Anatomy of Microfinance Frauds and Auditors’ bias - Frauds and the standard MO

Frauds are an area of concern for the MFIs and also for the microfinance industry. Depending on the scale of the fraud, it impacts various stakeholders. Most frauds are perpetrated either by an individual staff or a group of staff colluding. The frauds involving individual staff are frequent but limited in scale and longevity. They are likely to be reported either by the clients, by other staff or get detected in regular monitoring or internal audit.

Frauds in which a group of staff collude can continue for a longer period and can cause greater damage. They are more systematic in nature as colluding staff, working together, can hide more tracks. They are in a better position to fake applications, manipulate MIS, temper receipts, misreport cash positions and protect one another. But such frauds also get detected in a certain time frame depending on the strength of the - reconciliation system, monitoring process, internal audit and the usage of technology. Nevertheless, such frauds are indeed damaging, mostly for the institution concerned.

However, occasionally, the frauds are also executed at the top level wherein the CEO, CFO, Business Head, MIS Head and/or other key staff can collude. Such frauds are most damaging not just for the individual institution but for the industry as a whole. Since, the top level is involved, they are in a position to fake the entire MIS, manipulate accounts or alter various other reports and data, making it difficult to detect the fraud. As a result, such frauds can gather massive scale and can continue for years.

These frauds cause significant damage to their stakeholders resulting in monetary losses as well loss of trust among lenders, shareholders and other well-wishers. They tarnish the reputation of the industry and create question marks on auditors, rating agencies and also on the regulations.

An interesting aspect of frauds in microfinance is that no matter at what level the fraud is committed, the MO is mostly standard, which is – creation of fake clients or ‘ghost’ clients.

Whether it is the infamous scam of Sahara group on micro savings, fraud of Sahayata Microfinance, recent fraud of Sambandh Finserve or even international fraud at Telenor Microfinance Bank in Pakistan, the MO remains - creation of ‘ghost’ clients.

This is understandable, as any fraud with some significant scale in microfinance can only be achieved by somehow manipulating the client data and diverting the funds of the clients (either their savings or loans meant for them). Further, the large number of widely scattered

clients where transactions are mostly in cash, makes the verification process for auditors and assessors difficult; a fact that is often leveraged by the defrauding individuals.

Auditors’ bias
The auditors or assessors are often more focused on assessing the Head office processes, policy manuals and analyzing the reports generated from the software. The field level verification of actual clients in most audit or assessment exercises are rather limited.

Limited time, limited budget or logistical constraints result in selection of inadequate and biased samples in auditing. Many a times, field visits of teams are organized or guided by the MFI itself and the client verifications are done only in the scheduled centre meetings. So much so, that many MFIs have certain easily accessible model branches where most visitors are taken.

Auditors can also get influenced by the high-profile Promoters, Board members, media reports and even awards and accolades of an MFI, creating a favorable opinion bias in the minds of the auditors towards the institution.

Another typical or rather technical bias that auditors can have in auditing is of only auditing the partial portfolio. Assessment agencies could be engaged by lenders with the mandate of auditing only the portfolio assigned or hypothecated to them. This seriously impairs the efficacy of the audit process for the following reasons:

Tagging of portfolio to a particular funder is not a fool-proof exercise. Tagging is merely a marking in the MIS and MFIs can easily shuffle the tagging

An MFI intentionally committing fraud might be creating fake portfolio on the unencumbered part of the loan outstanding i.e. the portfolio not tagged to any funding source and generated out of own equity

If an MFI collapses, the quality or the credibility of the portfolio tagged to a funder alone does not ensure any protection to that funder. If the MFI goes down, then the delinquencies spread fast across the entire portfolio. Furthermore, the repayment to lenders is made by an MFI through its overall cashflow and not from the portfolio tagged to a particular funder. Thus, if the cashflow of the MFI collapses, all funders are equally likely to a default from the MFI, making quality of the tagged portfolio alone irrelevant.

Focus of audit
Auditors need to appreciate the fact that the reports coming out of any system, no matter how sophisticated, are only as good as the underlying operations, which are happening in the field. No level of audit of the Head Office reports and system checks can guarantee the veracity of the portfolio or the reported portfolio quality existing in the field.

In the overall audit framework, the highest weightage must be given to ascertaining the asset (loan) or the liabilities (client savings) in the field. Any audit of an MFI should be able to establish the identity of the clients’, the veracity of the reported loan portfolio or saving mobilized and the genuineness of the reported loan portfolio quality.

What this means for audit, is covering more field. The sample for audit should have adequate size in terms of branches, clients, centre meetings, loan cards, passbooks etc. The audit should be able to cover special features like very big branches, new branches, remote branches, branches with high PAR, overdue clients, branches with special products etc.

The sample drawn for audit should be free of common biases. The sample selection should not be guided by the MFI, not restricted only to portfolio tagged to a particular funder, not restricted only to scheduled centre meetings and not influenced by logistical concerns e.g. remoteness of branches, travel hardships etc.

Further, auditors should not get affected by the profile of promoters, board members, media reports, existing funders or awards and accolades. Experience has shown that these mean nothing when it comes to frauds.

Sahayata Microfinance had won the prestigious international award for ‘Commitment to Improved Implementation of Good Governance’ conferred by Hanson Wade. The Company was selected out of 80 international nominees. Sahayata Microfinance also received the ‘Srijan 2009 Emerging MFI Award’ and had the most illustrious of the equity investors and lenders. Even Sambandh Finserve won the ‘Microfinance Organisation of the Year Award’ in Small & Medium category at the Inclusive Finance India Summit 2017. As per the news reports, its CEO was also selected for the Harvard Business School – ACCION Program on “Strategic Leadership on Inclusive Finance”.

Thus, we can conclude by saying that in any audit exercise of microfinance institutions, the importance of comprehensive client level coverage cannot be overstated.

Since, at M2i we realize this fact, we have adapted our methodology of loan portfolio audits (LPA) accordingly. The focus of our LPA is to ensure at the very least, the existence of the branches, the clients’ identity, the veracity of the reported loan portfolio size and the report portfolio quality, among various other things.