Mt Kenya
University
P.O. Box 342-01000 Thika Email:
[email protected] Web: www.mku.ac.ke
222
COURSE OUTLINE Course Code: BBM 222 Course Title: Co-operative and Microfinance Management
Purpose: To expose students to principles of cooperative and microfinance management
Course Objectives: By the end of the course unit the student will be able to:•
Describe the role of cooperative in social and economic development
•
Discuss the organization, operations and management of cooperatives
•
Explain the regulation and supervision of cooperatives
Course Content:
Principles of cooperative management and social development; Cooperative enterprise management and operations; Cooperatives organization; Cooperative laws; Cooperative financing institutions- Credit unions; Microfinance principles and practice- credit principles, saving principles institutional requirements; Savings mobilization and microfinance; The process of Institutional development; The merging role of NGOs in financial intermediation; Principles of regulation and prudential supervision in microfinance;
References •
Maria O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building Health Financial Institutions Institutions for the the Poor , Kumarian Press.
•
Development of Co-operative Law and policy in Manyara K. Murungi, (2003), The Development Kenya, Oscan Print, Nairobi
•
•
G o K, (2004), The Co-operative Societies Act (Amended) , Kenya Gazette, Nairobi Sanjay S. (2008), Principle of Cooperative Management , Deep Deep Publishers New Delhi
MODE OF ASSESSMENT
MARKS (%)
C. A.Ts and Assignments
30
Final Examination
70
Total
100
Pass mark
40
ii
TABLE OF CONTENTS
Page COURSE OUTLINE....................................................................................................................i TABLE OF CONTENTS... ..........................................................................................................ii CHAPTER ONE: Co-operative Organization…………………........................................ ........................................1 1 1.1 Introduction…………………… Introduction……………………………………………………………… ………………………………………………………………1 ……………………1
1.2 1.3 1.4 1.5
Principles of Co-operatives Management and Social Development…………………..2 The Organization Structure of Co-operatives…………………………………………….3 Aspects the Co-operative Enterprise……………………………………………………….6 Other institutions of the co-operative enterprise…………………………………………8
Review Questions.................................. ........................ ........................ ....................... ..................9 CHAPTER TWO: Co-operative Management…………………………… Management……………………………………..…. ………..….11
2.1 Introduction…………………………… Introduction…………………………………………………………………… ……………………………………………………..11 ……………..11 2.2 Role of Management…………………………………… Management………………………………………………………………………..12 …………………………………..12 2.3 Resources Managed in a Co-operative…………………………………………………..15 2.4 Management Functions…………………………………………………………………….17 2.5 Management Tools………………………………………………………………………….18 2.6 Elements and Division of Responsibility…………………………………………………21 2.7 Managing Local Operations……………………………………………………………….25 2.8 Managing Regional Operations…………………………………………………………..29 2.9 Challenges to Co-operative Management……………………………………………….33 Review Questions.................................. ........................ ........................ ....................... ................34
35 CHAPTER THREE: Co-operative Financing Institutions- Credit Unions…….…... 35 3.0 Introduction…………………………… Introduction…………………………………………………………………… …………………………………………………….35 …………….35 3.1 Key Characteristics of the Credit Union Approach to Microfinance………………..35 3.3 Major Weaknesses and Constraints of Credit Unions…………………………………37 3.3 Major Weaknesses and Constraints of Credit Unions………………………………...37 3.4 Lessons from the Credit Unions………………………………………………………….38 Review Questions.................................. ........................ ........................ ....................... ...............39 CHAPTER FOUR: The Legal Framework of the Co-operative Movement
40 in Kenya…………………………… Kenya……………………………………………………… …………………………………………………. ………………………. 40 4.0 Introduction…………………………… Introduction…………………………………………………………………… …………………………………………………….40 …………….40 4.1 Cap. 490 of the Laws of Kenya, of 1966…………………………………………………40 4.2 Co-operative Societies Act, No. 12 of 1997……………………………………………..42 4.3 Co-operative Societies Act, No. 12 of 1997 as amended in 2004…………………….44 4.4 Role of Cooperatives in Social Economic Development………………………………44 4.5 Role of Government in Cooperative Development……………………………………..45 4.6 Benefits of Forming Co-operative Organizations………………………………………46 Review Questions.................................. ........................ ........................ ....................... ................47 CHAPTER FIVE: Microfinance Principles and Practice…………………………… 50
5.0 Introduction…………………………… Introduction…………………………………………………………………… …………………………………………………….50 …………….50 5.1 Credit Principles………………………………… Principles………………………………………………………………………… …………………………………………52 …52
iii
5.2 Savings Principles………………………………………………………………………….54 5.3 Institutional Requirements Financial Self-Sufficiency………………………………...54 5.4 Appropriate Institutional Structure………………………………………………..…….57 5.5 Policies for Promoting Microfinance……………………………………………………59 5.6 Savings Mobilization and Microfinance………………………………………………...62 5.6.1 Financial Savings at the Local Level…………………………………………63 Review Questions.................................. ......................................................................................66 CHAPTER SIX: The Process of Institutional Development………………………...68
6.0 Introduction………………………………………………………………………………….68 6.1 Framework for Institutional Development……………………………………………....68 6.1.1 Components………………………………………………………………………69 6.1.2 Stages……………………………………………………………………………..70 Review Questions.................................. .......................................................................................71 CHAPTER SEVEN: The Merging Role of NGOs in Financial Intermediation………….. 72
7.0 Introduction………………………………………………………………………………….72 7.1 Characteristics for NGOs Engaging in Financial Intermediation……………………72 7.2 Challenges for NGOs Choosing Financial Intermediation……………………………75 Review Questions.................................. .......................................................................................76 CHAPTER EIGHT: Principles of Regulation and Prudential Supervision and Their
Relevance for Microfinance Organizations………………………………………….77 8.0 Introduction………………………………………………………………………………….77 8.1 The Rationale for Regulating Depository Financial Intermediaries…………………80 8.2 Principles for the Regulation of Depository Financial Intermediaries……………...82 8.2.1 Frequently Adopted Instruments of Prudential Regulation………………..84 8.3 Principles for the Prudential Supervision of Depository Financial Intermediaries……………………………………………………………………………….87 8.3.1 The Methodology of Supervision………………………………………………88 8.4 Risks of Financial Intermediation………………………………………………………..89 8.5 Regulation of Microfinance Organizations……………………………………………..90 Review Questions.................................. ......................................................................................93
Sample Past Question Papers………………………………………………………..94
iv
CHAPTER ONE CO-OPERATIVE ORGANIZATION
Learning Objectives By the end of of this chapter chapter the learner learner should be able to: i) ii)
State the principles of co-operatives Describe the organizational organizational structure structure of a co-operative co-operative society society
iii)
Explain the the functions functions the different different types of general meeting meeting
iv)
Explain the the role of the the various institutions institutions of co-operatives co-operatives
v)
Describe the conditions conditions for all general general meetings meetings of co-operati co-operatives ves
1.1 Introduction
Co-operative is an organization owned by and operated for the benefit of those using its services. Co-operatives have been successful in such fields as the processing and marketing of farm products and the purchasing of other kinds of equipment and raw materials, and in the wholesaling, retailing, electric power, credit and banking, and housing industries. The modern consumer co-operative traces its roots to Britain's Rochdale Society of Equitable Pioneers (1844); the movement spread quickly in northern Europe. In the U.S., agricultural marketing co-operatives developed in rural areas in the 19th century; other contemporary examples include consumer and housing co-operatives Co-operative management, also co-management, tries to achieve more effective and equitable systems of resource management. In co-operative management, representatives of user groups, the scientific community, and government agencies should share knowledge, power, and responsibility. Co-operative management is closely allied with collaborative management, participatory management, community management, joint management, and stakeholder management. Co-operative management training gives students’ inducements to learn what is satisfying to them and useful in future work. The literature of the field is to survey and identify critical needs in co-operative and mid-management skills and develop an inquiry form career. The skills are needed to helping executive personnel in merchandising who supervise mid-managers and mid-managers who occupy such merchandising positions.
1
Co-operatives in Kenya are not a new phenomenon; its experience can be traced back from the time before colonial domination to recent where we experience business in cooperatives especially of financial institutions and agribusiness in nature. 1.2 Principles of Co-operatives Management and Social Development
i)
Voluntary and Open Membership
Co-operatives are voluntary organizations, open to all persons able to use their services and willing to accept the responsibilities of membership, without gender, social, racial, political or religious discrimination. ii)
Democratic Member Control
Co-operatives are democratic organizations controlled by their members, who actively participate in setting their policies and making decisions. Men and women serving as elected representatives are accountable to the membership. In primary cooperatives, members have equal voting rights (one member, one vote) and co-operatives at other levels are organized in a democratic manner. iii)
Member Economic Participation
Members contribute equitably to, and democratically control, the capital of their co-operative. At least part of that capital is usually the common property of the cooperative. They usually receive limited compensation, if any, on capital subscribed as a condition of membership. Members allocate surpluses for any or all of the following purposes: developing the co-operative, possibly by setting up reserves, part of which at least would be indivisible; benefiting members in proportion to their transactions with the co-operative; and supporting other activities approved by the membership. iv)
Autonomy and Independence
Co-operatives are autonomous, self-help organizations controlled by their members. If they enter into agreements with other organizations, including governments, or raise capital from external sources, they do so on terms that ensure democratic control by their members and maintain their co-operative autonomy. v)
Education, Training and Information
Co-operatives provide education and training for their members, elected representatives, managers and employees so they can contribute effectively to the
2
development of their co-operatives. They inform the general public — particularly young people and opinion leaders — about the nature and benefits of cooperation. vi)
Cooperation among Co-operatives
Co-operatives serve their members most effectively and strengthen the cooperative movement by working together through local, national, regional and international structures. vii)
Concern for Community
While focusing on member needs, co-operatives work for the sustainable development of their communities through policies accepted by their members.
1.3 The Organization Structure of Co-operatives
The co-operative enterprise is distinct in its management structure, than other enterprises management structure. The co-operative enterprise is composed of two elements. It stands on two legs: i) The ownership arm. The co-operative belongs to all its members individually and
equally, and they finance the assets of the co-operative entirely and equally. ii) The functioning arm. The members pay for the entire costs of operation of the
co-operative, but not equally. They pay for its operation according to their patronage in the co-operative. Other aspects of the co-operative management, its democratic structure are as follows: The Co-operative Enterprise general concepts, structure and characteristics is described at the operation and management of the co-operative, where its most important element is the members. In any other form of enterprise, the factors of production are derived from from different different sources. sources. Capital comes from investors. Labor comes from the employed workers. Administration is provided by a managerial staff
other
than
the
owners. In a co-operative enterprise, however, all factors are derived from one source.... the members. In the management of other organizations, the elements of authority can be recognized. rec ognized. The authority comes co mes from different sources such as professional or class standing, military rank, landlord status or the possession of capital. In a co-operative enterprise, however, the authority derives from the general meeting of the members.
3
In
the
administration
of other organizations, a hierarchy of responsibi1ity is
seen, with one person in charge at the top. From the apex, authority is delegated to those beneath, in progressively increasing numbers. In other words, a director delegates authority to the deputy directors, they delegate to the various executives, who, in turn, delegate to the various department managers. An organizational pyramid has therefore been generated with one in control at the apex and a broad base of responsibi1ity. In a co-operative enterprise, however, the top of the hierarchy is the members. This broad top base delegates authority to the council, which in turn delegates to the management. The management delegates to the manager, the one...at the bottom. In the case of a co-operative, the organizational pyramid is "upside-down".
1.4 Aspects the Co-operative Enterprise
The General Meeting
There are several different types of general meeting. i)
The Inaugural General Meeting
This meeting takes place in every co-operative but once. Its role is to inaugural the functioning of the co-operative, to discuss and authorize the 1ist of first members as wel1 as the
bylaws
and
other
regulations
of the co-operative. It must approve the
financial and operational plan for the first year's activities and elects all the institutions of the co-operative. ii)
The Annual General Meeting
The role of this meeting is to assess all aspects of the past year's activities and to approve financial, social and developmental plans for the following year, as wel1 as to elect continuing officers to the various bodies of the co-operative organization. annual
The
general meeting is never presided over by the Manager of the co-operative,
but rather by a special ad-hoc committee, responsible for all the sessions. iii)
The Extraordinary General Meeting
This meeting is called only in the event when the following subjects are to be discussed: a) Amendment to the bylaws.
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b) Acceptance of new members. c) Expulsion of members. d) Dissolution of the co-operative.
Decisions of the extraordinary general meeting require a special majority of 75% of the members present, whereas at other general meetings a simple majority is sufficient. iv)
The Special General Meeting
Whenever the need arises during the year, this general meeting may be called. It is presided over by the Manager of the co-operative; though it may be summoned upon request or demand of the management, the control committee, the audit union,
the
registrar of co-operatives or 10-30% of the members, according to the bylaws of the co-operative. Conditions for all general, meetings, regardless of type
A general meeting may be convened only when a legal quorum is present. Such a quorum consists usually of at least 50% of the members, though the bylaws may specify any number. If no quorum exists, the meeting is postponed to another time, from one hour to a month later. Members should be informed about the date, time and place of the general meeting wel1 in advance, and by appropriate means. Careful minutes should take the discussions and decisions of every meeting. They should include: a) The full name of the society b) The date of the meeting c) The number of members present d) The name of the chairperson presiding e) The name of the recorder taking minutes f) The agenda g) The decisions h) Any remarks of the chairperson
The general meeting is the highest authority in a co-operative, a role which permits and demands certain specific functions. a) It is a forum where the members can express their views freely.
5
b) It elects the various institutions of the co-operative. c) It approves or expels members. d) It makes decisions on basic issues. e) It controls, regulates and balances the executive institutions of the co-
operative enterprise. A mass general meeting has, however, certain inherent limitations, which should point up areas requiring very careful consideration. a) While every issue can be presented for discussion at the general meeting,
very few are in fact discussed; since many people are unwilling to reveal themselves before such a large, anonymous group. b) The powerful attraction of home based radio and television, coupled with
the natural desire to maintain and strengthen the family unit cause people to be less interested in spending time at general meetings. c) Increasing heterogeneity of co-operative members whether in professions,
branches of production, and fields of interest, economic situations or social rank
has caused increasing difficulty in getting people together for a
particular purpose. d) A general meeting may be more successful if a day is chosen when there
are no competing interests, when the agenda is not monotonous and when the points
at
issue
are
interesting.
In this way members may be
encouraged to keep away from other activities during a scheduled general meeting. e) Good management of the meeting by the chairperson of the meeting is
assumed, as is a courteous and encouraging attitude towards participation of the members in discussions. 1.5 Other institutions of the co-operative enterprise
i)
The Council
According to co-operative legislation there exists the possibility of electing an alternative body to the General meeting in the co-operative. This body, the Council, is summoned mainly when the general meeting has suffered a considerable drop in participation at all sessions. At the point when only ten or fifteen percent of an
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membership is present at a general meeting, decisions made by such a minority are hardly representative of the entire society. A council is therefore elected body, which becomes the second highest authority in the co-operative. It sits every three to four weeks to discuss and decide on current issues in the co-operative, those which require a forum wider than that merely of management. It decides as wel1 on matters of investments, management budgets, production quotas and matters of social and economic importance. The members of the Council are elected for terms of two years, every year half the membership being renewed. On one hand, management may pass to the council issues of great importance which require a broader forum for decisions. While, on the other hand, social problems, handled unsatisfactorily by a management committee may be submitted to the council by the members themselves. The Council is a relatively stable body where members feel
greater
personal
responsibi1ity than in the anonymity of the general meeting. The Council reflects greater variety of opinion than the management committee and has more public backing, though there is not the same discrete, personal approach to members' problems as in that body. ii)
The Management Committee
The Management Committee is the highest elected executive institution in a cooperative enterprise. Everything done in the co-operative must be approved by the management committee. General1y speaking, members of this committee are not paid for their services, and the time they devote to meetings is limited. Every member of the cooperative may present matters (personal problems, coop problems or public affairs) for discussion, but only a limited number of subjects can be considered in the twice weekly meetings of the management committee. Duties of this committee are; a) Approval and assignment of contracts b) Engagement and dismissal of workers c) Consideration of social problems d) Decisions on matters of co-operative policy e) Investment in other co-operatives f) Planning future activities of the enterprise
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g) Coordinating committees work
Members of the management committee are "blind" in the sense that they depend entirely on the Manager for the submission and explanation of issues. A central problem is therefore the selection of this officer, for if important issues are presented with incomplete or false information, resultant decisions may be wrong
or
totally
inappropriate. Management has a global responsabi1ity for all acts of the co-operative though there may not always be an immediately discernable connection. It must decide on the executive acts of the Manager and bears responsabi1ity for the successes and failures of that officer. It is incumbent on the management committee to ensure that decisions taken can in tact be executed. The management committee must guarantee a close correlation between theory and practice, between decision and execution. It is always good management policy to view every decision action in the context of the total activities of the enterprise, present and future. In this case, the management committee
must
seek
to
discover the correlation between current actions and their
future consequences. In a way, it is like seeing not only the forest as a whole, but also each tree as an integral part thereof. iii)
The Manager
The Manager of the co-operative is also the chairperson of all management committee, and frequently the only paid officer in the enterprise. 24 hours a day devotion to the co-operative is required of the person who plays this role, as wel1 as responsibi1ity for all its operations. It is the same manager who initiates and presides over the meetings of the management committee, and prepares the agenda for those meetings. It is this officer who is most directly involved in the personal problems of members of the co-operative and of its employees. The manager represents the co-operative in other forums, institutions and government bodies; and it is this person who is in charge of the operation of the different departments of the organization as well as for the preparation and execution
8
of the socioeconomic policy of the co-operative. It is the manager who proposes plans, executes and evaluates. iv)
The Treasurer
The Treasurer of the co-operative is responsible for its financial management. The person in this role has numerous specific responsabi1ities. a) Maintaining contacts with banks and other financial institutions dealing
with credit. b) Collecting money and paying debts on behalf of the co-operative. c) Representing the enterprise in different economic institutions. d) Supervising matters of insurance. e) Annual and monthly financial planning.
v)
Control/Supervisory Committee
The control committee is elected by the general meeting of the co-operative from among its members. It is an internal watchdog committee responsible for examining and supervising the activities of the co-operative in order to guarantee their being legal and in compliance with its bylaws and constitution, as well as being financially tenable. The control committee is completely independent from the management committee, but in no way replaces that committee. Nor, in tact, does it have the same powers. A member of the control committee cannot at the same time be a member in management, council or any other elected bodies of the co-operative. Some of the specific duties of the control committee involve supervision and checking of: a) The general functioning of the enterprise. b) The activities of management. c) Various decisions and their execution. d) The financial situation and the annual balance sheet. e) The behavior of the different committees. f) Complaints from members of the co-operative.
