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2009

MicroFinanza Rating

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INSTITUTIONAL DIAGNOSTIC

PEACE MFI S.CO – Ethiopia

June 2009

Objective The objective of the institutional diagnostic is to carry out a detailed analysis of the institution, paying particular attention to the organizational and qualitative aspects. The specific aim is to assess the level of development of the MFI and to identify the main internal weaknesses jointly with the existing opportunities and areas of improvements for the institution.

Output expected The output of this work is an operational tool which could help the executive management and the governance of the institution in strengthening its operational capacity and improving its policies and procedures.

MicroFinanza Rating Contact Caterina Giordano

[email protected] Sylvie Gal [email protected]

MFI Contact Tezera Kebede

[email protected] P.O. Box 5743, Addis Ababa, Ethiopia +251 11 6521541

mailto:[email protected]



2009

TABLE OF CONTENTS

1. SHORT INSTITUTIONAL PRESENTATION _____________________________________ 3

2. HIGHLIGHTS BY AREA OF ANALYSIS ________________________________________ 6

3. AREAS OF ANALYSIS ______________________________________________________ 10

3.1. OWNERSHIP, GOVERNANCE AND UPPER MANAGEMENT __________________________________ 11

3.2 STRATEGIC AND OPERATIONAL PLANNING ____________________________________________ 13

3.3 ORGANIZATION AND HUMAN RESOURCES (HR) ________________________________________ 15

3.4 MANAGEMENT INFORMATION SYSTEM (MIS) AND INFORMATION TECHNOLOGY (IT) ________________ 17

3.5 MARKET AND PRODUCTS _______________________________________________________ 20

3.6 CREDIT PROCESS AND CREDIT RISK MANAGEMENT ______________________________________ 22

3.7 ADMINISTRATIVE AND ACCOUNTING MANAGEMENT _____________________________________ 25

3.8 FINANCIAL MANAGEMENT ______________________________________________________ 28

3.9 RISK MANAGEMENT, INTERNAL CONTROL AND INTERNAL AUDIT ______________________________ 30

4. ANNEXES _________________________________________________________________ 33

ANNEX 1: ORGANIZATIONAL CHART __________________________________________________ 33

ANNEX 2: POSITIONING OF THE MFI (MAP). ____________________________________________ 34

ANNEX 3: DESCRIPTION OF THE FINANCIAL PRODUCTS ______________________________________ 35

ANNEX 4: DEFINITION OF THE RATIOS _________________________________________________ 36

ANNEX 5: WHAT IS INTERNAL CONTROL? _______________________________________________ 37

PEACE - Ethiopia, Institutional Diagnostic June 2009

MicroFinanza Rating srl 3

1. Short institutional presentation

Full name of the institution Poverty Eradication and Community Empowerment MFI S.CO (PEACE)

Legal Form Share Company and Non-Bank Financial Institution

Year of inception 1999

Legal Ownership Agri-Service Ethiopia and 14 individuals

Networks of reference Women's World Banking, Association of Ethiopian MFIs, Microfinance African Institutions Network

Audit firm TAY & Co.

Rating firm / examiner Planet Rating (2007)

Regulator / supervisor Regulated by the National Bank of Ethiopia (NBE)

Background

1 PEACE MFI S.CO Ethiopia

2was created in 1999 by Agri-Service Ethiopia, an ethiopian

NGO, as a consequence of the governmental ban to NGOs of offering financial services. PEACE has been then registered as a share company and as Non-Bank Financial Institution under the Proclamation Act 40/1996, thus being object of the National Bank of Ethiopia supervision. The MFI is owned by the NGO founder and other 16 individuals with a total paid in capital of 1,288,000 ETB. Moreover Oxfam Novib since 2000 represented the main source of donation supporting the development of PEACE. As of April 2009, PEACE operates 16 branches mainly in rural areas. . The Gross Loan Portfolio is US$ 3.4 million. The institution offers three main loan type: group loans (for agricultural and for non-agricultural activities) and an individual loan. Besides mandatory savings, Peace is also offering voluntary saving.

Funding Structure Portfolio by area and methodology

March 2009

22%

22%10%

33%

DEPOSITS (includingcompulsory savings)

LOAN GUARANTEEFUNDS

LONG TERMBORROWED FUNDS

EQUITY

Portfolio and portfolio quality by products3

Future plans Peace foresees to strengthen the ownership structure trying to attract new shareholders and at the same time to improve the BoD introducing new professional backgrounds. Moreover Peace is willing to attract new investors at local and international level to feed its

1 ANNEX 1: Organizational Chart.

2 In the following text it will be used the acronym PEACE

3 ANNEX 2: Description of the financial products.



growth. Another source of funds Peace will focus on is represented by the voluntary savings which will be promoted by the introduction of new attractive saving products. Another strategic axe is linked with the broadening of the operations and the diversification of the loans offer.

Financial needs (US$/’000)

2009 2010 2011

Projected Portfolio Size 4,181 5,922 6,905

Capital need: Equity 1,668 1,915 2,360

Capital need: Debt 3,619 4,177 4,645

External Context & Regulation

The Ethiopian Microfinance sector is governed by the National Bank of Ethiopia under the Microfinance Business Proclamation No 626/2009 The NBE issued 18 directives to effectively regulate MFIs, the directives outline the minimum capital requirement of Birr 200,000 (US$ 22 386), support deposit mobilization, prohibit participation of NGO and foreign ownership, among other things. Over regulation of the sector has limited the innovation of the industry especially in scope of services offered by MFIs to individual clients. Under the Cooperative Societies Proclamation in 1998, SACCOs became regulated by the Cooperative Commission (since 2006, CA). The country has 13 banks (3 commercial, 10 private), 30 MFIs and over 5,500 SACCOs. It is estimated that MFIs and SACCOs have reached two million people out of the targeted 25 million households in Ethiopia

4. MFIs have mobilized Birr 1.6 billion in deposits and

disbursed loans amounting to Birr 4.5 billion to their clients. Rural households in Ethiopia continue to be significantly underserved by the financial industry with an estimated unmet loan demand of 80% of the 4.2 million households targeted. The MFI sector has received significant support from the government through the Rural Financial Intermediation Program (RUFIP) with loans obtained from IFAD, ADB and the Ethiopian government amounting to $87 million providing for loan funds and capacity building. Other donors to the Ethiopian Microfinance sector are SIDA, USAID, World Bank, EU, IFAD and UNDP who have helped in capacity building, research, MIS support among others. The creation of the Association of Ethiopian Microfinance Institutions (AEMFI) in 1999 has facilitated growth of the sector through capacity building, industry fund raising and providing a network for MFIs to interact and exchange information. Risks faced by the MFI sector are represented by: lack of advanced MIS systems to keep up with growth, low penetration rate in rural areas, over-regulation, targeted lending by the government to reach under served households whose interest rates are unable to cover the real cost of loans, and limited access to foreign sources of funds. There currently is no national credit bureau or credit registry, thus limiting the availability of client credit history.

