and repeat loans all becomerelevant. After break-even, collaboration is more difficult, and the natural seeds of competitionare sown.

    The Evolution of Competition

    The nature of competition changes with time. At the beginning, the pioneer microfinanceinstitution operated as a monopoly with a mono-product. At that early stage, neither themethodologysolidarity group, individual loans, village bankingor the product is asimportant as the ability of the institution to actually deploy its service on the streets.

    In many ways, this stage is similar to the early days of the automotive industry. People knewthe horse was being replaced, but cars were out of reach for the average personjust as todaythe poor know that credit exists for the rich, but is only obtainable at the very high cost of thelocal moneylender. Then, Henry Ford introduced his Model T. For the first time it becamepossible for the average person to purchase a car. It was then that Mr. Ford said, You canhave any color Model T you want, so long as its black. Such was the demand for theproduct, and the lack of competition, that color was immaterial. Similarly in microfinance, atthe beginning, access to financial services was everything, and product design was secondary.

    But with the evolution of the market and the emergence of competition, the one-color carbecomes a vulnerability. As both clients and service providers begin to realize, one size doesnot fit all and choice becomes important. With competition, segmentation becomes paramountas new products, or variations of the old, are able to attract different pockets of the market.Increasingly, microfinance institutions will need to learn how to define and segment theirmarket to tailor products and services to various types of customers. This will prompt acompetitive response, which in turn will lead to another, and so on, until gradually the wholeindustry will generate a self-sustaining rate of innovation.

    Competing in the Market

    For the individual MFI, competition demands responding to several issues. First of all,following the dictum that what is not measured is not controlled, market share becomes a keyindex. Market share needs to be viewed on an absolute as well as on a relative basis.Absolute market share is the institutions portion of the entire market, whereas relative marketshare is the institutions position versus its competitors along some key dimensions.

    One of these dimensions is size, usually relative to the top competitor or, in the case of theleader, as measured against the next largest competitor. For example, if the entire market iscomprised of 1,000,000 microentrepreneurs, and Institution A has 30,000 of them, then itsabsolute market share is 3 percent. If the leader of the market were Institution B with 80,000clients, then one way of viewing As relative position is to express it as a multiple of the leader,or 0.375x (30,000/80,000). In the case of Institution B, assuming that A is the next largestcompetitor in the industry, its dominance may be expressed as 2.7x (80,000/30,000) largerthan its nearest rival.

    Another key dimension is the relative share by segment. Once competition has started todifferentiate products, competition ceases to take place on an overall basis and is fought on asegment by segment basis, whether that is defined by product, geography, or otherwise. The

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    importance of this concept can be seen by the hypothetical case of the original microfinancepioneer who, having started the industry, may continue holding a commanding No. 1 positionin terms of the overall market, while actually losing share in every relevant segment to strong,focused competitors who may dominate individual segments. In this instance, the leader hasbecome a weak giant.

    Accordingly, understanding segmentation becomes vital. Underlying all segmentation is thedifference in costs to serve a given population, however those costs are derived. Marketsegment is different than products, although a product may be designed specifically to serve asegment. One segment may evolve to require many products, and one product may serve manysegments. The most obvious example of segmentation is geographic because it is clear that thespecific logistics required for any given location will cause it to be more or less expensive toserve relative to other locations. Another relevant example of segmentation in microfinance isnew borrowers versus repeat borrowers, where presumably a new client will have a differentcost to serve than a borrower on her tenth loan. That is one reason why tracking the rate ofclient retention also becomes important.

    Analysis of market share and segmentation must be dynamic because once competition heatsup, the market evolves very quickly. Constant monitoring becomes a necessity. The Bolivianmicrofinance market provides a good example since it may be the most competitive in theworld. There, every major technology is represented and innovations in product and serviceare being constantly introduced to effectively compete for clients. It has arguably reached thestage of a competitive cluster, which ensures that the search for excellence is unremitting. Inthis environment, change is driven by the industry itself and donors are no longer majorprotagonists.

    In a competitive environment, the rate of change is also fed by the market itself. Successfulmicrofinance changes its clients. Accordingly, the Bolivian customer today is very differentthan five years ago. Microentrepreneurs are better informed, have a choice of products andmethodologies, and access to preferred services. The market is being designed to meet theirevolving needs. This is difficult for many institutions as there is a natural tendency,particularly in the more established institutions, to cling to what was successful in the pastrather than ensuring that its services are changing to meet the needs of a dynamic market.

    This evolution is a wonderful development. Competition brings about the final evolution ofmicrofinance. From initially viewing clients as the poor that need to be helped, competitionrepresents the profound change in seeing the poor as a market that must be served. Underthe former definition, the mere existence of the MFI is sufficient, regardless of the quality ofserviceafter all, an earthquake victim does not have the right to ask if the beverage beingprovided to her is tea or coffee. But in a competitive market, an institutions commitment ismeasured by such things as how long it takes to process a loan, how many clients are waitingin the lines at the cashiers, and how high is the interest rate being charged. That is the highestform of respect and the truest commitment to the microenterprise sector.

    Discussion

    Bolivia. In Bolivia, microfinance competition has evolved dramatically in recent years. Todaythere are 34 microfinance practitioners, including NGOs and regulated financial institutions,serving a market of perhaps one million prospective clients. PRODEM has adopted theattitude that it will not be afraid of the competition, but it must wake up very early in the

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    morning to stay ahead of its rivals. Currently, PRODEM has 40 branches, and only 3 of thosebranches do not have any competitors. Most branches are competing with 3 to 8 differentsources of microfinance services.

    Without a doubt, one of the most significant consequences of this competitive market has beenimproved customer service. In the past, people who studied microfinance proclaimed that themarket was not interest rate sensitive. Within reason, an MFI could charge whatever it wantedbecause it was still cheaper than the alternative, the moneylender. At that point, the importantissue was access to credit. Today, at least in Bolivia, access is not enough.

    Now the issue is price. Clients do not just want black Model T cars any longer. Nowcustomers are asking for pink and purple cars as well. Last year, PRODEMs annual effectiveinterest rate was 48%; today it is between 36 and 38%. And this is still higher than some of itscompetitors who are charging 31%. The worst kind of competition are those institutions thatare product dumping; that is they are charging unrealistically low rates to gain market share.

    Chile. The experience of Banco del Desarrollo in Chile helps to illustrate the impact ofcompetition. When the bank started its microfinance subsidiary, BandesarrolloMicroempresas, it only offered solidarity group loans. Today, only 40% of borrowers havegroup loans. The rest have graduated to individual loans, which the bank provided to meet thechanging needs of its clients. At the beginning, it took 3 to 4 weeks to process the first loan;now it takes just one week for first loans and 2 to 3 days for repeat loans. This improvedservice is the direct result of increased competition.

    Philippines. The topic of competition is relevant even in the Philippines. Since TSPIsbanking license only allows it to operate outside Metro Manila, it is trying to explore newmarkets. Some of these new sites are areas where TSPIs partners are operating. For manyyears, TSPI has served as a wholesale lender for seven NGOs operating outside Manila. Nowthat the regulatory environment is forcing TSPI to enter their geographic market, this iscreating some friction. This exemplifies the evolution described above. Before institutionsachieve self-sufficiency, the players in the field are allies. But once they break-even and beginto strive for scale, they become competitors.

    In addition, there is a highly sophisticated pawn shop industry in the Philippines. This is not adirect competition for TSPI at the moment since these lenders serve the consumer creditmarket, whereas TSPI provides microenterprise loans. Besides, pawnshops charge very highinterest rates (6 to 8 percent per month); while TSPIs highest rates are 4 percent per month.But if TSPI becomes complacent, by not processing loans fast enough or not offering the termsor loan sizes demanded by its target market, then competition from the pawnshops maymaterialize.

    Kenya. Competition is entering the microfinance field in many corners of the globe, andKenya is no exception. Five of the larger practitioners in Kenya, have formed a committee todiscuss several issues related to competition. The first issue involves unfair practices such asstealing clients from other MFIs rather than attracting them. This issue has induced themajor players to establish rules of engagement.

    A second issue involves publishing statistics. MFIs need to know how they compare to othersin the field to assess their relative market strength. This committee of practitioners has begunto generate comparable statistics such as the number of clients, desertion rates, andprofitability. In addition, these institutions are trying to ensure that they are not serving the

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    same clients because this would overstate the size of the market and could negatively affectportfolio quality if clients are over-indebted.

    This process has created a system for the main players in the field to establish standards tocheck unfair practices by new players, particularly those new institutions that are donor-drivenand do not follow best practices, as exemplified by not charging market interest rates. Thisgroup is now using its collective weight to influence donor and practitioner policies, not todiscourage competition but to maintain a level playing field.

    At the institutional level, competition has forced K-Rep to be more proactive about severalthings. One issue is new products. Competition is having a constructive impact on this fieldas evidenced by the fact that the impetus for new products, at least at K-Rep, is coming fromthe staff themselves, not senior management. This suggests that field staff are feeling thecompetitive pressure. Field staff are beginning to indicate that they cannot expand theirportfolio with their existing product, but with a different product or specific adjustments theycould significantly increase their market share. Field staff are the best source of suchinnovations because they hear what clients are saying.

    In the past, K-Rep did not need to make much of an effort to market its products or services.Clients heard about K-Rep by word of mouth and this generated more than enough demand.Today, the organization must seriously evaluate its promotion and marketing strategies, and itmust ensure that it understands its market. K-Reps primary form of market research isthrough frequent meetings with the leaders of its borrower groups to stay in touch with itscustomers as their needs evolve.

    Another change in perspective involves the shift from expansion plans to expansionstrategies. In the past, K-Reps branch managers would plan to achieve certain volumeswithin specific time frames. Today, targets are not enough. Now the organization also has todevise strategies to achieve those targets. One of the expansion strategies is to pursue intensivegrowth in existing offices rather than opening new branches. To do this, K-Rep has begunexploring new products, to reach different segments of the market within one geographic area.

    MARKETS

    Marketing Strategies in a Competitive Microfinance Environment

    Herman Krutzfeldt, Managing Director, BancoSol, Bolivia

    In the last five years, the Bolivian microfinance market has become increasingly competitive.This competition has resulted in a decrease in the concentration of credit, as shown in Table 4.In 1992, 91 percent of the borrowers in the financial system had loans under US$20,000 whichamounted to 18 percent of the total portfolio. In 1997, 95 percent of the borrowers have loansbelow US$20,000 amounting to 20 percent of the portfolio.4 Therefore the percentage of smallborrowers in the financial system has increased as has their total share of the credit market. A

    4 1997 data come from June 1997. However, since microfinance is extremely seasonal in Bolivia, withsignificant activity during the fourth quarter, comparable end of the year statistics will most likely demonstratean even more dramatic change.

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    similar improvement in savings ratios has not yet occurred, perhaps because many of theinstitutions serving the micro market are not mobilizing savings.

    The democratization of credit in Bolivia has resulted from an increase in the number ofinstitutions that are serving the low income market during the past five years, as shown inTable 5. Most of the new institutions are entities serving the lowest strata of the financialsystem, NGOs and FFPs.5 The establishment of many of these MFIs stems from regulatoryreform in Bolivia. The significant increase in the number of cooperatives is the result ofbringing existing cooperatives into the formal financial system. These are closed cooperatives,and therefore it is necessary to be a member in order to place deposits and receive loans.These cooperatives usually serve salaried people and they are highly concentrated in one regionin Bolivia, in Santa Cruz.

    1992 1995 1997

    Banks 17 17 17

    Savings and Loans 14 13 13

    Cooperatives 10 9 17

    FFPs 0 4 6

    NGOs6 5 8 12

    Total 46 51 65

    This diversification of the institutions has produced significant changes to the financial system,as demonstrated in Table 6. During this five year period, a 41 percent increase in the numberof financial institutions has resulted in a 70 percent increase in loan value and a 190 percentincrease in the number of clients. Accordingly, the value of the average loan has decreased by46 percent. These figures reflect the fact that non-bank financial institutions (NBFIs) nowserve 60 percent of the clients in the financial system, up from 34 percent in 1992. The

    5 An FFP (Fondos Financieros Privados or Private Financial Funds) is a category of non-bank financialinstitutions that was created to formalize the provision of microfinance services in Bolivia.6 Since NGOs are not a part of the formal financial system, the number of NGO credit institutions reflects onlythe most significant institutions. The NGO microlenders listed here typically operate on a commercial basis andthey intend to create FFPs.

    Table 4: Evolution of the Bolivian Financial System (1992-1997)

    1992 1995 1997

    % of total portfolio of loans under US$20,000 18% 16% 20%

    % of borrowers with loans under US$20,000 91% 93% 95%

    % of total savings in accounts under US$20,000 33% 30% 28%

    % of depositors with accounts under US$20,000 97% 98% 97%

    Table 5: Diversification of the Bolivian Financial System (1992-1997)

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    NBFIs percentage of the overall financial sector portfolio has also increased from 5 percent in1992 to 13 percent in 1997.

    Table 6: Changes in the Bolivian Financial System (1992-1997)

    1992 1995 1997

    % Changefrom 1992

    to 1997

    # of Financial Institutions 46 51 65 41%

    Loans (billions of US$) 2.6 3.8 4.4 70%

    # of Borrowers (000) 155 304 447 190%

    Average Loan (US$000) 16.8 12.7 9.0 -46%

    The success of BancoSol has contributed significantly to the opening up of the financial systemand the democratization of credit in Bolivia. However, as the pioneer in Boliviasmicrofinance industry, BancoSol also merits the description of a weak giant. As shown inTable 7, relative to the entire market for financial services, BancoSol has basically maintainedits market share. But, within the microfinance segment of the market, BancoSol has lost asubstantial market share. In 1992, it had a monopoly on the microfinance market with 100%of the clients and loan portfolio. While BancoSols overall portfolio and client numberscontinue to increase, today, BancoSol controls only 41 percent of the total number ofmicrofinance borrowers and just over half of the total microcredit portfolio.

    To determine why BancoSol has been losing its share of the microfinance market, it hasconducted extensive market research. The most simple explanation is that new players haveentered the field and they have brought new clients into the market. So, while the number ofBancoSol clients has steadily increased in that five year period, its share of the microfinancemarket has actually decreased because the total number of clients in the market has increased.