9
Review Questions i)
Differentiate between the council and the management committee of a co-operative and state the functions of each
ii)
Briefly explain the principles of co-operatives
iii)
Using an illustration differentiate the organization structures of co-operatives from those of corporations
iv)
Differentiate between an extraordinary meeting and a special meeting of a cooperative
v) vi)
Describe the conditions for all general meetings of co-operatives State the duties of the supervisory committee of a co-operative society
Suggested Further Reading Sanjay S. (2008), Principle of Cooperative Management , Deep Deep Publishers New Delhi Manyara K. Murungi, (2003), The Development of Co-operative Law and policy in Kenya, Oscan Print, Nairobi
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CHAPTER TWO CO-OPERATIVE MANAGEMENT
Learning Objectives By the end of this chapter the learner should be able to: i)
Explain the role of management in cooperative societies
ii)
Identify and describe the typical management functions
iii)
Identify some of the unique decisions faced by co-operative managers
iv)
Describe the resources managed in a co-operative
v) vi) vii)
Identify and explain the various tools used in the management of co-operatives Discuss the elements and division of responsibility co-operatives Describe the unique challenges of managing local and regional co-operatives
2.1 Introduction
Management has greatly improved as co-operatives have become larger, more diversified, and integrated to match similar advances in the marketplace. In the early years, local co-operative managers not only supervised operations but also maintained accounting records, waited on customers, and swept floors. Many co-operatives failed because of inept operating management and poor monitoring by the board. Specific examples included overextension of credit and unsound collection practices, poor technique in produce marketing, inadequate attention to keeping products in condition, overexpansion of facilities, underfinancing, and overadvances to growers in pooling operations, dominance of the hired manager, and interference in management of operations. Both surviving and new co-operatives learned important lessons from these experiences. As regional co-operatives developed and became stronger, they began providing more assistance to local boards and managers through general field representatives. This included helping recruit and train managers and assistants. Later, several provided financing and direct management service to the weaker locals, and auditing and analysis service to all member locals.
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With the advent of the Co-operative Bank, and the co-operative college valuable management and financial counsel became available to co-operative borrowers. In many cases, this perhaps is more valuable than the funds loaned to them. Regional cooperatives now employ university graduates with training in business administration, agribusiness, or sales management and place them in management trainee programs before moving them to managerial positions. Some regional co-operatives provide management training for local managers, using their own staffs or management consulting firms as trainers. Most regionals send key employees to management schools or seminars. Co-operatives have increased in size and diversity of products and services, and have departmentalized their operations. Most farmer-directors have become more business-minded as their own farm operations grew. They give more attention to their cooperative’s management. They employ managers with more training and expect them to improve their knowledge and skills. Also, a growing number of directors seek to become more proficient in directing the affairs of their co-operatives. Public concern about food safety, pollution control, health and the environment, monopoly, and related issues focuses attention on the competence, integrity, and behavior of co-operative directors. As a result, co-operatives are becoming more aware of the need to indemnify directors who are subject to increased legal exposure. The growing impact of world markets, even on the individual family operation, is changing the management perspective from the local co-operative level. The local is being viewed less and less as an independent entity and more and more as part of a system. Therefore, planning and strategy are evaluated in terms of the local’s relationship to neighboring co-operatives, other areas, agribusinesses, the regional co-operative in which it has ownership, to the markets into which members’ products flow, and to the ultimate use of those products.
2.2 Role of Management
Management combines ideas, processes, materials, facilities, and people to effectively provide needed services to member-owners. Management is the decision making element of the co-operatives. Broadly speaking, its role entails formulating and
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executing operating policies, providing good service, maintaining financial soundness, and implementing operating efficiencies to successfully meet its objects. A successful co-operative is viable in an economic or business sense and maintains or improves its co-operative character or features. A co-operative may succeed as a business, but gradually lose its co-operative character regarding member control, serving the needs of members, and distributing net margins. Likewise, it may succeed for a while as a co-operative, but fail as a sound business institution. Managing a co-operative is challenging and difficult. It involves not only managing resources and business operations, as in other businesses, but also dealing with problems stemming from the co-operative’s distinctive characteristics. Because the cooperative’s members are both owners and patrons, special relationships and problems arise concerning member and board of director roles and responsibilities. Seemingly conflicting answers to questions arise. What’s different in managing a co-operative from any other type of business? The answers can range from “all the difference in the world” to “none at all.” A former regional co-operative chief executive officer offered this answer: “Decision making techniques are identical, but the cooperative’s objectives are different; therefore, the manager’s conclusions will be different.” Co-operative principles and objectives present a distinctly different managerial premise. That premise is revealed in more detail through the following perspectives an executive must acquire to be a good co-operative manager: i)
Adjusting decision making to a business where the customers are also the owners.
In a supply purchasing co-operative, the manager of an investor-owned firm (IOF) may discover that many of the successful techniques associated with developing a salable and satisfactory product (for the customer) and achieving maximum return on capital (for the owner) no longer apply. A co-operative manager has to adjust priorities and objectives to the realization that what’s best for the customer (also the owner) really is best for the co-operative. This realization may explain why some low- or no-margin services continue to be provided and why certain unrelated and perhaps high-margin activities are not considered in a co-operative.
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The manager of marketing co-operatives must understand why the co-operative often is obligated to take all of the members’ products and attempt to find a market for them. The manager is not at liberty to pick and choose among such product suppliers and cut off marketing when inventories build up. And certainly to allow the member-producer to dictate the terms on which the co-operative business should receive the product would be a situation foreign to non-co-operative managers. ii)
Dealing with complex issues of equitable treatment of owner-patrons, the manager of an IOF will discover that distributing the net earnings of a co operative is much more complicated than declaring a dividend on capital stock.
The standard co-operative practice of distributing net earning on the basis of individual member volume, such as units marketed or quantity of supplies purchased, also will be new should he/she become a co-operative manager. For larger co-operative that handle many products and involve value-added activities, the issue of equitable treatment of member-owners can be complex. Another concept new to an IOF manager now heading a co-operative is the requirement that member-owners share equitably in financing the co-operative, and that management communicates that responsibility to them and develops financing programs they’ll accept. iii)
Working in a service-oriented organization is a spotlighted atmosphere.
The manager of a typical co-operative will find that members formed it to provide a needed marketing, purchasing or service. Hence, every time they use the cooperative they evaluate the service performed by its employees. Often, members may wish to express their views directly to the manager or to get management advice about supplies to use or when to market their products. Therefore, a co-operative manager may feel that he/she is operating in an enclosed environment, compared with the manager of an IOF whose only interface with most stockholders occurs at annual meetings when they want an accounting of why there were changes in the market value of their stock or in the dividends declared on it. Even in the day-to-day routine of a large co-operative, the new co-operative manager may encounter a different working environment. “an executive or professional joining a co-operative must adapt himself to the publicity surrounding his work.”
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iv)
Co-operatives
have
unique
management
implications
of
business
ownership and control
Managers perform under the influence of various motivational factors-pay, power, prestige, and a place in history. Not all are fully transferable from an investor-oriented business to a member-user oriented co-operative. An example concerns the ownership and control of the business. An investor-oriented business executive or manager looking for a company to “gain control of’ either by outstanding performance, political maneuver, or eventual ownership will be surprised if the company is a co-operative. A co-operative manager can never acquire “ownership rights,” and must become resolved to always being an employee. Further, the manager will discover it necessary to deliberately involve a majority of the member-owners, not just a few principal stockholders, in major decisions affecting co-operative policy and its business objectives. The prospective co-operative manager, therefore, needs to carefully assess whether his/her management style and personal performance motives and ambitions are compatible with the constraints of a co-operative owned and democratically controlled by member-users.
2.3 Resources Managed in a Co-operative
Like any other business, three major types of resources must be managed in a cooperative-people, capital, and facilities. i)
People
The most important resource in a co-operative is people. The success of all phases of the business depends on competent personnel working together smoothly and efficiently. Personnel management thus is a critical phase of business management. It begins with the selection of personnel, followed by training and evaluation. Much depends on personnel supervisors who must plan the work, delegate responsibilities and authority, analyze jobs, and set performance standards, as well as train workers, review performance, set up grievance procedures, and provide leadership. Proper compensation, including fringe benefits and incentives, is important in personnel management. Management should also motivate and reward employees. This coaching function involves seeking suggestions from staff, creating an environment
15
where employees can be innovative, establishing goals, inspiring and recognizing good performance, and developing teamwork and an esprit de corps among employees. In a co-operative, management also must strongly emphasize member relations because ownership, control, and patronage all are member functions. This involves adequate two-way communication and information from management to members and from members to management. Continuous efforts are also needed to obtain new members to maintain the organization and an adequate volume of products or services. Maintaining or improving good member-patron relations involves providing good, honest service and helpful information about the co-operative and the products it handles. It means keeping members informed about policies, operating practices, and financial requirements; and pointing out their responsibilities for making the co-operative successful. Management of a co-operative, as in other businesses, also must be concerned with public relations. If there is to be public understanding and acceptance of the co-operative, the public must have information on its objectives, accomplishments and benefits, and limitations. ii)
Capital
Financial management, a key to operating co-operatives, involves managing assets such as cash, accounts receivable, inventories, fixed assets, and investments in other organizations. It includes managing liabilities, such as accounts payable and current notes payable, and obtaining favorable long-term financing. Sufficient member or equity capital and a sound financial position must be maintained that will be acceptable to creditors, suppliers, or buyers of co-operative products. This requires periodic analysis of the co-operative’s financial position, its operating efficiency, and proposals for expansion. Financial management involves: a) Considering funds available and source for additional capital; b) Allocating funds among assets to be financed; c) Ensuring that all aspects of financing are dealt with in a manner
consistent with sound business practices and co-operative principles.
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iii)
Facilities
Building and equipment can represent a large proportion of a co-operative’s assets. Therefore, important management considerations include scheduled maintenance; rearrangement, remodeling, and replacement to improve operating efficiency; daily operating cost records; preventive maintenance programs for rolling stock such as delivery trucks; grounds maintenance and pest control; adequate insurance; disposal of unproductive assets; and observance of safety, health, and other environmental regulations.
2.4 Management Functions
Overall, management embodies four functions-planning, organizing, motivating, and controlling. Planning determines where the organization is going and how it will get there. It
sets organizational objectives and goals, forecasts the environment in which objectives must be accomplished, and determines the approach by which objectives and goals are to be accomplished. Planning is used to determine a policy and the procedures for putting it into effect. Planning usually considers several alternatives. Each should be judged on the basis of its economic or competitive effect and accompanying problems. Also, it must be consistent with co-operative principles and the association’s objectives. Planning helps a manager shape the future of the organization rather than being caught in an endless trap of reacting only to current crises or problems. Organizing is concerned with determining the specific activities needed to
accomplish the planned objectives and goals; grouping the activities into a logical pattern, framework, or structure; assigning the activities to specific positions and people; and providing means for coordinating the efforts of individuals and groups. Organizing is a bridge connecting the planned objectives to specific projects for accomplishing these objectives. Motivating concerns the people side of the organization. Co-operatives are
people-driven organizations, from the standpoint of both employees and members. Managers must have leadership skills and be effective communicators. The manager’s ability to influence members through leadership will help determine the extent to which
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both individuals and the entire organization accomplish their goals. A manager spends up to 95 percent of the time communicating. Good communication is essential to coordinating the organization’s human and physical elements into an efficient and effective working unit. In controlling, management monitors the progress of planned activities. If progress is lagging, necessary adjustments are made. Controlling is the checkup part of a manager’s job.
2.5 Management Tools
Management uses a number of tools to carry out its functions- accounting system, control reports, security and safety, training and evaluation, incentive programs, communications, and strategic planning. i)
Accounting System
A complete and accurate accounting system is vital for effective management. It must produce several financial statements needed in planning and controlling, such as: a) Monthly and annual balance sheets and operating statements b) Functional or enterprise accounts pertaining to departments or specific
lines of business; c) Special accounts such as patronage records, accounts receivable aging,
member equity, and patron financing An independent auditor periodically verifies the accuracy of the co-operative’s business records. This is especially useful to directors in performing their controlling and planning functions. It helps the board determine the extent to which the manager has followed financial policies, and evaluate how the co-operative is accomplishing its basic objectives. The external audit is primarily a board tool. Larger co-operatives also use internal audit reports. The internal auditor’s primary duty is to monitor the co-operative’s accounting policy. The auditor checks the cost of prescribed procedures, including their effect on patrons and personnel, and suggests ways to prevent errors. Usually, the auditor reports to the chief accounting officer, but sometimes to the general manager or even to the board of directors. Internal audits are primarily manager tools.
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ii)
Control Reports
Credit and inventory analysis include a monthly aging of accounts and notes receivable; selected financial and operating ratios; and a monthly accounting of selected inventories, including shrinkage reports. iii)
Security and Safety
To protect the co-operative, the board is responsible for adequately insuring employees and assets. Employees handling funds should be bonded. Facilities need to be appraised and arranged internally and fenced to minimize pilferage. The board should adopt programs to protect the health and safety of employees and patrons and measures to comply with environmental protection standards. iv)
Evaluation and Training
Management will be evaluated even if the process is not formally planned. Member-owners continually evaluate their hired management in terms of how well the co-operative is serving members. Regardless of co-operative size, supervisory personnel are evaluated on the basis of how they perform day-to-day. In addition, business leaders, who know about or deal with the co-operative, indirectly evaluate its management. While this type of evaluation may have a direct impact on the co-operative, the process usually doesn’t clearly identify weaknesses so they can be corrected. Larger cooperatives use professional management consulting firms to assess whether the cooperative’s management structure is efficient, locate weaknesses and strengths, and suggest what types of management training are needed. A co-operative of any size can lay a fundamental basis for evaluating its management. The essential requirement is to develop an evaluation plan and then follow it. Present and prospective supervisors can be encouraged to improve their management abilities by using a wide range of training resources. Co-operatives often send many of their top management staffers to commercial seminars on management or to specialized educational seminars such as the Co-operative College. v)
Incentive Programs
In addition to job descriptions and salary ranges, managers in an increasing number of co-operatives use incentive payment plans to encourage productivity. Also, many use certificates of merit or special activities to recognize superior employee performance.
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vi)
Communications
Managers communicate with employees, members, and the public in a variety of ways-membership and employee publications, annual reports, member and employee meetings, and reports by educational and Government agencies. vii)
Budgets
Budgets are valuable tools in planning and controlling the co-operative. Hired management usually prepares three types of budgets- operating, cash, and capital. Operating budgets are completed each year. The first step is to project revenue sources, an estimate of the sales or income volume in physical units and their values. Next, prepare estimates of variable and fixed costs based on the income projections. Last, calculate net earnings. To obtain maximum benefit of the budget, operating management should compare the actual income and expense against the monthly projections. Where actual results are worse than the projections, corrective actions should be taken. Cash budgets estimate the flow of funds for a fiscal year. If completed on a monthly basis, they help plan borrowing or investing of operating capital, the ability to take advantage of discounts, and serve as a financial control. Cash budgets are important for seasonal businesses. Capital budgets have a longer planning span, usually 5 years. These budgets might include the co-operatives needs for more land, buildings, equipment, services and operating capital. An integral part of this budget is feasibility studies on projected asset purchases and to consider alternative investments that could produce greater returns and still satisfy the mission of the association. Finally, identify the source of funds for capital projects. Sources to consider could be equity capital, borrowed funds, or retained net earnings. These three types of budgets quantify the financial resources needed to satisfy the capital requirement of the overall strategic business plan. viii)
Strategic Planning
Strategic planning is a formal and systematic process. It is long-term and different than short-term or annual budgeting. Its primary purpose is to determine the current position of the co-operative and chart its future direction. The planning horizon is usually 3 to 10 years.
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Strategic planning is objective oriented and focuses on specific measurable actions. It is based on available and factual information and assumptions regarding the future. It clarifies relationships, promotes understanding of established objectives, and assigns specific responsibilities, tasks, and time schedules. It includes orderly review of progress. Strategic planning uses the co-operative’s strengths to put it in the best possible position while change is occurring. It also devises steps to minimize the co-operative’s weaknesses, or even better, devises steps that turn weaknesses into strengths. Strategic planning helps obtain the confidence of lenders and investors. It evaluates alternative actions. In short, strategic planning makes a co-operative proactive instead of reactive.
