MICROCAPITAL PAPER WRAP-UP: Same Game, Different League: What Microfinance Institutions Can Learn From the Large Banks Corporate Governance Debate

By Maria Giovanna Pugliese, published by World Microfinance Forum Geneva, October 2010, 24 pages, available at: http://www.microfinancegateway.org/gm/document-1.9.48253/Same_Game_Diffe…

The paper summarizes lessons that have emerged from the recent corporate governance debate in the banking sector and point out parallels with, as well as differences from, the microfinance industry.

Many microfinance institutions (MFIs) are currently undergoing a transformation from small, nonprofit, donor-funded social enterprises focused on the provision of “simple” credit products to rapidly growing for-profit corporations, offering a multitude of products to a rapidly changing and increasingly diverse constituency. In the course of these transformations, new stakeholders, such as professional investors, are often brought in to expand the capital base available to MFI managers. As a result, new operational challenges and potential conflicts of interest emerge that require MFIs to adapt their governance structures.

The author identifies five main topics in the contemporary debate on large banks corporate governance that have implications for MFIs: role of board of directors in governance, role of institutional shareholders, management of risk, executive remuneration and several others that are addressed as one: transparency and disclosure, role of external service providers and complex group structures.

The board of Directors plays a crucial role as a governance organ in both large banks and MFIs. The responsibility of the board is to define and monitor the execution of the company’s strategy, vision and culture. The current banking crisis in developing countries has underscored the responsibility of the board for setting strategy, risk profile and risk appetite. A particular challenge for MFIs transitioning to for-profit models is how to articulate a vision and strategy to ensure their institution retains its social mission, preventing “mission drift” or departure from core values. The author proposes emphasizing stakeholder multiplicity and the “duty of care” requirement, which is a legal obligation to adhere to a standard of reasonable care while performing any acts that could harm others, as ways to mitigate the risk of “mission drift” for MFIs.

Shareholders play an important role in guiding and monitoring the institutions they own. The debate revolves around the extent to which institutional shareholders’ interests are aligned with those of the company and the effective exercise of institutional shareholders’ rights. Investors in MFIs typically invest through specialized funds known as microfinance investment vehicles (MIVs), which increase the separation between asset managers and the ultimate asset owners. To strengthen the governance role of institutional investors, the author recommends that MIVs and direct investors adopt the Principles for Responsible Investment, which provide a framework to incorporate environmental, social and corporate governance (ESG) issues in investor practice and decision-making progress. More information on the Principles for Responsble Investment can be found at https://www.microcapital.org/microcapital-brief-cgap-consultative-group-t

The management of risk is an essential function of all financial institutions. The current debate centers around the failure of large financial institutions to manage risk appropriately. Traditionally, microfinance institutions have been characterized by tight risk management, as evidenced by high loan repayment rates. However, as MFIs expand their product offerings the risk of default may increase. Also, as MFIs expand their capital base and begin to accept funding from external sources, they need to be aware of the risks associated with different sources of financing, such as liquidity risk. The author agrues MFI managers should structure appropriate controls around these risks, including, where necessary, the creation of new functions and roles within the organization.

Executive remuneration is receiving a lot of attention in rich countries. In corporate banking, executive remuneration is based not only on the wage market but can also be a way to align executives’ personal objectives with the institutions’ long-term interests. Although remuneration practices at MFIs are significantly different than those in corporate banking, MFIs can learn from this debate. The author contends that MFIs can use incentive structures to keep MFI executives focused on the organizational mission.

Finally, there is debate over transparency, the role of external service providers and complex group structures. The author advocates transparency with regard to both financial and social measures. As MFIs grow in size and complexity, they will become more reliant on external service providers, such as accounting firms. MFIs should put in place appropriate policies and processes to manage potential conflicts of interest with external service providers. The increasing organizational complexity of MFIs also highlights the need for clear definitions of the roles within the organization.

The paper concludes with a recommendation for further research of the role that corporate governance plays in MFIs, including the appropriate structure for the board of directors, the best way to improve risk management in a rapidly changing organization and how to include social goals in remuneration plans.

By Witt Gatchell, Research Associate

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