Strategic Management in Microfinance - Strengthening Internal Controls

This is part of a series which document the Strategic Management Projects (SMPs) undertaken by the Center for Agriculture and Rural Development Mutually Reinforcing Institutions (CARD MRI), which has set this network apart from other development organizations and micro finance institutions in the Philippines.

AUSTRIA SMP: RISK MANAGEMENT AND INTERNAL CONTROL FOR GOOD GOVERNANCE

Ms. Marivic Austria, Internal Audit Director of CARD MRI, undertook a comprehensive assessment of CARD Bank’s risk management and internal control systems. Her strategic management project is a case study on facilitating change management – how CARD Bank, in particular, and CARD MRI, in general, adopted and adjusted their internal audit procedures to create the best work environment, protect company and client investments, and manage risks in all aspects of their operation.

The Challenge: How to Manage Threats that Could Severely Impact Bank Operations

For microfinance institutions, the risk of income loss -- due to processing errors, inadequate information, non-compliance with loan policy, and excessive concentration of credit risk, counterfeit collateral and employee fraud -- are major risk exposures. Through the years and at various stages of CARD Bank’s evolution, it faced all or some of these risks.

CARD Bank provides small loans to a large number of clients and consequently handles a large number of transactions. The sheer volume of transactions requires that risk be reduced both before disbursement – through client appraisal – as well as post-disbursement, through a regular and comprehensive portfolio tracking system.

Adopting effective control mechanisms relative to loan administration and management is beneficial to CARD Bank in terms of cost avoidance, to control lapses and weaknesses in loan administration, as well as in increasing financial income and preventing future losses. Equally important, portfolio control performs the preventive and feedback function in the larger internal control system, making it a critical aspect in the Bank’s microfinance operations. Tracking facilitates regular monitoring of both financial (credit and liquidity) as well as operational (transaction and fraud) risks while also giving a picture of the institution’s operational performance.

There was, therefore, an urgent need to assess the current status of CARD Bank‘s internal control systems for it to better manage and mitigate risks using managerial resources.

The Solution: Improvement of Internal Audit Procedures and Risk Management Systems

Internal auditing involves the utilization of a systematic methodology for analyzing business processes or organizational problems. The scope of internal auditing within an organization is broad and may involve the efficacy of operations, the reliability of financial reporting, deterring and investigating fraud, safeguarding assets, and compliance with laws and regulations. Austria’s strategic management project is significant in its attempt to comprehensively assess CARD Bank’s existing internal control and risk management systems. The SMP mapped out:

1. The CARD MRI Internal Audit Unit, its resources, systems and procedures. Significantly, the SMP measured the unit’s internal audit function using the Balanced Scorecard approach, which is a recognized best practice in the measurement of the internal audit function.

2. The CARD Bank’s business process and the concomitant components of its Internal Control System. The SMP, interestingly, mapped out the control system in relation to CARD Bank’s changing loan products, procedures and processes. The Bank’s evolution from 1986 through 2004, and the resulting changes in its operations and controls, were exhaustively analyzed by Austria, who has been part of CARD MRI’s Internal Audit Unit for more than a decade.

3. The lapses in CARD Bank’s loan administration, as well as the risk potential of the Bank’s changes in products and procedures. The SMP provided details on the frequency and magnitude of the lapses, mapped the risks, and pointed priorities for immediate action.

4. The strategy that CARD Bank considered to enable it to better manage risks and prevent further losses. The SMP strategy was delineated into two components, namely, loss control and loss prevention.

The Results: Positive Financial Indicators, Loss Control and Loss Prevention

The strategic management project was able to meet expectations in terms of financial and qualitative results. Basically, the target was quality loan portfolio and high repayment rate, but positive financial indicators were also expected from a well-laid out risk management and internal control system. The SMP Metrics analysis showed positive results for CARD Bank’s financial indicators. Specifically:

1. There was an increasing trend in membership, and with the setting up of new branches, membership increase was high at 7% in June 2006 compared to only 1% in January through June of the same year. There was another 10% increase in membership in December 2006.

2. Portfolio yield exhibited an increasing trend from January 2006, but slightly decreased in October 2006 due to the implementation of the single loan policy for new members. Portfolio at risk (PAR) was high compared to the microfinance standard of only 5%.

3. Operational Self Sufficiency (OSS) was high because the branch was able to save operating expenses. In the establishment of banking offices, operating costs are expected to decrease because standards for equipment, supplies and other materials were set up.

4. Financial Self Sufficiency was also more than 100%; commercial cost and inflation cost were added to operating expenses to get the adjusted operating expenses.

In terms of qualitative results, the strategic management project resulted to the institutionalization of the following measures:

1. To control losses --

-Installation of control system through MIS customization
-Setting-up of banking offices for a streamlined management of operation
-Enforcement of control process through the installation of incentives and monetary penalties (Individual Level)
-Incentive at the Branch level using Risk Adjusted Return on Capital (RAROC)

2. To prevent losses –

-Re-orientation of officers and staff
-Series of re-training for operations staff
-Joint review by senior and branch management and audit team
-Increased frequency of audit
-Improved audit ratings of branches
-Process reengineering (Pilot testing of loan disbursement through automated teller machines in Candelaria banking units and for individual clients in the Las Piñas Branch)

Clearly, Austria’s SMP provided the needed impetus for CARD Bank, as a member of the CARD MRI network, to maximize the use of internal audit towards strengthening its risk management and internal control systems. By illustrating its success in implementing appropriate controls or countermeasures to address the risks in its operations, CARD Bank could serve as a model for other microfinance institutions in the area of risk mitigation.

Along development processes, the SMP illustrates how CARD Bank pursued good governance in its adoption of measures to promote:

-participation;
-rule of law;
-transparency;
-responsiveness;
-consensus orientation;
-equity and inclusiveness;
-effectiveness and efficiency; and
-accountability.

These characteristics of good governance assure that corruption is minimized, and the views of minorities taken into account and that the voices of the most vulnerable in society are heard in decision making. These policies are consistent with CARD MRI’s aim of empowering the poorest of the poor, clearly illustrated by the fact that the members of CARD MRI are mostly rural women belonging to the economically and socially marginalized sectors.