    However, the decline of BancoSols market share is also attributable to the fact that it hasexperienced desertion from some of its existing clients. BancoSols research on clientdesertion has determined that half of the deserters are actually temporarily inactive and theyintend to return to BancoSol for a repeat loan within twelve months. The biggest concern fromBancoSols perspective is that thirty percent of the deserters that have been lost, at leasttemporarily, to the competition. During the research, these lost clients indicated two major

    Table 7: Market Share: BancoSol and the Competition

    1992 1995 1997

    BancoSols Share of the Entire Financial System (banks, S&L, coops, FFPs, NGOs)

    - Percentage of Borrowers 15% 21% 16%

    - Percentage of Loan Portfolio 0.3% 1% 1%

    BancoSols Share of the Microfinance Market (FFPs and NGOs)

    - Percentage of Borrowers 100% 43% 41%

    - Percentage of Loan Portfolio 100% 60% 53%

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    reasons for leaving BancoSol: 1) high interest rates and 2) the inflexibility of the groupmethodology. BancoSol considers these clients temporarily lost because they indicated thatthey would return to BancoSol if it offers individual loans at the same or lower interest rates asthe competition. The final 20 percent of the deserters do not expect to need a loan in the nextyear for various reasons.

    BancoSols market research shows that the bank has high visibility and name recognition, andit is well positioned in the market. The market considers BancoSol a fast deliverer of creditand it is commonly known that the maximum approval time for first loans is 5 days. BecauseBancoSol is a commercial bank and its competitors are FFPs and NGOs, the bank has anadvantage of being perceived as highly solvent. The main drawback with regard to publicperception is the fact that BancoSol is considered expensive because of its high interest rate.

    With this information in hand, BancoSol has developed a two-pronged marketing strategy: acommunication plan to develop and promote the banks public image and a sales plan todeliver its new products. The communication strategy will position the banks new productsand the sales plan will roll them out. For a marketing strategy to be effective, a companycannot just publicize what it is doing, it also has to deliver.

    For this marketing initiative, the bank has developed two new products. BancoSol now offersindividual loans for new and old clients starting at US$1,000. In addition, the bank haslowered its interest rates for its best clients, i.e. for loyal borrowers with an excellent credithistory, who presumably represent a smaller credit risk. Although this marketing strategy hasonly been implemented recently, the early results are promising.

    Achieving Microfinance Market Penetration

    Shafiqual Haque Choudhury, Chief Executive, ASA, Bangladesh

    The situation in Bangladesh is quite different from Boliviaor anywhere else for that matter.The microfinance market in Bangladesh is enormous. The country has 120 million people, ofwhom approximately 50 percent live below the poverty line. Many of these low income peopleare engaged in some form of income-generating or microenterprise activity. At the same time,the competition for the microenterprise market is intense. There are three major players:Grameen, BRAC, and ASA, that collectively serve more than six million borrowers. There arealso seven or eight medium-sized NGOs, and literally hundreds of small organizationsproviding credit and in some cases savings services. But small in Bangladesh may mean tenthousand clients or more, which is large in many other markets.

    Wherever ASA operates it finds ten to fifteen different competitors. All MFIs want to workon the bank of river Nilethat is they want to operate in the choicest locations. Becausethere are so many microlenders in the same places, many clients have loans from multiplesources. If they do not have concurrent loans, there is a high likelihood that they willfrequently switch from one provider to another. This is especially true now that MFIs arebeginning to diversify their products. In the past, most Bangladeshi MFIs offered the samebasic Grameen-type loan, but market segmentation is beginning to take root. Grameen recentlyintroduced a larger loan size for growing businesses, and ASA now offers voluntary savingsand life insurance, which attract other segments of the market. To retain clients in thiscompetitive environment, it is necessary a) to know what clients want and b) for the

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    organization to position itself to be the best provider of that service, at least for specificsegments of the market.

    Achieving market penetration in this competitive environment is not easy. ASA has decidedthat its comparative advantage is its delivery speed and the quality of its service. ASA doesnot offer a large variety of loan products. It has one product that is very flexible. Clients canuse if for nearly any purpose and it is delivered immediately. Some of its competitors takemonths to provide their loans, but ASA provides a repeat loan for a client in good standing thevery same day. ASA deploys loans in half the time of its competitors. This market penetrationstrategy is important because clients treat the institution the way it treats themif an MFIhassles its clients in the application process, the clients will hassle it when they should berepaying their loans.

    To provide fast, quality service, ASA insists that its systems and procedures must be as simpleas possible. This keeps costs down and it is attractive to clients. ASA compares its operationsto McDonaldsthere is very limited choice, but quick service. Part of this simplicity includesthe fact that ASA does not conduct loan usage verification very strictly. The organizationtrusts its clients to use the loan for its intended purpose, or to use it for something else as longas they have the capacity to repay. The organization believes in its clients, as exemplified bythe fact that it does not require borrowers to undergo training to receive a loan. This faith isanother example of ASAs quality of service.

    An extension of this strategy includes simplifying the loan product. To increase its marketshare, ASA has conducted research to learn what bothers the clients of its competitors. It haslearned that they are concerned about the rigid policies of Grameen and other microfinanceservice providers.

    Accordingly, ASA has found ways of being flexible and innovative to attract the disgruntledclients of its competitors. For example, clients indicated that they did not like sitting throughtwo-hour group meetings each week. Initially, borrowers enjoyed the opportunity to get out oftheir houses and to see their friends, but when their enterprises are busy they do not like beingaway from them and not serving their customers. Consequently, ASA decided to offer loans togroups of varying numberseven groups of one. Instead of requiring group meetings, loanofficers go to the clients houses or business places to collect repayments. This provides betterservice to the borrowers.

    Another market penetration strategy is to create partnerships with local organizations. If ASAwants to operate in a village where there is a strong local NGO, rather than trying to competewith an organization that has public support, it serves as a wholesale lender and technicalassistance provider to the local institution. These partners are small players in the Bangladeshimarket, since they only serve 10 to 20 thousand borrowers, but they are large compared toMFIs in other countries.

    The speed with which ASA can hire and deploy staff for new or existing offices also serves asa market penetration strategy. It only takes ASA four and a half days to train a credit officer.There is no theoretical training at allit only consists of on-the-job training with anexperienced staff member. After their brief training, credit officers refer to a very detailedmanual that explains how they should do everything. In this way, ASA does not require largenumbers of middle management. ASA hires mostly high school graduates for their creditofficers, whereas its leading competitor employs more educated people, including some persons

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    with masters degrees. Yet the competitions educated staff go through much more extensivetraining than ASAs less educated employees. The difference in the duration of staff training isprimarily a function of the simplicity of ASAs operations.

    Not everyone repays on time. Each week a few borrowers have difficulty repaying theirinstallments for one reason or another. When clients are late with their repayment, ASAs staffknow that the company cannot pay their salaries if clients do not repay their loans. So thecredit officer stays at the house of the delinquent client and waitsthey even spend the night ifthey have to. Neighbors pass by and ask why the credit officer is waiting at their house, andthis indirect peer pressure will often cause the client to find some way to make the repayment.If they still do not pay, the credit officer will go to the village leader. Since the village leaderappreciates the service that ASA is providing the community, he makes sure that ASA is paid.This interactive relationship with the communities in which it operates serves as yet anothermarket penetration strategy.

    PRODUCTS

    New Product Development

    Rosalind Copisarow, President, Fundusz Mikro, Poland

    The microfinance market in Poland is quite different than it is in developing countries. Polishmicroentrepreneurs believe that they are bankable, but they choose not to borrow from banks.This means that prospective clients compare the services of a microfinance institution, not withthose of other microfinance providers, but rather with those offered by bankseven thoughthis is hypothetical since banks would not really lend to this market.

    In Poland, the banks have a peculiar way of measuring their interest rates. They completelyignore the time value of money. So-called real interest rates are quoted as the amount ofinterest the client pays over the life of loan divided by the loan capital, irrespective of theperiod. This allows banks to market their interest rates as extremely cheap. For example, on asix month loan at a 29 percent annual effective rate, which is what Fundusz Mikro charges, abank would quote the rate as 8.6 percent.

    Another complication stems from a high inflation period between 1990 and 1993. At that time,not long after Poland elected its first democratic government, inexperienced bankers did notknow how to assess the repayment capacity of businesses. They loaned too much moneyresulting in significant bankruptcy. Consequently, in Poland credit of any sort is associatedwith business failure and generates enormous fear in peoples minds.

    Market Positioning

    Given this environment, Fundusz Mikro has concluded that to expand its market share it willhave to educate prospective clients. It needs to inform them how to compare interest rates andit needs to explain the concept of optimal leverage to demonstrate that loans do not necessarily,or even usually, result in bankruptcy if taken in judicious measure. During the communist era,there were no advantages to risk taking, and there were many disadvantages. Consequently,educating the market about the pros and cons of risk taking is an important part of theorganizations marketing strategy. In this environment, Fundusz Mikro believes that it will not

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    expand by offering a unique product, but rather by demonstrating that the institution is fair,concrete, and transparentin contrast with the banks.

    Product Development

    To develop its product, Fundusz Mikro decided to try a variety of product features to see whatwould be most appropriate for this market. During a one-year pilot process, the organizationtested the variables outlined in Table 8. After a year of trying different combinations, itbecame apparent which products, which markets, and which delivery mechanisms were themost successful (as indicated by the boxes in the table).

    The only feature that was not entirely clear was whether group or individual loans were moreeffective. While the group approach only began to take off toward the end of the pilot period,it showed enough promise to be incorporated into Fundusz Mikros product linein fact,Fundusz Mikro may be the only MFI in Eastern Europe that is having success with grouplending. To combine the group and individual approaches, and to give independent-mindedclients a choice, Fundusz Mikro established a unique combination of costs, guarantors, andgroup members, as shown in Table 9.

    This arrangement creates an incentive to clients to take group loans, which are much cheaper,but it still gives them an option to take an individual loan if they would prefer. Fundusz Mikrobelieves strongly that clients should be given a choice, particularly in Poland where for decadespeople have not had a voice. However, to reduce its credit risk, the organization can influencethe decision by, in this case, widening or narrowing the interest rate differential betweenindividual and group loans to ensure that at least 80 percent of the clients select the groupproduct. The 8 percent differential shown below was determined by trial and error until the 80percent group selection target was achieved.

    Table 8: Fundusz Mikro Pilot Program Analysis

    Variables Tested Results: Best

    Location City Town Villages

    Lending Officer Seniority Senior Middle Junior Voluntary

    Loan Product Individual Group Rotational Livestock

    Distribution Network Own Staff Agency Independent Co-financing

    Client Gender Mixed Women-focused

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    The features of the loan product encompass perhaps half of what it takes to be competitive inPoland given the expectations and the mentality of the market. The other half of the equationrests firmly on the shoulders of the loan officer. Fundusz Mikro may interview 200 people tofind one loan officer because it is so critical to find the right person. It is difficult to findpeople who have the ability and the inclination to show initiative, rather than just following themanual or waiting for instructions. The quality of field staff is key because clients will keepcoming when they realize that they are dealing with someone who is fair, knowledgeable, andfast. They will keep repaying their loan when they feel the right mixture of support from andfear of their loan officer. A major component of Fundusz Mikros loan officer training dealswith how to create this kind of relationship.

    Creating Competition

    Since microfinance was new to Poland and there was a need to learn quickly how to providemicrofinance services, Fundusz Mikro decided to create its own competitor. Fundusz Mikrofunded Opportunity International, which at that time was the only international player withEastern European experience, to establish operations in Poland. Fundusz Mikros sponsor, thePolish-American Enterprise Fund, was dubious about this arrangement, but it has turned out tobe a mutually beneficial and productive form of competition. The two organizations operate indifferent regions and are completely open with information about what works, what does not,and why. This allows both organizations to learn more rapidly how to operate in the Polishmarket.

    In addition to creating its own competition, Fundusz Mikro also tested partnershiparrangements to see if channeling resources through existing institutions would be a moreeffective means of achieving scale. Some of the potential partners included mutual creditsocieties (ROSCAs), credit unions, and enterprise clubs. In general, the partnership approachwas not successful because the missions and direction of partner institutions were not in syncwith Fundusz Mikro, and it was significantly easier for Fundusz Mikro to set up its ownbranches.

    Scaling Up

    After the initial pilot process and the refinement of its basic methodology, Fundusz Mikrolaunched 15 branches immediately. In less than two years, it has already added eightadditional outlets, and plans to add 13 more branches in the next year. This growth pattern iscontrary to the conventional wisdom in the field where it is preferable to grow incrementally asbranches become sustainable.

    Fundusz Mikro has three reasons for adopting an adventurous growth strategy. First, becauseclient promotion required a labor-intensive education process to change the cultural bias aboutcredit, growth in each branch is very slow. A national initiative was necessary to demonstrate

    Table 9: Freedom of Choice: Guarantors and Interest Rates at Fundusz Mikro

    Number ofBorrowers

    Annual InterestRate

    Number ofGuarantors

    1 37% At least 3

    2 35% At least 2

    3 33% At least 1

    4 29% None Required

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    success, and to reach break-even as soon as possible. The second factor is Fundusz Mikrosunique funding arrangement. The institution was capitalized with US$24 million by thePolish-American Enterprise Fund. This has enabled it to invest heavily in infrastructure fromthe beginninga course it prefers because it is the fastest and cheapest way of reaching overallsustainability. Finally, with the prospect of Polands membership to the European Union by2002, it will be difficult to raise non-commercial sources of funds after 1999/2000. Therefore,the earlier the infrastructure building, the better.

    Fundusz Mikros success to date has been very encouraging. Its pilot project ran fromFebruary 1995 to February 1996. In the 18 months after the pilot, the organization hasdisbursed more than 7,000 loans and at the end of September 1997 it had 4,200 activeborrowers, including 37 percent women. The outstanding balance of its loan portfolio exceedsUS$4.3 million and its default rate is 1.2 percent (more than 180 days). The average loan sizeis US$1,700 for terms of six to twelve months (average 8.8 months).