4 Access to Finance in Ethiopia: Sector assessment study, July 2008, Martina Wiedmaier-Pfister et al.



The following analysis is based on the number provided by the MFI and provides some general indication of MFI’s performances5.

5 ANNEX 3: Definition of the ratios



2. Highlights by area of analysis

This chapter synthesizes by area of analysis the key points and aspects for improvement identified of the MFI and our recommendations.

The relevance attributed to each area depends on the importance of the area itself taking into account the legal form of institution, the phase of development and the external context under consideration and on the priority of the identified issues. In the next chapter there will be the detailed evaluation of the 9 areas of analysis.

1. Ownership, Board of

Directors & Management

Peace should draft a strategic plan in order to attract new shareholders not connected with the founder NGO and bringing in different backgrounds. At the same time the MFI should consider to extend the BoD including new expertise currently weakly present, such as the financial one in order to balance financial and social orientations. The drafting of a BoD manual will support this process streamlining the duties and functioning of the Board. In particular, it is advisable to develop and formalize in the same manual the organization of the Board in specific Committees better allowing the efficient supervision by the governance body (eg. Risk Management, Internal Audit, etc). Peace will need to organize ad hoc training to the Board members on the areas of competence of each Committee together with a general training on governance best practices to strengthen the skills of the Board and the understanding of their role and function. To support the BoD we find a good management team which shows some weaknesses at the Operations manager level characterized by a quite high turn-over in the last period and which is still covered ad -interim. Regarding the flow of communication the Internal Audit should report to the BoD thus guaranteeing the independency of its role.

Relevance MEDIUM-HIGH

2. Strategic and

Operational Planning The current Business Plan covering 2009-2013 shows some areas of improvement on which the MFI should work in order to have a better understanding of the current status and of the strategic approach to adopt. Peace should in fact carry out a better analysis of the MFI internal weaknesses and of the external context guiding the formulation of a marketing and new products development strategy. Moreover the objectives set should be linked to specific strategies to achieve them and translated into operational plans per areas and branches assigning specific timeframe and responsibilities. The financial projections elaborated are based on over optimistic hypothesis which can be revised adopting a more realistic approach while carrying out sensitivity analysis and a multiple scenarios analysis where it would be possible to use different type of hypothesis (optimistic, pessimistic, etc) and that can help to improve the readiness of the institution to better face external events.

Relevance MEDIUM-

HIGH

3. Organization

Structure and Human Resources (HR)

The institution should regularly update the staff job descriptions in order to have a clearer reference and to improve the segregation of duties bettering the internal control context. Furthermore in order to improve the staff performance and its motivation, which is having consequences on the best performing staff retention, Peace

Relevance MEDIUM



should revise and introduce some HR components, such as: the staff assessment system should be based on more objective criteria linked with the projected performance of the MFI and agreed between staff and superiors; the staff incentive scheme (at least credit staff) balancing branch and individual performance suited to the PEACE overall goals and adequate in orientating credit staff towards the right balance between loan disbursements and maintaining loan quality standards; the possibility of introducing an insider loan system; a staff training need assessment followed by a better planning and budgeting of training. Adequate reporting on HR and particularly the regular carrying out of staff satisfaction survey may support the monitoring of the results of the implementation of such components and allow the MFI to promptly identify arising problems at staff level which may lead to inefficiencies or to the loss of staff in an increasingly competitive market.

4. Management

Information System and IT

A responsible for the MIS is not yet foreseen in the organization, and, together with the lack of a MIS manual as a guide, may lead to incorrect use of the systems and errors in inputting and reporting of data. In particular the lack of skills to customize the MIS to obtain requested data forces staff to manually elaborate reports which is more time consuming and is entailing a higher risk of errors. Manual intervention is also required to reconcile Excel and TMS since not all the branches are currently using it. Additional problems identified are related to the security policies in terms of: backup whose frequency should be increased and which should be done on means kept outside the office; the creation of stricter password policies limiting the access of certain function only to allowed staff; a disaster recovery plan should be still elaborated. In the long term Peace should also look at the infrastructure and IT issues and, if allowed by internal resources and external conditions, interconnect all the branches to speed up the information production and purchase electricity generators (if the electricity problem persists).

Relevance MEDIUM

5. Market and Products

(MFI Positioning) Although a marketing and product development function has been already introduced in the MFI structure, it would be advisable to connect it to the Operations manager facilitating the communication and collaboration between the two positions. To support the well performing of this function strategies should be developed regarding new products development, marketing and products promotion which should be then translated into polices and procedures formalized in manuals. To maintain those strategies pertinent it is important to regularly carry out market studies (first developing adequate tools) and consequent analysis on Peace positioning by product and by branch with respect to its competitors. Such exercises should result in reports useful to inform the decision making by the management and the Board.

Relevance MEDIUM

6. Credit Process and

Credit Risk Management

Portfolio concentration guidelines for risk management do not exist yet and therefore should be developed through an active discussion between the Board and top management. To mitigate risk associated to the credit process, Peace should enforce limits already set for disbursement at branch level. No prudential guidelines on loan installment ceiling are yet in place and the

Relevance MEDIUM-

LOW



client repayment assessment is still limited. Therefore, in the short term Peace should work to establish and train all credit staff on implementing a better client repayment assessment as well as set and enforce a prudential installment ceiling to follow throughout the organization. It is also advisable to elaborate a restructuring policy (with additional provisioning and separate tracking within the MIS to mitigate the risk of external events determining the incapacity of repaying of farmers who are representing the majority of Peace clients. Moreover it is important to set a policy and insert clear clauses in the contract allowing PEACE to systematically use the savings deposited as guarantee by the clients in case of loan losses Finally, the collection and maintenance of important client information and data should be improved, including a checklist for information to be included in the client loan file.