2.6 Elements and Division of Responsibility
Management of the co-operative is a team effort that combines three elementsmembers, elected directors, and hired management. Often, management is construed to be only the full-time general manager, or chief executive officer, and department heads. This is understandable because this is their full-time responsibility. Members and directors look to them for information and guidance. Obviously then, the responsibilities of these three elements should be clearly understood and followed. 1. Members
Articles of incorporation spell out member’s specific powers. Members also have moral and legal responsibilities in relationship to these powers. Members are involved in the broad management aspects of a co-operative because they are both its owners and patrons. They live close to it and exercise more control than the stockholders of other corporations. Powers of the membership are: i) Adopt and amend articles of incorporation, bylaws and agreements; ii) If necessary, select and recall a board of directors; iii) Examine annual reports; and iv) Study major issues and cast informed votes. Examples of issues include: a) Adoption of long-range strategic plans, b) Major expansion in facilities,
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c) Changes in capital structure, d) Adoption of a marketing contract, e) Addition of a major type of supply or service, f) Sale of major assets and, v)
Dissolve or merge the association.
Members are responsible for: i) Providing the necessary ii) Capital, iii) Patronizing the co-operative to the fullest possible extent, iv) Paying the cost of operations, v) Assuming the business risk, vi) Controlling the co-operative through its elected board of directors, vii) Keeping informed about the co-operative.
2. Management Committee
The Management Committee represents members within the framework of an official board of directors. All corporate powers of the co-operative, other than those specifically conferred upon members, are vested in its directors. These powers and responsibilities are outlined in the bylaws. Three major responsibilities are to set policies, employ a general manager to carry them out, and then evaluate the manager’s performance. Ten more specific management responsibilities of the board are: i) Functioning as trustees for the members in safeguarding assets in their co-
operative; ii) Determining the mission of the co-operative and setting objectives and general
policies iii) Defining and adopting long-range strategic plans; iv) Employing a competent manager; v) Preserving the co-operative character of the organization; vi) Requiring accounts and records; vii) Appointing an outside auditor; viii) Controlling the total operation; ix) Distributing corporate net earnings or savings;
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x) Redeeming equities in an expedient manner.
The member elected to become a co-operative director probably wonders, how much of my time will this job require? And perhaps present directors wonder if they’re spending too little or too much time fulfilling their co-operative responsibilities. Past studies revealed that 37 percent spent 2 weeks or less; 52 percent spent between 2 weeks and a month; and 11 percent spent more than 1 month per year. Sixty-eight percent of the co-operatives compensate their directors for attending meetings. The frequency of meetings ranged from two or three per year to monthly. 3. Hired Management
The board of directors, in turn, delegates much of its overall management responsibility-the daily operations-to a full-time manager or chief executive officer. The manager, in turn, is empowered to employ and discharge key employees such as department heads, who together with the manager comprise the hired top management staff or team. Generally, the ability to work with people-employees, directors, and members-is exceedingly important. This includes ability to hire, train, supervise, and motivate competent employees and to delegate responsibility. A second trait is business knowledge. A third is the ability to keep the co-operative meeting the needs of members and following sound co-operative principles. Education, training, and knowledge of the business were reasonably good predictors of managerial performance, but only knowledge and management experience were good predictors of economic success of the co-operative. The study also indicated some indirect relationships or correlations. For instance, managers with the most education tended to acquire more training and thus gain more knowledge. This eventually boosted the co-operative’s net earnings. Common management responsibilities are: i)
Manage or direct daily business activities;
ii)
Set goals and develop short-term strategic plans including budgets and cash flow statement as requested by the board;
iii)
Employ, appraise, and terminate employees as necessary;
iv)
Organize and coordinate internal activities and subordinates;
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v) vi)
Control daily operations; Maintain an accurate bookkeeping system;
vii)
Prepare and present accurate financial and operational reports;
viii)
Attend all board meetings.
Often, questions arise about the division of responsibilities between the board of directors and hired management. Sometimes they overlap and an exact division cannot be made. Consider these factors: i)
Long-term decisions are the responsibility of the board and operational decisions are those of management;
ii)
Idea decisions are usually handled by the board and action decisions by management;
iii)
Trustee decisions involving policy are the responsibility of the board while trustee actions are handled by management;
iv)
Broad primary control activities fall to the board while secondary controls pertaining to short-run operations are the responsibility of management;
v) vi) vii)
Employment of the manager is the responsibility of the board; but Employment, supervision, and evaluation of co-operative Employees is the responsibility of hired management
The use of policy and procedure manuals and job descriptions along with frank discussion of problems when they arise help maintain an understanding of the division of responsibility.
2.7 Managing Local Operations
Management of the local co-operative is perhaps the most difficult and demanding on the total personality and ability of the manager. Local managers, in most cases, cannot disappear into their offices to make business decisions while skilled supervisors “run the shop.” The local manager may have supervisors, and good ones, but usually the manager must do much of his/her thinking in the middle of daily operations. The manager is highly visible to member-owner-customers and may be faced with timeconsuming and varied decision making situations.
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a) Marketing
Marketing products involves local assembling, packing, semi-processing, processing, storing, selling, merchandising, and transporting the commodity. Many farm products are perishable. Co-operatives sell them either in an unprocessed (fresh or whole) or processed form. Co-operatives also market them in two basic ways- buy-and-sell or pooling. These are some typical basic business decisions that characterize the daily operations of a marketing co-operative. Where large businesses, including co-operatives, may have economic and business analysts to assist the manager, the smaller local associations must rely largely on the knowledge, experience, and judgment of the individual manager. Among decisions the manager faces are: i)
Providing assembling or trucking services and rates.
Decisions must be made regarding the level of service from farm to market and rates to be charged. Should the co-operative own or lease trucks or contract for hauling? ii)
Pricing or paying for products, including handling or pooling expenses and sales proceeds.
In buy and sell operations, co-operatives determine how daily paying prices will be set and what the gross margin per unit of product should be. Also, discounts and premiums for quality considerations are part of the activity. In pooling operations, policies regarding cash advances to growers at time of delivery are important. There may be no advance, an initial small advance with succeeding advances or progress payments, an advance based on a fixed percent of the market price, or the advance may reflect the current market price. Also important is the length of the pool-daily, weekly, or seasonal. Will a pool be established for each product or a group of similar products, and for each grade or quality of the product? iii)
Using marketing contracts or membership agreements.
These stipulate the responsibilities of members and of the co-operative and penalties for lack of compliance. They provide for commitment by members, thus aiding management in dealing with customers for the products and projection of operating capital.
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iv)
Establishing patron storage or warehousing policies and rate.
Considerations include policies for accepting products if storage space is limited, handling costs, storage pool charges and accounting, and keeping the product, such as grain, in condition by proper aeration, drying, and frequent inspection. v)
Managing inventories.
Careful attention to inventory levels, commodity values, and physical condition is necessary to minimize risks of and shrink or loss of inventory. vi)
Merchandising and selling the product.
Merchandising involves commingling like products to attain desired grades or quality. Co-operatives owning the product, such as grain, may use strategy based on the commodity futures and options markets to sell inventory. Wool marketing pools, for example, may use sealed bids or private negotiations, and they can sell wool by forward contract or on a spot basis. Ownership in and use of co-operative sales and bargaining agencies is a major aspect in selling products. vii)
Establishing the credit rating of buyers.
Firm credit terms or escrow policies in dealing with them are needed. viii)
Providing current information to producers
Co-operatives can be of real service by providing research findings on production and handling practices that will develop products that meet the quality demands of buyers and consumers. ix)
Determining market potential.
Management needs annual estimates on expected trends in agriculture and business activity in the trade area. b) Supply
Handling farm supplies involves several levels or operations. These include purchasing or producing ingredients, manufacturing, wholesaling, retailing, and transporting at each of these levels. Local co-operatives are best characterized as retailing operations. However, some of them have feed manufacturing facilities, bulk petroleum plants, fertilizer blending plants, seed processing operations, and offer transportation services.
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The local manager’s job may be easier if the co-operative is affiliated with regional co-operative suppliers who offer a wide range of products. This means the local manager deals with fewer people for more supplies. Regional co-operatives are oriented to the needs of the locals and lift some of the burden from the local manager for comparing supplies for quality, price, uniformity, and performance and serves as an assured source of supply. A local manager has to substitute expertise and experience for the larger organization’s team of specialists in making decisions connected with daily operations. Typical areas requiring decisions are: i)
Purchasing supplies and ingredients
The manager with board approval determines the types and qualities of supplies and equipment to handle. Managers determine the quantity, when to buy, and factors like warehouse space, volume discounts, seasonal needs, and the price trends. Ingredients purchases include those for feed milling or soil amendments. The wholesale sources of supply involve decisions by the manager. Many local cooperatives are members of regional wholesaling-manufacturing co-operatives and buy their needs through them if their pricing structure is competitive. Some belong to several regional supply co-operatives. Most co-operatives buy, warehouse, and resell supplies, while others own franchises or dealerships. ii)
Warehousing and managing inventories
Warehousing, handling materials, and controlling stock are important in retail operations. Inventories may be carried at plants, wholesale warehouses or terminals, and at retail warehouses, stores, and bulk storage facilities. Decisions must be made as to the frequency of taking a physical count of inventories and whether to use a perpetual or periodic system. Managers need to know how frequently the inventory turns to determine if inventory capital is being used effectively. Personal computers and user-friendly software packages have helped to reduce labor costs of these management practices.
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iii)
Pricing supplies
Co-operatives usually price their supplies “at the market” for items of comparable quality. But sometimes other pricing practices are necessary when price wars occur, or other firms have lower prices and fewer services. Decisions must also be made about using quantity or volume discounts, cash discounts or credit carrying charges, and discounts for early booking or delivery of supplies and the rates to offer on each. Discounts, services and delivery charges, and booking programs must be communicated to all patrons and applied fairly. iv)
Establishing distribution methods
This area involves the selling, merchandising, and delivering of supplies. Bulk feed and petroleum products are generally delivered by the co-operative with the product and delivery costs figured into price. Some provide allowances for patrons who want to do the hauling. Wholesale firms may set separate prices for products purchased at their plant or warehouse and another if delivered. The local co-operative may haul its supplies or contract for transportation service. Co-operatives generally use common merchandising methods such as displays, newspaper, television, or radio advertising, newsletters, flyers, or sales campaigns and contests. Providing technical services and field support augments the sales effort. v)
Controlling credit.
Management of supply co-operatives continually faces the problem of controlling credit extension on accounts receivable. Specific policies adopted and followed by the board are the first prerequisite. Use of cash discounts, service charges, and seasonal financing must be determined. Knowledge of the costs of extending credit and sound business practices for controlling it are essential. vi)
Providing custom and technical services
Demand for custom and technical services increase as farm labor become costlier and production technology becomes more advanced. Conservation and environmental issues demand increased technological advice. Management with board approval must decide what services to offer and whether they should become self-supporting or be subsidized by product margins.
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vii)
Providing information to patrons
Co-operatives can be of real service by providing facts to farmers on the right kind and amount of supplies to use that will give them greatest yields, gains, or satisfaction. Some co-operatives offer recordkeeping, accounting, and hedging or optional markets to their patrons. viii)
Determining the market potential
Management needs annual estimates on potential volumes for various supplies, and trends in agriculture and business may affect this potential in the trade area.
2.8 Managing Regional Operations
Managing regional co-operatives involves the same principles and problems as managing local operations, but on a much larger scale. It requires more delegation of responsibility and authority and the use of more staff personnel. Regional operations often include vertically integrated services such as processing farm products and wholesaling and manufacturing farm production supplies. There are three types of co-operative regionals: large-scale centralized associations deal directly with farmer-members; federated associations deal with member local co-operatives; and combinations of direct-farmer membership and affiliated local co-operatives. Distinctive functions of managing regional co-operative marketing/supply operations i)
Establishing line and staff departments
As co-operatives merge and increase in size, complexity, and number of locations, departmentalization of line operations and staff becomes necessary.
Delegation of
responsibility and authority is required to attain specialization and control of services and efficient performance. Staff assistance often available includes personnel, legal, longterm strategic planning, engineering, and economic research. Several associations have formed wholly or majority-owned subsidiaries, and joint ventures with others to perform certain types of commodity or service-related operations. ii)
Developing “team” management
When departments are established, their heads or managers usually participate in the overall management process. They may serve in the management council of the chief
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executive officer who receives their counsel in making final decisions. This system replaces the more autocratic management in small co-operatives. iii)
Working with relatively large boards that meet quarterly
Regional co-operative managers present more information dealing with policies and major problems and less with details than is customary in small co-operatives. Also, many items are handled by an executive committee of the board, which meets more frequently than the full board. Some regionals appoint nonmembers or non-producers as “outside” board members. Bankers, lawyers, professors, and consumers, although not eligible to vote, often are appointed to these positions. iv)
Managing a group of employees, many of them located in outlying districts or plants
This is accomplished using a network of supervisors in various departments, sections, or units. Assistance is available from the personnel department in recruiting, training, and evaluating employees and in developing compensation programs, including incentive systems. Management in regional co-operatives, especially those in processing, manufacturing, warehousing, and transportation, may involve working with labor unions on employee compensation, benefits, and working conditions. v)
Communications with a large number of members over wide geographic areas
Member relations become more difficult as co-operatives become larger. Userowners cannot talk directly with the general manager or department heads. Many may not live near the director serving their district. Farmers must rely mainly on a local supervisor, field representative, and employees who deliver supplies or pickup products. Newsletters, magazines, and area meetings are used to complement communications with members. Local co-operatives affiliated with regionals that serve several States have less frequent contact with regional top management and must rely more on field representatives and telephone contact. vi)
Establishing fair operating policies among branch outlets
Outlying divisions of regional co-operatives may encounter different types of competition, operating costs, and realize varying degrees of success. These situations may pose problems of pricing, patronage refunds, compensation for local managers, or
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possible subsidization of location losses. Some of these problems involve both operating management and boards of directors. vii)
Determining whether and when to expand services into adjoining territories
Officials of regional co-operatives occasionally have to make expansion decisions. Such factors as member interest or demand, types of services, transportation costs, market potential, and competition must be considered. If more than one area can be served, priorities must be set. viii)
Deciding when to integrate operations on a vertical basis or participate in joint ventures
This usually means decisions on whether to manufacture a production input such as feed and fertilizer or to process a farm product such as fruit. If the co-operative operates over a wide geographic area, the problem of location priority may arise because the association cannot build or acquire all plants needed at one time. In addition to economic soundness or feasibility of such proposals, the availability of capital may be a deciding factor. ix)
Deciding whether to market or process supplies and products alone or jointly with others.
As co-operatives see the need to integrate operations forward in marketing farm products or backward in purchasing supplies, they should decide whether to do this alone or in cooperation with others. Often, lack of funds or in-compatibility of management personnel and operating policies may delay these moves. x)
Exploring opportunities and challenges presented by an increasingly “global” economy.
As multilateral trade agreements such as the COMESA and PTA ease national border restrictions to create both larger markets but greater competition, co-operatives like other types of firms must plan strategically either to take advantage of new marketing opportunities or to protect once-stable domestic or foreign markets. Co-operatives can use a wide array of creative mechanisms and structures which complement core business and can put them on a more competitive footing without necessarily sacrificing their unique mission and structures. Subsidiaries, co-ventures, or
31
other joint agreements -with other co-operatives or non-co-operative firms can be used successfully to gain access to additional resources and markets. Marketing co-operatives may grow horizontally-to supplement their corecommodity base, broaden product lines, lengthen marketing seasons, tap new markets through the addition of foreign growers as members or through procurement of limited volumes of nonmember products. Both marketing and supply co-operatives can craft non-price strategies involving market segmentation, niche marketing, and product differentiation to remain competitive. Supply co-operatives may find foreign producers a ready outlet for farm inputs, and liberalized trading and investment climates could facilitate development of new supply or raw material sources. xi)
Meeting requirements of Government agencies
Co-operatives, especially those operating on an interstate basis, are subject to increasing Government scrutiny. Laws and regulatory requirements, for example, apply to competitive behavior and pricing practices, income taxes, sale of securities, environmental problems, and occupational health and safety protection. Additional attention and expenditures are necessary to comply with these requirements. xii)
Exhibiting leadership and obtaining public approval
The general public gets a favorable image of co-operatives if, through its efforts, the marketing system becomes more efficient with the resulting economic benefits shared by consumers as well as with farmers. In addition, democratic control of co-operatives also conveys a favorable image to the general public. Regional co-operatives, by their performance and leadership, are expected to serve agriculture and consumers in a manner that will warrant a considerable degree of public approval.
2.9 Challenges to Co-operative Management
A growing concern about directors’ legal responsibilities confirms the adage that serving as a director is not simply an honor and reward for being a “good person.” Nevertheless, real or imagined legal constraints are not deterring directors’ considerations of practical solutions to co-operatives’ economic problems.
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With producer-marketer becoming highly specialized and capitalized, and their co-operatives reflecting a greater market orientation, the demand for sharpened executive leadership skills becomes imperative.
The individual producer-marketer asks these logical questions i)
How can I improve the quality and reduce the cost of supplies I manage in my farm operation?
ii)
How can I increase the returns from the products entering the marketing stream from my farm?
In a figurative sense, therefore, the organization’s management antennae rotate 180 degrees from a production orientation to one quite sensitive to the needs and requirements of the marketplace.
Co-operative management must influence membership to adapt and change its production habits to conform to the market’s needs. This evolution of co-operative function and orientation places a further requirement on co-operative management: The burden of leadership. The calls to leadership are evidenced by signals flashed from different sources. For example, signals from government carry a warning: Are cooperatives becoming too big or anti-competitive? Will co-operatives adversely affect prices to consumers? Signals come from large financial centers: Are co-operatives the stabilizing force in agriculture that provides an opportunity to broaden our loan portfolios in the agricultural industry we once perceived as too risky? So the challenge to co-operative management in coming decades is not just to improve managerial skills. Rather, it is to accept a leadership role in allocating resources so the whole economic process- from assembling production inputs to the ultimate marketing process-can be operated in the common interest of co-operatives’ members and the public.
