CHAPTER ONE

INTRODUCTION

1.1. BACKGROUND OF THE STUDY

Microfinance institutions (MFIs) play an important role in the financial system in most developing countries. They have a double bottom-line objective: a poverty-reduction mission and a sustainability goal. The Microcredit Summit Report 2011 (Reed, 2011) reveals that MFIs have enabled about 175 million people access to financial services (savings and credit). These organizations have thus undoubtedly facilitated the financial inclusion of people typically excluded from the banking sector. These institutions have also become more sustainable. The implementation of best-governance practices, increasingly required by the ratings agencies and donors, partly explains social and financial performance of MFIs (Armendáriz and Morduch, 2010).

Empirical literature on governance issue in microfinance is still scarce. Some studies simultaneously analyze the impact of internal and external mechanisms on MFI performance (Hartarska, 2005; Mersland and Strøm, 2009; Hartarska and Mersland, 2012) and yield conflicting results regarding the role played by board size and composition, ownership structures, and incentives mechanisms. Other studies specifically analyze the effectiveness of regulation as an external governance mechanism and provide consistent results about the relationship between regulation and MFI performance (Hartarska and Nadolnyak, 2007; Hartarska, 2009; Cull et al., 2011).

At least three issues are not addressed by the existing literature. First, these previous studies seem to neglect the impact of board activity on MFI performance. This relationship is considered as an empirical issue (de Andrés and Vallelado, 2008) and remains largely unexplored in microfinance. Second, previous studies in the field of microfinance focus on individual corporate governance mechanisms and view governance mechanism in isolation. These microfinance studies have not consistently identified a strong relationship between individual corporate governance mechanisms and MFI performance. Yet, a stream of the corporate governance literature considers corporate governance indexes to be corporate governance measures (Bhagat and Bolton, 2008; Romano et al., 2008; Ge et al., 2012). Some studies consider governance indexes to be proxies of the firm-level quality of governance (Renders et al., 2010; Ge et al., 2012). Others consider governance indexes to be a separate measure of governance and assume that governance indexes complement other governance mechanisms (Ashbaugh-Skaife et al., 2006; Bowen et al., 2008). To date, the relationship between governance ratings, which I assume to be an overall assessment of the effectiveness of the board of directors, and MFIs’ performance, has not been subject to empirical investigation. Third, previous study findings contrast with the transformation thesis of not-for-profit MFIs into shareholder-based financial institutions (for-profit MFIs). This transformation thesis advocated by some microfinance practionners (White and Campion, 2002; Fernando, 2004; Ledgerwood and White, 2006) is based on the assumption that nonprofit MFI governance systems are less effective than their for-profit counterparts, implying in turn that the latter performs better. Existing literature in microfinance shows that the MFI for-profit status has no influence on its performance, and except for Galema et al. (2012), who provide evidence that the presence of powerful CEOs in microfinance NGOs is associated with lower performance, little is known about the moderating effect of legal status. I thus add to the existing literature by answering the question of whether the effect of board activity and governance varies depending on whether the MFI is a shareholder-based microfinance institution or not. This article thus aims to fill these gaps by studying the relation among board activity, governance ratings, and MFI profitability, and by comparing the impact of governance ratings and board activity according to an MFI’s legal status.

