Business Magazine

Banking on Governance

Posted on the 31 March 2011 by Center For International Private Enterprise @CIPEglobal

Banking on governanceThere are always losers when banks make poor lending decisions. Unfortunately, those losers often extend beyond the banks themselves, whether we’re talking about state-owned banks in China, banks that are essentially donor-backed in Afghanistan, or microfinance banks in India.

In China, the losers are middle class citizens who do not have much choice when deciding where to keep their savings – the Chinese government controls most of its financial sector.

Seeking projects that will increase their prestige and lead to promotions, political leaders direct bankers to invest in inefficient and financially leaky state-owned enterprises that build railroads, highways, and airports that do not deliver high rates of returns. Needless to say, many of these loans are never repaid. All the while, the government’s near-monopoly of the financial sector provides a constant stream of cheap funds from middle class depositors

In Afghanistan, Kabul Bank – the country’s largest financial institution – has recently caused a scandal for making $900 million in bad loans, some of which has simply disappeared. While there are some borrowers who have agreed to modest repayment schedules, many have not and others dispute the full amount of their loans to be repaid. There are even loans that were granted without paperwork to unknown or anonymous borrowers.

Unlike Chinese banks whose deposits come from citizens, Kabul Bank’s largest depositor is the Afghan government itself, which is largely funded by donors such as the United States government. What’s also unfortunate is that some of the money seems to have disappeared with Afghani elites, making it even more difficult for Afghanistan’s Central Bank to get any of the money back.

Microfinance institutions in India face their own unique lending challenges. Owing in part donor-driven programs as well as the Priority Sector Lending Act, which directed 40 percent of domestic lending into 14 “priority sectors” including microfinance, capital has practically overwhelmed Indian microfinance institutions (MFIs). In this Economic Reform Feature Services article, CIPE’s Oscar Abello argues that, “Pressure to extend loans out of kindness or to meet quarterly portfolio targets are a tremendous temptation to circumvent checks and balances in the loan approval process – assuming checks and balances exist at all.”

Given that in India’s Andhra Pradesh state outstanding microloans grew from one million in 2005 to 25-27 million in 2010, valued at $4 billion, did this pressure lead to Andhra Pradesh’s microfinance crisis in which bank customers were “exploited by private microfinance institutions through coercive means of recovery resulting in their impoverishment and in some cases leading to suicides”?

Banks of every size are vulnerable to governance challenges. As microfinance grows to include populations that are already vulnerable to the ups and downs of poverty, can microfinance institutions implement good business practices where other banks have failed? If so, there are important implications for financial inclusion, SME access to finance, and democracy. In this article, Abello details how: greater attention to corporate governance.

Article at a glance:

  • An estimated three billion people around the world have limited or no access to formal financial services. Such financial alienation leads to social and political alienation, which undermines democratic development.
  • In order to be effective in improving access to finance for the poor, microfinance institutions (MFIs) must better manage key risks they face, including client credit risk, industry reputation, competition, and governance.
  • Better corporate governance can make the operations of MFIs – both profit and non-profit – more sustainable and more scalable, and have a multiplier effect of increasing transparency and inclusiveness beyond the financial sector.

Read the full article here:

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