7. Administrative and

Accounting Management

The speediness of the production of consolidated F/S can be improved and it would be advisable for the institution to install everywhere TMS for the accounting avoiding manual reconciliation between TMS and excel. Moreover to guarantee an homogeneous application of accounting policies it is important to develop a complete administrative and accounting manual inserting policies not yet in use such as off-the balance items. Regarding the inputting of data to assure a more efficient internal control and a more complete segregation of duties, the portfolio data entry should be assigned to other staff than the accountants. Peace must also work to improve bank reconciliation procedures and higher the frequency. As far as the disbursement procedures are concerned Peace should reduce to the minimum the practice of disbursing loans on the field. External Audit Report shows also room for improvement:

Off the balance item is not disclosed

change of equity statement is not showed

verification of loan loss provision is not done

the structure of FS and the overall transparency should be improved

Relevance MEDIUM

8. Financial

Management The in-depth financial analysis and monitoring of financial risks is considered necessary given the deposit-taking nature of the institution. Limits and targets for the main financial ratios should be set and approved by the management and the Board of Directors at least annually. In the long term and according to the availability of financial resource, business process reengineering and an in depth analysis of expenses with a consequent cost-reduction plan are advisable. Also a complete analysis of profitability by product would be important for the management decision making. To streamline the financial management within the organization Peace should develop a financial manual and carry out training on specific aspects of the financial management on which the management is particularly weak.

Relevance MEDIUM-

HIGH

9. Risk Management,

Internal Control and Internal Audit

Peace has not a formalized risk management system lacking a risk management manual and a risks evaluation. It is advisable to create a Risk Management Committee to develop some risk management culture in the institution and successively to hire a risk manager separated from the internal audit function (and who reports to the Board). There is limited measurement of financial risks which are important in particular for deposit

Relevance MEDIUM-

HIGH



taking institutions as Peace. The top management should also identify specific strategies and policies for a better control and monitoring of the risks of the institution (define risk tolerance, limits and alerts). As for the internal control Peace shows good policies and manuals. We recommend guaranteeing the strict implementation of them through the enforcement of a system of sanctions (eg. the disbursement ceilings are not respected by the branches). On the other side it is advisable to strengthen the internal audit function through the recruitment of additional staff and the gradual extension to other areas (accounting; security of the MIS; reconciliation between the accounting and loan tracking system; expenditures decisions and approval; bank reconciliation; technical control of the data-processing platform software and information technology) through the development of tools and policies and ad hoc training to the staff on certain audit techniques. The Audit Manual should be accordingly extended.



3. Areas of analysis

In this chapter a detailed evaluation of the following areas is carried out:

3.1 Ownership, Governance and Upper Management (Decision Making & Supervision)

3.2 Strategic and Operational Planning

3.3 Organization Structure and Human Resources (HR)

3.4 Management Information System (MIS) and Information Technology (IT)

3.5 Market and Products

3.6 Credit Process and Credit Risk Management

3.7 Accounting and Administrative Management

3.8 Financial Management

3.9 Risk Management, Internal Control and Internal Audit

For each area the potential consequences and risks related to the identified areas of improvement for the Institution are highlighted. The policies and procedures set up by each institution are compared with internationally recognized best practices. The particularities of the external context and of the legal framework are taken into account in the evaluation. Starting from this analysis, a set of specific recommendations is made. These recommendations will help the design of a work plan for the improvement of the operational, organizational and strategic capacities of the institution, with the aim of coping with the identified weaknesses and, secondly, preparing itself to a future external rating. The recommendations are divided in recommendations for the short/medium term (1-2 years ) and for the medium/long term (later than 2 years). Recommendations for the short/medium term are set on a 5-level priority scale (A to E, where A represents a priority).



3.1. Ownership, Governance and Upper Management

Sub Area Key points Potential risks or consequences Recommendations

short/medium term medium/long term

Legal structure 1 Given the current legal form of the institution dividends are not distributed among shareholders

1. This aspect might hinder the capacity of attracting different shareholders coming from the private sector lowering the concentration of shares in the NGO founder. On the other side distribution of dividends will lead to the loss of the tax exemption benefit that is available to the MFIs.

1. Assess the potential benefit related to the distribution of dividends against the benefit of tax exemption.

Composition and quality of the BoD

2. Currently the PEACE BoD counts on 5 members out of those only one has a banking and microfinance background. 3. Four out of five board members are connected to the founder of the MFI (Agro Service Ethiopia) 4. Lack of dedicated Committees such as Risk Management, Internal Audit, etc and of related skills within the members facilitating their creation and effective functioning. 5. No specific training on good governance practices has been provided to the BoT members.

2. The low presence of members with specific backgrounds in finance and microfinance might hinder the BoD capacity of effectively supervise PEACE, of decision-making and in particular its role of strategic guidance. 3. The predominant presence of members connected to the founder NGO can affect the independence and objectivity of the Board which should characterize its strategic and guidance role. 4. Less effective supervision and (preventive) control by the BoD on key aspects of the MFI functioning such as the overall risk profile of the MFI, internal control, etc. 5. The lack of knowledge of good governance practices can reduce the understanding and the effective performing of the assigned functions.

2. It is advisable to strengthen the microfinance and finance skills of the existing BoD members (B)

4. Creation of key Committees (B) such as

Risk Management Committee, Internal Audit with objectives and responsibilities. Specific training of the participating members on those functions (B).

5. Plan and budget specific training and seminars on good governance practices ( C) and develop

2. Draft a strategic plan for identifying and attracting new potential members with more financial skills. (D) 3. While attracting new shareholders Peace should foresee to diversify the composition of the BoD with external members to the NGO founder




short/medium term medium/long term consequently governance

manual specifying function and functioning aspects (C).

2

Functions and duties of the Governance

6.Lack of Board of Directors’ policy manual.

6. The absence of well defined and written procedures regulating the functioning of the BoDs can reduce the effectiveness of the governance

6 It is advisable to develop such a manual (C)

Upper and middle management

7. Weaknesses related to some key top management positions. In particular there has been a high turn-over at the operation manager position level which is now covered ad interim by a previous branch manager

7. Affecting continuity of operations and an effective monitoring and supervision of the core business of the MFI

7. Initiate the hiring process of the operation manager (B) and strengthen top and

middle management on risk management in the area of competency through delivery of training (internal and external) (A)

Communication with the top management and information flow

8. Internal Auditor is not directly reporting to the BoD (not having a dedicated Committee in place) but still to the General Manager

8. The dependency of the Internal Auditor on the General Manager might negatively affect his independent role guaranteeing the effectiveness of his control functions

8. Put in place a structure and procedures such that the Internal Auditor will report directly to the BoD keeping open communication channels (B).



3.2 Strategic and Operational Planning 6



Business Plan formation

1.Multiple scenario analysis is done informally by the management without formalising it in the Business Plan. There is no sensitivity analysis on different variables and it is worth mentioning that the inflation rate has grown dramatically in the last years. 2. An annual operational plan has not been developed in relation with the strategy, objectives and goals defined in the Business Plan. Furthermore responsibilities and timeframe are not explicitly defined.