This study comprises a sample of 215 MFIs rated by Planet Rating between 2003 and 2009. Performance refers to profitability and financial viability, that is to say, the ability of MFIs to cover operating expenses by its operating revenues, which I measure by two accounting indicators, namely, the return on assets (ROA) and the operational self-sufficiency ratio (OSS). I extend the previous literature on MFI governance in many ways. Empirically, I test the relationship between board activity and MFI financial efficiency after controlling for some board characteristics, external governance mechanisms such as regulation, and endogeneity biases that result from the reverse causality between board characteristics and firm performance (Vafeas, 1999; Hermalin and Weisbach, 2003). I provide evidence that board activity increases MFI profitability. Comparative tests show that the impact of board activity does not differ according to an MFI’s legal status. I also contribute to the literature by evaluating the impact of governance indexes on MFI profitability. On the methodological standpoint, this study differs from previous research in the field of microfinance in which the effectiveness of governance mechanisms is assessed either by using panel data econometrics (Hartarska, 2005; Hartarska and Nadolnyak, 2007; Mersland and Strøm, 2009) or a stochastic cost frontier model (Hartarska and Mersland, 2012). Indeed, the inclusion of governance ratings in the profitability model induces a selection bias because the governance ratings index is observed only if the MFI decides to be rated. Moreover, the reverse causality between profitability and governance ratings creates an endogeneity bias because poor performance may cause changes in governance (Bhagat and Bolton, 2008; Romano et al., 2008; Renders et al., 2010). Estimating the impact of governance ratings on MFI profitability thus induces selection and endogeneity biases that I address by using the Mroz three-stage procedure. I provide evidence that MFIs with better rating scores that is, those with better internal governance quality, seem to be more profitable. I also perform a series of robustness tests. These tests include an alternative measure of performance of MFIs based on the estimation of a stochastic cost frontier, the choice of instruments, and a logarithmic transformation of the activity of the board of directors in order to show that the functional forms do not drive the results. These robustness checks yield consistent evidence and improve the reliability of the results.

Microfinance institutions (MFIs) in sub-Saharan Africa1 include a broad range of diverse and geographically dispersed institutions that offer financial services to low-income clients: non-governmental organizations (NGOs), non-bank financial institutions, cooperatives, rural banks, savings and postal financial institutions, and an increasing number of commercial banks.

Overall, MFIs in Africa are dynamic and growing. Of the 163 MFIs that provided information for this study, 57 percent were created in the past eight years—and 45 percent of those in the past four.2 African MFIs appear to serve the broad financial needs of their clients. Unlike trends in most regions around the globe, more than 70 percent of the reporting African MFIs offer savings as a core financial service for clients and use it as an important source of funds for lending. MFIs in Africa tend to report lower levels of profitability, as measured by return on assets, than MFIs in other global regions. Among the African MFIs that provided information for this study, 47 percent post positive unadjusted returns; regulated MFIs report the highest return on assets of all MFI types, averaging around 2.6 percent. The microfinance sector in Africa is quickly expanding, and institutions have increased their activities. In fact, African MFIs are among the most productive globally, as measured by the number of borrowers and savers per staff member. MFIs in Africa also demonstrate higher levels of portfolio quality, with an average portfolio at risk over 30 days of only 4.0 percent.

Still, African MFIs face many challenges. Operating and financial expenses are high, and on average, revenues remain lower than in other global regions. Efficiency in terms of cost per borrower is lowest for African MFIs. Technological innovations, product refinements, and ongoing efforts to strengthen the capacity of African MFIs are needed to reduce costs, increase outreach, and boost overall profitability. Overall, African MFIs are important actors in the financial sector, and they are well positioned to grow and reach the millions of potential clients who currently do not have access to mainstream financial services

The history of microfinance is closely linked with poverty reduction. Although the beginning of cooperative savings and credit activities can be traced back as far as in 1849 with the foundation in Rhineland of the first cooperative society of saving and credit by Raiffeisen, it is truly with Yunus in 1976 with the creation of the Gramen Bank that one can situate the birth of “modern microfinance” (Blondeau, 2006). Microfinance was originally conceived as an alternative to banks, which in most developing countries serve only 5 to 20% of the population (Gallardo et al., 2003), and informal moneylenders. With the passage of time, the microfinance sector has evolved. Microfinance institutions now have more than 100 million clients and achieve remarkable repayment rates on loans (Cull et al, 2009).

 The rapid growth of microfinance has brought increasing calls for regulation, but complying with prudential regulations and the associated supervision can be especially costly for microfinance institutions (Cull and al., 2009). Since regulation remains a precondition for deposit taking in many countries, more MFIs seek to transform into regulated entities to access cheap and local currency deposits. Regulation also opens the door to a variety of funding opportunities and helps to reduce the overreliance on subsidies. Donors and microfinance practitioners are well aware that micro lenders need to prepare for the day when subsidies disappear (Aghion and Morduch, 2005).