This concept does not imply that co-operatives control production. Co-operatives can correct the inefficiencies of the marketplace and seek opportunities for expanding purchasing and marketing simply because of the inherent advantage a unified member based organization provides.
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Thus, leadership should pursue avenues of commerce that can most effectively take advantage of volume, grade, size, uniformity, and quality factors that co-operatives bring to the marketplace. Co-operative leadership will only succeed through intelligent use of the tools of economic planning. The leader must become prepared for such a role by accumulating skill in managing assets, corporate growth, research, executive development, outside industry relationships, and, most critically, people. The future belongs to those cooperative managers who translate knowledge, experience, and understanding into action. It belongs to those who evolve from skilled managers into astute leaders.
Review Questions i)
Explain the role of management in cooperative societies
ii)
Identify the resources managed in a co-operative. Are they different from the resources managed in a typical corporation?
iii)
Identify some of the unique decisions faced by co-operative managers
iv)
Identify and explain the various tools used in the management of co-operatives
v)
State the specific management responsibilities of the management committee of a co-operative
vi)
List the powers of the membership to a co-operative society
vii)
Explain the functions of hired management in a co-operative society
viii)
Describe the unique challenges of managing regional co-operatives
ix)
Describe the distinct decisions faced by local supply operations of a co-operative
Suggested Further Reading Sanjay S. (2008), Principle of Cooperative Management , Deep Deep Publishers New Delhi Manyara K. Murungi, (2003), The Development of Co-operative Law and policy in Kenya, Oscan Print, Nairobi
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CHAPTER THREE CO-OPERATIVE FINANCING INSTITUTIONS- CREDIT UNIONS
By the end of this chapter chapter the learner learner should should be able to: to: i) ii)
Describe the the different different levels of the credit union union system Describe the the key characteristics characteristics of of credit union union approach approach to microfinancin microfinancing g
iii)
Explain the methods methods of risk managemen managementt in credit unions unions
iv)
Identify the major weaknesses weaknesses and and constraints constraints of credit credit unions
v)
Identify the lessons to be learned from credit credit unions in microfinan microfinancing cing
3.0 Introduction
Credit unions are cooperative financial institutions that began operating in developing countries in the 1950s. The credit union system that comprises the World Council of Credit Unions (WOCCU) is made up of four different types of institutionscredit unions, leagues, regional confederations, and the worldwide confederation-each of which has a specific role and purpose. Credit unions or savings and credit co-operatives are the base-level financial institutions that provide savings and credit services to individual members. As cooperatives, they are organized and operated according to basic cooperative principles: There are no external shareholders; the members are the owners of the institution, with each member having the right to one vote in the organization. The policy-making leadership is drawn from the members themselves, and in new or small credit unions these positions are unpaid. Credit unions are legally constituted financial institutions-chartered and supervised, for the most part under national cooperative legislation.
3.1 Key Characteristics of the Credit Union Approach to Microfinance
i)
Client Focus
Credit unions in the developing countries tend to serve low-income and lower middle-income segments of the population. This low-income market niche of credit unions is a result of two different factors. First, many credit unions were established by
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socially oriented groups that are working with a low-income membership base. Second, credit unions provide a basic set of services that low-income members find valuable, because they do not have access to these services through existing formal-sector alternatives. These services typically are not attractive enough to entice a more affluent clientele. Loan amounts are not large enough, interest rates and other terms are not favorable enough, and credit unions lack the legal power to provide some of the services that more sophisticated clients need ii)
Services
For the most part, credit unions in the developing countries are single-purpose cooperatives that specialize in providing financial services to their members. Savings and relatively short-term installment credit are the two principal financial services offered by credit onions Very few have developed more sophisticated services such as open-ended lines of credit, pension programs, checking accounts, or investment services. iii)
Savings
Credit unions develop both a savings and a loan relationship with their members. The savings relationship is generally first and is the key to the eventual loan relationship. In most developing countries, members are required to establish and maintain regular saving programs before they become eligible for loans. This Th is reduces risk by allowing the credit union to gain experience with the member before making a loan. iv)
Credit
Credit unions follow a “minimalist approach” to credit delivery, very rarely do they provide training, technical assistance or ancillary services to their microfinance members. This approach assumes that member is capable of running their business and determining their financial resources. The role of the credit union is to attempt to serve members’ requests and not to evaluate those decisions except when they relate to members’ ability to repay the repay loan. v)
Institutional Structure
As cooperatives, credit unions are owned and operated by their members, who are also the beneficiaries or clients. The people who are saving in and borrowing from the institution are also those in making the basic decisions on interest rates, terms, and other
36
policies. This is significantly different from standard microfinance programs, in which the institutions are established and staffed by outsiders to channel externally provided resources to local clients. Credit unions are local institutions, owned and operated by the local population and using locally generated resources within the community. In this way they are similar to the village banks. vi)
Financial Structure
One key characteristic of credit unions throughout the developing world is that they operate on self-generated capital. The loans made by credit unions are in most entirely financed by member savings, not external donations or loans. Savings exceed loans outstanding. Finally, with only rare exceptions, credit unions are self-sustaining on the basis of operations; they are generally gene rally not dependent on operating subsidies or subsidized capital funds from either donors or governments
3.2 Managing Risks in Credit Unions
The credit union movement has developed numerous methods for minimizing credit risk. In employee-based credit unions, the credit union can have knowledge about the work history and salary of the member. Similarly, in association-based credit unions, the member is usually affiliated with the group that formed the credit union (such as a parish) and is known to the membership. Both cases ca ses lower information costs, reduce risk, and increase the rate of collections. Community- chartered credit unions have less knowledge of their members and have traditionally been weaker than either industrial or associational credit unions.
3.3 Major Weaknesses and Constraints of Credit Unions
Several factors constrain the performance of credit unions in the developing world, particularly in the context of their ability to serve the enterprise sector. Credit unions tend to be small , credit unions of this size cannot be expected to
greatly expand their activities and could not assume the risk involved in developing or implementing specialized programs designed to reach large numbers of small-scale enterprises.
37
Credit rationing, in one form or another, is the standard practice, it is carried out
through queuing (in which loan applications are processed as funds become available) or limiting the member’s loan to a relatively low multiples of the amount of savings. Most are conservative, highly traditional organizations that do not have a modern
growth- and service-oriented philosophy. Internal credit union policies and operating procedures need modernizing if
credit unions are to significantly expand their role in small scale enterprise lending. In particular, poor delinquency control and weak portfolio management capabilities limit the ability of many credit unions to expand loan portfolios or add new services. Management operational systems and even basic accounting systems need improvement, particularly in smaller credit unions
3.4 Lessons from the Credit Unions
Savings mobilization- Domestic savings mobilization is both possible and
important. Poor people in developing countries are capable of generating large volumes of savings. Fiduciary responsibility- Managing savings implies a fiduciary responsibility.
The fiduciary responsibility requires external regulation and supervision. Size-related limitations- Benefits are a function of scale, small institutions and
programs, with small client bases, can have only a minimal impact on their clients. Institutions with small memberships simply cannot generate sufficient resources to satisfy the financial needs of their membership and provide meaningful levels of credit to significant numbers of people. Donor support- Credit union experience in many countries has shown that
dependence on donor agency support can be destabilizing and constrain institutional growth. It is tempting for a relatively new institution to achieve scale by accepting externally provided resources.. Many leagues and confederations have had severe financial problems resulting from the premature termination of donor assistance, on which they had come to depend. Diversity- Successful financial intermediation requires a diverse client base. It
requires a client base composed of both net savers and net borrowers-the savers to
38
generate the resources used for loans to the borrowers. It also requires a clientele with different cyclical requirements, so that loan demand during peak periods does not exceed the institution’s available liquidity. Both these criteria are likely to be missing in programs specializing only in small-scale enterprise credit, placing even further constraints on capital adequacy. Review Questions i)
Describe the different levels of the credit union system
ii)
Describe the key characteristics of credit union approach to microfinancing
iii)
Explain the methods of risk management in credit unions
iv)
What are the major weaknesses and constraints of credit unions?
v)
What lessons can be learned from credit unions approach to microfinancing?
Suggested Further Reading Maria O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building Health Financial Institutions for the Poor , Kumarian Press.
39
CHAPTER FOUR THE LEGAL FRAMEWORK OF THE CO-OPERATIVE MOVEMENT IN KENYA
Learning Objectives By the end of this chapter the learner should be able to: i)
Trace the development of the cooperative societies legal framework since 1966
ii)
Discuss the role of government in co-operative development
iii)
Explain the role of co-operatives in social economic development
iv)
Explain the benefits of forming co-operative organizations
4.0 Introduction
The legal framework of the co-operative movement in Kenya can be trace from Cap. 490 of the Laws of Kenya, of 1966, Co-operative Societies Act, No. 12 of 1997and Co-operative Societies Act, No. 12 of 1997 as amended in 2004 which is the current law
under which cooperatives operate in Kenya.
4.1 Cap. 490 of the Laws of Kenya, of 1966
The Co-operative movement in Kenya was governed by the Co-operative Societies Act (Cap. 490 of the Laws of Kenya, of 1966) which came into force on 31st December, 1966 and as revised in 1972. Kenya’s economy was state-controlled and regulated; a position which was quite understandable given the country’s level and state of development and the government’s commitment to fast socio-economic development using all available channels. One of the major concerns of the government during the 60s and even today has been how to inject developmental impetus within the rural areas, especially in the agricultural sector where the majority of the farmers are at best at subsistence level and at worst, peasants. Some of the provisions of Cap 490, and the rules made thereunder, however run counter to co-operative principles. For example, under section 9, the Commissioner may require Primary Societies to join and form co-operative unions or a primary society to
40
join a co-operative union. And such an action is founded on what the commissioner considers desirable for the efficient functioning of the co-operative movement. Such powers deprived the societies and their members of their freedom to co-operate with others of their own choice, which was inconsistent with the co-operative principle of cooperation among cooperatives. Some of the highlights of Cap.490, 1966 include: i)
Society may enter into contracts with their members to dispose of all or part of their agricultural produce section 30(1).
ii)
Penalty for violation of the societies’ by laws is Ksh. 500.00.
iii)
Societies have first charge over the assets of indebted members
iv)
The monopoly enjoyed compelling non members of a co-operative society to sell through the society, if such society controls 60% of a certain produce ensured a captive market.
v) vi)
The charge over the assets for the members lasted for one year If the societies were to charge their property, they had to seek the approval of the Commissioner
vii)
Societies are supposed to send Annual returns to the Commissioner (Section 24)
viii)
The committee members’ duties were contained in the co-operative societies rules 1969 i.e. Rule 34 (6).
ix)
Before charging the societies properties, the Commissioner’s consent must be sought and obtained first
x)
Under Section 77 (1) the Commissioner had power to impose surcharge. 94.
xi)
All Co-operative disputes were supposed to be referred to the Commissioner for arbitration under section 80(1).
xii)
After an inquiry under Section 61 of the Act, if the Commissioner “is satisfied.” he may remove the committee from office and replace it with a Commission to run the society. This had been abused on many occasions e.g. people with no co-operative background have often been appointed to run societies and their performance has been very poor
41
xiii)
It is the duty of the Commissioner to approve salaries, honoraria of societies’ officers.
xiv) xv)
Societies can only employ graded staff with the Commissioner’s consent. Under the Act and Rules, the Commissioner had absolute powers in the day to day running of the affairs of the registered co-operative societies.
xvi)
Under this Act, the co-operative principles were not enumerated.
4.2 Co-operative Societies Act, No. 12 of 1997
Then came the 1992 tide of economic liberalization and the bottom of all that the government had done, and was doing for the co-operative sector, fell off. That was the beginning of the pressure leading to the need for revision of the legislation to put it in harmony with the market economy and privatization. It is generally agreed that the major problems with Cap. 490 hinged on its excessive regulatory powers and controls over the co-operative movement In 1995, as the Co-operative Policy was being formulated in Kenya, another study was going regarding the Co-operative Societies Act, Cap. 490 (1966). This study on the Co-operative Legislation in Kenya, was commissioned by the then Ministry of Cooperative Development, Government of Kenya with the objective of reviewing and analyzing the Co-operative Societies Act, (Cap. 490) of the Laws of Kenya and making the necessary revisions that would bring the Act in line with the economic liberalization principles, and provide for independent, member-controlled cooperative movement in Kenya. This resulted in Co-operative Societies Act, No. 12 of 1997 some of the highlights of this Act included: i)
Society may enter into contracts with their members to dispose of all or part of their agricultural produce section 30(1).
ii)
The penalty for violation of the societies’ by laws was Ksh. 5000.00.
iii)
Societies have first charge over the assets of indebted members
iv)
The monopoly enjoyed compelling non members of a co-operative society to sell through the society, if such society controls 60% of a certain produce was removed.
42
v)
The first charge over the assets for the members to last or subsist for such period as the loan remains unpaid.
vi)
Societies free to charge the whole or part of their properties if their by-laws allow them to do so, provided the annual general meeting allows.
vii)
Societies free to get their own auditors provided that such auditors are professionally qualified. The audit under Section 25(1) must be prepared in accordance with generally accepted accounting standards.
viii)
The Act introduced a Chapter VII— Management of Cooperative societies Section 2 7(6) which, requires the committee to be prudent and diligent in their operations and comply with the Act, rules, by-laws and the directions of the general meeting. Failure to do so will render the committee jointly and severally liable for the losses experienced through their negligent acts. Committee members are therefore agents and should act as such under the principles of the law of agency and good corporate governance principles.
ix)
The Commissioner had power to compel societies to amalgamate; The Registrar does not have such dictatorial powers.
x)
Societies may charge the whole or part of their property if their bylaws approve and subject to a resolution of the general meeting.
xi)
The Registrar may now only inquire into the conduct of a person who has committed a surchargeable act and report his findings and recommendations to the annual general meeting who will take action accordingly.
xii)
Registrar may carry out an inquiry and then table his findings and recommendations to the annual general meeting who will take any action they deem appropriate.
xiii)
Under section 89, the society may pay its officers or members such honorarium, salary, commissions or other payment, as the society may resolve at a general meeting.
xiv)
Like other business entities, societies have the power to hire and fire according to their by-laws.
xv)
The penalty for violation of the provisions of the Act was Ksh. 10,000.00
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The Act empowers the members to be responsible for their own registered co-
xvi)
operative societies. They should, through their elected committees run their societies in accordance the internationally accepted co-operative principles i.e. open and voluntary membership, democratic member control, economic member participation, autonomy and independence, education, training and information, co-operation among co-operatives and concern for the community in general. (Section 4). The Act gave a new relationship between societies and the government. The
xvii)
Commissioner under Section (3) is only responsible for cooperative development and growth.
4.3 Co-operative Societies Act, No. 12 of 1997 as amended in 2004 Co-operative Societies Act, No. 12 of 1997 was amended in 2004 and is now the
current law under which cooperatives operate in Kenya. Download the Co-operative Societies Act (Amended), 2004 from the internet and read it.
4.4 Role of Cooperatives in Social Economic Development i) ii)
Co-operatives serve as a means of: Improving the economic, social and cultural situation of persons of limited resources and opportunities as well as encouraging their spirit of initiative;
iii)
Increasing personal and national capital resources by the encouragement of thrift, by eliminating usury and sound use of credit;
iv)
Contributing to the economy an increased measure of democratic control of economic activity and of equitable distribution of surplus;
v)
Increasing national income, export revenues and employment by a fuller utilization of resources, for instance in the implementation of systems of agrarian reform and of land settlement aimed at bringing fresh areas into productive use and in the development of modern industries, preferably scattered, processing raw materials;
vi)
Improving social conditions and supplementing social services in such fields as housing and where appropriate health, education and communication;
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vii)
Helping to raise the level of general and technical knowledge of their members
4.5 Role of Government in Cooperative Development i)
Formulation and implementation policies under which co-operatives would receive aid and encouragement, of an economic, financial, technical, legislative or other character without affecting their independence
ii)
Ensure that in elaborating such a policy, regard should be made to economic and social conditions, to available resources and to the role which co-operatives can play in the development of the country
iii)
Ensure that the policy was integrated in development plans in so far as this is consistent with the essential features of co-operatives
iv)
Keep the policy under review and adopted to change in social and economic needs and to technological progress
v)
Ensure that the existing co-operatives should be associated with the formulation, and where possible, application of the policy
vi)
Advise the co-operative movement to seek collaboration in the formulation and, where appropriate, application of the policy, of organizations with common objectives
vii) viii)
Associate co-operatives on the same basis Ensure measures are taken to disseminate knowledge of the principles, methods, possibilities and limitations of co-operatives as widely as possible among the peoples.
ix)
Ensure that co-operatives are subject to a form of supervision designed to ensure that they carry on their activities in conformity with the objects for which they were established and in accordance with the law.
x)
Ensure that supervision should preferably be the responsibility of a federation of co-operatives or of the competent authority.
xi)
The adoption of special measures should be encouraged to enable cooperatives, as enterprises and organizations inspired by solidarity, to respond to their members’ needs and the needs of society, including those of disadvantaged groups in order to achieve their social inclusion.
