Prudential Management in Rural Financial Institutions

Prudential management includes both safeguarding against risk in the loan portfolio and keeping intermediation costs under control to ensure the institution's viability. The relatively high covari-ant risk associated with agricultural lending has to be recognized and addressed in order to assure the long-term sustainability of a financial institu tion. Of course, careful screening of borrowers and close monitoring of them help to reduce the risk. However, additional measures are needed.

A direct response to the risk issue is simply to require higher proportions of capitalization for rural financial institutions - though the absolute amounts may be small when the institutions are small.

. .. most countries have relatively brief experience with microfinance: in the absence of decades of empirical data about microfinance institutions' performance, regulators may wish to begin cautiously in fixing leverage ratios [for capital]. Second, because microfinance institutions operate with relatively high costs and lending rates, a given percentage of non-performing portfolio will decapitalize a microfinance institution faster than it would a commercial bank. Taking all these factors into account, several analysts . . . suggested an initial capital/asset ratio of about 20 percent for microfinance institutions, subject to downward adjustment as the institution and the industry gain experience.142

Because of the covariant risk associated with agricultural production and incomes in a given area, a higher capital/asset ratio than the Basel Convention's norm of 8 % also can be suggested for banks that cater to medium- and large-size farms, although it may not have to go as high as 20 %, owing to the wider use of tangible collateral and lower unit lending costs. However, policies like these on capital requirements have not been implemented in very many instances to date.

Another tool of prudential management is liquidity. For the above-mentioned reasons, institutions dedicated to microfinance and agricultural lending can maintain higher than usual levels of internal liquidity or ensure that ready access to additional liquidity exists, through a central fund

141. Op. cit., pp. 2-5 [emphasis added]. Similar conclusions are drawn from four case studies of rural financial institutions in Asia and Latin America in the paper by Joyita Mukherjee and Sylvia Wisniwski, 'Savings Mobilization Strategies: Lessons from Four Experiences', Focus, Note No. 13, The Consultative Group to Assist the Poorest, Washington, DC, USA, 1998, pp. 2, 4-6.

142. R. Rock, M. Otero and R. Rosenberg, 1996, p. 2.

(in the case of small-scale financial institutions) or access to the interbank market (for commercial banks):

For prudential liquidity management, each of the [four micro-finance institutions analyzed]143 has established an internal liquidity pool or is linked to the liquidity pool of a partner organization. .. . The internal liquidity transfer price is set high enough to encourage savings mobilization. Empirical evidence from the Bank Rakyat Indonesia and the Banco Caja Social shows that an internal liquidity price close to the interbank rate is conducive for savings mobilization.144

Again, the same considerations would apply, to a lesser extent, to commercial banks that are principally oriented toward lending to agriculture. An institution's own auditing procedures can contribute to prudential management. 'In the absence of effective supervision and the lack of a reliable deposit insurance system, internal auditing often takes on a more important role than external supervisors'.145

It should not be overlooked that one of the most basic safeguards a rural financial institution can institute is portfolio diversification. As mentioned previously, such a strategy has been carried out successfully by Bancafé in Honduras, although it still lends a higher proportion of its portfolio to agriculture than other commercial banks in the country do. The same may be said of Banco Ganadero, which has lent relatively more to medium- and large-scale ranchers and farmers than Bancafé does. Generally, it is not recommended that the proportion of a portfolio devoted to agricultural production exceed 40 or 50% of total assets. However, those levels are significantly greater than the agricultural proportion of most commercial banks' portfolios, which usually are in the 10 to 20% range at most.

On the cost side of financial intermediation, control of salaries is the most important consideration for microfinance institutions, owing to their high unit costs of lending. In the study of 11 microfinance institutions by Christen et al. (summarized in the Focus note by Malhotra and Fox, 1995) it is pointed out that 'programs paying lower salaries were more profitable than those that paid more [and they] used local personnel to staff their operations, which gave them a distinct cost advantage' (p. 3).

An effective way to control costs is demonstrated by the unit desa operations of the Bank Rakyat Indonesia. After sweeping reforms in 1983:

Each unit became a separate profit center. . .. The income statement of the unit desa recorded transactions such as interest paid on excess funds borrowed from the district-level branch offices to meet liquidity needs, and interest received on any excess liquidity maintained as deposits with the branch office.