Just like many other African countries, the microfinance sector’s springboard in Cameroon was the banking system restructuring engaged by the Ministry of Finance (MINFI) and the Banking Commission for Central Africa (COBAC). The expansion of MFIs in Cameroon during the 1980s can highly be explained by the gap left by the restructuring of the banking sector in most developing countries, which was characterized by the restraining or rationing of credit opportunities. Cameroon was not an exception.

In Cameroon, the history of microfinance dates back to more than one century in its traditional form popularly known as “Njangi or Tontine”1. The introduction of “modern” microfinance in Cameroon started in 1963 by a Catholic priest Father Alfred Jansen, in Njinikom in the North-West Region of Cameroon (Creusot, 2006). This idea of Credit Unionism spread all over the North-West and South-West regions of Cameroon and by 1968, 34 credit unions that were already in existence joined together to form the Cameroon Cooperative Credit Union League (CamCCUL) Limited. CamCCUL is therefore the umbrella organisation of cooperative credit unions and the largest MFI in Cameroon and the Communauté Économique des États de l’Afrique Centrale (CEMAC) sub-region (www.camccul.org). There are more than 460 registered MFIs in Cameroon with a sum amounting to over FCFA 258 billion which has been accumulated by way of deposits from close to one million customers (Gwasi and Ngambi, 2014).

Microfinance has been defined therefore as “a credit methodology that employs effective collateral substitutes to deliver and recover short-term, working capital loans to micro entrepreneurs”(CGAP’, 2003). The roots of microfinance lie in a social mission of enhancing outreach to alleviate poverty. More recently there has been a major shift in emphasis from the social objective of poverty alleviation towards the economic objective of sustainable and market based financial services (Rauf and Mahmood, 2009). The difference between microfinance and commercial lending lies within the concepts of joint liability or group lending, dynamic incentives that allow for an increase in size of loans over time, regular repayments schedules and alternative collateral through forced savings (Gine 2003). For example, joint liability helps to overcome adverse selection (borrowers know who in their community is a credit risk) and moral hazard (borrowers can monitor each other). and to enforce auditing (by ensuring borrowers are honest in the case of default) and repayment as borrowers can impose social sanctions on defaulters (Ghatak and Guinnane, 1999). These alternatives to collateral are especially important for borrowers who do not have assets to pledge, and for lenders who operate in countries with weak secured lending laws and enforcement.

On a global note, the microfinance industry has realised important growth rate and as the number of microfinance institutions and customers continue to grow, regulation of the industry becomes a question of interest since the sustainability of these institutions is highly debated. A more efficient micro financial sector may eventually translate into higher rates of economic growth and thus the ability of governments to alleviate poverty. Despite the increasing regulation of the microfinance sector in Cameroon and the constant efforts being made by the government authorities” to enhance the performance of these MFIs, the sector still faces a lot of challenges. Regular news about the microfinance sector in Cameroon is the constant close down of several microfinance establishments or the sudden and spectacular bankruptcy of some MIs which reduce customers’ confidence. We still have in mind the COFINEST and FIFFA cases. The sector is also criticized for providing services only to bankable customers and on almost same conditions as banks forgetting their social responsibility of providing financial services to those who are excluded from the traditional banking system. This can be explained by the fact that these MFIs are mostly emanations of banks and therefore operate with their mother bank conditions. According to the COBAC report on the microfinance sector (2008), the level of not performing loans and default rate are still very high in the sub-region.

Moreover, interest rates still remain globally very high than those of the banks although less than interest rates charged by informal moneylenders in spite of competition (COBAC 2008). The volume of loans and savings mobilised by the sector is still very low as compared to that of the banking sector (about 5.5% of the banks’ deposits and 4.8% of the banks” loans in 2008 against 7% and 6% respectively in September 2007). More so, there is uneven geographical distribution of MFIs across the national territory (Fotabong, 2012; Kobou et al.2009), with less than 48% of these MFIs located in rural areas meanwhile close to 60% of the population of Cameroon leaves in rural areas. Despite the remarkable expansion of savings, the transformation coefficient into credit still remains very low and more seriously, is the violation of basic prudential norms stipulated by the Banking Commission as well as poor internal control.