    Small-scale KUPEDES: Product Development at the BRI Units

    Jarot Eko Winarno, Manager, Product Development, BRI Unit Division, Indonesia

    As many people are aware, Bank Rakyat Indonesia (BRI) is a large government bank. Theunit division of BRI is its microfinance arm. The unit division consists of some 4,000 retailoutlets, including units and service posts, serving approximately 16 million depositors and 2.5million small-scale borrowers. For the unit divisions main loan product, KUPEDES, the BRIunits require collateral, usually in the form of land title or property tax receipts. While there isan enormous market for this product, the unit division realizes that it can avoid being a weakgiant by expanding and diversifying its client base by offering a product for a new market:traders who are unlikely to have land titles to offer as collateral.

    The trend in the microfinance industry in other countries is for MFIs to find ways of providingclients with larger loans, perhaps because their businesses have outgrown the smaller loanstraditionally offered by the institution. Since BRI is a commercial bank that is already servinglarger clients, the unit division has instead chosen to find a way of reaching lower than itscurrent market. While these clients may be more expensive to serve, the unit division believesthis is an important and profitable market segment.

    Rationale and Objectives

    A thoughtful analysis produced several compelling reasons for creating this new product:

    The bank wanted to prepare itself to stave off competition. Although competition is notsignificant yet, the unit division is introducing this product to be proactive.

    The unit division is responding to the increasing percentage of KUPEDES that are forsalary-based loans. Approximately 30 percent of the unit divisions total portfolio is forfixed-income earners, as opposed to self-employed persons, and this percentage has beenrising steadily. BRI does not want the salary-based loans to increase further because thistype of lending is fairly easy to dowhich means it is also easy for the competition. Thebank wants to focus on segments of the market where it has a strategic advantage, such asmicroenterprise lending.

    The unit division wants to serve the governments social agenda of poverty alleviation, andto help the informal sector become familiar with doing business with banks. At the same

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    time, this will allow the unit division to build a client base which may ultimately borrowKUPEDES loans.

    Fifth, BRIs market research indicated that the informal money lender is the only source ofcompetition for this market.

    The unit division defines the informal sector as the target market for this pilot project. Theseenterprises consist primarily of vendors in the traditional market place with daily sales ofUS$30 to 100. This target market is not able to access financial services from banks becauseof their small sales, lack of collateral, and difficulty meeting administrative requirements.Because of these problems, they rely on moneylenders for financial services. Moneylendersprovide convenient and timely service, daily or weekly installments, door-to-door service, withno collateral requirements. For these services, moneylenders in Indonesia charge a flat rate of5 to 20 percent per month.

    In response to this environment, the unit division decided to make adjustments to itsKUPEDES loan to offer small-scale KUPEDES (SSK) to this market. In the process ofdefining and piloting this product, the unit division established three short-term objectives: 1)to map out the socioeconomic conditions in Indonesia; 2) to penetrate new markets; and 3) todevelop an appropriate lending methodology for this market. Through this pilot project, BRI ismapping the market potential of various regions in the country to test its assumptionsregarding the discipline and credit worthiness of different tribes. In addition, BRI made astrategic decision to penetrate lower, rather than upper, markets because of its success withKUPEDES loans and because it would have more competition in the larger loan market.

    The long-term objective of this product is to introduce the bank to the target market, whichinvolves introducing the service as well as the institution. This will allow the bank to build acustomer base and customer loyalty for clients that will later graduate to become KUPEDESborrowers. When the unit division thinks of expanding its business, it thinks first about thenumber of clients and second about the outstanding portfolio. Clients who borrow very smallamounts today may need larger loans in the future. In doing so, this strategy anticipates futurecompetition and gets a head start on any financial institution that wants to reach lower thanBRIs unit division. In addition to these institutional objectives, this product will also helppromote the economic development of the informal economy.

    Market Research and Pilot Testing

    The market research for small-scale KUPEDES has determined that there is significant marketpotential for this product. Research has also found that BRI has a well-known brand name formicrofinance. The pilot project has established that the terms and conditions of the small-scaleloans are competitive with the moneylenders. Its interest rate is lower and BRI offers a promptrepayment incentive: the unit division refunds clients 25 percent of the interest charges if theyrepay on time for six consecutive months. BRI also has the delivery mechanism to serve thismarket through its nationwide retail outlets.

    On the other hand, there are some difficulties providing financial services to this market.Because they are informal businesses, they operate in the margins of the economy and are veryvulnerable to economic dislocations. Since the SSK would not require traditional collateral,like loan titles which KUPEDES requires, this increases the risk of this product. At the sametime, this market demands timely and convenient service that they currently receive from themoneylender, which puts extra pressure on unit staff.

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    Product Features

    Based on the experience of the research and the pilot, the unit division has developed thisproduct with the following features:

    1) Applicants do not need a business license (just copy of identification card)

    2) Applicants do not need cosigner

    3) BRI will accept any movable asset as collateral used for the business

    4) Loan maximum = US$150; maximum term = 12 months

    5) Simple loan analysis on a one page application

    6) Quick service: for new customers, 3 day turnaround maximum; for repeat borrowers,1 day turnaround

    The most significant adjustment for the small-scale KUPEDES is with the repaymentprocedures. For KUPEDES, BRI requires monthly installments. With the SSK, BRI stillcollects installments on a monthly basis, but it encourages borrowers to repay on a daily basis.To accommodate this arrangement without excessive transaction costs, BRI provides a boxwith the BRI logo into which clients place a daily installment. From its experience with thisrepayment mechanism during the pilot phase, BRI has learned that clients usually have anexcess at the end of the month, which BRI places in their savings account. At the beginning ofthe pilot, BRI arranged to collect the money from the boxes at the clients place of business.However, as clients became more comfortable with the institution, they preferred to bring thebox to the unit office.

    The unit division began the pilot for the small-scale KUPEDES in Denpasar, Bali in October1994. After one year it was introduced in the Semarang region, and in 1997 two other regionsbegan offering this product. Thus far, approximately 15 percent of the units have disbursedSSK loans, and they have maintained excellent portfolio quality. The gradual roll-out of theproduct reflects the conservative nature of the bank as well as the logistical complications oftraining 14,000 staff members. But this has actually worked to BRIs advantage. In eachregion that this product is introduced, the unit division learns more about its features,efficiencies, and about the market. These lessons are then incorporated into productrefinements before the product is widely available. Since the unit division is being proactiveabout introducing this product, and it is not yet experiencing problems with competition, it canbe deliberate in the product development process.

    STAFF

    Preliminary Thoughts On How To Retain Good Staff In MFIs

    Marguerite S. Robinson7

    In a competitive market, in addition to losing their best clients to their competitors, MFIs mayalso lose their best staff members. This is particularly painful for two reasons. Microfinanceis a service industry, which means that an institutions field staff serve as the intermediarybetween the institution and its customers. Recognizing this critical role, most MFIs invest 7 Marguerite S. Robinson was not able to attend the conference because of illness, however she sent herpresentation to be distributed among the participants.

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    heavily in training so staff understand the products they are delivering and provide high qualityservice. MFIs hate to lose these well-trained staff after making a significant investment inhuman resources. The second reason involves proprietary knowledge. Every MFI has its owntricks of the trade and it is disturbing when the competition learns those tricks after pinchingkey staff members.

    There are, of course, different kinds of staff. This presentation is concerned primarily withmiddle-level staffnot high-level managers at the head office, and not guards and messengers.Nevertheless, some of the points are relevant for the former, and many are relevant for thelatter. However, the thoughts below are specifically directed towards retaining good credit andsavings officers, cashiers, bookkeepers, branch managers, and regional office staff in acompetitive environment.

    Since an MFI can keep its staff only if the staff member wants to stay, the primary issue ishow to build institutional loyalty. This is addressed by the five points discussed below.

    1. Basic package. An MFI should recruit locally, usually at the high school graduate level;and then (a) invest heavily in training; (b) give the staff the responsibility to make their owndecisions as appropriate to their particular positions; (c) pay them well compared with whatlocal high school graduates in the area can earn; (d) offer substantial incentives for goodperformance that is clearly measurable;8 (e) emphasize the relationship between accountabilityand incentives; and (f) provide an attractive career path.

    Local recruitment helps to increase the probability that staff will stay in the area, which isespecially important for rural areas. Recruiting at the level of high school graduation holdsdown salary costs and seems to increase institutional loyalty. This combination ofresponsibility and accountability; good training (so that staff members knows how to do the jobwell); and good pay (so staff are financially comfortable and not tempted into fraud)coupledwith incentives for performance and with promotion possibilities (so that the staff want to dothe job well and want to remain loyal to the institution)is an all-or-nothing package. Bitsand pieces do not work.

    2. An important route to staff retention is through good MFI service to the clients. Thismay seem strange, but it is an important point. It is especially relevant for field officers, butapplies to all staff to some degree.

    In a well-run institution, staff are encouraged to develop good relations with clients and arerewarded for doing so. The MFI goes the extra mile with the clients: personal attention; giftson religious holidays and major family events; well trained and courteous staff to answerquestions and provide advice on products and services. Good staff know their clients well;clients appreciate the staff and in many small ways they let them know this.

    A significant part of job satisfaction comes from the knowledge of the staff that they are likedand respected by many people. They knowboth from their employer and from their clientsthat they are doing a good job and that their services are appreciated. The trust that developsbetween clients and staff should not be underestimated in building the kind of job satisfactionthat enables good MFIs to retain their good staff.

    8 See point 4 below as well as the following presentation on ABAs incentive scheme.

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    It should perhaps be mentioned that this does not necessarily refer to long-term continuingrelations of staff with particular clients. This can lead to possible collusion, which has to beanticipated and, to the extent possible, prevented. For example, the Bank Dagang Bali (BDB)has two staff members in each savings team. The team develops very close relations with itsclients, but every six months one member of the team is rotated.

    It is not particular clients who are crucial to a staff members job satisfaction. Rather,borrowers and savers who receive good products, good service, and the trust of their MFI,show their appreciation to the staff with whom they interact. Client appreciation is one of theleast understood and most powerful methods of retaining good staff.

    3. Developing creative jobs for experienced staff. Some successful MFIs have developedgood relations with regional and local governments and with private corporations. Suchorganizations invite the MFI to send representatives to talk with their employees aboutfinancial instruments that are suitable for the education of their children and for the employeesown retirement funds. This not only helps the institution and the MFI, but also providesprestige to the MFI staff members involved.

    4. Staff incentives for good performance. This is a much discussed and controversial issue.Staff retention is enhanced by substantial, performance-based incentives of various types,which are given regularly for good performance that is clearly measurable. To be effective,incentives need to be of several types. On one axis are (a) cash incentives and (b) recognitionawards. On the other axis are (a) individual incentives and (b) incentives to all staff of thelowest-level unit or branch that is accountable as a profit center. All these types of incentivesare useful.

    a) Cash incentives to lowest-level units. These should be based on the profitability of thebranch, paid annually, and should be calculated as a percentage of the unit profitability upto a cap of not less than one months salary and probably not more than two monthssalary. Everyone who works in the unit should receive the cash incentive by pegging theincentive to the salary of the particular staff member.

    b) Cash and recognition awards to unit staff. After units become profitable, the profitabilityincentive tends not to act as a significant incentive, but it must be continued as long as theunit remains profitable. At this stage an additional incentivebased on a weightedpackage of targets (such as an increase in loans outstanding, increase in savings, increasein new customers, decrease in arrears, increase in profitability)can be given to all staffof the unit. At BRI, for example, this is done through a two-level competition between theunits, which is carried out twice a year. At the first level, all staff of any unit that meetsthe target receives incentives. At the second level, all staff of those units which are judgedto be the best in region and the best in the country receive extra awards.

    In this instance, unit-based cash awards are provided to the staff. However, the mainincentive in this program is the recognition and publicity given to the staff of those unitsthat have achieved their goals. Important ceremonies are held, certificates are presentedpersonally to each staff member by the President-Director or Managing Director of thebank, and substantial publicity is given to the ceremonial recognition of staff achievement.Staff really appreciate this. Regional and national winners are given special awards, trips,publicity, and consideration for promotion.

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    c) Cash and recognition awards to individuals. These can be effective, but they can also bedangerous. This should be given for only strictly measurable performance. Thus, in caseswhere individual credit/savings officers have clearly demarcated areas of coverage, theycan be rewarded for measurable improvements in loans outstanding/decreased arrears;savings; etc. In a different approach, the BDB pays a bonus to individual staff forbringing in new clients. This has to be carefully worked out. Bank Dagang Bali pays thebonus to a staff member for bringing in a new borrower after the loan is repaid. Thebonus for a new saver is paid after some period of time.

    It must be remembered, however, that incentives have to be carefully designed and must bewell balanced. For example, an MFI that is beginning a voluntary savings program may betempted to provide incentives for savings mobilized. This is a mistake! Since staff will turntheir attention to whatever the incentives encourage, the MFI could end up with lots of savingsand a rapidly deteriorating loan portfolio. However, well-designed incentives schemes of allthe types discussed above seem to encourage staff pride and institutional loyalty.

    Perhaps the most important incentive is the way that some MFIs have inculcated the idea thatMFI management and staff are a single family. Some MFIs have done excellent jobs atmaking their employees feel that they are important to the institution, that the MFI cares aboutthem, and that if they perform well there is a lifetime career track ahead.

    5. What is the competition doing? An MFI also needs to keep up with what its competitorsare doing. The purpose is to sift those things that competitors are doing into three categories:

    a) Good ideas that the MFI can analyze, improve, and offer clients in a better way. Forexample, when BDBs competitors allied themselves with vehicle dealers who advertised:Buy our vehicle with Bank As credit, BDB advertised: Why let your bank decide yourvehicle? Take a loan from us and select your own vehicle.

    b) Ideas that customers may like but that are contrary to the MFIs mission. While someMFIs offer everything from medical insurance to beauticians training courses, it isimportant to remember that the successful MFI is a financial institution not a supermarket.Since MFIs tend to know little about the other activities in which they sometimes engage inorder to attract clients, they often fail in the long run (sometimes even in the short run). Aswe all know, microfinance clients are intelligent and shrewd. Most will prefer expertmicrofinance service to a mix of mediocre services.

    c) Terms that are attractive to borrowers but that sustainable MFIs cannot offer such asbelow market interest rates. Sustainable MFIs may face temporary problems fromcompetition providing subsidized loans. However, because of capital constraintswhichnegatively affect the amount of funds available for lending and the quality of the staff andproducts of the competitorcompetition of this type is unlikely to be a serious long-termissue. Clients prefer to pay higher interest rates for better service.