45
xii)
Establish an institutional framework with the purpose of allowing for the registration of co-operatives in as rapid, simple, affordable and efficient a manner as possible.
xiii)
Promote policies aimed at allowing the creation of appropriate reserves, part of which at least could be indivisible, and solidarity funds within co-operatives;
xiv)
Provide for the adoption of measures for the oversight of co-operatives, on terms appropriate to their nature and functions, which respect their autonomy, and are in accordance with national law and practice, and which are no less favorable than those applicable to other forms of enterprise and social organizations;
xv)
Encourage the development of co-operatives as autonomous and self- managed enterprises, particularly in areas where co-operatives have an important role to play or provide services that are not otherwise provided.
xvi)
Develop the technical and vocational skills, entrepreneurial and managerial abilities, knowledge of business potential, and general economic and social policy skills, of members, workers and managers, and improve their access to information and communication technologies;
xvii)
Promote education and training in co-operative principles and practices, at all appropriate levels of the national education and training systems, and in the wider society;
xviii) xix) xx)
Facilitate access of co-operatives to credit; Facilitate access of co-operative to markets; Promote the dissemination of information on co-operatives;
4.6 Benefits of Forming Co-operative Organizations
Co-operatives as vehicles for socio-economic development contribute to economic growth and development in various ways. The major benefits or advantages that are derived from this association include inter alia; i)
Collection, transportation, processing and marketing of agricultural produce; Mobilization of savings and channeling the funds to individual members for specific development projects;
46
ii)
Support to agricultural production through distribution of farm inputs;
iii)
Dissemination of applied technology of members;
iv)
Provision of credit to members for defraying urgent expenses such as school fees, funerals, hospital bills etc. at affordable costs;
v)
Assisting in income distribution by participation through enabling large sections of population to engage in various income generating economic activities;
vi)
Creating employment directly through engagements for various cadre of staff and more importantly, self employment as farmers and artisans;
vii)
A co-operative is an institutional framework through which: a) Otherwise small economic surplus can be harnessed by tapping economies
of scale b) Poverty can be alleviated by planning, organizing, implementing and
managing income generating economic activities c) Agricultural producers can reap maximum benefits out of their produce by
eliminating middlemen d) Development funds are channeled to individual members e) Members can be educated on economic and social issues affecting them
including HIV/AIDS and SARS f) Wealth and capital can be created and owned jointly by large groups of
low income earners g) The national economy can be indigenized as cooperative members tend to
be largely the indigenous people. h) Social control mechanisms become an acceptable substitute for physical
assets as collateral for loans. Review Questions i)
Read the Co-operative Societies Act, No. 12 of 1997 as amended in 2004 (the Act is given may be downloaded from the internet) and answer the following questions. a) According to the Act, who is charged with the responsibility of registering cooperative societies? Who was responsible in the past?
47
b) What is the minimum requirement for registration of a cooperative union or an apex society? c) What is the penalty for violation of cooperative by laws? How has it changed over time? d) Section 3 of the cooperative Act deals with disclosure of provisional registration status of cooperative. What is the penalty for contravention of this section? e) How should change in the name of a cooperative be effected without violating the law? If such change is effected legally what happens to the obligations of its predecessor? f) Does the Act limit share capital contribution in a cooperative by its members? g) According to the Act what is the consequences to the management committee of not having the books of accounts audited within the stipulated period? h) Does section 27 cover all the types and roles of cooperative meeting covered in class? i) What does the act say with regard to declaration of wealth by management committee members? j)
What are the consequences to a cooperative for not registering a charge on cooperative property with the commissioner of cooperatives?
k) What is penalty to any cooperative officer who refuses members and creditors to inspect register of charges? l)
What is the penalty for any member or official of a cooperative who receives remuneration, salary, commission or other payment without a resolution by the general meeting?
m) What is the penalty for violation of the Act? How has it changed over time? ii)
Discuss the role of government in co-operative development
48
iii)
Explain the role of co-operatives in social economic development
iv)
Explain the benefits of forming co-operative organizations
Suggested Further Reading Manyara K. Murungi, (2003), The Development of Co-operative Law and policy in Kenya, Oscan Print, Nairobi G o K, (2004), The Co-operative Societies Act (Amended) , Kenya Gazette, Nairobi
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CHAPTER FIVE MICROFINANCE PRINCIPLES AND PRACTICE
By the end of this chapter the learner should be able to: vi) i)
Trace the development of microfinance Identify microfinance credit and savings principles
ii)
Describe the institutional requirements financial self-sufficiency
iii)
Describe the various institutional structure that microfinance organizations can adopt
iv) v)
Identify the policies for promoting microfinance Describe the benefits of institutional savings
5.0 Introduction
The term microfinance refers to the provision of financial services such as small collateral free loans, deposits, pension and retirement, and insurance to low-income groups and their micro enterprises. Microfinance institutions also frequently add to their portfolio of financial services the provision of social services such as healthcare, literacy training or business development consulting services. Microfinance institutions lend money to small scale business persons/firms. Examples includes; K-Rep Bank, Faulu Kenya, Jami Bora, Pride Africa etc. Origins of Small Lending
Micro lending often starts in small villages, where family members and friends get together in money-sharing groups. These savings clubs can be traced to all parts of the world and have operated for centuries probably since the introduction of currency. From region to region, these clubs developed their own names. In West Africa, they were known as "tontines;" in Bolivia, "pasanaku;" and across Mexico and Central America, "tandas." Tanda means "shift" in Spanish and works on the premise that members of the group contribute to a pool of money, which shifts to a single member that has the most need. The tontines of West Africa can be traced back to 17th-century and are named for the Italian banker Lorenzo de Tonti.
50
An early version of micro lending was the Irish Loan Fund system, introduced in the early 1700s, by writer and nationalist Jonathan Swift. Swift's early success helped the Irish when many were living in impoverished conditions. Swift's original system was standardized in 1837, when hundreds of independent loan funds were brought under the control of the Loan Fund Board. By law, no loan could be more than £10 or run for longer than a 20-week term, with weekly repayments. As with many contemporary micro credit institutions, interest rates were low – in this case around 8 percent per year – much lower than those charged by local profiteers. The Pioneers of Modern-Day Microfinance
The concept of micro loans took a big leap in the 1960s and 1970s, when groups such as ACCION International, in Venezuela, and Yunus's Grameen Bank, in Bangladesh, began to institutionalize the process. By formalizing and expanding the basic concept of sharing programs, these microfinance institutions helped to build capital for small businesses rather than just loaning for basic necessities such as food, water and clothing. Yunus first came across the idea of micro credit while studying the lives of poor entrepreneurs in his native Bangladesh during the famine of 1974. He began by loaning to groups of women, and his program soon proved that small loans could not only quickly improve lives but were paid back with interest and on time. The next step was setting up a consistent on-the-ground program. In the case of the successful institutions, this meant sending a representative, or "field manager," to the prospective region to educate and advise and to oversee the loans locally. After a few members of the group were accepted for a loan, the rest had to wait for that initial loan to be repaid before they could obtain their own loans. "Peer pressure" from other members of the group to repay the initial loan helped to set the bar high. In 1961, another early pioneer, ACCION, opened its doors in Caracas, Venezuela, when law student Joseph Blatchford raised $90,000 to start a community development program to help the poor jump-start their own businesses. Over the next two decades, ACCION set up scores of independent microfinance institutions and expanded across Latin America. It, too, offered people a choice besides
51
the local loan shark, who would charge rates as high as 500 percent a year and often pushed people into permanent debt. Like the founders of ACCION, Yunus realized that if individuals who wanted to start their own businesses could not free themselves from start-up debt, they would never be able to grow. Since the Grameen Bank was founded, it has paid out more than $5.7 billion in loans, and more than $5.1 billion of that has been repaid -- a recovery rate of approximately 98.9 percent. It has made more than 950,000 loans and has 6.7 million members, around 96 percent of whom are women. The Norwegian Nobel Committee has recognized Yunus's long-term vision of eliminating poverty in the world. That vision cannot be realized by means of micro credit alone. But Muhammad Yunus and Grameen Bank have shown that in the continuing efforts to achieve it, micro credit must play a major part. Following the success of these early institutions, other microfinance organizations began to launch throughout the developing world. Among the largest is FINCA International, established by economist and Fulbright scholar John Hatch. Hatch believed that using locals' knowledge rather than bringing in outsiders was key to building successful local economies. Using an approach he has always stood by, Hatch said, "Give poor communities the opportunity, and then get out of the way!" By 2005, FINCA had 400,000 clients in 21 countries across Latin America, Africa, Central Asia and Eastern Europe. One year after the United Nations called 2005 the International Year of Micro credit, the World Bank estimates that there are more than 7,000 microfinance institutions now operating around the world.
5.1 Credit Principles
Microenterprise lending programs now operate in Asia, Latin America, and Africa. However much these programs differ from one another, beneath these differences is a common thread that makes them effective credit delivery systems. All have found ways to streamline their activities so that the costs of lending are commensurate with the small size of the loans being made. The techniques employed resemble, often by
52
conscious adaptation, those that have developed in the informal financial sector over many years. The following three principles represent the core of the new techniques: Know the market- the poor are willing to pay for access and convenience. The
major service need among the poor is credit for liquidity and working capital, with loan terms of one year or less and with little attempt to direct credit to specific uses. Transaction costs for borrowers are lowered by locating lending outlets near the client, providing simple application processes, and disbursing quickly. Interest rates are high relative to prevailing rates in the formal financial system, but they are low compared with typical informal-system rates. Special techniques slash administrative costs . The simplest procedures are used
for the smallest loans. Loan applications are often no more than one page. Approvals are decentralized and are based on readily verifiable eligibility criteria rather than business appraisal. Borrower groups often handle much of the loan-processing burden. Special techniques motivate repayments. Lenders substitute other techniques for
security and loan appraisals, such as group guarantees or pressure from social networks, the promise of repeat loans in increasing amounts, and savings requirements. Although programs dealing with larger microenterprises may require tangible collateral, most do not. Application of these principles is the foundation for financial viability of a lending operation that serves poor microenterprises. The essence of the difference between these techniques and commercial banking practices is the use of a repayment incentive structure instead of costly information gathering. This substitution enables lenders to serve micro enterprise at a reasonable cost. Group formation is often employed by microenterprise programs, particularly for the poorest clientele. The group plays a role in reducing the cost of gathering information about the borrower, but its more important role in motivating repayments through shared liability for default. Lenders can shift some of the loan-processing and loan-approval tasks onto groups because the groups have better access• to information on the character and creditworthiness of potential borrowers. When very poor clients care more about access to credit than the terms on which it is offered groups can be used without significantly imp airing demand.
53
5.2 Savings Principles
Just as there, are proven principles of lending to the poor, there are principles of savings that have emerged from experiences in various places. 1ndictions are that when savings
are
approached
using
the
following
principles,
customers
respond
enthusiastically. First, the most widely desired savings instruments offer safety, convenience, ready access to money, and a positive real return. Second, more people want a good place to save than want loans. Thus, savings services can reach deeper into the community. The opportunity to save should not be limited to those who borrow. Last, lending to microenterprises can be financed to a significant extent by savings from the same communities provided savings services are designed with customer needs in mind. Traditionally, most microenterprise programs with savings elements used some form of compulsory savings, whereby borrowers were required to save a portion of the amount they borrowed. Typically, under such programs, borrowers did not have access to their savings until their loan was repaid. The savings mechanism thus functioned as asset storage in a very illiquid form. A voluntary savings instrument, such as passbook savings with free access to deposits, better meets savers’ requirements and has the potential to raise much larger amounts of funds. The BRI Unit Banking system in Indonesia, is now fully savings financed, demonstrating this potential. Nevertheless, the programs employing these principles should still be regarded as incomplete. Their full potential to grow, spread, and achieve greater financial selfsufficiency has not yet been reached. Below are the institutional requirements for expanding the use of these techniques, beginning with questions of internal financial selfsufficiency and then moving to the external institutional and policy settings.
5.3 Institutional Requirements Financial Self-Sufficiency
Financial self-sufficiency is a prerequisite for making financial services widely available to microenterprises. A financially self-sufficient credit operation must cover the
54
following through fees and interest charges: operating costs, including loan loss reserves; the cost of funds; and inflation. To achieve genuine commercial viability, it must also yield a profit to owners. Institutional performance can be analyzed in terms of four distinct levels of self-sufficiency. Level One
The lowest level, level one, is associated with traditional, highly subsidized programs. At this level, grants or soft loan cover operating expenses and establish a revolving loan fund. When programs are heavily subsidized and performing poorly, however, the value of the loan fund erodes quickly through delinquency and inflation. Revenues fall short of operating expenses, resulting in a continuing need for grants. Many microenterprise credit programs operate at this level. Level Two
Most programs that use the proven principles described here can attain the second level of self-sufficiency. At level two, programs raise funds by borrowing on terms near, but still below, market rates, Interest income covers the cost of funds and a portion of operating expenses, but grants are still required to finance some aspects of operations. Most programs at this level are quite proud of their breakthrough, as they should be, because the subsidy required is significantly smaller than the one required at level one. Level Three
At level three, most subsidies are eliminated, but programs find it difficult to eradicate a persistent dependence on some element of subsidy. This is the level associated with most of the well-known credit programs, and it is probably necessary to reach at least this point in order to achieve large-scale operations. Programs at this level are rarely required to take the next step, because both they and their sources of support are pleased with performance at this level. Level Four
The final level of self-sufficiency, level four, is reached when the program is fully financed from the savings of its clients and funds raised at commercial rates from formal financial institutions. Fees and interest income cover the real cost of funds, loan loss reserves, operations, and inflation. The only major microenterprise programs to have
55
reached this level are those of the credit union movement in certain countries and the BRI Unit Desa system in Indonesia. Programs should be judged less by their current level of achievement than by their progress toward higher levels. By analyzing each type of cost as well as fee and interest income, we can determine how credit programs move from one level to the next. Operating Costs- Traditional credit programs at level one typically have very
high operating costs; it is not uncommon for programs to spend a dollar to lend a dollar, particularly among smaller programs. Programs at higher levels of self-sufficiency achieve most of their movement toward viability by using methods that cost far less, that is, by adopting the principles outlined above, which brings them to level two. Once these methods are adopted, however, changes come incrementally from increasing efficiency and scale economies in operations. Efficiencies may come from marginal improvements in processes, computerization of management information, improved financial management, and the like. Staffing and physical plant are major costs that must be addressed on a case-by- case basis. Therefore, continued streamlining is not the primary strategy for moving to higher levels of self sufficiency. Loan Losses- Programs that have adopted the principles outlined here have
achieved substantially better repayment rates than traditional programs, often reaching levels that compare favorably with commercial bank operations. One can observe many programs, particularly at levels two and three, that claim losses at or below 3 percent of principal. Delinquency and default cannot be eliminated, but they can be maintained at a level that does not threaten the financial integrity of the institution. Cost of Funds- Lending operations must pay to raise funds, either by borrowing
or by generating savings. Programs operating on grants and very soft loans are spared this cost: Donors bear it. Dependence on soft sources of funds is a limiting factor, as soft sources are in short supply. Institutions at level two may still use them, but by level three the transition to commercial or nearly commercial sources should have been made. This is, in fact, one of the key distinctions between the two levels. Inflation- All programs bear the costs of inflation, whether they recognize them
or not. In a well-functioning financial system, the inflation factor is built into the interest rate paid on funds raised or offered to depositors. This practice returns the real value of
56
the funds to the suppliers and therefore maintains that value in the financial system. However, when programs use concessional funds, they are not charted this inflation factor. Despite an appearance of self-sufficiency, the real value of the loan fund dwindles, and the programs are able to serve fewer clients. If hyperinflation sets in, virtually all progress toward self-sufficiency is destroyed. Microenterprise programs have a good chance of reaching levels three and four only if they operate in countries where inflation is kept to moderate levels. Fee and Interest Income- Traditional loan programs have been reluctant to
charge full-cost interest rates to microenterprises. in many level-one programs, the rate charged is negative in real terms.
5.4 Appropriate Institutional Structure
The expansion financial services for microenterprises outlined above can be realized through the following institutional arrangements. i)
Linking Non-Governmental Programs to Sources of Finance
Many of the microenterprise credit programs run by NGOs are not in a position to become true financial institutions that finance their lending largely from deposits. They may face legal restrictions on deposit taking, or they may decide not to take on the added responsibilities that come with handling individual deposits. The future of such programs depends on their ability to forge funding relationships with formal financial institutions. The simplest arrangement is for microenterprise programs to finance their lending by borrowing from commercial banks. In order to be able to borrow in this way, microenterprise programs must meet two stringent criteria: First, they must be able to repay borrowed funds at a rate acceptable to the bank. Second, programs must be able to assure banks that they are creditworthy. Very few microenterprise programs have as yet been able to meet these tests on their own. ii)
Transforming Programs into Specialized Financial Institutions
Microenterprise programs are carried out by a variety of institutions, from grantoriented NGOs to those striving for self-sufficiency. These institutions must undergo several changes to become financial institutions that engage in lending and capturing deposits.
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At the structural level, these institutions must reorganize to provide both savings and credit in a manner that will allow for expansion. At the first opportunity, the organizational structure must be modified to support the capturing of deposits and the provision of credit. The functions and the makeup of each department, as well as the relationship among departments, must also be reorganized. A second structural change required is for the organization to use some form of franchise or branch office system to continue expanding its operations. Therefore, the organizational structure would require information systems adequate for a decentralized operation. Legal considerations are a key factor in defining how these institutions will change internally. The legal framework in a country determines whether an institution can take deposits. In some countries, the law permits organizations outside the banking system to capture savings directly. In most countries, however, this is not the case. Institutions may modify themselves in order to fit within the existing law, for example, by creating a cooperative or a credit union arm, iii)
Specialized Operations within Commercial Financial Institutions
A handful of commercial banks have shown interest in taking on the microenterprise client group. Yet it is possible for such an arrangement to succeed, as demonstrated by the tremendous success of the BRI Unit Banking system, which is run by a large government owned bank and serves over eight million savers and two million borrowers. Major advantages of placing microenterprise operations in commercial banks include the infrastructure available to banks through branch networks, access to liquidity, and commercial orientation. Banks must be educated in the special techniques described above, however, for no bank can succeed with microenterprises by applying its standard operating procedures. At this time, banks are generally unaware of these techniques, of the promise these techniques may hold for serving microenterprises commercially, and of the changes required to make microenterprise lending successful.