Many research studies have been carried out on the effect of financial regulation on micro financial institutions performance among which are those of Hubka and Zaidi, 2005; Cull and al., 2009; Ndambu, 2011 and broadly on the determinants of MFIs performance (Kobou et al., 2009; Kablan, 2010. However, these empirical studies yield divergent results. While some studies revealed a positive relationship between regulation and MFI performance other showed a negative effect. Also, a third group of studies showed no significant effect of financial regulation on MFI performance. Though increasing regulation has become an issue in the microfinance sector; studies analyzing its effect on performance remain limited in number in Cameroon (Fouda-Owoundi, 2010). Even when these studies exist, they failed to account for the dual mission of MFIs which is providing banking services to the poor while remaining financially sustainable. Most importantly, there is no definite answer as to whether increasing regional regulation affects MFIs financial performance positively or negatively.

Internal control is a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of a firm’s objectives in the effectiveness and efficiency of operations, reliability of financial and management reporting, compliance with applicable laws, regulations and protect the organisation’s reputation (Kaplan, 2008). There are many controls that a microfinance institution (MFI) can institute to protect its resources against loss to improve performance. A collection of internal controls put in place by the MFI is what forms internal control system (ICS). An internal control is a topic that cuts across a number of disciplines including financial accounting and auditing. It can be traced back to ancient times. In Hellenistic Egypt there was dual administration where one side was involved in collation of taxes while the other supervising them. Internal controls became apparent at the beginning of 21st century following major corporate scandals.

Otieno (2014) holds that internal control consists of five related components which are derived from the manner in which management runs its business. These components are control environment; risk assessment; control activities; information and communication systems and monitoring. These components of internal control apply to all business entities though Micro-finance Institutions may apply them differently to large corporations. Micro-finance Institutions’ internal control systems could be less formal and unstructured but at the same time be very effective. According to Ledgerwood and White (2016), an internal control adopted by Microfinance Institutions need to be orderly, practical and efficient enough to help them conduct business.

Internal controls are most effective when they are directly incorporated in the process that support operations and enable quick response to changing economic conditions. Micro-finance Institutions use internal control mechanisms to make sure the staff respect its policies and procedures. Everyone in an organisation has the responsibility to ensure internal control succeeds to some extent. Virtually all employees produce information used in the internal control system or take other actions needed to effect control.

The evolution towards financial inclusion is driven by microfinance Institutions who combine the credit cooperatives’ willingness to serve poor people with the commercial banks’ capacity and professionalism (Research Insight, April 2013). Micro-finance Institutions in Kenya have been resilient despite local droughts and the high inflation rates that were experienced in the year 2008 and 2009. Microfinance Institutions have been projecting strong growth in borrowers in the recent past in line with the governments over emphasis on access to financial services as key to modernizing the economy.

Management has three objectives that guide the designing of an effective internal control system, (McPeak et al., 2012) it is entirely responsible for preparing financial statements for investors, creditors and other users. The second objective of an internal control system is to encourage efficiency and effectiveness of operations that is effective use of resources. Lastly the internal control encourages compliance with laws and regulations. The performance of an organisation is determined by how well and acceptable the internal control is and how it affects the financials of the companies.

The framework for internal control help microfinance institutions in managing their business in terms of regulations and policy. Frameworks for internal controls are factored by the processes affected by the board of directors, senior management and all levels of personnel. They are not entirely procedures or policies performed at certain point in time but rather continually operating at all levels within institutions. Most microfinance institutions have embraced a more business-oriented outlook and maintained their target groups of economically-active poor, in order to achieve financial sustainability (Baguma, 2008). The micro finance institutions in developing economies are widely growing from time to time.

