Good Governance Is a Prerequisite for Good Business

It is impressive how the microfinance industry has changed since its beginning in Bangladesh and Bolivia just some forty years ago. The concept of granting loans to low-income people based on no more than a solidarity guarantee has evolved into a multibillion dollar industry. The sector is now an integral part of the financial system of many countries. It is an industry with multiple players that goes beyond providing short-term, small loans for working capital.

While the industry as whole is doing quite well, not everything has been or is perfect. During recent times of crisis the deficiencies of microfinance institutions (MFIs) became more evident.  Far from reaching their financial and mission goals, instead several MFIs failed. I was involved in an investigation of those failure cases, which resulted in several papers that probed the “why” of their failure and asked what lessons could be learned for the broader industry.   One common element comes out loud and clear from the “failure papers”:  good governance is key to the success of MFIs.

Having been personally involved as a Board Member in more than a dozen MFIs, I have followed closely the evolution of faulty decision making processes that could have been avoided or mitigated had appropriate governance safeguards been in place.  In retrospect, I wish that the CEO had not also been the Chair of the Board (and effectively in control of it), that there had been more external/ independent directors, and that executive sessions had been a common practice, etc.   Most likely, if we had known better, many of the very negative consequences of these governance shortfalls could have been avoided.

To be clear here, I am not saying that good governance is by itself sufficient to guarantee success.  However, bad governance proved to be present in almost every instance in which MFIs failed.  Based on this, it would seem safe to conclude that good governance is essential to ensure continued success of MFIs (particularly during times of hardship, changing market conditions and/or rapidly evolving enabling and operating environments).

The perils brought about by poor governance are more obvious and more far-reaching as MFIs grow rapidly.  Such rapid growth brings structural changes including in some cases transformation of an MFI born as a nonprofit into a commercial business with all the implied dangers (and benefits). This requires a big adjustment in thinking and business practice.

The crucial question is how clearly the industry itself recognizes these changes, and how well it is adapting to them.  In fact, I think we must focus the question on one specific set of people: the directors and senior executives at MFIs who are personally responsible for the business, and have the job of ensuring that it survives and flourishes. Do they understand the risks in the new environment, and do they have the capacity to manage them?  How strong are MFIs, “at the top”?

From my experience as an investor, director, and advisor, the quality of governance at MFIs varies a great deal: some are as well run as their peers in the commercial world, but others are not. Some have strong boards of directors and some have weak boards. Some MFIs have adapted well to change, and others have not. But overall, the microfinance industry’s players are beginning to recognize that the quality of microfinance governance is a key issue for all MFIs. One piece of evidence that supports this is the annual Microfinance Banana Skin survey carried out by the CSFI, an independent London think tank. This survey ranks the risks in microfinance based on the views of several hundred microfinance practitioners, analysts and regulators around the world. Since the series started in 2008, corporate governance risk has consistently been close to the top of a list of more than two dozen concerns.

MFIs have been slow to react to their changing risk environment. A number of reasons might explain this. Lack of experience and know-how surely is a crucial factor.  Directors and managers simply might not know what to do when circumstances deteriorate.  However, yet another factor might be resistance to change and/or entrenched interests.  It is not surprising that it does not always suit the managers and directors of an MFI to change a business model that they have become comfortable with, especially if those changes might imply negative consequences for those very same managers and/or directors that are being called to make the decisions.

Investors, donors and MFI stakeholders in general are beginning to recognize that strong and effective governance is essential for the health of MFIs. There is a need and there seems to be a growing willingness on the part of stakeholders to intervene and act more forcefully to get the ball rolling on governance reforms if existing MFI managers and boards are dragging their feet.

Many options exist on how to take action.  Industry associations such as the Council for Microfinance Investors (CMEF), most Microfinance Investment Vehicles (MIVs) and other investors and donors, and other organizations (including the BBVA Microfinance Foundation, Center for Financial Inclusion at Accion, the Calmeadow Foundation, COSUDE, IFC, CGAP,  CAF and MIF/IADB, to name but a few)  have already become actively engaged.  Nevertheless, more is needed to support good governance reforms of specific MFIs, conduct practical research, and disseminate the results so as to raise awareness and motivate concrete progress. Unless this broader group of stakeholders gets involved, the quality of MFI governance is likely to continue to fall short.