    To conclude, clients do not often walk away from a microfinance program because the interestrate on loans was too high or because the interest rate on savings was too low. But manymicrofinance clients leave programs because the service was not good. It is expensive andsomewhat risky to invest in staff and service, but there is no alternative in microfinance.Heavy investment in staff training and incentives, broadly defined, is the best way to competeand succeed in this field.

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    It is perhaps worth remarking that both BRI and BDB, respectively the largest and oldest ofsustainable MFIs, have faced increasing competition in recent years, but both have high staffretention. Both banks have been made more efficient by the competition. In 1995, BRIreduced its KUPEDES loan interest rates and in recent years BDB has adjusted its prices andimproved its products. Both remain profitable.

    In discussing the increasing competition, Mr. Oka, President-Director of BDB, stated:

    Competition is not a bad thing because it helps the poor. It also keeps our bankefficient. It keeps our staff continually learning about the market and providing betterservice to our customers. If a competitor has something worth learning we learn itand if possible improve it. Then we can provide even better service. Not only can youlearn from the competition, you can also join in alliances with them. Thus, at BankDagang Bali we have made syndication arrangements with several banks. One shouldnever be afraid of competition. What is important is how you treat your own staff andclients. If they are treated like family they will stay with you.

    Staff Incentive Schemes

    Nabil El Shami, Managing Director, Alexandria Business Association, Egypt

    While the Alexandria Business Association (ABA) is not experiencing significant competition,the organization is managed professionally to achieve the greatest social and commercialimpact. One of the features of this professional management is that, from day one, it haslinked staff productivity with pay. This results in a win-win arrangement, with highlymotivated staff on the one hand, and very efficient operations on the other.

    Background

    The Alexandria Business Associations Small and Micro Enterprise Project is a financiallysustainable non-profit organization, which is in the process of establishing a for-profitinvestment company to assume its credit activities. ABA only offers individual loans tomicroentrepreneursit does not offer group loans or savings services. Most of its clients aremen, and the majority of them are involved in manufacturing. Three quarters of its clientshave micro loans (loan sizes between US$300 and $900), and one quarter of the borrowershave small loans (loan sizes from US$1,500 to $7,500). Microenterprises are defined as thosebusinesses with up to five employees; while small businesses have 6 to 15 employees. As ofSeptember 1997, ABA had over 13,200 borrowers in Alexandria and nearly 600 clients inKafr El-Sheikh where it has recently established operations.

    Newly hired extension officers (EOs) all have university degrees. EOs at ABA are paid a basesalary equivalent to the prevailing wage of civil servants in Egypt, which is approximatelyUS$40 to $45 per month. However, this salary is insufficient to make a living. To generatesufficient income, civil servants typically hold second and third jobs. For field staff, ABAoffers a lucrative monthly incentive scheme that allows them to earn up to five times their basicsalary in incentives depending on their productivity.

    Extension Officer Incentive Scheme

    For extension officers, the incentive scheme consists of three variables: the number of acceptedloans, the repayment rate, and the number of active clients. These variables delicately combine

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    portfolio quality and quantity to ensure quality is maintained while the organization continuesto expand. For quantity, ABA emphasizes the number of clients rather than portfolio size toavoid encouraging field staff to offer larger loans.

    The compensation for these variables is presented in Table 10 and Table 11. Table 10 showsthe monthly incentive earned by EOs for the number of approved loan applications, both newand repeat. If they generate 35 or more approved loans in a month, they will earn an additional$45, which is already double their base salary. If they generate less than 15 approved loans,they do not earn an incentive from Portion A. Another feature not presented in the tables is abonus for EOs that generate more than 10 new loans per month.

    Table 11 shows how ABA balances its rewards for quality (repayment rate) and quantity(active clients). EOs with repayment rates below 97 percent or fewer than 70 clients do notearn any incentives, from Portion A or Portion B. The relationship between these twovariables is in part designed for fairness, since it would be unfair for EOs with more clients toearn the same quality incentives as their peers with fewer clients, if they had the same portfolioquality. But Portion B also serves as an encouragement for EOs to increase their number ofactive clients.

    Some MFIs may feel that the quality requirements in this incentive scheme are too strict. ABAbelieves this strictness is critical to sensitize staff to the importance of maintaining near perfectportfolio quality. And it is achievable. Approximately two thirds of the ABAs extensionofficers have 100 percent repayment rates each month. The high quality expectations have aprofound influence in the EOs client selection process. If they earned incentives with an 85,90, or even 95 percent repayment rate, then they may not be as concerned about client selectionas they are knowing that each month their portfolio quality must be between 97 and 100

    Table 10: ABA Incentive Scheme/Portion A

    Number of AcceptedLoans Provided by the EO

    Amount of Incentivein US$

    15-19 9.0020-24 15.0025-29 24.0030-34 32.50> 34 45.00

    Table 11: ABA Incentive Scheme/Portion B

    Number of Active ClientsRepayment Rate 70-90 91-120 121-150 >150

    97.0% $27 $36 $45 $52

    97.5% $31 $40 $49 $56

    98.0% $36 $45 $53 $62

    98.5% $42 $50 $58 $68

    99.0% $48 $56 $65 $74

    99.5% $57 $67 $74 $83

    100% $71 $82 $89 $100

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    percent to qualify for any incentives. Since the incentives form such a large portion of theirpotential salary, not qualifying for incentives is fairly painful.

    ABA did not start with this particular incentive scheme. It has evolved as the organization hasgrown, and the quantity targets have periodically been pushed back as EOs have demonstratedthat they can manage larger volumes of clients. In Kafr El-Sheikh, where ABA has recentlystarted new operations, it is using the older version of the incentive scheme for that region.This dynamic incentive scheme allows the targets to be realistic and achievable, and then oncestaff attain certain milestones the targets can be shifted to improve the institutions efficiencyand productivity.

    Incentives for Other Staff Members

    ABA also offers incentives for branch managers, branch lawyers, and back office staff.Branch managers receive incentives in a grid similar to Table 11, based on the number ofactive borrowers per EO and the repayment rate of the branch. Each branch also has a lawyerwho assumes responsibility for all past due loans. The lawyers earn incentives based on theamount of past due installments collected during the month. A collection fee of 2 percent foramounts up to US$1,500 and 3 percent if greater than US$1,500 encourages aggressivecollections.

    ABAs incentives for office staff include employees in the MIS, accounting, and personneldepartments. For these staff members, it is much more difficult to assess the quality andquantity of their performance than it is for field staff. Since the volume of loans processedeach month reflects the relative work load of back office staff, ABA uses this as the primaryvariable in calculating their incentives. In addition, to emphasize the importance of portfolioquality on the overall health of the organization, they also receive a smaller incentive based onthe repayment rate, as outlined in Table 12.

    Benefits of the Incentive Scheme

    There are two sets of benefits from this incentive scheme: financial and non-financial. Foremployees, the most significant financial advantage is that they receive higher pay. ABAslarge ratio between the base salary and the potential incentives makes this feature particularlycompelling. Field staff who can earn 20 or 30 percent of their salary in incentives will not benearly as motivated to achieve the established targets as employees who can earn four to fivetimes their base salary.

    Table 12: ABAs Incentive Scheme for Back Office Staff

    Portion A Portion BNumber of Loans

    ProcessedIncentive as % of Base

    SalaryABAs Overall

    Repayment RateIncentive as % of

    Base Salary

    800 - 1000 65% 97.0% 20%

    1001 - 1200 70% 97.5% 30%

    1201 - 1500 75% 98.0% 40%

    1501 - 1800 80% 98.5% 50%

    1801 - 2100 85% 99.0 and more 60%

    2101 - 2500 90%

    > 2500 95%

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    For the institution, since the scheme is linked directly to performance, ABA benefits fromhigher productivity, increased net income, and better portfolio quality. These factors made itpossible for ABA to achieve operational sustainability two years after it began lending, and tobecome financially self-sufficient two years later. The incentive system also helps theorganization to produce one of the most efficient operations in the microfinance industry. In1996, ABAs administrative expenses over average outstanding balance was 8.2 percent. ForABA, the net financial benefits of higher productivity greatly exceed the financial costs of theincentive system. This point is critical in any incentive scheme, and organizations shouldconduct careful analysis and projections to establish the viability of the scheme beforeintroducing it on wide scale.

    The non-financial benefits of the incentive scheme accrued by the institution and its staff arealmost as important. The incentive scheme allows ABA to establish clear performanceobjectives with staff. Performance evaluation is therefore easily measured based on theaccepted standards outlined in the scheme. This transparent relationship between performanceand compensation results in high levels of staff motivation and job satisfaction. At the sametime, this form of compensation quickly identifies staff who are unable to perform atacceptable levels. Non-performing staff usually resign if they cannot earn sufficient incentivessince the base salary alone is not enough to live on.

    Other Experiences with Incentive Schemes

    Banco del Desarrollo. Banco del Desarrollo in Chile implemented an incentive schemesimilar to ABAs. While it produced many of the advantages described above, it also hadsome negative ramifications. One negative consequence was the fact that portfolio qualityproblems do not typically manifest themselves until three or four months after a loan is booked.Some loan officers became preoccupied with current loan volume only to experiencesubsequent quality problems. Another disadvantage to this type of scheme is that it onlyrewards the individual performance of loan officers. This can result in staff competing witheach other rather than working together to achieve better branch performance. This can createa disincentive for loan officers to cover for a colleague who is out of the office.

    PRODEM. PRODEM has also tried a similar scheme and found similar problems. Tocompensate for these limitations, PRODEM is considering a radical change in its approach. Amain feature of the proposed scheme is that it only pays incentives once a year. This correctsfor the delinquency lag that many MFIs experience, as well as the seasonal fluctuations whichare profound in the Bolivia microfinance sector. The other feature of this incentive system isthat it rewards field staff based on branch rather than individual performance. This means thatone credit officers delinquency problem becomes the problem of the entire branch, and thishelps to mobilize the resources necessary to address the problem. The payment of theseincentives will be done after the annual audit, and it will be based on the income and expensereport for the branch as well as its efficiency ratios.

    BRI. At BRI, the introduction of staff incentives in 1984 was an important feature inchanging the unit division from a conduit of subsidized credit to a profit-driven microfinanceinstitution. For unit staff, BRI has three types of incentive programs: annual profit sharing,semiannual achievement contests, and bad debt collection.

    The profit sharing incentive reinforces the units primary objective of generating profits. Unitstaff share 10 percent of their units profits up to a maximum of 1.5 months pay. There are

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    two main advantages of a profit sharing incentive. First, the institution knows that it canafford the incentive because it only rewards units that are generating a surplus. The secondadvantage is that it rewards teams rather than individuals. This is particularly important atBRI where staff functions are differentiated into credit officer, teller, bookkeeper, and unitmanager. Therefore, for the unit to succeed all staff members have to work together.

    The achievement contest incentive allows BRI to adjust emphasis regularly while continuing toreward staff. For each semi-annual contest, the head office establishes the targets and theweighting for five indicators. This allows the head office to communicate targets and policiesof the unit division. For example, if liquidity becomes a problem, then the bank can emphasizesavings mobilization in the achievement contest. Or if loan volumes are not sufficient, theachievement contest can reward new loan disbursements.

    The third incentive at BRI is for bad debt collection. For loans that are in arrears for morethan one year, the unit assembles a collection team that follows up on the bad loans. Teammembers earn 2 percent of the bad debts they collect.

    Centenary Bank. In Uganda, Centenary Rural Development Bank takes the incentive schemeone step further by including a penalty as well. In this way, the bank makes use of the carrotand the stick. On the carrot side, the bank employs an incentive scheme similar to ABAs.This scheme pays a maximum monthly incentive of US$300, which represents a 100 percentincrease in the monthly base salary of a credit officer. On the stick side, if credit officers donot achieve the established targets then they must pay up to US$150. If an employee has topay a penalty twice, then they must appear before the banks disciplinary committee, and athird offense results in termination. In addition, if a branch experiences fraud or is involved incosmetic accounting, it will not be eligible for incentives.

    Private Sector Incentives for Senior Management

    Michael Chu, President and CEO, ACCION International, USA

    The fundamental principle behind incentive plans, whether it is for the staff at large or topmanagement, is to align what is good for the individual with what is good for the institutionand, by extension, the shareholders. The need for such incentive plans arises because in mostorganizational structures of the private sector ultimate ownership of the assets may reside inthe shareholders, but day-to-day control of those assets rests in the hands of the employees thatcomprise management. Accordingly, absent specific and very deliberate mechanisms, there isno natural assurance that managements agenda will coincide with that of the institution or theshareholders.

    While the abuse of perquisites by top management in large companies has been profiled by themedia, scandals like the excesses of the former president of United Way (who had limos, NewYork apartment, and star salaries) show that the nonprofit field is not exempt from suchrealities. But on a day-to-day basis, far removed from corruption and malfeasance, the tensionbetween individual and institutional agendas exists in normal NGOs and microfinanceinstitutions, evident in such tradeoffs as job security and comfortable stability vs. rapidinstitutional change, personal friendships vs. job performance.

    Really hard management decisions are not difficult because large sums of money are involved,but because they deal with people. Good incentive plans recognize that managers are not

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    driven by economic incentives alone, especially in mission-driven institutions like MFIs.However, experience has shown that monetary compensation is often synonymous with familyresponsibility, and that is a powerful addition pulling on the side of institutional aims,especially when management must make the difficult decisions that leave dead and woundedin its wake.

    Basic Principles for Incentive Schemes

    In designing an incentive scheme for senior management (or any other staff member), it isimportant to consider the following principles:

    Key indicators in the incentive scheme must be limited to those few factors that reallymatter. In microfinance, portfolio size and quality are obvious choices, but for seniormanagement institutional factors such as profitability, number of clients, and staffturnover may also be considered.

    Incentives should reward people for issues that are within their span of control and for abehavior that they can directly affect.

    Incentive systems should be simple. No more than five, and preferably fewer, variablesshould be selected.