1.The lack of scenarios and sensitivity analysis affect the readiness of the MFI to cope with different development patterns and to identify early mitigation measures. 2. The mismatching between the objectives and the activities, the absence of clear attribution of responsibilities within a defined framework can hamper the fulfillment of the strategy and achievement of objectives.

1. The sensitivity analysis and different scenarios should be formally included in the business plan (D).

2. The preparation of an annual operational plan with a clear timeframe and attribution of responsibilities by area and by branches is required (C). This

will help to put the long-term strategy into practice and also allow a better monitoring of the achievements of the objectives set.

Business Plan structure and procedures

3. The Institutional assessment of PEACE in terms of weaknesses, review of current products and procedures, analysis of potential new products (also in relation with the external analysis) is quite weak.

3. A weak understanding of the MFI internal context and the lack of a marketing and product development strategy might result in a wrong strategic objectives formulation.

3. Better formalized analysis of the MFI internal context (B) and

development of a marketing and product strategy (C) also as a

consequence of the MFI positioning with respect to the main competitors by product and by branch.

6 Business Plan: it includes strategic planning, operational planning and financial projections (business case):

Strategic planning: identification of a mission and a vision; analysis of the external (market size, demand and target client, etc.) and internal (institutional

assessment identifying operational and financial weaknesses) context; definition of the overall goals and of a strategy to achieve them.

Operational planning: action plan to implement the strategy (number of staff, training, information technology, organisational structure and decentralisation, financial

products, etc.) and identification of people responsible for the implementation of each specific goal.

Business case: financial projections and financial analysis (determination of the break-even point and of the pay-back period, cash flow projections and identification

of the necessary financial resources, projections for each cost centre, etc.).




short/medium term medium/long term 4.The Objectives defined in the Business Plan are not followed by the elaboration of clear strategies leading to their achievement. 5. The BP shows a quite weak and not detailed external analysis in terms of competition, market, clientele segmentation, etc

4.The lack of a strategic plan translating the objectives into practice makes the Business Plan loosing its guidance meaning and hampers its fulfillment. 5. A weak external analysis may mislead the formulation of strategic objectives.

4.Elaboration of a clear and detailed strategy incorporating the set of objectives defined in the Business Plan (B)

5. Revise the analysis of the external context in the BP (C)

supporting the elaboration of a marketing and product development strategy (C)

Relevance and coherence of the Business Plan

5. The financial projections are built on optimistic hypothesis, which seem in some cases not realistic. For example for the portfolio and savings it is foreseen a 89% and 79% growth rate respectively from 2008 to 2009 which seems unrealistic also given the historical data and growth.

5. Not realistic/reasonable hypothesis could lead to wrong financial projections and making them loose their guidance function.

5. Revise some hypothesis of the financial projections (LO productivity, growth, etc.) (A)



3.3 Organization and Human Resources (HR)

Sub-area Key points Potential risks or consequences Recommendations


Organization 1. Job descriptions of the existing positions are not yet updated. 2. In the last period there has been a quite high turn-over concerning top management positions such as the one of operational manager.

1. Job descriptions not updated may create confusion in the separation of roles and responsibilities of the staff. 2. The high turn-over might result in continuous loss of trained resources and know-how having negative effects on the efficiency and productivity of the institution.

1. Update and completion of job descriptions for each function (B).

2. Carry out a staff satisfaction (feedback form) study (C) ,

realize periodic salary surveys (C) , and elaborate an action plan to limit staff turn-over (B).

Infrastructure 3. Obsolete and inadequate fixed assets at the branches and poor IT structure.

3. Not adequate work conditions might result in low staff motivation and therefore in low efficiency and productivity. An inadequate office infrastructure affects also the image of the MFI towards the clients.

3. In order to improve the service quality for the clients and the working environment for the staff, and at the same time it is advisable that the institution identifies and set a branch model.

HR policies and procedures

4. HR Policies and manual have been only recently updated which should be a regular practice. 5. Weak staff assessment system mainly based on subjective and qualitative criteria and not directly related to follow up actions (reward. penalize, dismiss) .

4. The lack of a rule for updating regularly the HR manual (and all manuals in general) transform it in an obsolete tool which my result in an uneven implementation and policy gaps. 5. The absence of an efficient staff assessment and evaluation system may affect the level of understanding of real performance and skills level of staff. Moreover the salary and the annual bonus are not related to performance and assessment results, which may result in the loss of well performing staff.

4. Set of a policy for regular updating and review of the HR Manual (B). 5. Set of a staff assessment and evaluation system based on more objective criteria both qualitative and quantitative (A).

Moreover transparent goals and objectives should be set at the beginning of each year by each staff member together with the superior and results of the assessment should be clearly linked to follow up actions (B).




short/medium term medium/long term 6. Weak Incentive Scheme especially for loan officers and field staff which is not linked at least partially to their individual performance. The MFI is not able at the moment to measure it since loan officers are not responsible for a precise portfolio of clients and consequently it is not able to monitor their related performance. 7. Lack of insider loans system which is foreseen in the HR Manual but not yet implemented 8. A formalized succession plan is not in place.

6. The lack of an equilibrated Staff Incentive Scheme may have a negative effect on the efficiency/productivity and the portfolio quality of the MFI. Moreover there is the risk of loss of skilled personnel (in particular as competition for skilled staff in the market is increasing). Moreover in case of portfolio quality problems the MFI will have more difficulties in tracing the source of the malfunctioning (eg responsibility of a particular loan officer). 7. The absence of an insider loan system may have a negative impact on the staff motivation. 8. The lack of a succession plan may hinder the regular progress of operations in case of a vacancy.

6. It is advisable to carefully analyze the formulation and implementation of a staff incentive scheme (at least credit staff) balancing branch and individual performance and evaluate whether it is suited to the PEACE overall goals (A).

The MFI should evaluate whether such a scheme is adequate in orientating credit staff towards the right balance between loan disbursements & maintaining loan quality standards.

8. A succession plan should be formalized and approved by the BoD. (C)

7. Compatibly with availability of resources, Peace should look at the possibility and way to establish an insider loan system (D)

Staff training 9. Lack of a formal and systematic training need analysis which should be followed by the consequent elaboration of an annual training plan related to the budget allocation.

9. Limited training opportunities can result in hindering staff motivation.

9. Develop specific policies, procedures and a plan on training for staff (training need assessment, training plan, etc) (B).

Reporting and communication

10. Lack of regular staff satisfaction survey

10. This lack hinders the capacity of the MFI to promptly identify and answers problems at HR level which might represent a cause of increasing turn-over

10. Elaboration of a staff satisfaction survey tool and definition of frequency for its implementation (C).



3.4 Management Information System (MIS) and Information Technology (IT)7

Sub-area Key Points Risks or potential consequences Recommendations


Organization 1. At the moment there’s only a person in charge of IT technologies and their maintenance while not yet a responsible for the MIS. The inputting of data in the accounting and loan tracking system is mainly done by the accountants within the Finance and Administration Department.