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5.5 Policies for Promoting Microfinance
Governments in many countries are moving toward including informal-sector enterprises in their national agendas. The sectors that must review their policies include national, regional, and local governments; financial institutions; and multilateral and bilateral donor organizations. The policies should: i)
Make it easier for programs offering specialized financial services to microenterprises to become financially self-sufficient.
ii)
Support the efforts of NGO-based programs to gain access to commercial sources of funds.
iii)
Support the efforts of NGO-based programs to become specialized financial institutions.
iv)
Encourage mainstream financial institutions to develop specialized microenterprise operations of their own.
In addressing each of these tasks, the first priority should be interest rate deregulation. The ability to charge full-cost interest rates is the best strategy microenterprise lending programs have for becoming financially self-sufficient, after they have adopted the lending techniques advocated here. v)
Governments, lenders, and donors can lead the way in changing attitudes by making and following firm policy determinations to require full-cost pricing policies from any organization that requests financing or special assistance from them.
vi)
Interest rates on deposits should also be allowed to rise, in order to provide appropriate incentives for microenterprises to use savings rather than credit to finance lending operations.
vii)
Regulations governing acceptance of deposits must also he reviewed, although this will be a thorny issue. In many countries, NGO programs are prevented from accepting deposits by banking laws.
viii)
Governments have a responsibility to both depositors and financial institutions to ensure that depositor confidence is not violated. Therefore, when non-financial institutions begin to accept deposits,
59
governments are legitimately concerned. This was thought very remote in the past but has started taking root in some countries such as Kenya The donor organizations, together with successful microfinance institutions, should take the lead in, advocating a financial systems perspective toward microenterprise development by demanding better performance from the programs they fund promoting learning across countries, and encouraging governments to adopt more supportive interest rate and regulatory policies. ix)
Macroeconomic Management- Good macroeconomic management and
rural development are requirements for the sustainable development of a successful rural banking system operating on a large scale, there must be rural development, inflation must be controlled, deposits must be mobilized, and financial institutions must be permitted to set interest rates that will enable institutional profitability. In some circumstances, local financial institutions may function well in the absence of some of these criteria, but all are crucial for sustainable large-scale systems of rural banking. x)
Political Stability- A reasonable level of political stability is required so
that people have trust in the broad continuity of institutions and policies. Viable financial institutions serving the local level are dependent on savings mobilization, the success of which depends heavily on trust. Thus, reasonable macrostability is required for voluntary savings mobilization, which, in turn, is required for profitable rural banking. xi)
Market Analysis and Staff Training- Analysis of markets and the training
of institutional staff in Understanding the markets they finance are essential for the design and implementation of successful financial instruments and services and for the development of sustainable financial institutions, Successful rural banking is founded on analysis of rural markets and their inter-linkages, understanding changing social and economic conditions, and knowledge of the financial requirements and aspirations of microfinance clients who control different economic
60
resources and whose households are at different stages in the developmental cycle of domestic groups. xii)
Leadership- Effective leadership and management are essential for
selection of the priorities required for the development of viable microfinance institutions and for the successful implementation of appropriate services and instruments. xiii)
Coordinated Planning- Lending and deposit instruments and the spread
in their interest rates should be planned in conjunction with each other. These need not be implemented simultaneously (for example, an institution may need to build up trust through lending before mobilizing voluntary savings), but if one is planned without regard for the other, the system cannot be sustainable over the long term. xiv)
Rural-Urban Financial Intermediation- In a country undergoing
significant rural development, there is likely to be substantial demand for rural-urban financial intermediation. In addition, banking instruments and services that work in rural areas can be adapted for urban neighborhoods, and vice versa. Given the recent large-scale rural-urban migrations and the widespread communications facilities that link urban and rural areas in developing countries, the economics of rural organization cannot be considered apart from the wider context. Under these circumstances, there is considerable opportunity for the expansion of successful methods of rural financial intermediation into urban areas. xv)
Social
and
Economic
Profitability-
The
Indonesian
experience
demonstrates that a spread between lending and savings interest rates can be set that permits bank profitability while offering loans at interest rates significantly below those of informal commercial lenders and providing savers with generally positive real rates of return on their deposits. The fundamental lessons from Indonesia are that institutional viability, rural development, enterprise finance, and improvement in equity can be achieved simultaneously; and this can happen only if
61
savings mobilization is transformed from the forgotten half to the sustaining half of rural finance.
5.6 Savings Mobilization and Microfinance
Throughout the world and across many cultures and income groups, people save for varied purposes this includes: Emergencies
i) ii)
Investment
iii)
Consumption
iv)
social obligations
v)
education of children
vi)
pilgrimages
vii)
sickness
viii)
disability retirement
ix)
Extensive household savings have been reported from developing countries around the world for at least three decades. Neither the reality of extensive liquidity among households in many rural and urban areas of developing countries nor the importance of savings mobilization for local financial markets and enterprise development has yet been sufficiently understood. One consequence is that few financial institutions provide appropriate deposit instruments in rural areas of developing countries, and few policymakers or donor agencies have made savings mobilization at the local level a high priority for economic development. Savings has rightly been called the forgotten half of rural finance. However this notion is being debunked by experiences such as that of Equity Bank in Kenya. The Myths
Two widespread myths prevail with regard to household savings in developing countries, particularly in rural areas. i)
The first is the myth of pervasive rural under savings
ii)
The second is the assumptions that demand for financial savings instruments is low in most rural areas of developing countries.
62
Such misguided assumptions are often extended to middle-and lower-income urban households as well. It has been widely assumed that low institutional deposits in rural area is a demonstration that rural households cannot save because they are too poor, will not save because they prefer to use their incomes for consumption, or choose to save in other forms. Since there is no significant demand for financial savings instruments, the argument goes, why develop financial institutions with savings programs? The Reasons for Lack of Deposits
The reasons for low institutional deposits, however, are often neither under savings nor lack of demand for financial savings instruments, but the structure of services and institutions. The majority of projects for local finance are still concerned only with credit, usually subsidized credit. The low interest rates that characterize subsidized credit programs discourage savings mobilization. Organizations dispensing subsidized credit normal either are forbidden to mobilize savings or do not collect voluntary savings because financial regulations make deposit mobilization unprofitable. Shattering the Myths
Indonesia’s rural banking system administered by the Bank Rakyat Indonesia (BRI) and experiences such as that of Equity Bank in Kenya have recently debunked the myth by mobilizing massive savings within short time spans Types of non-financial Savings i)
Grain
ii)
Animals
iii)
Jewelry and precious stones
iv)
Land etc
5.6.1 Financial Savings at the Local Level
Household, enterprise, and group savings in financial form may be held in ways that are informal, quasi-formal, or formal. Informal financial markets are ubiquitous. Although they are largely unregulated and unreported, it has long been recognized that these markets are not unorganized. They form part of the local political economy;
63
financial channels and market shares of lenders are inextricably related to the local distribution of wealth and power, market inter linkages, political alliances, information flows, and so forth. The extent and character of the interactions among formal, quasi-formal and informal financial markets in rural areas can vary considerably, depending on the degree of regulation in the formal sector; the extent of monetization in the rural areas; the public’s confidence in the government in general and in the available financial institutions in particular; the ease of customer access to formal financial services; the activities of parallel and black markets; and a variety of geographic, economic, cultural, and other factors . Benefits of Institutional Savings
Well-designed and well-delivered deposit services can simultaneously benefit households, enterprises, groups, the participating financial institutions, and the government. Good savings programs can contribute to local, regional, and national economic development and can help improve equity. The benefits from institutional savings at local levels may include the following: Benefits to Households: Institutional savings provide numerous benefits to
households, including the following: Liquidity- Rapid access to at least some financial savings is considered essential
by many households in monetized or partially monetized economies. Liquidity is crucial for mobilizing household savings. The demand for deposit instruments permitting an unlimited number of withdrawals is high because people save for emergencies and for investment opportunities, which may arise at any time. Thus, in areas characterized by economic growth and development and by a reasonable level of political stability, potential household demand for liquid deposit instruments in financial institutions may he unexpectedly high. Returns on deposits- Positive real returns on deposits are typically not available at
low-risk outside financial institutions. When such institutions offer appropriate deposit instruments, the interest can be used by the household as an income flow or as savings. Fixed-deposit accounts featuring lower liquidity and higher returns, especially when held
64
in conjunction with liquid accounts, are suitable in various ways for the types of savings mentioned below, Savings for consumption- Households with uneven income streams ‘(from
agriculture, fishing, and enterprises with seasonal variations) can save for consumption during low-income periods. Savings for investment- Saving for development of household enterprises is
discussed below. Households also tend to save for other kinds of investment, such as children’s education, house construction, and electrification. Savings for social and religious purposes and for consumer durables- Social
ceremonies birth, puberty rites, weddings, and funerals) and religious donations or pilgrimages are some of the long-term goals for which people frequently save. Others are consumer durables; depending on household income level, these vary from cooking pots to automobiles. Savings for retirement, ill health, or disability- Saving for old age or disability
may take the form of building retirement savings or helping to establish junior members of the household, who will then have the responsibility of caring for their elders. Savings instead of or in addition to credit- Households save in order to self-
finance investments and to avoid paying what are often very high interest rates in the informal commercial credit market, Self-financed investments are particularly important for middle- and lower-income households, which often do not have access to institutional credit. Savings to build credit ratings and as collateral- Institutional savers may also use
their deposits to build credit ratings and as collateral for loans. These features are especially important for those who do not own land. Benefits to Enterprises: Many of the benefits gained from institutional savings by
households are also applicable to enterprises (security, returns, self-finance of investment, and so on). Enterprises at all scales tend to have high demand for liquidity many also have high demand for transfer facilities. Household savings are typically the main source of small and microenterprise finance, but in many cases small entrepreneurs must also borrow on the informal credit market.
65
Therefore, small and microenterprises can benefit from institutional savings programs both directly, through the encouragement of self-finance of investment, and indirectly, through the expanded volume of institutional lending at much lower rates than are otherwise available. Benefits to Local Groups, Organizations, and Institutions: Deposit instruments
that permit savings to be held in the name of organizations and institutions provide significant benefits to the depositors. The provision that savings accounts may he held in the name of a group, organization, or institution opens a large new market for rural deposits derived from village treasuries, government offices, schools, religious institutions, development programs disbursing funds for rural projects, and a plethora of local organizations (for example, employees’, women, youth, and sports associations; informal savings and loan associations; and voluntary agencies). Institutional savings also provide groups with the opportunity to earn returns on their deposits. Benefits to Financial Institutions: Deposits mobilized in conjunction with
commercial credit programs enable sustainable financial institutions. Benefits to the Economy, Development, and Equity: Local savings mobilization
benefits the economy directly by increasing the resources available for productive investment. Effective savings mobilization is crucial for local development because it encourages self-finance of investments; it permits the supply of a large demand for credit at commercial interest rates; which typically range from 5 to 50 percent of the rates charged by informal commercial lenders; and it enables the growth of sustainable financial institutions. Review Questions i)
Trace the historical origins and development of microfinance
ii)
Explain microfinance credit and savings principles
iii)
Describe the myths surrounding savings among the poor and hoe the debunking of these myths has helped in the development of microfinance
iv)
Describe the levels of
and institutional requirements of
financial self-
sufficiency v)
Describe the various institutional structure that microfinance organizations can
66
adopt vi)
Identify the policies that may be adopted by governments and individual institutions in promoting the development of microfinance
vii)
Describe the benefits of institutional savings
Suggested Further Reading
Maria O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building Health Financial Institutions for the Poor , Kumarian Press.
Lee, Nirmala, (2008), Principles of Lending, Global Professional Publishing Ltd David Lawrence and Arlene Solomon, Managing a Consumer Lending Business , Solomon Lawrence partners
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CHAPTER SIX THE PROCESS OF INSTITUTIONAL DEVELOPMENT
By the end of this chapter the learner should be able to: i)
Illustrate the framework for institutional development
ii)
Describe the components of the framework for institutional development
iii)
Describe the stages of the framework for institutional development
iv)
Explain the relationships between the components and the stages of the framework for institutional development
6.0 Introduction
Institutional development is a complex process touching on values, mission, program, and intended goals. Contained in its definition are four important concepts: Process- Institutional development is not static, it is organic and evolving. It
affects all facets of an organization and it implies learning, adaptation, and change. Capacity- Institutional development involves human resources as well as
organizational structure and systems. Both need to be strengthened in concert. Sustainability- The aim of institutional development is an organization that can
sustain the flow of valued benefits and services to its members or clients over time. Impact- Institutional development is not a goal. It is a means to solve problems,
create a more favorable economic or policy environment, and improve the quality’ of people’s lives.
6.1 Framework for Institutional Development
Institutional development is a dynamic process of becoming a learning organization capable of influencing and adapting to a continually changing environment. It is a two-way street, strengthening both partner organizations, it leads to financial, material and human resource autonomy and self-reliance. Institutional development is a complex concept because the life of an organization is a complex process. A framework that expresses the fundamental ideas and concepts and permits an analysis of the principal elements involved is a useful approach to addressing the complexity.
68
A Framework for Institutional Development of Microenterprises STAGE DEVELOPMENT
SUSTAINABLITY
EXPANSION
VISION CAPACITY RESOURCE CAPABILITY LINKAGES 6.1.1 Components
Vision-Vision is the ability to think creatively and critically about the
organization. Vision is guided and formed by basic principles and beliefs that define the mission and purpose of an organization. It articulates a picture of the world that would result from the successful achievement of an organization’s goals It is important that vision grow out of , and respond to, locally defined needs. Finally, it should reflect the social and moral principles, and contain principles of cost-consciousness, sustainability, autofinancing of credit, growth, and expansion. Capacity- Capacity is the ability to move thinking to action. It is the institution’s
ability to organize itself to achieve its mission effectively and efficiently. Capacity requires a structure through which people can channel their energy and creativity, which anchors the organization in the mold of the vision, supports the organizations activities, is responsive to program and client needs, ensures that decisions get made at appropriate levels, and engenders appropriate forms of participation. Systems and procedures that ensure that the structure operates smoothly, that there is a timely flow of accurate information and that staff and clients are treated fairly. A staff with the skills and motivation to implement the programs and manipulate the systems to achieve the objectives of the organization, a methodology that is an organized set of tactical steps that allows the organization to carry out its mission. Resource capability- Resource capability is the ability to earn or raise sufficient funds
to cover expenses without compromising vision or program design. An organization operating efficiently has achieved an assured flow of money that matches client demand and operational need. In addition to acquiring funds, organizations must be able to do financial planning and management and ensure accountability. Key factors include fund69
raising policies and practices, credit policies budgeting and accounting systems1 financial projection and cash flow analysis, and portfolio management. Linkage- Linkage is the ability to develop productive relationships with t wide
variety of organizations. Linkage includes regular communication, interaction, and exchange of information and resources. To he an effective implementer of its activities, an organization must be perceived by the community in which it works, and by external entities, as carrying out activities that meet community needs in socially and culturally appropriate ways. Additionally, it must be seen as contributing to the overall improvement of the community. This legitimacy strengthens an organization and further supports the accomplishment of its mission. Each component of the framework represents a distinctive organizational ability and involves an integral set of roles, policies, procedures, and tasks that need to be accomplished in systematic ways. The nature of the issues faced in each component and their importance and impact on the organization change over time and thus require constant attention. Failure to appropriately address any of these issues has the potential to seriously weaken an organization and reduce its ability to serve its client population.
6.1.2 Stages
The three stages identified in the framework present new challenges to be mastered. Development Stage- The development stage begins at the initial point when an
organization decides to undertake a small enterprise activity. During this stage, the organization makes major strides in crafting its methodology and begins structuring itself to carry out its mandate. The discussion of this stage is relevant for both new organizations in the process of establishing themselves and existing organizations. This stage can he further divided into the preparation phase, during which planning is carried out and the foundation is laid for an organization and its program methodology; the start-
up phase, when the program model is tested and modified; and the implementation phase, which involves the execution of a program ample enough to achieve visible levels of impact.
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Sustainability Stage- This second stage is the period during which an
organization achieves a certain amount of maturity, becomes an efficient implementer, attains a degree of financial viability, and can grow. It is during this stage that an organization makes the transition from effective implementation in accordance with predetermined impact targets, to a consolidation phase of more efficient delivery of services to clients, to a growth phase where the organization is increasingly capable of reaching larger numbers of clients with greater effect. Expansion Stage- In the expansion stage, an organization makes a structural
transformation in order to scale up its operations to reach a significantly greater number of people. Indicators that the threshold has been crossed include the clear existence of an organizational choice to reach larger numbers and the consequent decision to embark upon some form of structural change in the organization to make that goal a reality.
This framework, like any analytic tool, is an abstraction of reality, reflecting and highlighting key elements to facilitate understanding. The actual process of institutional development is much less continuous than the logical progression the framework implies.
Review Questions i)
Illustrate the framework for institutional development
ii)
Describe the components of the framework for institutional development
iii)
Describe the stages of the framework for institutional development
iv)
Explain the relationships between the components and the stages of the framework for institutional development
Suggested Further Reading
Maria O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building Health Financial Institutions for the Poor , Kumarian Press.