    The rationale for the selected indicators should be clear for them to have legitimacy. The targets set must be achievable and measurable. It is no use to select a variable that

    everyone agrees is very important, like customer service, but no one knows how to reliablymeasure, or for targets to be set so high that they cannot be reached.

    Differences between Senior Management and Other Staff

    While the basic principles above apply to all staff, incentive plans for top management musttake into account additional factors. This is not because top management positions are moreimportantindeed, in an MFI it can be argued that the most important post is the loan officer,the key point of intersection between the organization and the client. Rather, it is because inpositions at the base of the organization chart the decisions are tactical in nature, involvingissues such as the number of clients and portfolio quality. Compensation alone is anappropriate incentive for this tactical function.

    Top management, however, is responsible for tactical and strategic issues. In decidingwhether to open or close branches, to turn an NGO into a bank, to develop new financialproducts, the potential for conflict between individual and institutional goals is more prevalentand more difficult to detect as the issues become more complex. Top management incentiveplans must therefore combine both current compensation (to cover the tactical or short termimpact of the function) and ownership (to take into account the strategic or long termdimensions).

    Without the ownership piece, management is considered successful if it improves the efficiencyof the operations without making fundamental changes. Indeed, fundamental change threatensshort-term results, which undermines annual performance indicators. For example,multinational companies used to appoint country managers for three year periods. Say thecountrys operations revolved around one manufacturing plant. Under these conditions, goodmanagement would concentrate on generating the greatest productivity out of that plant. Butwhat if the soundest business decision is to completely retool the plant so that it will remaincompetitive globally, at the cost of two or three years of zero or negative productivity? If the

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    manager leaves in three years, there is no incentive to take on the hard work and leave thebenefits for somebody else. In this example, what makes sense for the managers career doesnot make sense for the corporation.

    Structuring the Ownership Incentive

    To make the ownership piece effective in the incentive system, the corporation needs tostructure sweat equity properly. For ownership to work, management must have a real stakein ownership. This does not mean just having shares. A real stake is when the outcome,whether good or bad, will make a fundamental difference in the managers life.

    Most conventional incentives only go one way: they reward accomplishments withoutsignificant repercussions if things go sour. For example, it is common in the United States formanagers to receive stock options as an incentive. But that only addresses the positive side ofthe ownership incentive. Because management does not put anything at risk, but receives theoptions as additional compensation, there is little perceived pain if things go wrong. Mostincentives work this way because, frankly, professional management designed them. Tostructure ownership effectively, sweat equity must be viewed as a privilege not a right, so thatownership is not confused with compensation.

    If an MFI becomes a private institution with shares, top managers should be encouraged topurchase some of those shares at the initial price, so that they have a stake in the institutionand their interests are perfectly aligned with those of any other investor. The size of thatinvestment should be significant enough so it is meaningful if it is lost. If management doesnot have sufficient resources to make such an investment, then the institution can considerfinancing the purchase. Servicing that loan on a monthly basis will remind managers that theyhave something to lose and that ownership will feel very real to them.

    Likewise, to ensure that the upside is also effective, ownership should be structured somanagement really benefits if things go well. If the initial stake purchased by management isvery small in relation to the total investment, management can be given options to acquireadditional shares as a multiple of the initial investment. The number of options can beestablished as a multiple of the initial purchase, perhaps three to one, or even ten to one.Therefore, if originally a manager put $1,000 at risk, he or she ends up with the potential tobenefit as if the stake had been a $10,000 investment. The option can be exercised at a strikeprice which is the same as the price at which every investor came into the original deal, i.e. it isonly worth anything if value has been created. Such stock options should not be available theminute the deal is closed. It makes sense to include the concept of vesting so, for example,every year options vest in 20 percent increments. With this arrangement, management needs tostay for at least five years before being fully vested. If they leave or are fired before the end ofthe vesting period, they can only exercise the vested portion of their options, and must sell themback to the institution under a pre-established formula.

    With compensation and ownership working in tandem to ensure that managements agenda andthe shareholders agenda are aligned, the full power of the staff can be channeled to fulfill theinstitutions mission.

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    THEME III: CONTROL

    OVERVIEW ON MICROFINANCE FRAUDLiza Valenzuela, USAID, USA

    Fraud is a deception deliberately practiced in order to secure unfair or unlawful gain.

    There is extensive literature on the field of microfinance, but no publication has dealtsufficiently with the critical issue of fraud. In addition, there have been few frank discussionson this topic in public settings. There are two possible explanations for this. First, perhapsthere is a dearth of information and discussion on this topic because fraud is insignificant andtherefore it is not worth the effort. The second explanation is that most MFIs may prefer tohide it in the closet and not expose their dirty laundry because they fear that their reputationsmay be damaged.

    The first explanation does not hold up to scrutiny. Every member of the MicroFinanceNetwork has experienced fraud to greater and lesser degrees. In fact, all financial institutions,micro or otherwise, have to deal with fraud as a serious issue at some point. Wherever there ismoney, there is an opportunity for fraud. For fortunate organizations that have notexperienced fraud yet, it does not mean that they will be immune to it in the future. In fact, asMFIs grow, as their portfolio size increases, and their operations become more complex, thesize and frequency of fraud also tends to grow.

    The second explanation is more plausible, but it is unfortunate that microfinance institutionsfeel this way. There are important reasons to air out that laundry. Fraud is a reality and MFIsshould not be scared or defensive about talking about it. By discussing this subject, MFIs canlearn from each other how to lessen the frequency of fraud by identifying vulnerabilities andeffective internal control practices. Through practitioner forums on this fraud, institutions maylearn about innovative infractions as well as effective internal control procedures. Fraudcannot be eliminated, but MFIs can develop ways to reduce it through procedural and internalcontrol practices.

    Table 13 is a summary of 14 cases of microfinance fraud from around the world. This is aninitial effort to document fraud occurrences in order to identify common causes, types, anddetection methods. Based on this review, it is possible to categorize perpetrators ofmicrofinance fraud into three main categories:

    Loan Officers are probably involved in most cases of fraud, although the money lost throughloan officer fraud is not usually large. These cases may involve fictitious loans or ghostborrowers, kickbacks from clients for the privilege of receiving a loan, and cash theft, eitherfrom petty cash or loan repayments. Sometimes cash theft involves delaying payments so thatthe credit officer uses the resources for a period of time. Loan officer fraud may also involveclaims for expenses that did not occur or for more than is due.

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    Table 13: A Sample of MFI Fraud Cases from Around the World

    Case Detection US$ LostLoan officer in rural area program makes fictitiousloans. Repayment comes from the new loans, althoughsoon the loans become delinquent. Accountant is incollusion.

    Increase in delinquency noticed by centraloffice and investigated.

    $100,000

    Loan officer sets up 18 fictitious loans for personal use.The loans become delinquent.

    USAID officer wants to show high volumebranch for Ambassador visit. A client isselected for visit that does not exist.

    $2,500

    Loan officer takes money from petty cash for use overthe weekend.

    Missing funds are discovered in a cashcount exercise the next working day.

    $100

    Loan officer pays a microentrepreneur to use his nameand address to originate a loan for his own use. Loanofficer does not make payments.

    Increase in delinquency reports for loanofficer is noticed by central office andinvestigated.

    Unknown

    Loan officer collects repayments from clients and keepshalf for himself. Records only half paid on the books.

    Internal audit department reviews reportsdaily and discovers insufficient paymentfrom clients of one loan officer.

    $500

    Loan officer charges his clients a fee to apply for aloan. Officer keeps the fee.

    Tip from a client. $100

    Loan officer in remote rural area disburses and collectsloans in cash. Officer keeps some of the repayments.Argues that he lost loan payment receipts. Most clientsdo not demand receipts.

    Loan officer under suspicion because ofsloppy paperwork. Delinquency increasesand central office investigates.

    $3,000

    Loan officer, in conjunction with supervisor andregional internal auditor, set up ghost groups in a verysuccessful high growth branch. Loans were repaidfrom new loans.

    Tip from an employee. Taken to court. $900,000

    Highly trusted credit manager makes 13 large loans tomicroentrepreneurs and takes back a major portion ofthe loans for personal use. Manager has authority toapprove loans.

    Increase in delinquency is noticed on theselarger loans. Collections lawyerinvestigates.

    $6,000

    MIS specialist issues fictitious loans on smart cards,withdraws the loan funds from participating banks, andrecords non-existing payments on the informationsystem.

    Tip from an anonymous source. Externalauditors were beginning to discoveraccounting anomalies.

    $67,000

    Cashier steals last group loan repayment of the day.Does not record payment on the system, yet stampsclients receipt.

    Credit officer notices group has not paidits loan. Visits group and discovers thefraud.

    $100

    Branch manager (also loan officer) in rural area givesout loans to relatives. As delinquency rises he issuesmore poor loans to reduce his delinquency rate. Asdelinquency rises again, begins to steal from petty cashto repay loans

    Increase in delinquency. Accountantconducts a surprise visit and discoversmissing petty cash.

    $10,000

    Highly trusted administrative officer purchasedcomputers and furniture at higher than market pricesreceiving a kickback. Officer leaves to take a better job.

    When new furniture is purchased monthslater, new administrator discovers the highprices paid by previous administrator.

    Unknown

    Highly trusted finance manager, who controls allprogram accounts, transfers funds to his personal bankaccount, with the apparent intention of repaying soon.Finance manager is then switched to anothermanagement position in a reorganization.

    New finance manager discovers missingfunds. Manager confesses. Case taken tocourt.

    $10,000

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    Managers are involved in the second type of fraud. There are usually fewer instances of fraudinvolving management, but they tend to be for larger amounts of money. Fraud bymanagement may involve collusion in the issuance of loans, manipulation of financial dataincluding computer fraud, transfer of funds into managers personal accounts, and kickbacks oncontracts or asset purchases.

    Clients are also involved in fraud, typically by bribing loan officers to receive loans. Theprevalence of this type of fraud is hard to measure, but it probably varies widely from countryto country. Client fraud tends to be for small amounts, particularly since the loan sizes areusually small. However, where stepped loan sizes increase too rapidly, clients have beenknown to repay small loans quickly in order to receive larger loans, which they have nointention of repaying.

    Regarding fraud amounts, in cases where larger sums were lost, some level of managerperpetrated the fraud and usually collusion was also involved. The people committing largescale fraud were often highly trusted employees. Collusion is very hard to detect especiallywhen trusted staff members are involved. These findings suggest that microfinance institutionsshould be regularly scrutinized by well trained internal and external auditors who verify loanbalances with a statistically significant sample of clients.

    Fraud is usually detected in three different ways. The most common detection method is thatthe institution notices increases in delinquency and investigates the matter. For this method tobe effective, the MFI must have an information system that is current and accurate. The othertwo typical types of detection are through accounting anomalies and tips from other employees.Institutions that are aware of these sources of detection can create internal control strategies tocultivate them or heighten their effectiveness. For example, the institution can create anenvironment in which employees feel compelled to expose dishonest colleagues. Similarly,unusual increases in delinquency in a branch should be examined by an objective outsider as amatter of course.

    Institutions Vulnerable to Fraud

    There are several features that make MFIs more vulnerable to fraud:

    A weak information system exposes the institution to fraudulent practices. If an MFIcannot detect instances of delinquency at the loan officer level, then it could havesignificant problems with fraud.

    A change in the information system is a time of particular vulnerability. To protectagainst fraud when an institution introduces a new computer system, , it is commonpractice to run the old and new system in parallel until both have been audited;

    Weak or non-existent internal control procedures create an environment in which fraudcan be prevalent. Many MFIs do not have an internal audit function and their externalauditors do not even visit branches, much less confirm client balances. In theseinstitutions, fraud is likely to be rampant;

    MFIs are vulnerable when they have high employee turnover at management,administrative, or loan officer levels;

    If the organization offers multiple loan products or if its products are not standardized,staff and clients have an opportunity to negotiate mutually beneficial arrangements;

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    If loan officers handle cash and if clients do not understand the importance of demandingan official receipt, the MFI is extremely vulnerable to wide scale, petty fraud;

    When an MFI experiences rapid growth, it is difficult to cultivate the depth of integritythat is required among staff, and it creates a challenge for internal control practices to keeppace. A rapidly growing institution often creates a thriving environment for fraud.

    Key Challenges

    An awareness of the causes and vulnerabilities of fraud raises three key challenges formicrofinance institutions. The first challenge is to maintain effective control of fraud withoutexcessive costs or burdensome procedures as the program grows. It is important to realize thatfraud cannot be eliminated. It can only be reduced. The institution needs to make decisionsregarding internal control to avoid straight-jacketing the staff and undermining the quality ofservice provided to clients.

    Second, it is a challenge to promote staff morale and a culture of ethics in a large, growinginstitution. When the MFI is small, it often has a family atmosphere, and people are less likelyto steal from their family. But as it grows, and the top and bottom of the organization getfurther apart, it is easier for credit officers to consider stealing from faceless names that theyhave never met. Morale can also be a problem if the institution does not respond swiftly andmercilessly when fraud becomes apparent. If staff are aware that a colleague is getting awaywith fraud, it may encourage others to get involved as well, or at least it will discourage themto the point where they care less about the quality of their performance.

    The third challenge is for senior management to develop an awareness of new, more complextypes of fraud, such as computer fraud, to which the institution will become increasinglyvulnerable as it develops new products and increases its level of sophistication. This isparticularly important since this is the type of fraud where the organization can lose large sumsof money, and where detection can be the most difficult.

    PANEL ON FRAUD AND INTERNAL CONTROL: BRI, K-REP, PRODEM

    Internal Control Procedures at BRIs Unit Division

    Suharsono, Managing Director for Operations, Systems, and FinancialAdministration, Bank Rakyat Indonesia

    As a financial intermediary, Bank Rakyat Indonesia (BRI) is responsible for managing otherpeoples money. If the bank is unable to set the right goals, monitor its progress, or motivateits staff, it will fail. One of the clearest signs of institutional failure is fraud. It reflects afailure of systems and a failure of managementparticularly the management of humanresources.

