MicroFinanza Rating: Setting up adequate Internal Control Systems Laura Profiri Regional Manager Central Asia, Russia and Caucaus AMFA conference 4-5 October 2012

Content 1. MicroFinanza rating: who we are and what we do 2. Internal Control Systems in MFR rating scoring: Importance and absolute weight What we evaluate 3. Operational risk and Credit risk 2

Who we are  Private and independent rating agency specialized in microfinance and rural finance  Rating agency registered in the IADB Rating and Assessment Fund and in the ADA Microfinance Rating and Assessment Initiative  Headquarters are in Milan (Italy) with 5 offices in 4 continents Ecuador: covering Latin America Mexico: for Mexican MFIs Kenya: covering Africa Kyrgyz Republic: covering NIS and Central Asia Philippines: covering Asia 3

Market coverage  More than 750 evaluations in 70 countries  LARGEST MARKET SHARE in 2008 according to the last ADA-KPMG “Rating Market Outlook Report 2009”  MicroFinanza Rating has pioneered the social rating for microfinance institutions, developing an innovative methodology which include the direct collection of client-level data (120 SR conducted so far). 4

Different approaches Pre Rating Services Financial Rating Social Rating Training and Other - Mini – Assessment - Institutional Diagnostic - Microfinance rating - Credit Rating - Standard Social Rating - Comprehensive Social Rating - 6 Training Modules - Other customized services (e.g. Country Screening) Identification of the main internal weaknesses jointly with the existing opportunities and areas for improvement. Evaluation of the risk profile and performances Assessment of the MFI’s capacity to translate its mission into practice and to achieve its social goals. 5

In the rating scoring 1.Internal Control Systems in MFR rating scoring: Importance and absolute weight What we evaluate 6

Rating scoring model DimensionsWeight 1. External Context4% 2. Mission, Governance and Strategy23% 3. Organization and operations 4. Assets quality and structure21% 5. Financial structure and management18,5% 6. Financial and Operational results12,5% 21% The final synthetic rating grade is the result of the scoring of factors grouped into 6 dimensions:

Internal Control Systems 8 INTERNAL CONTROL comprises the MFI’s mechanisms to monitor risks before and after operations

IC and Operational RISK It involves all divisions and products of a financial institution. This risk includes the potential that inadequate technology and information systems, operational problems, insufficient human resources, or breaches of integrity (i.e. fraud) will result in unexpected losses. 9 Operational RISK is a function of Internal Controls

Operational RISK Transaction RISK: it is particularly high for MFIs that handle a high volume of small transactions daily. Since MFIs make many small, short-term loans there are more opportunities for error and fraud. Fraud RISK: is the risk of loss of earnings or capital as a result of intentional deception by an employee or client. Effective internal controls play a key role in protecting against fraud at the branch level. 10

In the rating scoring Organization and Operations Human Resources Management Information System Processes and Systems

HR policies and procedures 12 Moral checks Social Attitude Hiring To promote core values Coaching on “zero tolerance” Training Market salary base Effective incentive scheme Remuneration Clear message ex-ante Gradual termination step approach Termination

MIS: Reliability of Information 13 ACCURACY SECURITY EFFECTIVENESS RECONCILIATION ITEMS MISREPRESENTING THE LOAN PAYOFF RESCHEDULING PROCEDURES COMPLIANCE BREAKDOWN OF PORTFOLIO LOAN WRITE OFF LOAN PROVISION

Internal Control and Internal Audit Limits Segregations of functions Physical Control Crosschecks Dual controls Computer-related controls Rotation of duties Manuals of policies and procedures Documentation Independence of Internal Audit Multi-copy receipts and forms 14

Risk Management Framework 15 Source: Anita Campion, “Improving internal control, a practical guide for microfinance institutions”, Technical Guide No. 1, MicroFinance Network with GTZ, Risk Management Internal Control Internal Audit

Correlation between the Internal Control Systems' score and the rating grade 16 Sample of 72 MFIs

Operational risk often brings to credit risk. What to do? Clear distinction between operational risk and credit risk Measure, assess and prioritize operational risk Control Monitor 17

Contacts Thank you!!! MicroFinanza Rating LLC 231 (apt.14) Tynystanov Str. Bishkek, Kyrgyzstan. Phone: (+996)