1. Given the current size of the MFI the absence of a MIS person can hamper the coherent production of data and reports, the systematic formation of staff in handling the different systems at different levels, etc. No control moreover is done on the adequacy of the MIS.

1. A plan for departmental growth should be formulated in order to add a MIS function to ensure an adequate development and functioning of the MIS either through recruitment of external personnel or through training of existing staff (B).

Data-processing platform, software and information technology

2. PEACE is currently using TMS as an integrated MIS for accounting and loan tracking. Although some branches are still using excel. TMS has not been updated since the purchase given the high related costs and still presents some weaknesses, which are, solved through a manual elaboration of data (eg Calculation of retained earnings, total number of savers, etc). Moreover no technical assistance for prompt problems solving and customisation is available in the country. 3. Only a limited number of branches is connected to the HQ. 4. BG doesn’t have an automatic and integrated liquidity and treasury management

2. The unavailability of both internal and external technical assistance to correct the errors and malfunctioning of the system might generate inefficiencies in the information production and affect its reliability. Moreover the use of excel which is imported in TMS at HQ level might imply risk of error and represents a duplication of work. 3. The lack of connectivity between the branches and the HQ may affect the overall control of operations as well as the efficiency and effectiveness of problem solving and decision-making. 4. It might hinder the efficient management of resources increasing the related risks, which

2. Creation of an internal post or training of existent staff on the MIS functioning to assure a certain degree of technical assistance and maintenance (B). Considering the availability

of resources and the external context the MFI should assess the feasibility of activating the TMS in all the branches, which should be followed by training of the related staff on its use (A). 4. Develop a system for cash analysis and integrate it with the

2. Considering availability of resources BG should assess whether buying an updated version of the MIS. 3. Implementation of online connectivity at the branch level for increased efficiency and improved communications (as long as the country infrastructure will allow it).

7 MIS: we mean the software for the management of all operations (accounting, loan tracking, provisioning, treasury, etc.), the system supporting the software and the

information flow management. IT: we mean the communication system, hardware and the general technical equipment.




short/medium term medium/long term function within the MIS and an integrated cash flow analysis system with the accounting system.

is particularly high for institutions mobilizing savings.

accounting system. (C) Develop

or make use of the existing integrated liquidity and treasury management function (D)

Policies and procedures

5. A comprehensive MIS and IT policy manual approved by the BoD does not yet exist, even though the IT manager has currently developed an IT manual which is still showing some weaknesses in certain area: precise procedures for backup are missing, etc. The accountants dealing with MIS don’t receive any training and don’t have any manual for reference and guiding the use of the MIS. 6. Backup policies are not strict enough and the backups are foreseen with a too low frequency. 7. A password security policy is not yet in place 8. Lack of UPS and generator at HQ and branch level.

5. The lack of a complete set of formalized policies and procedures can result in uneven implementation and policy gaps. 6. The lack of complete and enforced policies on backup may result in a higher risk of data losses. 7. Inadequate password procedures might affect the security of the information, not preventing the misuse of data (intentional or accidental). 8. Given the unstable electricity provision in the country the lack of UPS and generator may increase the risk of data losses

5. A complete IT and MIS Manual should be drafted and approved to facilitate adequate production and transfer of information (A).

6. Draft of stricter rules on backup at HQ and branch level (A).

7. Establish specific policies for regular change of passwords and foresee a precise attribution of access rights according to the different kind of use, in order to prevent from access of non-authorized employees (A).

Nominate a person in charge of the password changes (A).

8. Given the financial resources available, Peace should assess the possibility of purchasing UPS and an electricity generator at HQ and at branch level




short/medium term medium/long term 9. Lack of disaster recovery plan

9. The absence of a Disaster Recovery Plan might result in data losses and result in a consequent lengthy recovery actions

9. Elaboration of a disaster recovery plan (B).

Reporting and Communication

10. The TMS is not currently able to produce key financial indicators, which are still calculated manually by the accountant. 11. The frequent lack of electricity is delaying the update of the PEACE financial situation. Monthly financial statements are produced with 20 days of delay

10. The creation of reports and information manually might generate errors and create bottleneck in the reporting. 11. Delayed reporting hinders the prompt identification of problems related to portfolio quality and performance as well as the subsequent management decision-making process. Management oversight and control is thus limited.

10. Automated MIS reports should continue to be updated and revised according to management information needs for effective decision-making (C).

11. Identify problems slowing down the timely production of data and try to solve the,

11. Given the financial resources available, Peace should assess the possibility of purchasing an electricity generator at HQ and at branch level



3.5 Market and Products



Organization and structure

1. In the current organization structure the marketing function is under the responsibility of the Head of Planning and Business Development Department, who reports to the Executive Director. 2. A specific strategy for new products development, responding to precise needs arising from the field has not been developed yet. 3. No formalized strategy for product promotion is in place

1. The lack of reporting line between the Planning and Business Manager and the COO might generate conflicts due to the close correlation between the 2 functions. 2. The lack of a clear strategy guiding the development of new products based on a market study may lead to a weakening of the market position. 3. Without adequate product promotion strategy the institution may incur in a potential market share loss in particular in areas characterized by high competition.

1. Marketing & Business Development Manager should report to the Head of Operations Department in the Organizational Chart (A)

2. Formalize a new product development strategy, defining the different steps of the process (market analysis, development, testing, marketing etc.) and the timeframe for implementation (C).

3. Develop a comprehensive strategy for products promotion (B).

Market and competition

4. Although the business plan includes a brief overview of the main competitors, a detailed analysis of the competition and of the potential for growth is not regularly carried out.

4. Weak analysis of Peace market positioning may lead to the weakening of its market position and may reduce the capacity to adequately exploit its competitive advantages.

4. Formal and periodic analysis of products and services delivered by the main competitors (C)

Policies and Procedures (Products & Services)

5. The institution has not developed a marketing manual yet. Moreover Peace has not yet formalized policies and procedures to realize a market and a product study in order to support the development of new branches or products. 6. Limited offer of financial products such as savings for Peace target clients.