    BRI views fraud as morally, ethically, and legally unacceptable. In microfinance, there aretwo main types of fraud: misuse of cash and savings, and loan fraud. As with banks ingeneral, the risk of fraud is mainly internal. It is difficult to defraud banks that haveestablished procedures without staff involvement. This is evident from the data in Table 14,based on a 1993 survey on bank fraud in the United States. Nearly two thirds of the cases offraud involved just bank staff, and in another third of the cases, fraud was perpetrated by staff

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    colluding with an outsider. This highlights the point that fraud is primarily a human resourcemanagement problem. This table also illustrates how the more sophisticated types of fraudinclude significantly larger amounts of money.

    Realistically, a financial institution will never be able to eliminate fraud. To attempt to do sowould carry heavy costs and would inevitably cause the bank to miss opportunities for profit.It is possible, though, to institute internal control measures to help prevent, detect, and correctfraud. Indeed, microfinance institutions have some advantages over commercial banks in fraudcontrol and prevention. The unit division of Bank Rakyat Indonesia helps to illustrate theseadvantages, as well as the costs.

    The BRI Unit Division

    The BRI unit division is an important part of BRI, a large state-owned commercial bank. TheBRI units offer simple, non-subsidized credit and savings services to their customers, whichare mainly low income households and microentrepreneurs. There are over 3,600 unit bankoffices and nearly 400 service posts throughout Indonesia. A BRI unit is typically staffed byfour or five well-trained people from the local area. On average, there are about 200 reportedcases of wrongdoing per year within the unit division, but only a few involve amounts morethan $4,000. Given that the unit division has 2.5 million borrowers and a loan portfolio ofUS$1.7 billion, and US$2.8 billion in 15 million deposit accounts, overall BRI has done aneffective job at minimizing fraud.

    The unit division represents the microfinance activities of Bank Rakyat Indonesia. The unitsaccount for 17 percent of BRIs loan portfolio and 41 percent of the banks deposits. As astrategic business unit of the bank, the units are directed by their own division at the BRI headoffice. The current performance of the unit division is excellent, and the units contribute asignificant portion to the profitability of Bank Rakyat Indonesia, indicating that microfinancecan be at least as profitable as traditional banking.

    The units have existed since the early 1970s as a lending body of the BIMAS (integrated massguided) national rice intensification program. The main activity of the units at that time was toextend subsidized BIMAS credits. In 1984, when the government decided to discontinue the

    Table 14: Fraud Survey: United States Banks (1993)

    By Whom?

    - Own Staff 63%- Collusion with outsider 32%- Outsider 5%

    Why (Motivation)?

    - Financial purposes 74%- Intellectual challenge 19%- Other 7%

    Average Loss (per case)

    - Computer Fraud US$500,000- Non Computer Fraud US$ 23,500- Theft US$ 450- Robbery US$ 250

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    BIMAS program, it was decided that the existence of the units, including 3,600 offices and14,000 people, must be protected. The only appropriate means of continuing operations wasto convert them into a fully commercial division of BRI.

    To address this challenge, the units introduced a new loan product, KUPEDES or general ruralcredit. This was designed to serve the credit needs for all productive activities, not justagriculture, and it was priced at non-subsidized interest rates. In addition, the units becamerural financial intermediaries by getting actively involved in savings mobilization as well aslending. The operations of the unit division are no longer associated with BIMAS or any othergovernment program, but it is a profit generating division of the bank.

    Key Attributes of the Unit System for Fraud Prevention and Control9

    Over time, BRI has identified six key factors in preventing and controlling fraud in the unitdivision. In practice, the factors which help prevent and control fraud are the same ones whichhelp ensure the units commercial success.

    1. Market Pricing. Lending at market rates is probably the single most important step that amicrofinance institution can take to reduce fraud. Below-market pricing will guarantee thattwo types of distortions occur. First, well connected persons will attempt to secure theinexpensive money, taking it away from the target market. Second, subsidized rates will invitebribes to persons who make loan decisions. At below market rates, the borrower can afford topay a bribe to the credit officer. Market pricing reduces the attractiveness of these behaviors.Market pricing signals to the customer that the bank is in the business of lending, that the bankchooses productive borrowers, and that the bank intends to be repaid.

    2. Simplicity. The second key feature is simplicity: in the number of activities at a lendingpoint, in loan structure (interest rates and loan terms) and in administration. Fraud thrives oncomplexity. The BRI units are structured very simply, with small offices, limited products,and specific assignment of responsibilities. A typical fraudulent scheme would be for a loanofficer to take a bribe in exchange for arranging a sweet deal such as a low interest rate witha long time lag before repayment. At the BRI units, there are standardized loan terms with nonegotiation of interest rates, reducing the chance for this type of fraud.

    3. Transparency. The ability to see clearly what is happening at a unit and to pinpointresponsibility for outcomes starts with the accounting system and the loan product. Each BRIunit is a separate profit center with its own balance sheet and profit and loss statement. AllKUPEDES loans carry clear repayment schedules, usually in installments, without thepossibility of ever-greening (i.e., rescheduling repayment dates).

    Transparent unit-level accounting simplifies the job of detecting unusual transactions orsudden changes that may indicate fraud. If there is a deterioration in repayment at one unit,decentralized reporting makes it easier for supervisors to spot than if the units loan totals aremixed with other units. Keeping the units on a cash rather than accrual basis further simplifiesthe accounting and makes it easier to notice problems that may indicate fraud.

    9 This section draws on the USAID Microenterprise Development Brief Number 6, Controlling Fraud inMicrofinance Programs, June 1995.

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    To help ensure transparency, BRI requires all transactions to take place inside a unit or servicepost. The units are conveniently located for clients, and customers have to come to the unit toreceive money or make payments.

    Accountability and the Loan Process. The BRI Unit Manager and the loan officer are heldresponsible for making good loans and ensuring repayment. A point of fraud vulnerabilityoccurs at loan origination. At the units, loan origination consists of a field visit to thecustomers business, a character check, and the approval process. The field visit is essential tomake sure that the loan makes sense in terms of the scale of business, and to determine thatassets actually exist. The field visit allows the credit officer to estimate the value of assets,liabilities, earnings, and cash flow, as well as interview key local people to obtain insight intothe applicants character.

    It is not a good idea to have the person who makes the field visit also approve the loan. At theunit level, the Unit Manager is the only person with authority to approve loans. The creditofficer is responsible for initiating and analyzing applications, and recommending theirapproval. Collusion is possible, but involving two people helps keep the process honest andharder to cover up. Putting a limit on the authority of the unit manager is also useful inreducing fraud, at least for larger loans. Loan limits are reviewed regularly and adjusted up ordown as Unit Managers demonstrate their ability through repayment rates.

    Intensive, Purposeful On-site Supervision. Monitoring at the Unit Division consists of areview of monthly reports from each unit plus weekly visits by a supervisor. BRI has onesupervisor for every five units who serves in an internal audit capacity.

    To keep the information system simple, the units submit only five reports each month: Profitand Loss Statement, a Balance Sheet, the Credit Report (including aging of arrears), SavingsReport, and the Unit Development Report, which includes a summary of key indicatorsarranged in a time series. These reports are read by the units supervisor as well as by othermanagement layers. If a problem appears, auditors are called in from the regional office toconduct a special internal audit.

    Supervisors visit each of their units one day each week. At the unit, the supervisor checks thecash, inspects the books to see if they are current and in balance, ensures that the teller isissuing valid receipts, and discusses any problems with the Unit Manager. In addition, thesupervisor checks directly with customers to see whether the records of the unit agree with thecustomers records. Ideally, the supervisor checks 100 percent of loan customers who are inarrears for more than one month, plus a percentage of savings customers and loan customersnot in arrears. Most corruption is found from checking of loan customers in arrears. Since theunits have become computerized, savings fraud is relatively rare.

    This running audit by a supervisor is critical to reduce instances of fraud. An annual auditby the banks internal auditors is not sufficient. The portfolio of a unit can be destroyed withinmonths by corruption or a slackness in pursuing arrears.

    Effective Human Resources Management. Paying attractive salaries to employees, at leastequal to their best alternative employment, also deters fraud. In addition to good salaries, BRIoffers performance-based bonuses, which serve as a significant salary supplement. BRI alsohas a dependable and attractive pension plan. Finally, the bank is working to ensure that unitstaff can pursue a genuine career path, and that performance reviews and promotion scales arefrequent and fair. Not all incentives are purely financial. System managers report that the

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    recognition unit staff receive for winning the semi-annual Unit Performance Contest is at leastas important as the cash bonus, though the money is also appreciated.

    On the other side of the coin, unit staff are aware of the exact penalties for improper action.BRI publishes a list of the thirteen most common types of wrongdoing and the associatedpenalties. Once the facts are established, unit staff have no doubt that sanctions, includingfiring, will be carried out.

    Conclusion

    The six key factors outlined abovemarket pricing, simplicity, transparency, accountability,on-site supervision, and effective human resources managementare generally applicable toany financial institution. Ultimately though, even strong systems will not work unless there isa commitment to implement them starting at the top of the organization. To be effective incurbing fraud, senior managers must show that they are committed to upholding high standardsof ethical behavior and expect the same from the entire organization. Fraud may be a fact oflife, but that is no reason to tolerate it.

    The arrangement and implementation of a strong control system within the organization willdefinitely help in preventing and detecting fraud in daily operations. Strict and adequatecontrol-oriented operation procedures are needed for all levels of staff to execute their jobs.Control has to be done continuously with two main purposes. First, it needs to evaluate theadequacy and sufficiency of the standard operating procedures. Second, control practices mustevaluate and maintain the assurance that all tasks are in compliance with the standard rulesand procedures. These two control purposes are depicted in Table 15.

    Finally, it is important to consider the importance of the rapid development of bankingbusiness operations driven by the advancement of information technology (IT). A very carefulapproach must be taken when implementing information technologies in microfinance. Fromthe operations perspective, microfinance can benefit significantly from the IT utilization. IT

    Table 15: Management and Control Function for Financial Institutions

    ManagementSet Standard Procedures for Operations(with built-in control requirements)

    Operations-funding-lending-other services-settlement-support: accounting general affairs reporting

    Control-prevention-detection-correction

    Minus(-)

    Equals(=)

    CalculatedAcceptableBusiness Risk

    Control Function

    Review and evaluateimplementation compliance

    Review adequacy and sufficiency ofstandard procedures

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    can increase the efficiency and the scope of microfinance operations. On the other hand, thereare limitations to the implementation of technology due to the clients low education levels,limited infrastructure (particularly in rural areas), and the high costs of equipment and trainingbank staff. However, the rapid advancement of IT for microfinance has to be anticipated,including the improvement and perfection of controls.

    The Experience of Fraud at K-Rep

    Janet Mabwa, Finance and Administration Manager, K-Rep, Kenya

    At K-Rep, fraud incidences started emerging once the organization reached approximately 100employees and 10,000 clients. At that point, K-Rep had outgrown its intimate family culture.Administrative responsibilities of managers increased to the extent that they were not able topay sufficient attention to the operations. About the same time, K-Rep began introducingflexibility into its loan products, for example credit officers could vary loan sizes. Thesechanges, which gave more responsibilities to loan officers, were put in place in the interest ofimproving customer service by simplifying some of the procedures. They however createdfraud opportunities.

    The fraud situation at K-Rep is complicated by an inefficient and corrupt court system inKenya. When the court process works, it takes too long and corrupt officials are often willingto work out deals to let fraudulent staff off without penalty, making it difficult for K-Rep toprosecute fraud offenders. Recently, K-Rep took a staff member to court for fraud, but theperson bribed corrupt government officials who threw the case out of court for insufficientevidence. Now that person is suing K-Rep for falsely dismissing him. In addition to the courtsystem, there is widespread corruption in Kenya, which tends to promote a culture thatgenerally permits corrupt practices.

    Types of Fraud

    The most common type of fraud is collusion between credit officers and clients. This may takethe form of fictitious clients or inflated loan sizes. In this latter scenario, the group may wantUS$100, but the staff member colludes with one or more group officials to request $200, ofwhich $100 goes to the credit officer. Another type of staff fraud is outright theft by creditofficers who pocket repayments rather than depositing them.

    Another type of fraud involves the group methodology. Group leaders have been known tosteal loan repayments and savings deposits entrusted to them, or to collude with some groupmembers to withdraw money from the group savings account. Occasionally, bank staff arealso involved in this collusion. These arrangements are forcing K-Rep to reevaluate itsprocedures to reduce the opportunities for fraud and to heighten its control practices.

    Impact of Fraud

    Staff fraud ultimately results in declining staff morale and a lax attitude. As repayment ratesplummet, good staff become depressed because they do not see an end in sight. Discipline anddiligence are replaced by a civil service mentality. Group formation, loan applications, anddelinquency follow-ups are done poorly. Hard working staff despair when they see corruptstaff going free. Managers tend to give up when they perceive a helpless situation. At thesame time, corrupt staff feel invincible because they can find jobs with other microfinanceinstitutions that employ staff who have been sacked from organizations that they defrauded.

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    At the client level, this situation promotes a default culture whereby some clients may perceiveMFIs to be like most corrupt government schemes. This perception encourages some clients toform designer groups for the sole purpose of defrauding K-Rep. When fraud takes root,word spreads fast, causing good clients to turn bad. In one branch, for example, K-Rep had acorrupt credit officer, and soon clients throughout the entire area tried to take advantage of thesituation. If clients do not take advantage of the situation, there is a likelihood that they willstop borrowing from the organization. Good clients do not want to be associated with acorrupt system. Consequently, fraud results in clients desertion, a reduction in staffproductivity, and an increase in operation costs arising from extended clients recruitmentcampaigns.

    Controls

    To address this problem, K-Rep has introduced a series of controls, policy changes, and humanresource initiatives, which collectively are beginning to have an effect. It is possible to keepfraud in check in this environment, but it is a significant challenge.

    Lending Policies: K-Rep has standardized all loan procedures and removed flexibility sostaff cannot make any decision outside the regulations. All clients and all applicationsmust be authenticated by a manager so no staff member is solely responsible for theirportfolio and the decision making process.

    Management: The organization has emphasized management training to increasemanagers capacity and to introduce strict supervision processes. K-Rep has also addedassistant managers to share the work load and reduced the areas that branches are servingso that the distance is more manageable.