. .. Direct responsibility for loan approvals and repayments rested with unit desa staff, particularly loan officers. ... an incentive bonus that distributed 10 percent of a unit desa's annual profits among its staff was introduced. .. . Internal supervision and audit capacities were also strengthened. The number of internal supervisors/auditors was increased from one per six unit desas to one per four. A standard audit manual provided simple and clear guidelines on supervision rules. Most importantly perhaps, supervisors, auditors and unit desa managers and staff underwent a periodic training program, over three years, on reporting and supervision techniques. Greater supervision led to early detection of problems and early remedy.146

143. The Bank for Agriculture and Agricultural Cooperatives (BAAC), Thailand, the Banco Caja Social, Colombia, the Bank Rakyat, Indonesia, and the Rural Bank of Panabo, Philippines.

146. J. Mukherjee, 'State-owned Development Banks in Micro-Finance', Focus, Note No. 10, The Consultative Group to Assist the Poorest, Washington, DC, USA, August 1997, p. 4.

Fiebig (2001) has summarized basic prudential management norms in terms of a series of basic approaches for effective internal control of a rural financial institution, elaborating on guidelines laid down by the Basle Committee147 [emphasis added]:

Management oversight and control culture: Board of Directors should decide on and monitor overall business strategies, organizational structure, policies and major risks run by the bank.. . . boards should recognize [risks] . .. define acceptable risk levels as well as risk management policies.. . . Senior management, in turn, has the main responsibility for implementing strategies and policies regarding agricultural lending It also should develop a valid control process as well as maintain an organizational structure with clear responsibilities, authority and reporting requirements between . . . levels. In rural intermediaries, the delegation of responsibilities together with the setting of internal off-site and on-site control policies is crucial.

Reform of the internal regulation of development banks has been a particularly challenging part of development bank reform. But also in other institutional types, such as for example NGOs, the change of attitude towards enhanced internal control is often problematic. . .. While small NGO-type institutions may well survive and prosper without explicit focus on internal regulatory issues, a medium-sized NGO can be severely struck by fraud, lack of management oversight and weak Board control.

Risk recognition and assessment: Management information systems in financial institutions involved in agricultural lending should provide the applicable data to manage the client-specific and external risks of the agricultural sector. Recognition of risks and their assessment needs to involve branch and credit officer levels and cannot stop at headquarter/aggregate data levels.

Control activities and segregation of duties: Systems of checks and balances between different organizational layers form basic control activities.. . . Internal auditors need to be operationally independent to carry out their assigned tasks in a prudent manner.. . .

Substantial institutional changes that led to

BRI Unit Desa 's success:

(1) Major reorganization of BRI management at all levels from head office to the unit banks.

(2) High priority accorded at the head office to the management of the unit banking system.

(3) Extensive reorganization and training of staff throughout the country.

(4) Establishment of a system of promotion and development of promotion criteria that reflect new expectations for performance.

(5) Fundamental revision of bookkeeping, audit and supervision systems, which permitted the establishment of the unit banks as independent profit centers (rather than branch windows) and made accountability and a sustained anticorruption drive possible.

(6) Opening of new unit banks and relocation of others to areas with high demand.

(7) Attention to learning about rural financial markets and emphasis on using this information to avoid potential problems with moral hazard and adverse selection.

(8) Crucial improvements in communications and computerization facilities.

(9) Overhaul of BRI's public relations.

(10) Implementation of an effective unit bank staff incentive system rewarding good performance.

147. Basle Committee on Banking Supervision, 'Framework for Internal Control Systems in Banking Organizations', Basle, Switzerland, 1998.

Information and communication: Information generation and communication of information obtained is a severe problem in rural contexts. ... In decentralized institutional structures, management information systems and internal control mechanisms need to be designed taking this into account.

Monitoring activities and correcting deficiencies: Management information systems that collect all risk relevant data are of little use as long as they are not used as part of proactive management, which should range from fraud detection to the active management of portfolio diversification.. . .

Incentive schemes: Positive control incentives should complement the control mechanisms in the form of staff motivational and remuneration incentive systems. Incentive systems for staff are crucial for the well-being of a financial institution. . .. The behavior of State-owned banks is particularly difficult to change as compensation is very rarely based on performance.

0 0

Post a comment