Lee, Nirmala, (2008), Principles of Lending, Global Professional Publishing Ltd David Lawrence and Arlene Solomon, Managing a Consumer Lending Business , Solomon Lawrence partners
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CHAPTER SEVEN THE MERGING ROLE OF NGOs IN FINANCIAL INTERMEDIATION
By the end of this chapter the learner should be able to: i)
Identify the reasons why NGOs choose to the path of financial intermediation
ii)
Describe the characteristics for NGOs engaging in financial intermediation
iii)
Challenges for NGOs choosing path financial intermediation
7.0 Introduction
There are a growing number of examples of microenterprise in development organizations that have decided to move toward financial intermediation. The decision to engage in financial intermediation brings with it the need for a fundamental transformation in the approach to microenterprise development. NGOs that have made this decision believe that such a transformation is the only way to address the demand for financial services over the long term and in a viable in manner. Financial intermediation is the route taken by NGOs that have decided to specialize in financial services, scale up their microenterprise lending activities, and reach tens of thousands of borrowers. Expansion of lending activities becomes the vision that drives these NGOs forward, influences their operations, and ultimately differentiates their work from that of other NGOs. These organizations become specialized lending institutions whose primary objectives are to improve the quality and efficiency of their lending operations and expand them significantly. Once an NGOs decides to follow this “expansion-led’ app roach, its potential area of coverage becomes the whole country.
7.1 Characteristics for NGOs Engaging in Financial Intermediation
i)
Governance and Boards
The governance function and the composition of boards under the expansion-led approach are crucial considerations because the board will decide whether the NGOs should move toward financial intermediation. Key factors are at play in this decision, in particular the increased level of effort the board members must accept to make it happen
72
and the much higher level of risk that they assume, both for themselves and for the institution. Perhaps the first way in which NGOs link into the financial systems in their countries is by choosing private-sector individuals, business-people and bankers as board members. Private-sector board members create access to institutions and sources of finance that are otherwise unreachable. They also outline a vision for the NGO that can take it toward financial viability and intermediation. They provide the technical financial expertise necessary to prepare for expansion and institutional transformation. They become a priceless and essential resource for the expansion process. ii)
Clients Reached
The scaling up of operations is the characteristic that most clearly differentiates the NGOs that are moving toward financial intermediation. Scaling up refers to gradual but consistent expansion of operations to reach thousands of small-scale entrepreneurs. Scaling up leads programs to develop a market perspective and to focus on financial services that respond to the preferences of their clients. NGOs must maintain clarity about their ultimate oh1ective: provision of services to the poor. Two indicators assist in determining whether they are lending to the smallest and neediest borrowers. The average size of a loan indicates who is borrowing. Small loans tend to reach smaller businesses. Gender is a second indicator. Those NGOs reaching a significant percentage of women are providing services to the poor, since women predominate at the bottom of the pyramid of microenterprise production. NGOs coverage must shift from local to regional and eventually, where feasible, to national Most NGOs open branches or regional offices in different cities, developing decentralized systems of operation that resemble bank branches. iii)
Sources of Capital
The shift from being a donor-funded organization to being one that blends grants and soft loans with funds borrowed from banks constitutes the most dramatic change for NGOs. The objective of these organizations is to eliminate subsidies gradually for their lending operations NGOs moving in this direction currently borrow part of their funds from banks and still rely on grants and soft money. Expansion into new areas, for example, continues to require subsidized money.
73
Access to borrowed money and the capacity to use it fundamentally change the relationship between NGOs and donors and between NGOs and financial-sector institutions in their countries, the challenge for these NGOs is to find effective ways to link up with commercial at sources of funds and to work with donors and commercial and institutions to overcome the internal and external barriers that constrain Nods from gaining access to adequate sources of capital. iv)
Methodology and Operations Management
The techniques for providing financial services to the poor pro1iferated in the 1980s, various NGOs demonstrated that one can lower transaction costs and in maintain high repayment rates while reaching large numbers of people. To move toward financial intermediation, NGOs must perfect their lending methodology and concentrate only on financial services. As NGOs move toward financial intermediation, their objective is to improve efficiency and increase the size of their lending operations rather than experiment with new methodologies. v)
Self-Sufficiency and Financial Standing
NGOs on the expansion-led track are concerned not only with operational selfsufficiency (covering their costs with income earned) but also with taking on the financial costs of borrowed money The high unit cot of making very small loans is reflected in the interest rates they charge, which in some successful programs is 10 to 12 percent above the market rate. The ability to operate at or near level three of self-sufficiency is one of the most important determining factors an NGOs capacity to borrow from commercial sources. vi)
Financial Management
For expansion-led organizations, investment in effective financial management is essential for continued growth and any move into financial intermediation. Information systems are at the heart of good financial management (Christen 1990), An NGO must allocate substantial resources so that its system provides timely and accurate information, conducts needed analysis of performance, and generates projections for future planning. vii)
Personnel and Staff Development
Staff training is essential to maintain clear objectives, motivate performance, and increase skills. The closer an NGO gets to financial intermediation, the greater the need
74
to train its staff. Also, the NGO will have to combine staff from social science disciplines with finance professionals. Training must provide both the technical and the social framework to work with the poor in financial intermediation. The most useful approach to staff training integrates training into ongoing operations to ensure that staff members receive training in a structured and systematic way. In addition to training staff in topics related to their specific responsibilities, the NGOs should upgrade financia1 skills for all staff and in prove their financial management skills. Financial intermediation requires all staff members to move up the learning curve in these areas. Program expansion brings with it rapid growth in staff size.
7.2 Challenges for NGOs Choosing Financial Intermediation
Three of the most important challenges are: i)
The Social Development versus Profit Dilemma
The NGOs work as development organizations is based on a strong foundation built on social development and equity considerations. Their priority continues to be increasing the poor’s access to financial services. In the process, they are entering the world of financial intermediation in settings where financial systems lack the capacity to reach this population. By assuming this role, NGOs are incorporating the basic thinking of financial institutions making loans while reducing risks and charging an interest rate that reflects the costs of lending into their own social objectives of reaching the poor. The conflict that arises is quickly apparent. These organizations seek to maintain their social development objectives and combine them with the profit objective of a financial institution. One challenge for these organizations is to maintain the integrity of this duality of purpose and not allow one part to overtake the other. The ownership profile-who invests in these institutions and what values they bring a shareholders will either safeguard or compromise the social commitment of the institution. ii)
Savings Mobilization
Capturing savings is an essential part of financial intermediation. NGOs have not developed expertise in this area for two reasons. First, they have always conceived of their programs as lending operations and have concentrated on perfecting their methodology in this area. Second, as mentioned above, regulatory policies in many
75
countries prevent nonprofit organizations from capturing sayings. Finally, some organizations believe that accepting savings should be a second step because an organization must first establish itself as a competent lender before it can safeguard the funds it accepts. The experience of some successful programs shows that savings can be introduced as a compulsory feature of lending activity. Savings mobilization must become an integral part of an NGOs move toward financial intermediation. Chose institutions that for legal reasons cannot capture savings can nevertheless facilitate their clients’ access to formal savings services. Those NGOs that choose to become financial institutions must recognize that savings should become their major source of capital. iii)
Institutional Sustainability
The long-term viability of an organization becomes much more difficult when donor funds are not the source of capital. Although all microenterprises NGOs aspire to sustainability, this goal is traditionally seen in the context of available donor monies. In the case of expansion-led organizations, however, sustainability must be discussed in the context of decreasing grant funding and increasing borrowed monies or deposits. If an NGOs borrows money to lend, its continued operation will depend on its capacity to pay back its loans. Very close supervision of lending operations becomes an important ingredient for institutional sustainability. The role of the board in this supervisory function is essential. Review Questions i)
Identify the reasons why NGOs choose to the path of financial intermediation
ii)
Describe the characteristics for NGOs engaging in financial intermediation
iii)
Challenges for NGOs choosing path financial intermediation
Suggested Further Reading
Maria O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building Health Financial Institutions for the Poor , Kumarian Press.
Lee, Nirmala, (2008), Principles of Lending, Global Professional Publishing Ltd
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CHAPTER EIGHT PRINCIPLES OF REGULATION AND PRUDENTIAL SUPERVISION AND THEIR RELEVANCE FOR MICROFINANCE ORGANIZATIONS
By the end of this chapter the learner should be able to: vii)
Define and differentiate the terms Regulation, Prudential financial regulation, financial repression, Financial intermediary supervision and Internal control
viii) ix)
Explain the rationale for regulating depository financial intermediaries Explain the
principles for the regulation and supervision of depository
financial intermediaries x) xi) xii)
Describe the frequently adopted instruments of prudential regulation Discuss the risks of financial intermediation Describe the unique characteristics of MFOs that require specialized regulation
8.0 Introduction
Regulation refers most broadly to a set of enforceable rules that restrict or direct
the actions of market participants and, as a result, alter the outcomes of those actions. In this sense, regulation may be performed by the market itself, without government intervention or participation of other external forces. Efficient markets regulate economic actors by rewarding or penalizing them for their performance. In principle, an efficient market guarantees that actors who make incorrect choices eventually go bankrupt. The ability of markets to regulate actions and enforce contracts should he taken into account in the design of government regulations. The more regulation by governments imitates regulation by efficient markets, the more effective it will be. Optimal regulation seeks to replicate the mechanisms of a perfect market. Enforceable public regulation substitutes the mandates of the government for market incentives. In this context, financial regulation becomes the coercive imposition of a set of rules that affect the behavior of agents in financial markets. The replacement of market incentives with government rules that restrict certain behavior may have either beneficial or harmful effects on the performance of the economy. Since financial markets have been among the most regulated economic activities in every country in the world, it
77
is easy to observe examples of both beneficial and harmful regulations on the basis of their effects on market efficiency. Prudential financial regulation refers to the set of general principles or legal
rules that aim to contribute to the stable and efficient performance of financial institutions and markets. These rules represent constraints placed on the actions of financial intermediaries to ensure the safety and soundness of the system. This type of government intervention should serve three basic policy goals: i)
The first one, macroeconomic in nature, is to ensure the solvency and financial soundness of all intermediaries, in order to protect the stability of the country’s payments system.
ii)
The second objective is to provide consumer (for example depositor) protection against undue risks that may arise from failure, fraud, or opportunistic behavior on the part of the suppliers of financial services.
iii)
The third goal of financial regulations is to promote the efficient performance of institutions and markets and the proper working of competitive market forces.
Achievement of the first two objectives of prudential financial regulation is simultaneous. Once the authorities provide depositors with reasonable protection, the stability of the payments system is guaranteed. The objective of promoting efficiency, however, implies increased competition and the possibility that inefficient firms will exit the market. This means, in turn, that some consumers may be exposed to deposit losses and that some degree of instability may arise. These seemingly conflicting objectives must be balanced in a system that allows the market mechanism to work while keeping the system safe. We refer to financial repression as those forms of regulation that distort financial markets and reduce the efficiency of their performance. Financial repression encompasses the set of government-imposed rules whose purpose is to tax or to subsidize financial transactions, thereby redirecting resources away from market- determined uses. Important tools of financial repression are confiscatory reserve requirements; interest rate ceilings, inflation tax, overvaluation of the domestic currency, and excessive restrictions on entry to the market. Other examples are credit subsidies, through loans
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granted at below- market interest rates; mandatory credit allocations that target loans for particular sectors; and usury restrictions, Frequently, some of the most repressive regulations have been adopted with the best of intentions. In other words, badly conceived prudential regulations may become repressive. For instance, excessive barriers to entry into the financial industry are frequently raised with the intent of promoting a safe and resilient system. Such barriers may shield existing inefficient organizations from competition from new, more efficient intermediaries. The observed negative consequences of financial market repression suggest that inappropriate regulation may frequently be more dangerous than no regulation at all. Financial intermediary supervision consists of the examination and monitoring
mechanisms through which the authorities verify compliance with and enforce either financial repression or prudential financial regulation. Supervision includes the specific procedures adopted in order to determine the risks faced by an intermediary and to review regulatory compliance. Supervision of compliance with rules that promote stability and efficiency is both desirable and a key component of financial progress. Internal control refers to the activities undertaken by the owners of a given
financial institution in order to prevent, detect, and punish fraudulent behavior by the organization’s personnel; to ensure that the financial policies adopted by the owners are properly imp1emented; and to ensure that the owners’ equity is protected. Internal control activities are, in general, in the private interest of the intermediary’s owners and normally should not be an overriding concern for the supervisory authorities. It is important to maintain the distinction among the concepts of regulation, supervision, and internal control, since each leads to separate policy issues. Regulation requires, in most cases, a legal framework. Once the appropriate regulation is in place, supervision may be more discretionary. Although these activities are complementary (regulation without supervision would be useless), one should be able to identify the separate virtues and defects of each set of activities in order to focus any corrective actions. Microfinance organizations (MFOs) are organizations that offer credit and
sometimes savings services to microenterprises and others in poor communities. The
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main types of microfinance organizations include nongovernmental organizations (NGOs) running solidarity group or transformation lending programs; NGOs sponsoring village banking programs; credit unions; specialized government banks; and private commercial banks. Regulation and supervision of each of these MFOs depend first on the types of services they offer, particularly the nature of their savings services, and second on their ownership and management structure.
8.1 The Rationale for Regulating Depository Financial Intermediaries
Depository intermediaries- banks may be distinguished from other financial institutions by three characteristics. On the liabilities side of the business, banks issue fixed-value claims, more commonly known as deposits, to their customers. They carry large amounts of debt, in the form of deposits, as compared to equity. On the assets side, banks hold a substantial portion of their portfolios as nonmarketable and risky securities, in particular business and personal loans. The fact that fixed-value deposit claims are backed by risky loans makes the regulation and supervision of depository intermediaries necessary (all loans are risky by
virtue of their nature as promises to deliver at a future date). Imperfections in financial markets arise from information asymmetries among depositors, the financial institution, and borrowers about the likelihood of the promises being kept. Depositors cannot know as much as bankers about the safety of their deposits, and banks cannot know as much as borrowers about the likelihood of loans, being repaid. Excessive risks threaten some of the crucial functions of banks, including the safety of deposits, the allocation of credit in the economy, the management of the payments system, and the ability to provide portfolio management and risk-sharing services. Depository financial intermediaries are particularly important in developing
countries, where other dimensions of financial markets are undeveloped or absent. The nature of the contracts between depositors and the owners of financial organizations provides ample occasion for opportunistic behavior by depository institutions. Banks can take advantage of depositors by, for example, investing in
excessively risky loans. Once depositors have supplied the funds, bank managers and equity holders may be encouraged to greater risk taking, since they keep any extra
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rewards while depositors bear the additional risk. Because deposits carry fixed interest rates, the owners of the depository institution keep any extraordinary profits if the loans or investments turn out well, but they can go bankrupt and walk away from losses, This problem is referred to as Moral hazard, which can be defined as the incentive by someone (an agent) who holds an asset belonging to another person (the principal) to endanger the value of that asset because the agent bears less than the full consequence of any loss. This problem of moral hazard is also present between a bank and its borrowers. This is precisely why banks impose requirements on their borrowers-an example of regulation through the market. These requirements are voluntarily agreed-to loan covenants designed to ensure-or at least increase the probability-that borrowers will behave responsibly. All forms of collateral are examples of such loan covenants. For microenterprises, regulation through the market often takes the form of collateral substitutes such as group guarantees, the promise of future loans, or the value of the borrower’s reputation. The market failure that results from the asymmetry of information between banks and depositors and the associated moral hazard on the part of banks is significant enough to warrant government intervention. The difficult question is how best to intervene. A second type of concern that originates from opportunistic or morally hazardous behavior relates to spillover effects that go beyond the direct (private) costs faced by the depositors and the owners of a failed depository intermediary to other depositors and other institutions. There are several ways these spillover effects can take place. For
example, an intermediary that lends to very risky clients would be likely to charge and receive a high rate of interest on loans. This depository intermediary would, in turn, be willing to pay higher rates of interest on its deposits. In a competitive market, other intermediaries would be forced to match the increased deposit rates, covering the increase by higher interest rates on loans. This price race might escalate the level of risk in the system as a whole. Alternatively, the failure of one intermediary may cause a panic or run on the deposits of other intermediaries that otherwise have healthy financial situations. Runs on deposits are sudden, massive, and unexpected withdrawals that endanger prudent and
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imprudent Institutions alike. Even depositors who have informed themselves about the financial health of their intermediaries may find it rational to suddenly withdraw their deposits in the expectation that others are doing so or are about to do so.
Q Why it is necessary to restrict potentially opportunistic behavior and other
forms of mismanagement by depository institutions (preventive regulation) rather than punish them afterwards through the judicial system (remedial action), as is the case with most transactions in the economy?
The combination of the limited liability and high levels of financial leverage that characterize banks implies that the amount owners stand to lose is rather small, especially when compared with the size of potential damages (deposits lost). This supports the case for regulation. The case is even stronger when the costs from instability of the system are considered as well. In addition, the lower the likelihood that remedial action will be taken by a court of justice, the more the system should rely on regulation. There wi1l usually be a multitude of comparatively small depositors, who may find it too costly to organize together to bring suit. Moreover, the cause of morally hazardous behavior in bank failures may be difficult to establish in a court of law. When these general criteria for prudential regulation-from the point of view of consumer protection-are applied to MFOs, the argument for a solution closer to the preventive end of the scale is even stronger. It may even imply that some MFOs should be regulated more closely than other types of depository intermediaries. This is so because in some MFOs, those in control do not own the capital of the organization, and any negligent action on their part leading to the loss of deposits, would be punished, at most, with the loss of their jobs.