5. The lack of a complete set of formalized policies and procedures can result in uneven implementation and policy gaps and may hinder the transmission of knowledge within the MFI. 6. The poor savings offer for its target clients decreases the possibility of mobilizing cheaper funding resources and result in a loss of clients going to institutions offering attractive saving products

5. Develop and draft a marketing and product development manual, including the guidelines to be followed for the realization of market studies (B)

6. Analysis of clients needs, market analysis and consequent development of new saving product (B)





Reporting and Communication

7. Peace doesn’t produce a periodic report for the management on the status of the MFI positioning on the market. 8. A complete and updated market study has never been carried out so far.

7. The weak information production hinders the management decision making on its marketing and product development strategy. 8. Poor information on the market where the MFI is operating affects the capacity of revising products and strategy according to competitors and market evolutions

7. Develop and draft a periodic report on the MFI market positioning by product and by branch (C)

8.Undertake an in depth market study (C).



3.6 Credit Process and Credit Risk Management



Organization and structure

1. Branch staff is signing all cheques for disbursement even above the ceiling set by the related policy. In terms of approval there’s a respected ceiling limiting the responsibility at branch level. 2. There is no person (internal or external) specifically in charge of loan recovery function.

1. The possibility of disbursing any sum at branch level is entailing a higher risk of fraud. 2. The absence of specific staff in charge of loans recovery might hamper the effectiveness of the function and thus negatively affect the portfolio quality.

1. Enforce effectively the rule related to disbursement limits at branch level and monitor its application (A).

2. Assign a few dedicated staff members to the loan recovery function, or alternatively hire contract staff for the recovery of bad loans, in order to increase the efficiency and effectiveness of the task

Credit and credit risk management policies

3. No established portfolio concentration guidelines. 4. Weak emphasis on application of the instalments’ ceiling associated with a weak analysis of the clients’ repayment capacity (in particular for group loans). 5. Interest rate cannot be modified according to the fluctuation of the market prices.

3. The lack of portfolio concentration limits can lead to an unwanted concentration in higher risk credit areas (e.g. agriculture) and low risk diversification. 4. Lack of application of the instalments’ ceiling or a weak analysis of the client’s repayment capacity can lead to low portfolio quality 5. Risk that market rates could rise and PEACE is unable to cover costs if unable to adjust interest rate charged to clients accordingly.

3. The management and BoD should define portfolio concentration limits in line with the mission and its credit risk definition/tolerance (B).

4. Monitoring of enforcement by loan officers of prudential instalment’s ceiling (A). Revision

of the assessment of clients’ repayment capacity and accordingly train credit staff (C).

5. Consider inserting contractual clause to allow for interest rate modification linked to market changes for loans with a term more than 1 year and an explicit declaration that product pricing aims at the full recovery of




short/medium term medium/long term 6. Loan rescheduling/refinancing is not foreseen in the credit policy. 7. The use of the obligatory saving to recover unpaid loan balances is not systematically enforced since it is needed prior written approval by the clients themselves

6. The lack of rescheduling/restructuring policies might have a negative impact on clients who are unable to pay due for eg to natural calamities. Such a problem is particularly sensitive for MFIs working in rural context. 7. The incapacity of using automatically the savings (part of the guarantee) to recover loan losses hampers the credibility of PEACE and has a negative impact on its value as a deterrent for clients.

costs.(C)

6. Elaborate a restructuring policy, in particular in relation to additional provisioning and separate tracking within the MIS (B).

7. Elaborate a policy and insert clear clauses in the contract allowing PEACE to systematically use the savings deposited as guarantee by the clients in case of loan loss (A).

Credit procedures

8. Original client documents are stored at the HQ without a specific and safe location. Moreover no checklist of submitted documents and disbursement vouchers is included in the client loan file. 9. No separate file of rejected clients is maintained (clients are mainly rejected during the first period of induction and training). 10. Client repayment capacity analysis presents some weaknesses in terms of analysis of the economic activity financed (a basic cost and revenue assessment is done) and field visits to clients, which are

8. Incomplete client files can lead to difficulties in client follow up and recovery, particularly in case of delinquency. The lack of specific and safe structure for important documents storing increase the risk of key documents losses (loan contracts, etc) and of fraud. 9. Failure to retain rejected client files hinders the creation of client credit history. 10. Inadequate analysis of client repayment capacity can lead to a decline in portfolio quality.

8. Insert a checklist for each client file (B). Develop dedicated

and safe storing structure for key loan documents (B). The access

should be limited only to authorized people and monitored (A).

9. Retain rejected groups and track of its members in a separate file and possibly in the MIS (B).

10. Elaborate a better analysis of the clients’ economic activities, which is financed by the loan (C) and more precise

policies on visit of clients




short/medium term medium/long term not systematically carried out by the loan officers. The members of the group have the main responsibilities for both. 11. Inadequate client follow up after disbursement and monitoring of use of the loans by visiting workplace.

11. Inadequate client checks can expose the institution to fraud (e.g. ghost clients) or client forgery, as well as lead to a decline in portfolio quality.

business premise and house by the loan officers (B). Train loan

officers for carrying out an improved analysis (C).

11.Create a specific form to be filled by group members and LOs at field visits to enhance control function (A). Mandate

field visits to both home and workplace at a minimum by the group members and also by LOs for higher loan amounts (A).

Reporting & Communication

12. Informal exchange of information on delinquent client is not systematically carried out among MFIs in particular in most sensitive areas with high concentration of financial institutions targeting the same type of clients 13. No periodic report with information on loans written off.

12. Client credit history is not available and exchange of black list of bad clients among MFIs is not in place thus increasing the risk of over indebtedness by the clients and consequently the institutions’ credit risk. 13. Creates difficulties in follow up on written off loans, also with inadequate information for related decision-making.

12. Branch staff should seek to informally exchange delinquent client lists with other institutions, and between branches (A). MFI

management should try to establish some formal agreement with the MFIs working in the same geographical areas and targeting similar segments of clients to formalize somehow the exchange of clients’ information (at least on delinquent clients) (B).

13. Create systematic report on loans written off (A).



3.7 Administrative and Accounting Management



Organization 1. Accounting is fully decentralized although some of the branches are still using Excel and not TMS.

1. The use of Excel in some of the branches requires a following manual reconciliation with the current MIS thus implying a certain degree of errors creation.

1. All the branches should be equipped with TMS and the staff should be trained on its use in order to speed up the accounting process and reduce the risk of errors generation (A).

1.

Manuals and policies

2. Peace has a financial manual, which includes administrative and accounting policies. The administrative procedures don’t include certain areas (such as the insurance one which is only informal) while the accounting part is lacking the formal description of some policies (interest accrued, etc). Moreover such manual doesn’t go through an automatic and periodic update (the manual has been elaborated in 2000 and is currently under revision). 3. The accountants enter data both in the accounting and loan portfolio system. 4. Lack of “Off the balance” accounting policy.