    Inspections Unit: K-Rep has established an inspection unit that performs random checkson all aspects related to lending staff. This unit is manned by experienced credit officers,not auditors.

    Human Resource Policies: K-Rep fires staff involved in fraud immediately and circulatestheir names to other MFIs. The human resource department has developed a profile offraudulent staff to determine their personal characteristics and how they were employed.This profile has resulted in refinements to the recruitment process to avoid employingpersons with similar characteristics. In addition, staff are no longer posted to their homeareas to reduce the opportunity and the temptation for collusion.

    Clients: Since clients are often unwilling participants in staff fraud, K-Rep has introduceda client education campaign to encourage them to speak out against corrupt staff andgroup leaders. This is important not only to enlist their support in the fight against fraud,but also to send the message that fraud is not acceptable at K-Rep.

    To circumvent fraud that stems from desperation on the part of staff members, K-Rep hasintroduced staff loan products. K-Rep also ensures that it pays its staff well relative to otheravailable employment to reduce the temptation and to increase the penalty if they areterminated. Other measures under consideration to reduce fraud and collusion are regular staffrotation within a branch and periodic transfers of staff to other branches.

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    Everything You Wanted to Know about Fraud (But Were Afraid to Ask)

    Eduardo Bazoberry, Managing Director, PRODEM, Bolivia

    When PRODEM was a small institution, it thought of itself as a family. Senior managementknew the names of all the employees, and often knew their spouses and childrens names aswell. People do not usually steal from their families. But as the organization has grown andbecome less intimate, it has become increasingly vulnerable to fraud.

    From 1992 to 1996, PRODEM believed that there were only three cases of fraud. The largestfraud was for $4,300, and the perpetrator went to jail for two years because the organizationproved that he took money from their clients. This was well publicized within theorganization, which helped to minimize other occurrences of fraud.

    But as PRODEM grew, it became increasingly apparent that the institution required moreserious internal control practices, including an internal audit department that reports to theboard of directors. Once this team was in place, it realized that there has actually been anongoing series of fraudulent practices that had gone unnoticed until the three-person internalaudit department began closely scrutinizing branch practices. For the most part, these involvedminor but frequent occurrences of field staff using PRODEM money for personal business andthen replacing the money in time so that no one knew. Even though this is a relatively minorissue compared to the tens or hundreds of thousands of dollars lost at some MFIs, if employeesget away with minor fraudulent practices that can feel bolstered to try things that are moredamaging. Fraud must not be taken lightly or it will escalate.

    While PRODEM is very serious about fraud, it also feels strongly that the internal auditorshould not be perceived as the bad guy. The organization wants to have an institutional cultureof trust. If branches feel that the internal auditor is there to look over their shoulders, it willundermine this culture. If the auditor adopts an inspector-like approach, then field staff will beuncooperative and this will not promote appropriate working relationships. The internalauditor needs to be a facilitator. There has to be an appreciation throughout the institution thatthe internal audit team is good for everyone, from credit officers all the way up to the board.

    Creating this appreciation is a challenge because it requires the internal auditor to assume adual function. If the internal auditor finds procedural problems in the branch that are inconflict with the manuals, his role is to serve as a trainer to prevent fraud, telling staff that it ishis job to train them on internal control procedures. But if he finds that money is missing, theinternal auditor will close the branch immediately. He will call the regional manager and theaccountant from the head office. PRODEMs internal control policies require that they are inthat branch in less than 24 hours.10

    To support the efforts of the internal audit department, regional and national managers havealso been trained to conduct similar inspections when visiting the branches. Staff do not viewthese inspections as if management is policing them because PRODEM has done extensivetraining to explain that internal audits are for their own protection. This is achieved byconvincing them that if they follow the procedures to the letter, no one can accuse them offraud. But if they lock money in their desks overnight instead of putting it in the vault, for

    10 The margin of time depends on the location of branches; branches in regions that are close to the head officewill receive a visit immediately.

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    example, and it gets stolen or misplaced, that staff member will be accused of fraud. Toprotect themselves, they need to follow the control procedures.

    The most important fraud prevention strategy is to create a culture in the organization, fromthe top down, that fraud is unacceptable. Fraud prevention begins with staff training. Fromthe very first day of training, PRODEM emphasizes the following core values: teamwork,transparency, and responsibility. At the end of the training, there is an exercise where newhires write a list of the ways they could destroy the organization. For example, one creditofficer trainee wrote: If I am irresponsible, if I am late for work, if I touch the institutionsfunds, steal, lie, make bad use of the methodology, issue bad loans, do not work with mycolleagues, issue ghost loans, or if there is no common objective. After a series of fraudcases, management reviewed the training records of staff members who were fired for fraud,and nearly all of them neglected to write that stealing would destroy PRODEM. Now theorganization reviews these exercises more closely to see who neglects to mention that stealingcould destroy the organization.

    There are two main types of fraud: treasury and operational. Treasury fraud involves howmoney is handled, between the till and the vault, and the transfer of funds between branches,the regional and head offices, and between PRODEM and the banks. PRODEM conducted aninternal assessment to outline the types of treasury risks that might exist, and appropriatecontrol and audit mechanisms to guard against that risk. The results of the assessment,outlined in Table 16, have helped the organization to design its treasury manual.

    Operational fraud occurs with the loan application, or between the loan officer and the client,and may involve bribes from clients. PRODEM has done a similar exercise with operationalfraud to outline the risks, and the control and audit mechanisms. A critical aspect ofconducting internal audits to test for operational fraud involves visiting clients. The internalauditor needs to ensure that borrowers exist, that their businesses exist, and that they believetheir outstanding balance is the same that PRODEM believes it is.

    PRODEM does not believe that higher salaries and incentives are sufficient to reduce orprevent fraud. Higher salaries will not solve the problem because when people make moremoney they spend more money. In fact, since PRODEM introduced incentives two years ago,it has had more incidences of fraud, of people trying to beat the system by trying to show noarrears in the branch through creative reporting or mixing personal money with PRODEMmoney.

    The answer to fraud prevention lies in ethics and the institutional culture. Everyone in theinstitution has to care if one dollar is lost. In addition to training, one way of promoting thisculture is through a horizontal institutional structure that makes everyone feel that they have animportant responsibility. If the horizontal structure is supplemented with an effectivecommunication channel and a participatory planning process, it will promote openness andcommitment that will discourage fraud.

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    AUDITING: THE MISSING DIMENSION IN MICROFINANCEHenry Jackelen, Special Unit for Microfinance, UNDP, USA

    All substantial microfinance institutions are audited, usually on an annual basis. However,there is reason to believe that the accuracy and effectiveness of this vital exercise inguaranteeing transparency in this infant industry is far from the standards of traditionalfinancial institutions. The fundamental structural differences that exist between microfinanceand other forms of finance have not been considered and incorporated in developing a distinctand reliable methodology that will allow the same level of verification and validation forunsecured lending operations to low-income clients.

    Table 16: Treasury Risks, Controls, and Auditing Procedures

    Treasury Risks Treasury Controls Treasury Auditing Procedures Collection of money not

    declared by cashier

    Repayment of loans that are notin the system

    Too much cash in the safe Branch bank accounts not

    maintained in the name of thecompany

    Accounts kept with high riskbanks

    Not establishing policies forauthorized signatures

    Not canceling authorizedsignatures of former employees

    Over priced purchases Maintaining lazy resources

    (money without generatingearnings)

    Not executing daily closing inthe branches

    Structure a clear organizational planidentifying authorization levels andprocedures

    Develop a functions manual thatspecifies the general and specifictasks that should be followed at alllevels

    Develop a treasury manual thatspecifies:

    Qualifying banks Authorized signatures limited to

    certain amounts Maximum amounts to be

    maintained in the till Use of combination and keys for

    safe or vault Installation of alarm systems and

    training of the employees in itsuse

    Develop clear instructions for thedisclosure of cash

    Establish weekly and monthlyprojected cash flows for each branch

    Restrict access of non-authorizedpersonnel to areas where cash andsecurity are managed

    Establish levels of security so userscannot modify transaction files

    Establish physical and logical keys(password) to enter computer

    Conduct daily back-ups of computersystem

    Conduct surprise audits of tilland petty cash in all offices(including head office)

    Detect flows of unusualamounts or abnormalfluctuations

    Review historic record ofcashiers with surpluses anddeficits

    Verify balances over theestablished limit in the till

    Verify that money is declaredentirely on the date of collection

    Verify that expenses arepertinent and properlyauthorized

    Compare balances of the tillwith the backup reports fromthe information system

    Verify the movement of fundsin bank accounts is incompliance with authorizedsignatures

    Confirm account balances withbanks

    Evaluate operation of computersystem with emphasis on levelsof security, levels of access,accountability, and theoperating environment

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    In traditional commercial banking, at a very basic level, the external auditor is the final cross-check. But few auditors have developed an effective means of auditing a microfinanceinstitution, nor do they necessarily understand how microfinance works. It is important toremember that the Colombian affiliate of a major international accounting firm issued a cleanaudit on Finansol about six months before the crisis was discovered.11

    There is one basic difference between microfinance and normal commercial banking thatundermines the application of standard auditing practices to MFIs. In banking and most formsof commercial finance, an inherent check and balance exists by the fact that all lending issecured in some form. On the other hand, by definition microfinance is predominantlyunsecured lending. In traditional banking, a substantial element of the prudent creditprocedures has to do with verification, registry, and control of security and guarantee. Theseare largely absent in microfinance.

    External auditors in traditional finance have a much easier job than those dealing with MFIsbecause the most crucial measure of financial healthquality of assetshas a number ofinternal procedures and cross-checks that allow for external verification and validation. Thelack of collateral in microfinance throws auditing off-balance. The financial assets of amicrofinance institution are not backed by the type of assets or security with which an auditorfeels comfortable.

    As unsecured lending, microfinance is often compared to consumer finance. But in consumerfinance, there is a television or a refrigerator attached to that loan, which can be collected ifthere is no payment. Even in corporate working capital lending, it is possible to secure theloan through stock, receivables, or other methods. A credit card is also similar tomicrofinance, but a self-employed person, particularly in the informal sector, cannot usuallyobtain a credit card. They need to have an employer, a salary, and a credit history. Inaddition, banks that do unsecured lending do not have their entire portfolio unsecured. In fact,the Basle Committee created risk-weighted assets for that very purpose. But if BancoSolfollowed the Basle Committee rules, it would have to close its doors today. It would not beallowed to have all of its portfolio unsecured.

    Unsecured lending places microfinance in another risk category. Microfinance loan officersare basically given the authority to create an asset without counterbalancing security. Ifmicrofinance wants to enter the formal financial system, it has to figure out a way of either a)playing by the traditional rules, or b) creating new rules that meet the same objectives, but aremore appropriate for microfinance practices. If MFIs play by traditional rules, then they willbe involved in traditional rather than micro finance. The only real option is to create newrules.

    How can auditors make up for this lack of collateral to create the necessary standards formicrofinance auditing? What does this industry need to allow external audits to function inpredictable, clear, and universal terms, and to be taken as a serious validation? Since MFIs donot hold assets as security, it is necessary to determine what else is available. There are fourpossible solutions that should be considered. By themselves, none of them are sufficient, buttogether they may provide a solution:

    11 This crisis is described in detail in the Networks publication, Establishing a Microfinance Industry, 1997.

  • Moving Microfinance Forward

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    1) Procedural audit. All MFIs have policies and procedures that are designed to achieveinstitutional objectives, including minimizing fraud and loan loss. In unsecured lending,the procedures are one way of compensating for the lack of collateral, and therefore it iscritical that procedures are strictly followed. For audit purposes, the issue is whether fieldstaff are properly implementing these procedures as outlined in the operations manual. Anaudit of procedural practices gives auditors an anchor to something that is methodologicalrather than to security. The procedural audit would include checks to ensure items suchas:

    applications and loan analysis were done correctly loan sizes and terms comply with company policy loans were approved by the proper people legal documents were properly signed and notarized and kept in the appropriate place delinquency management timing and procedures are correctly followed

    The challenge for a procedural audit is that it cannot just be done by looking at documents.Auditors need to observe many of the procedures in action to assess whether they werefollowed properly. Yet, if staff are aware of the procedures, and they are aware that theyare being observed, this process is not likely to expose any discrepancies. Another meansof observing the procedures is through client interviews, but this has to be handledcarefully to gather accurate information without upsetting clients or hurting the client-staffrelationship.

    2) Portfolio quality. For an MFI, the biggest issue is the quality of its assets. If assets arebad, the organization can be destroyed. Consequently, auditors need to verify theorganizations arrears. The head offices portfolio data needs to be reconciled with thebranches data, which then needs to be reconciled with the clients information. The twokey issues are the actual amounts outstanding and the accuracy of the portfolioclassification. For example, is the MIS indicating that a loan is current when it belongs inthe 1 to 15 days delinquent category? This requires client confirmation as well as ananalysis of the information system. In addition, auditors need to look closely at non-performing and restructured loans to ensure that the MFI is not involved in creativeaccounting.

    3) Client sampling. Auditors do not take anything at face value; everything must be verified.In microfinance, the real source of this verification are the clients themselves. But MFIsserve tens or hundreds of thousands of clients. It is not realistic to verify every loan.Auditors need to verify information with a statistical sampling of clients. The size of thesample will depend on the total number of active borrowers, an agreed upon error margin,and the confidence level that the institution wants to achieveand it will probably dependon how much money the organization is willing to spend. For the development of themicrofinance industry, sampling procedures need to become a science so that all MFIssample in the same way.

    More crucial than the number of clients sampled is the verification process. Auditors arelikely to pursue either negative or positive sampling. Positive sampling involves writing toselected clients, please confirm that this is your outstanding balance; negative samplingmeans writing to clients, do not bother to contact us unless this balance is wrong. Giventhe characteristics of microentrepreneurs in developing countries, neither of these

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    approaches are appropriate. It is necessary to go to the client, make sure that they exist,and to have them volunteer their account balances rather than just verify the institutionsbalances with theirs.