8.2 Principles for the Regulation of Depository Financial Intermediaries
Economic theory has yet to offer standard principles for the determination of the optimal degree of regulation. They are very specific in terms of time, location and institutional structure of the organization being regulated. We can however present the general principles of regulation as follows:
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i)
Regulation should attempt to allow a competitive balance among financial intermediaries- this principal of competitive neutrality requires, other things
that the regulatory environment provides all market players with a level playing field. ii)
The negative effects of regulation upon the efficiency of the financial system should be minimized- Allocative efficiency requires that resources
flow to the units that offer the highest prospective risk adjusted rates of return. Operational efficiency requires that the costs of financial intermediation be as low as possible. Finally dynamic efficiency requires that intermediaries adapt over time to the needs of the users of the system. Thus good regulation should minimize distortion in each of the areas. iii)
The regulation of financial markets should not be used to promote the achievement of social objectives (for example poverty alleviation) or to substitute particular sectors of the population or priority industries- Most
often such regulation falls into the category of financial repression because it taxes the financial system or some of its participants in order to subsidize other sectors of the economy. iv)
The purpose of regulation should not be to avoid bank failures at all costs-
Such a policy objective may not be achievable and to pursue it may induce severe negative effects. Financial intermediaries that cannot withstand competition or adapt to changing environments should be allowed to exit without damaging their depositor’s interests r the stability of the market the objective of regulation and supervision should be to avoid unnecessary bank failures and to minimize the negative effects of failures that must take place. v)
Regulation must rely, as much as possible, on the self-interest of economic agents- Government regulation should simulate, as much as possible, the
ability of the market to enforce contracts; In general, there are two possible ways to prevent opportunistic behavior. The first is to keep the discretionary powers of the intermediary within narrow and closely supervised limits. The second is to rely on the self-interest of the intermediary by introducing incentives that induce banks to reduce excessive risk taking.
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vi)
The regulatory framework should not be static; it must recognize that there will inevitably be innovations adopted to avoid the original regulation-
Efforts to alter market solutions through coercive regulation induce innovations to avoid the initial regulation, such as new products and services (for example, off-balance sheet liabilities or product substitution. The efficiency of the process of prudential regulation is reduced as such innovations spread in the market. vii)
The regulatory framework should be flexible enough to regulate different intermediaries in a different manner when necessary- The differences that
may be important for regulatory purposes have to do with the environment in which the intermediaries operate, the market niches they serve, and their institutional design-property rights and rules of control over the organization’s assets. For example, a cooperative’s assets are controlled by the one-personone-vote system, while the corresponding rule for a commercial bank is one share one vote. The need for flexibility arises because such differences may imply different types of exposure to risk-idiosyncratic risks-for different intermediaries.
8.2.1 Frequently Adopted Instruments of Prudential Regulation
The types and scope of government regulation of depository intermediaries vary significantly across countries. Preventive regulation attempts to control the risk exposure of the system in order to reduce the probability of failure in the aggregate. Protective regulation focuses on assuring depositors that they, as individuals, will not face losses if a particular intermediary experiences financial difficulties. a) Preventive Regulation i)
Licensing of Financial Intermediaries- Almost every government has
restricted the entry of firms into the formal financial industry by requiring them to obtain a license or legal charter. From a purely regulatory perspective, the only purpose of any licensing requirement should be to ensure adequate capitalization and the availability of sound management
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(competence and moral standing), not to limit entry and reduce competition. ii)
Capital Adequacy-The first dimension of requirements dealing with
capital adequacy is a pre-established minimum level of capital required for entry. This is an absolute amount of money. The second dimension is to require the maintenance of some solvency or leverage ratio; this is a minimum proportion of the assets of the intermediary. Capital plays two roles. The first one is to absorb losses on the income account. For moderate losses, capital would allow depositors to redeem their claims at full value. Nevertheless, due to high levels of debt relative to capital on the liability side of depository intermediaries) capital does not represent a significant protection. Even losses that are small as a percentage of assets may wipe capital out. The second, authentic function of capital in terms of consumer protection is to perform the role of a deductible, in the sense of an insurance policy. Equity capital is the amount that would be lost by the owners of the bank in the event of bankruptcy. The larger the deductible (expected owner losses), the more cautious the behavior of the intermediary (less risk assumed). iii)
Prohibitions on Loans to insiders- One common and very important
regulation of financial intermediaries is to limit the amount of loans that may be, granted to bank insiders (large shareholders, related companies, employees). Insider loans are usually not properly collateralized. More importantly, credit to insiders may be used by the intermediary’s owners to recapture their equity capital, thereby eliminating its function as a deductible. In the event that insiders receive loans equivalent to a large portion of their capital, they are able to escape their share of the losses from bankruptcy by falling in default on the loans they have received. Restrictions on credit to insiders are necessary for the successful enforcement of any capital adequacy regulation. iv)
Diversification Rules- This regulatory constraint is aimed at preventing an
intermediary’s loan or investment portfolio from being concentrated around a few individual customers or a group of customers that face
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similar economic risks, such as farmers growing the same’ crop. In such a situation, many investments or loans may fail at the same time, causing sudden deep losses to a system designed to cope with small, regularly occurring losses. This is a problem for the long-run stability of many MFOs. v)
Regulations About Admissible Activities- Some countries have tried to
separate banking activities from non-banking areas of business. The practical implementation of the regulation has been to prohibit or restrict stock market and other equity investments by depository intermediaries. However, direct investment can also pose problems. Credit cooperatives in developing countries, for example, have invested in and managed all sorts of businesses (for example, grocery stores) side by side with their financial intermediation operations. This has been an important source of financial distress for these organizations. Multiple activities seriously endanger the effectiveness
of
supervision
and
risk
assessment
of
financial
intermediaries, and hence endanger depositors. vi)
General Powers for the Enforcement of Regulations-The regulatory framework should provide the supervisory agency with enough authority’ to perform its mandate. Among the most frequently observed—and needed—general powers granted to regulators are the abilities to require standard formats for the reporting of financial performance, to restrict or suspend dividend payments, and to force intermediaries to create appropriate reserves.
b) Protective Regulation
The main purpose of protective interventions is to avoid runs on deposits by removing the incentive for a depositor to be the first one to withdraw funds from a troubled intermediary. i)
Government as a Lender of Last Resort- Governments, most frequently
through central banks, may intervene in financial markets to provide liquidity loans to troubled intermediaries. This is different from the openmarket operations of the central bank aimed at increasing the liquidity of the
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entire system for macroeconomic reasons. The idea behind the lender-oflast-resort facility is that there may be intermediaries that are temporarily illiquid but are solvent and fit for long-term survival. ii)
Deposit Insurance- The main purpose of deposit insurance is to remove the
depositor’s incentive to be the first one to withdraw funds from a troubled intermediary, thereby preventing mass runs by depositors. This is thought to increase the stability of the system. However the establishment of protective measures in the absence of prudential regulation and supervision remove discipline from the market and encourages risks that may be greater than those resulting from the absence of regulation. It is better to have no regulation than to adopt protective regulation alone.
8.3 Principles for the Prudential Supervision of Depository Financial Intermediaries
Prudential supervision refers to the process of enforcing the regulatory framework. Efforts are aimed at monitoring and directing individual intermediaries to ensure that they obey regulatory requirements and do not behave imprudently. There is little advantage in having good regulatory policies in the absence of efficient enforcement mechanisms. There basic principles of prudential supervision include: i)
Supervisory activities should not be used to enforce rules different from those related to prudential regulation- In some countries, bank supervisors
are, asked to verify compliance with tax laws, foreign exchange controls, central bank reserve requirements, and the like. Additional mandates affect the ability of supervisors to concentrate on their main task of risk assessment and control activities, while creating additional incentives for the regulated ones to hide information. ii)
Supervisory authorities should not manage intermediaries- Supervisory
activities and management tasks should be kept separate. Supervision should attempt to make intermediaries comply with a comparatively small number of clear rules. It should have nothing to do with personnel management, pricing policies, or even technical operational advice to financial intermediaries.
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iii)
Supervision requires frequent monitoring- There should he no extended
intervals between supervisory activities. Given that financial contracts involve maintaining and honoring promises over time, the risks involved in banking change constantly. Thus, the probability that an intermediary will be able to honor its deposits may change at any time. iv)
Supervision
of
financial
intermediaries
should
have
a
significant
component of prediction- The assessment of the risk levels faced by an
intermediary should not be based on past performance alone. Effective supervision requires a better predictive ability than that provided by the traditional methods of bank monitoring. One suggestion is to undertake simulations about the performance of intermediaries under different reasonable scenarios, such as changes in market interest rates. v)
Prudential supervision, as the process of enforcing the law and regulations, should show a high degree of flexibility and neutrality toward charter arrangements and the market segments served by particular intermediaries-
Questions such as how does a bank examiner estimate the necessary provisions for loan losses in an intermediary whose portfolio is backed by character
references
only
suggest
the
need
to
differentiate
across
organizations. Similarly, regulators should be flexible enough to understand that appropriate delinquency rates may vary with the nature of the clientele and the loan product.
8.3.1 The Methodology of Supervision
An efficient mechanism for the surveillance of financial intermediaries should have two basic components. The off-site component should be an early-warning system based on analysis of data reported to the supervisory authority by the intermediaries themselves. Its main purpose is to provide a frequent depiction of the financial health and risks of each intermediary. The on-site component involves actual visits to the intermediaries. On-site supervision is necessary to make those inspections that cannot be performed by an off-
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site analysis (for example, quality of internal control) and to verify that the data fed to the off-site surveillance system are correct.
8.4 Risks of Financial Intermediation
There are several common sources of insolvency for financial intermediaries. i)
Credit Risk
Whenever a financial intermediary acquires an earning asset, it bears the risk that the borrower will default, that is, not repay the principal and interest according to the contract. Credit risk is the potential variation in the intermediary’s net income and in the value of its equity’ resulting from this lack of or delayed payment. Different types of assets exhibit different probabilities of default. Typically, loans carry the greatest credit risk. ii)
Interest Rate Risk
This risk results from the potential variability in income and equity capital due to changes in the level of market interest rates. Interest rate risk, together with lack of appropriate diversification, is the most common source of bank failure in developed countries. This risk originates from the mismatch of the term to maturity of assets and liabilities with fixed interest rates (that is, from term transformation). When interest rates rise, intermediaries must pay more for deposits and short-term liabilities while not necessarily being able to raise their income on longer-term loans or other long-term assets. iii)
Liquidity Risk
Liquidity refers to the owner’s ability to convert assets into cash with minimal loss, that is, the ability to sell an asset quickly without incurring significant losses. Typically, liquidity is needed to meet variation in depositor demand for withdrawals. iv)
Internal Control or Fraud Risk
Internal control risk refers to the variation in income and equity capital that results from misappropriation of, theft of, or processing errors against the intermediary’s assets by a customer or employee.
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v)
Special Risks Associated With Donors
Excessive levels of the risks described above are the most frequently observed causes of failure among traditional financial intermediaries, as widely discussed in the literature on finance. All these risks affect traditional intermediaries and MFOs alike. The literature on finance does not recognize, however, risks that are characteristic of organizations supported by external donors. One example that is frequent in MFOs but hardly observable in traditional intermediaries is what may be called subsidy-dependence. Such a risk occurs in an MFO that is largely dependent on subsidies but mobilizes savings from the public as well. The problem, from a supervisory perspective, is that reductions in the annual flow of subsidies may endanger the stability of the intermediary and, therefore, the savings of its depositors. The supervisor should be concerned with the degree of dependence that a given intermediary has on volatile and uncertain subsidies (for example, government transfers and donor grants) and with the potential impact of their reduction or elimination. Another example of these differences in risk between MFOs and traditional intermediaries is the result of the external influence exercised by donors or governments. MFOs are often flooded with cheap donor hinds, accompanied by demands that these funds be allocated quickly. Frequently, donors target particular clientele without concern about creditworthiness, severely reducing the organization’s degree of freedom in credit screening. All this imposes severe credit risks on the organization as it has to abruptly increase its pool of borrowers, frequently from a narrowly defined subset of the population. Rapid and disproportionate growth in the number of borrowers is highly correlated with portfolio kisses from default.
8.5 Regulation of Microfinance Organizations
Depository institutions are defined in terms of the structure of their liabilities (for example, large debt as compared to equity), the fixed-value nature of their debt (for example, deposits), and the predominance of nonmarketable loans among their assets, Clearly, whenever microenterprise finance organizations introduce significant savings elements, they resemble depository financial intermediaries and share many of the characteristics that make regulation necessary.
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Thus, as MFOs seek to enhance their savings mobilization efforts, they must prepare themselves to be regulated and seek dialogue with regulators concerning appropriate forms of regulation. MFOs have a series of special needs arising first from the type of financial services they offer, and to whom, and second-from their institutional structures. Unique characteristics of MFOs that require specialized regulation: i)
Collateral and Credit Risk
Many microenterprise loan programs do not require formal collateral. Instead, character-based loans, group loans and the promise of subsequent larger loans are the main motivators for repayment. Instead of collateral, the best indicators of portfolio value would be past performance of the portfolio and current status of arrears. Recent experience has shown that sound microenterprise loan operations need not generate high delinquency or default rates, but allowable levels of delinquency and default may need to vary from those sought in more standard commercial lending. ii)
Insufficient Diversification
Most MFOs have found it necessary to specialize in providing one loan product to a limited client group. Specialization has helped MFOs hone their programs to reach greater operational efficiency, but specialization may also increase risk, particularly in areas where geographic coverage is limited and risks are highly synchronized. Village banking programs are highly exposed to this type of risk, followed closely by credit unions (which are not quite as limited in terms of number of members and which offer loans for a wide variety of purposes). The benefits of such diversification must be balanced against the increased difficulty of managing a wider array of activities. In general, the best way for regulators to deal with the difficulty of diversifying in most microenterprise programs is to require higher emergency reserves than would be required for standard bank lending. iii)
Ownership and Capital Adequacy
As discussed above, equity capital plays the central role in ensuring that owners have a stake in the solvency of the financial institution, and hence in the safety of deposits. In most countries, lack of investor capital prevents NGOs from taking savings (other than limited forced savings from borrowers). This restriction should probably not
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be relaxed unless NGOs are required to maintain extraordinarily high capital reserve-toasset ratios that can protect against large losses and are subject to stringent monitoring of their internal controls. For credit unions and village banks the ownership issue is different. In these organizations, capital is jointly owned by all members. These types of organizations, the different interests of savers and borrowers have been the source of conflicts. Particularly when borrowers are the dominant force, decisions may be made that are in the short-term interest of borrowers, but because they discourage savers, they work to the long-term detriment of all parties and may threaten the viability of the financial institution. These conflicts may make these organizations particularly unstable warranting outside regulation and supervision. iv)
Liquidity Risk
Small MFOs are likely to be exposed to high levels of liquidity risk, particularly seasonal liquidity risk. If they are financially solvent and operating in a relatively healthy financial system, they should be able to deal with this risk through short-term borrowing and lending. Non-creditworthy MFOs will not be able to solve liquidity problems. Regulators must ensure that MFOs permitted to accept deposits are able to handle liquidity risks. v)
Costs and Information
Practical problems surrounding regulation of MFOs may be serious. They include the need for regulated MFOs to provide regular, high-quality financial information and the high cost of supervision (relative to assets protected) of MFOs. vi)
Donor-Related Risks
As discussed above, MFOs receiving grants or concessional loans from donors are exposed to special types of risk, including those arising from subsidy dependence and donor influence. This list of potential regulatory issues facing NGOs suggests that many MFOs need to implement significant structural and operational changes before accepting deposits. It also suggests that some NGOs should decide not to become depository institutions. As more MFOs reach this threshold, regulatory authorities will also need to consider the changes they can safely make to respond to the special characteristics of microenterprise finance.
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Review Questions i)
Differentiate the following concepts a) Regulation b) Prudential financial regulation c) Financial repression d) Financial intermediary supervision e) Internal control
ii)
What is the rationale for regulating depository financial intermediaries
iii)
Explain the principles for the prudential regulation of depository financial intermediaries
iv)
Explain the principles for the prudential supervision of depository financial intermediaries
v)
Describe the frequently adopted instruments of prudential regulation
vi)
Discuss the risks of financial intermediation
vii)
Describe the unique characteristics of MFOs that require specialized regulation
Suggested Further Reading
Maria O, and Elisabeth R, (2003), The New World of Microenterprise Finance: Building Health Financial Institutions for the Poor , Kumarian Press.
Lee, Nirmala, (2008), Principles of Lending, Global Professional Publishing Ltd David Lawrence and Arlene Solomon, Managing a Consumer Lending Business , Solomon Lawrence partners
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Sample Papers
Mt Kenya
University
DEPARTMENT OF BUSINESS AND SOCIAL STUDIES Main Examination - May - August, 2010 (Evening Program) BBM 222: CO-OPERATIVE AND MCROFINANCE MANAGEMENT Time: 2 Hrs Instructions to Candidates: Answer question 1 (Compulsory) and any other TWO questions.
QUESTION 1 a) Explain microfinance saving principles (6mks) b) Describe the principles of co-operatives (6mks) c) Briefly explain the institutional structures that organizations may adopt for microfinancing (6mks) d) Explain the meaning of “prudential financial regulation” and describe its goals (6mks) e) What are the qualifications for a membership to a co-operative society according to the Co-operative Societies Act No. 12 of 1997 as amended, in 2004? (6mks) QUESTION 2 a) Describe the elements and division of responsibility in co-operative management (6 mks) b) Explain the role of government in co-operative development (14mks) QUESTION 3 a) Describe the principles of prudential regulation of depository financial intermediaries (12mks) b) Explain the benefits of institutional saving to households (8mks) QUESTION 4 a) Discuss the framework for institutional development for microenterprises (10mks) b) Discuss the role of the government in microfinance development (10mks) QUESTION 5 a) Explain the various marketing decisions that a manager of a local co-operative has to make, in managing the it’s daily operations (12mks) b) Describe the role of various types of co-operative meetings (8mks)
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