2. Weaknesses at policies and manual level impact the effectiveness of the internal control and entails a potential failure in the transmission of knowledge and understanding of procedures by the new staff. 3. The absence of segregation of duties at data entry level doesn’t allow a double-checking of data and might facilitate manipulation of data. Moreover the high work load on the same position may hamper the efficient and timely processing of data. 4. Less transparency (see please International Accounting Standards).

2. Elaboration of clear and written and complete administrative and accounting policies (A). Setting of a rule for

regular update and revision of all manuals (B).

3. The portfolio data entry should be assigned to other staff in order to implement a complete segregation of duties thus facilitating a more efficient internal control (B) (tp consider

the availability of financial resources to make the necessary changes) 4. Introduction and use of the “off the balance” item (e.g., includes written-off loans in the past) (B).




short/medium term medium/long term 5. PEACE is lacking a specific restructuring of loans policy and related accounting policy.

5. Less transparency and protection

5. Elaborate a restructuring policy, in particular in relation to additional provisioning and separate tracking within the MIS (B)

Procedures 6. Bank reconciliation is done only on a monthly basis. 7. Although cheques are prepared for the loans disbursement the distribution of money has place in the branch or at the client venue if the clients live faraway from the branches and banks.

6. Given the deposit taking nature of Peace the lower frequency of bank reconciliation may affect the effectiveness of the internal control. The problem will become more urgent as soon as the MFI will start offering more saving products other than the obligatory one linked to the loan. 7. The loan money distribution on the field may entail a certain risk of frauds.

6. Increase the frequency of bank reconciliation. given the deposit taking nature of the MFI (D)

7. Reduce where possible the distribution of money on the field (A).

6. In the long term we recommend to negotiate with the banks to download a daily user-friendly format (Excel) of the bank accounts from Internet. Create an automatic procedure to match internal accounts and downloaded bank accounts in order to produce a “bank reconciliation sheet” (priority to the amount and to the date).


8. External Audit Report shows room for improvement:

Off the balance items are not disclosed in the Financial Statements.

A change of equity statement is lacking

Verification of loan loss provision movements

The financial statements elaborated by the auditors seem improvable in terms of transparency and structure (see International Accounting Standards)

9. The timely of monthly consolidated

8. Limited transparency of audit report and F/S hampers the overall control from supervisory bodies as well as the understanding from external actors. 9. Information on the institutional performance if not timely provided to the top

Communicate and propose to the External Auditor changes and integration in his reports (B). Tracking of changes in

accounting policies and their impact on the income statements have to be disclosed by External Auditor (B).

9. It may occur once an on-line MIS is installed and the internal




short/medium term medium/long term Financial Statements and other accounting reports to the CEO shows room for improvement.

management can hamper the efficient supervision and identification of risks.

control structure is improved.



3.8 Financial Management



Organization 1. Although a financial manager position is in place, to date some of the tasks typically attributed to the CFO are not yet fully performed in terms of financial management.

1. The weaknesses at financial management level might hinder the capacity of the top management of having a full overview of the MFI financial situation directly affecting the effective decision making and sound management

1. The financial manager should receive an intensive training on financial management in order to fully perform his function (A)

Manuals and policies

2. A manual on financial policies and procedures has not yet been developed 3. Alerts and targets of the main performance & financial indicators are not yet defined and approved by the CEO and the Board. 4. Peace has not yet undertaken an analysis and developed a plan to reduce costs (ABC, business process reengineering).

2. The lack of polices and procedures for financial management (liquidity management , budgeting, cost reduction strategies, interest rate management, etc) could hamper the sound management of the MFI (in particular given it's a deposit taking institution) and an efficient decision making 3. Supervision and decision making less effective. 4. Unnecessary and avoidable expenses affect the capacity of the MFI to generate profits.

2. Update of the financial manual, which currently only includes accounting and administrative procedures, with adequate financial policies and procedures (A).

3. Limits and targets for the main performance & financial ratios (proposed by the Financial Manager) should be revised and approved by the CEO and the Board of Directors (at least annually) (B)

4. In order to develop an expense reduction plan, Peace should carry out: a detailed mapping, business process reengineering, analysis of expenses by process. Introduce as a regular activity in the operational plan the analysis of the expenses by product and by process.

Procedures 5. The financial statements are not 5. The lack of inflation adjustments may 5. Revision of financial




short/medium term medium/long term adjusted for inflation. 6. A complete and detailed analysis of profitability by products has never been realized. 7. The evaluation of the main financial risks is generally poor although for some of them the relevance is lower (eg currency risk given that Peace doesn't receive any loans denominated in foreign currency )

lead to an overall overestimation of the MFI results 6. The lack of a complete analysis on profitability may lead to the wrong pricing of products, the misallocation of resources which on their turn can have a negative impact on the MFI profitability. 7. The lack of control of financial risks can lead to unexpected losses in particular considering that the MFI is mobilizing savings from clients.

statements taking into consideration financial adjustments (A)

6. Undertake an analysis of product profitability in order to better inform upcoming decisions related to product revision and development (C).

7. The evaluation and monitoring of key financial risks is advisable (gap analysis and sensitivity analysis tools to be implemented).(B)


8. Targets, alerts and limits are not showed in the reporting on financial indicators.

8. Lack of clear targets, alerts and limits in the reporting of financial indicators might result in a weaker supervision and mislead the decision-making.

8. Integrate targets, alerts and limits approved by the Board in the reporting on financial indicators .(B)



3.9 Risk management, Internal Control and Internal Audit



Risk Management Organization and Manuals

1. A Risk Management function or committee who reports to the Board and to the Executive Director does not exist yet. 2. Lack of a risk management manual.

1. Less measurement and assessment of the MFI risks. 2. Lack of an important support in the understanding, development and transmission of the knowledge about each type of risk factor.

1. Organization of intensive training on risk management to key staff members.(A). It is

advisable to create a Risk Management Committee to develop some risk management culture in the institution (B)

2. Draft and approve a risk management manual. (C)

1. To hire a risk manager separated from the internal audit function and who reports to the Board (when the MFI will overcome at least US$ 10 million of assets).

Identification & assessment of risk exposures

3. Peace does not have a formalized risk management system in place and the BoD is not involved in the review and approval of risks and risk tolerance levels. Although adequate attention is given to credit risk (portfolio at risk monitored and limits are set) there is a limited awareness of the other risks (especially financial and governance risks).

3. The institution is not able yet to calculate the exposure to some risks without a comprehensive risk management system.

3. In the medium term more pro-active risk identification at both the management and BoD level should be implemented and placed in a wider framework of a risk management system (C). At

BoD level specific Committees (Internal Audit, Risk Management ) should be put in place through prior training of the members.(B)

3. Gradually, the comprehensive set of potential risks affecting an institution needs to enter into the risk management analysis.