 1.2. PROBLEM STATEMENT

Recent incidence of corporate failures and accounting frauds like Worldcom and a host of other companies has heightened the demand for sound accountability practices on regular and timely basis. These scandals and frauds are mostly preceded by failure in companies’ internal control structures (Anyanzwa, 2013). Internal control systems have become very popular and important in recent times in the wake of these fraudulent financial reporting in different countries around the globe. According to Kaaya (2015), one of the key determinants of the effectiveness of internal control within microfinance institutions is the level of management commitment and support. The study suggests that without strong commitment and support from the management team, the implementation and maintenance of an effective internal control system can be challenging. Agyei-Mensah (2016) identified the competence of the internal audit function as a crucial determinant of the effectiveness of internal control within microfinance institutions. The study found that the effectiveness of the internal control system is heavily reliant on the expertise, independence, and objectivity of the internal audit team.

For MFIs to carry out its business there must be some factors put in place for the smooth running of the institution like materials, machines, money etc. These need to be well coordinated in order for the success of the MFIs to be achieved. These factors are used by a group of persons known as management. Every organisation both profit or non-profit organisation has its objectives and goals in mind to achieve. In the effort to achieve these goals, supervision more often than not play a vital role. The size and scope of these organisations have sometimes made it hard for the executors to exercise personal and first hand supervision of operation. It is in this light that internal control established by management is initiated.

The absence of adequate internal control measures exposes the management of a MFIs to certain threats such as loss of assets and properties, mismanagement of MFIs through the stolen of vital documents which may be carried out by a staff or a host of them and due to the incorrect and unreliable financial records MFIs integrity may be loss.

According to Uwaoma and Urdu (2015), there is a general consensus that any organisation without an Internal Control system in place is generally exposed to several threats that are capable of crumbling the organisation in less or no time. Prominent amongst such threats are: Problem of incorrect financial statement and loss of the company’s’ assets; stealing and miss-management of organisational vital documents which may be done by an employee to take undue advantage. There is also the issue of incorrect and unreliable financial records which may lead to loss of organisational integrity; non implementation of accounting policies in consistent with the applicable legislation appropriate in presentation of financial statement as well as non-adherence of annual budgets and implementation of planning policies.  Internal controls check the governance of MFI’s to achieve profitability growth and development (Cha 2009). Microfinance Institutions are prone to risks that are life threatening to the existence and sustainability. Operational and strategic risks are of non-financial character and result mainly from human error, frauds, system failure, through regulatory environment. However, when they materialize, they lead to financial losses for the organisation. A number of MFI’s face collapse or near collapse if they are unable to set up internal controls. Enofe et al. (2013) identified the quality of the control environment as a key determinant of the effectiveness of internal control within microfinance institutions. The study suggests that factors such as the organizational structure, management philosophy, and ethical values can have a significant impact on the overall effectiveness of the internal control system. Also, according to Wakiriba et al. (2014), the level of staff competence and training is a crucial determinant of the effectiveness of internal control within microfinance institutions. The study found that the effectiveness of internal controls is heavily dependent on the knowledge, skills, and ability of the employees responsible for implementing and monitoring the control systems.

 1.3. Research questions

1.3.1. Main research question

1. What are the determinants of the effectiveness of internal control systems in MFI’s in Bamenda?

1.3.2. Specific research questions

1. How does management commitment influence the effectiveness of internal control systems within MFI’s in Bamenda?
2. How does organizational structure impacts the effectiveness of internal control system within MFI’s in Bamenda ?
3. what is the role of training and capacity building in enhancing the effectiveness of internal control systems within MFI’s in Bamenda?

 1.4. Research objectives

 1.4.1. Main research objective

1. The determinants of the effectiveness of internal control systems in MFI’s in Bamenda

 1.4.2. Specific research objectives

1. To determine the influence of management commitment on the effectiveness of internal control systems in MFI’s in Bamenda
2. To determine the impact of organizational structure on the effectiveness of internal control in MFI’s in Bamenda
3. To determine the role of training and capacity in enhancing the effectiveness of internal control systems within MFI’s in Bamenda