    4) Industry benchmarking and trend analysis. For effective microfinance auditing, thisindustry needs established standards or benchmarks. This will allow auditors to comparethe performance of an organization to similar institutions. Finance people do not likefluctuations. They can deal with trends, but not fluctuations. Another feature ofmicrofinance audits should be trend analysis of portfolio quality. This will demonstratethat unsecured lending can be safe, but it must be demonstrated over a period of time.Given the fast rotation of a microcredit portfolio, performance standards may be bestderived from approaches similar to actuarial or insurance concepts. The statisticalanalysis of performance and risk based on a number of client variables may be animportant tool in developing quality indicators and the means of predicting performance.The quality and the form of the data is crucial to establishing creditability with auditorsand investors.

    These four dimensions represent initial thinking on this topic, but microfinance auditingthemissing dimensionrequires a more thoughtful discussion. Unfortunately, the auditingindustry is not interested in developing standards and procedures for microfinance auditsbecause the number and scale of MFIs is relatively insignificant. So it is up to themicrofinance industry to develop its own requirements and communicate them to auditors.

    There are some significant challenges to creating effective audits. One of the biggestchallenges is the cost involved. If external auditors were asked to address the four issuesoutlined above, a proper audit might bankrupt fledgling MFIs. Perhaps the most centralrecommendation is the fundamental need for a carefully defined internal auditor position in anyMFI, regardless of size. The four elements discussed are a starting point to develop thisposition and allow an external auditor greater latitude in verification and reconciliation. Witha well defined set of internal audit procedures and functions, the external audit will be easierand will facilitate a higher level of sophistication.

    In an age of rapidly expanding capital flows and evolving financial markets, microfinanceneeds to establish the benchmarks, parameters, and methods which enforce universal standardsthat allow the quality of assets of these institutions to meet international criteria. This is abasic requirement not only to expand access to equity and loan capital, but to build the level ofconfidence and transparency that allows the infant microfinance industry to mature and endurein a global economy. The undesirable alternative is to remain donor dependent and vulnerableto the changing whims of political agendas.

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    LIST OF CONFERENCE PARTICIPANTS

    Network Members

    ACCION International Michael Chu President and CEO USA

    ACCION International Maria Otero Executive VP USA

    Accion Comunitaria del Peru Manuel Montoya Executive Director Peru

    Alexandria Business Association Nabil El Shami Executive Director Egypt

    Association for SocialAdvancement

    Shafiqual Choudhury Chief Executive Bangladesh

    BancoSol Hermann Krutzfeldt Managing Director Bolivia

    Bandesarrollo Microempresas Mauricio Rojas President Chile

    BRAC Fazle Hasan Abed Executive Director Bangladesh

    BRI Unit Desa Sugianto Managing Director Indonesia

    BRI Unit Desa Jarot Eko WInarno Manager Indonesia

    Calmeadow Martin Connell President Canada

    Calmeadow Paul Royds Managing Director Canada

    Centenary Rural DevelopmentBank

    Januario Ntungwa Operations Manager Uganda

    CHISPA Joaida Castillo Managing Director Nicaragua

    Citi Saving and Loans Peter Ocran President Ghana

    Cooperativa-Emprender Claudio Higuera Manager Colombia

    FED Cesar Alarcon Executive Director Ecuador

    Fundacion Emprender Juan Padilla Executive Director Argentina

    Fundusz Mikro Rosalind Copisarow Executive Director Poland

    Get Ahead Financial Services Yvonne Radinku HR Manager South Africa

    K-Rep Kimanthi Mutua Managing Director Kenya

    K-Rep Janet Mabwa Finance Manager Kenya

    MicroFinance Network Craig Churchill Network Coordinator USA

    PRODEM Eduardo Bazoberry Executive Director Bolivia

    PRODEM Fernando Romero President Bolivia

    TSPI Development Corp. Dennis Isidro President Philippines

    Special Guests

    CIDR Renee Chao-Beroff France

    DFID David Wright Senior Advisor UK

    EQI Mounir S. Neamatalla Chairman Egypt

    FONCAP Juan Pena Executive VP Argentina

    King Finance Corporation Barry Coetzee Regional Office South Africa

    MEDA Ronald Braun Vice President Canada

    UNDP, Private Sector Henry Jackelen Unit for Microfinance USA

    USAID Liza Valenzuela Microenterprise Office USA

    USAID - Egypt Magdy Khalil SME Branch Chief Egypt

  • Moving Microfinance Forward

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    MICROFINANCE NETWORK MEMBER LIST

    ACCION InternationalMaria OteroExecutive Vice President733 15th Street, Suite 700Washington, DC 20005 USATel (202) 393-5113Fax (202) 393-5115Email mariab@hers.com

    Accion Comunitaria del PeruManuel MontoyaDirector EjecutivoAv. Republica de Chile 683, Lima 11Calilla Postal 1744, Lima 100 PERUTel 51-1-433-5916Fax 51-1-433-5903Email accion@mail.cosapidata.com.pe

    ACEPMayoro LoumDirector General35 Avenue BourguibaB.P. 5817Dakar SENEGALTel 221-825-29-32/3Fax 221-825-29-35

    Alexandria Business AssociationNabil A. El ShamiExecutive Director52 El Horeya AvenueAlexandria EGYPTTel 20-3-483-4062Fax 20-3-482-9576E-mail nelshami@dataxprs.com.eg

    Association for Social AdvancementMd. Shafiqual Haque ChoudhuryChief Executive23/3 Block-B, Khilji Road, ShyamoliMohammadpur, Dhaka-1207BANGLADESHTel 880-2-810934, 9116375Fax 880-2-811175Email asa@bd.drik.net

    BancoSolHermann KrutzfeldtGeneral ManagerNicolas Acosta #289; P.O. Box 13176La Paz BOLIVIATel 591-2-318-363Fax 591-2-391-941Email hkrutzfeldt@bancosol.com.bo

    Banco del DesarrolloAlvaro ReamalesGeneral ManagerBandesarrollo MicroempresasAv. Libertador Bernardo OHiggins 969Santiago CHILETel 56-2-674-5860Fax 56-2-674-5644Email microemp@cmet.net

    Bank Rakyat IndonesiaSugiantoManaging DirectorUnit DivisionJl. Jend. Sudirman No. 44-46P.O. Box 1094Jakarta 10210 INDONESIATel 62-21-251-0312Fax 62-21-251-0313Email briunit@ibm.net

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    BRACFazle Hasan AbedExecutive Director66 Mohakhali C.A.Dhaka 1212 BANGLADESHTel 880-2-884-180Fax 880-2-883-542Email general@brac.bdmail.net

    CalmeadowPaul RoydsManaging Director365 Bay Street, Suite 600Toronto, Ontario M5H 2V1 CANADATel (416) 362-9670Fax (416) 362-0769Email international@calmeadow.com

    Centenary Rural Development BankDirk B. van HookCEOPlot 7 Entebbe RoadPO Box 1892Kampala UGANDATel 256-041-251275Fax 256-041-251273

    CHISPAJoaida Castillo BarqueroManaging DirectorPaseo La Reform, del hospital HilarioSanchez 1 y cuadras al norteBox 85, Masaya, NICARAGUATel 505-522-3805, 522-4711Fax 505-522-4478Email chispa@ibw.com.ni

    Citi Savings and LoansChristine DadsonExecutive DirectorWatson HouseP.O. Box 353Accra GHANATel 233-21-779-152Fax 233-21-722-409

    Cooperativa EmprenderClaudio Higuera MartinezGerenteCarrera 33 No. 89-68Santafe de Bogota COLOMBIATel 57-1-6-180362, 6-214889Fax 57-1-6-180483Email coopera1@latino.net.co

    Fundacion EmprenderJuan PadillaDirector EjecutivoParaguay 1039, El TalarProvincia de Buenos AiresARGENTINATel/Fax 54-1-740-5257E-mail emprender_ar@compuserve.com

    FEDCesar AlarconDirector Ejecutivo9 de Octobre #1212 y ColonQuito ECUADORTel 593-2-547-864, 547-873Fax 593-2-509-084Email fed@ecuanex.net.ec

    FINAMERICA (formerly Finansol)Jose Manuel MontanoPresidentCarrera 16 No. 6-66 Piso 32Santafe de Bogota COLOMBIATel 57-1-243-1004Fax 57-1-336-6030

    Fundusz MikroRosalind CopisarowExecutive Directorul. Zurawia 2200-515 Warszawa POLANDTel 48-22-629-0092Fax 48-22-628-8811Email fmwawa@ikp.atm.com.pl

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    Get Ahead Financial ServicesMpumzi PupumaManaging DirectorP.O. Box 6560101 DuToit Street, Topkor South Bldg.1st Floor, Office 6Pretoria 0001 SOUTH AFRICATel 27-12-323-1496Fax 27-12-323-1513Email getfin@mweb.co.za

    PRODEMEduardo BazoberryDirector EjecutivoCalle Pedro Salazar No. 509Sopocachi, La Paz BOLIVIATel 591-2-419-323Fax 591-2-418-148Email prodemebo@bo.net

    K-RepKimanthi MutuaManaging DirectorRing Road, KilimaniP.O. Box 39312Nairobi KENYATel 254-2-572422, 718-301/2Fax 254-2-711-645Email kimanthi@arcc.or.ke

    SEWAJayshree VyasManaging DirectorSEWA Reception Center, opp. VictoriaGardenBhadra, Ahmeabad-1, INDIATel 91-079-550-6477Fax 91-079-550-6446

    TSPI Development CorporationBenjie MontemayorManaging DirectorP.O. Box 12690, Emerald AvenuePasig, Manila PHILIPPINESTel 632-892-8389, 893-1460Fax 632-892-8389E-mail tspi@wtouch.com.ph

    MicroFinance NetworkAnita CampionDirector733 15th Street, NW, Suite 700Washington, DC 20005 USATel (202) 347-2953Fax (202) 347-2959Email acampion@sysnet.net

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    MICROFINANCE NETWORK MEMBER STATISTICS

    Network Member No. of Annual % Average Outstanding Portfolio Value ofand Country Borrowers Growth Female Loan Portfolio at Risk Deposits

    Rate Size (US$) (M US$) (M US$)ABA 14,443 12% 12% $841 $11.3 1.6% na(Egypt)ACEP 5,506 -1% 30% $526 $10.3 5.2% $2.0(Senegal)ACP 33,549 25% 61% $530 $12.6 5.4% na(Peru)ASA 638,294 0% 82% $106 $41.8 0.1% $15.0(Bangladesh)BancoSol 75,755 6% 65% $833 $63.0 2.0% $14.7(Bolivia)Banco del Desarrollo 19,861 18% 45% $1,250 $21.9 6.4% $2.0(Chile)

    BRAC 1,719,016 13% 97% $97 $94.7 2.0% $41.3(Bangladesh)

    BRI Unit Desa 2,615,679 5% 25% $386 $669.3 4.7% $1,262.4(Indonesia) Centenary Rural Devlop. 6683 14% 27% $1,110 $7.8 10.1% $11.4Bank Ltd. (Uganda)CHISPA 6,059 23% 72% $355 $1.7 3.8% na(Nicaragua)Citi Savings and Loans 3040 543% 80% $363 $1.1 32.0% $1.8(Ghana)Cooperativa-Emprender 41 8% 57% $700 $0.2 0.4% na(Colombia)Emprender 3,200 19% 42% $1,280 $3.2 8.6% na(Argentina)

    FED 11,945 0% 61% $615 $3.6 10.2% na(Ecuador)Fundusz Mikro 5,585 184% 37% $1,700 $6.7 2.9% na(Poland)

    Finamerica S.A. 9601 -40% 49% $1,243 $9.1 8.2% $6.3(Colombia)Get Ahead 17,239 65% 92% $192 $1.9 7.1% na(South Africa)

    K-REP 7,078 -17% 58% $878 $4.1 na $1.7(Kenya) PRODEM 36,000 33% 68% $450 $18.6 1.20% na(Bolivia)SEWA 8,000 33% 100% $415 $2.1 1.0% $5.0(India)TSPI Development Corp 8,852 49% 75% $514 $4.0 7.2% $1.1(Philippines)

    NETWORK TOTALS 5,245,426 7% 57.4% $685 $988.9 $1,364.7

  • PUBLICATIONS FROM THE MICROFINANCE NETWORK:

    CONFERENCE PAPERS: Current Governance Practices of Microfinance Institutions Moving Microfinance Forward 1998* Establishing a Microfinance Industry 1997* Key Issues in Microfinance 1996*

    OCCASIONAL PAPERS: The Regulation and Supervision of Microfinance Institutions: Experience from

    Latin America, Asia and Africa by Shari Berenbach and Craig Churchill,1997.**

    The Regulation and Supervision of Microfinance Institutions: Case Studiesedited by Craig Churchill, 1997.*

    *Also available in Spanish.

    **Also available in French and Spanish.

    The MicroFinance Network

    The MicroFinance Network is a global association of leading microfinance practitioners. Networkmembers are committed to improving the lives of low-income people through the provision ofcredit, savings and other financial services. The Network believes that this sector should beserved by sustainable microfinance institutions. The MicroFinance Network is a vehicle foraccomplished institutions to provide each other with technical assistance and to learn from eachothers experiences.

    Non-governmental Organizations Support Institutions Regulated Financial InstitutionsASA, Bangladesh ACCION International, USA ACEP, SenegalABA, Egypt CALMEADOW, Canada BancoSol, BoliviaBRAC, Bangladesh Banco del Desarrollo, ChileCHISPA, Nicaragua BRI Unit Desa, IndonesiaEmprender, Argentina CERUDEB, UgandaFED, Ecuador Citi Savings and Loans, GhanaFundusz Mikro, Poland Cooperativa-Emprender, ColombiaGet Ahead, South Africa FINAMERICA S.A., ColombiaPRODEM, Bolivia K-Rep Bank, KenyaTSPI, Philippines Mibanco, formerly ACP, Peru

    SEWA Bank, India

    MicroFinance Network 733 15th Street NW, Suite 700, Washington, DC 20005 USATel (202) 347-2953 Fax (202) 347-2959 Email: mfn@sysnet.net

    Web Site: http://www.bellanet.org/partners/mfn

    Network Sponsor: Calmeadow 365 Bay Street, Suite 600 Toronto, Ontario M5H 2V1 CanadaTel (416) 362-9670 Fax (416) 362-0769 Email: international@calmeadow.com

    Web Site: http://www.calmeadow.com

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