Strategies to measure and track risks

4. Strategies and policies to control and monitor major risks have not yet been written and formalized. Risk tolerance, limits and alerts are not defined yet.

4. Lack of strategies and policies to control and monitor risks might lead to a weaker risk management system.

4. The top management should identify specific strategies and policies for a better control and monitoring of the risks of the institution. It is recommended to identify key indicators for the assessment of each risk area (and ranges of acceptable risk exposure).




short/medium term medium/long term Internal Control and Internal Audit organization, policies and procedures

5. The Internal Audit Department is composed by 2 people who carries out all the controls and the visits to the branches. 6. At the moment Peace relies more on ex-post controls while there's room for improvements for the ex-ante controls. One example is related to the segregation of duties which shows some weaknesses (eg cashier allowed to carry out loan officers task, loan officers allowed to collect money) 7. Although limits on disbursement and signature of cheques are set at branch level, rules are not strictly respected. 8. The internal auditor department reports to the General Manager and not to the BoDs. 9. The Internal Audit function is currently focusing on the Branches auditing without carrying out control on: accounting; security of the MIS; reconciliation between the accounting and the loan tracking system; expenditures decisions and approval; bank reconciliation; technical control of the data-processing platform software and information technology (equipment).

5. Sub-dimensioned internal audit department can lead to less effective controls. 6. Risk of frauds and creation of inefficiencies in the operations 7. Risk of frauds. 8. .The dependency of the Internal Auditor on the General Manager might negatively affect his independent role guaranteeing the effectiveness of his control functions 9. A partial internal audit of the organization may lead to inefficiencies, frauds, errors and hinder the overall performance of the MFI

6. Revise jobs description of staff in order to improve segregation of duties and ex-ante control (B)

7. Enforcement of disbursement ceilings through strengthening of control (A)

8. Put in place a structure and procedures such that the Internal Auditor will report directly to the BoD keeping open communication channels (B)

5.Recruit additional Audit Assistants also depending on the growth size of the MFI. 9. Peace should gradually extend the internal audit function to the previously mentioned areas through: development of tools and policies, ad hoc training to the staff on certain audit techniques. If needed Peace should recruit additional staff in the Internal Audit department depending on the extension of functions to carry out and on the growth size of the MFI.






10. No risk evaluation and monitoring format exists. No risk reports are yet produced.

10. Lack of a support in identifying and monitoring risks.

10. Create a RISK evaluation format / report to be sent to the CEO and the BOARD (or a Risk Management Committee).



4. Annexes

ANNEX 1: Organizational Chart



ANNEX 2: Positioning of the MFI (map).

Addis Ababa- HQ

Branches: Bichena, Bekoji, Bereh, Alelitu, Delelo Sebro, Dododla, Enebse Sarmdir, Gassera, Ginir, Kuy, Mlyu Burka, Molale, Motta, Robe Goba, Zefne

QuickTime™ and a decompressor

are needed to see this picture.



ANNEX 3: Description of the Financial Products



ANNEX 4: Definition of the ratios

Description of the ratios Formulas

Profitability & Sustanaibility

Return on equity (ROE) Net income before donations / Average equity

Return on assets (ROA) Net income before donations / Average assets

Operational self-sufficiency (OSS) (Financial revenue + Other operating revenue) / (Financial expenses + Loan loss provision expenses

+ Operating expenses).

Financial self-sufficiency (FSS) (Adjusted financial revenue + Other operating revenue) / (Adjusted financial expenses + Adjusted loan

loss provision expenses + Adjusted operating expenses)

Portfolio quality

Portfolio at Risk (PAR30) Portfolio at Risk > 30/ Gross portfolio

Provision expense ratio Loan loss provision expenses / Average gross portfolio

Risk coverage ratio ( > 30 days) Accumulated reserve / Portfolio at risk > 30 days

Efficiency and productivity

Staff allocation ratio Loan officers / Total staff

Loan officer productivity – Borrowers Number of active borrowers / Number of loan officer

Staff productivity – Borrowers Number of active borrowers/ Number of staff

Operating expenses ratio Operating expenses / Average gross portfolio

Cost per borrower Operating expenses / Number of borrowers

Financial management

Portfolio Yield (gross portfolio) Interest income from portfolio / Average gross or net portfolio

Cost of fund ratio Interest expenses on funding liabilities / Period average funding liabilities

Funding expense ratio Interests and fee expenses on funding liabilities / Average funding liabilities

Debt/Equity ratio Liabilities / Equity

Outreach Average disbursed loan size Amount issued in the period / Number of issued loans



ANNEX 5: What is internal control?8

According to the Basle Committee on Banking Supervision

9, the primary objectives of the internal control process in a financial institution are:

1. To verify the efficiency and effectiveness of the operations 2. To assure the reliability and completeness of financial and management information 3. To comply with applicable laws and regulations

An effective system of internal control allows the MFI to assume additional risks in a calculated manner while minimizing financial surprises and protecting itself from significant financial loss. The following concise definitions are commonly accepted:

RISK MANAGEMENT = it is a systematic approach to identifying, measuring, monitoring and managing business risks in an institution (internal control alone cannot ensure that MFI is adequately minimizing its risk exposures)

INTERNAL CONTROL = it comprises the institution’s mechanisms to monitor risks before and after operations

INTERNAL AUDIT = it is a systematic “ex post” appraisal of an institution’s operations and financial reports (it is a component of the internal control process)

Practitioners in microfinance often confuse internal control with internal audit, which is an integral part of internal control. While internal audit focuses solely on evaluating risk management “ex-post” (after operations), internal control comprises both the “ex-ante” and “ex-post” (before and after the operations) measures to control risks. Internal control and internal audit play important roles in the risk management feedback loop, in which the information generated in the internal control process is reported back to the Board of Directors and senior management. Internal control mechanism work to improve decision making by ensuring that information is accurate, complete and timely so that the BoD and the management can respond to control issues promptly as they arise. In addition, if the MFI links its internal control mechanism to risk management, internal control can identify remaining risk exposures and inform management.

8 Anita Campion, “Improving internal control, a practical guide for microfinance institutions”, Technical Guide No. 1, MicroFinance Network with GTZ, 2000.

9 The Basle Committee is a group of supervisory authorities established by the central bank governors of the Group of 10 countries that developed a framework for the

evaluation of financial institutions internal control systems (1998).

Internal audit

Internal control

Risk management

Relationship between risk management and internal control

Internal audit

Internal control

Risk management

Relationship between risk management and internal control

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