CHAPTER ONE INTRODUCTION

1.1 Background To The Study The growth and expansion of Microfinance Institutions (MFIs) in terms of the services and products they offer has necessitated the adoption of an effective risk management framework. Nevertheless the internal risk management systems of MFIs are often a step or two behind the scale and scope of their activities (Microfinance Network, 2000). Strong internal capacities to identify and anticipate potential risks to avoid unexpected losses and surprises have been necessitated by the rapid growth experienced by most MFIs. The spurring growth of microfinance institutions in our economy and the world over is evidence of their increasing importance, and the demand for their products and services. This increasing demand for the services of microfinance institutions is backed by the large mass of poor and low-income people who need and want a range of financial products and services to build income and wealth, smooth expenditure patterns, and reduce risk (African Development Bank [ADB] & African Development Fund [ADF], 2006).

Apparently, the traditional financial institutions represented by commercial banks have not been able to meet the need for financial services of the poor and economic operators in the informal sector. In sub-Saharan Africa small enterprises and the poor population have very limited access to deposit and credit facilities, and other financial services provided by formal financial institutions. In Ghana and Tanzania for example, only about 5-6 percent of the population have access to the banking sector (Basu, Blavy, & Yulek, 2004). A similar

situation exists in Gabon with only about 5.1% of the population having access to financial services. Poverty is still a critical challenge for the region, with an average of 70% of the population living under $2 a day, and GNI per capita averaging approximately USD $965 (compared to $38,000 average in the industrialized countries). Its combined GDP in 2008 was US$744 billion, which was equivalent of 28% of Chinas GDP, 69% of Brazils, or 80% of Indias. In addition, it consistently scores the lowest ratings in the Human Development and Millennium Development indices relating to health and education levels (International association of Microfinance investors, 2010).

Similarly, in Cameroon approximately 7.3 million Cameroonians live below the national poverty line. The situation is even worse in the rural areas dominated by agricultural activities. When examining the rural population of 8.1 million, it is found that approximately 4 million are defined as living in poverty, thus a full 50% of the rural population, versus 41% of the total population. Our GDP per capita is 2,300 USD, ranking 178th in the world, and our GDP growth rate is 3.3%, 115th in the world; but, taking population growth into account, the GDP per capita growth rate is much lower, at 1.6%, a statistic that is a much more accurate reflection of quality of life. This GDP is heavily driven by agriculture which comprises 43.6% of GDP and 70% of labor-force employment. Unfortunately, the access to financial services for those living in rural areas and hence those involved in agriculture is severely limited, especially to the 4 million rural poor. This deficiency in the supply of financial services to the poor has led to the birth of over 500 microfinance firms between 1990 and 2009 who are attempting to give the poor and very poor access to savings, loans, and other financial services (Ruffing, 2009).

These MFIs are spread across the country offering diverse products and services to the average Cameroonian including deposits, loans, payment services, leasing, money and remittance transfers, pensions, and insurance. There are over 481 MFIs in Cameroon located in all the ten regions of the country (COBAC Annual Report, 2008). They are constantly penetrating the financial markets especially in the rural areas offering less stringent loan policies and conditions; a move which is believed will facilitate the attainment of the Millennium Development Goals (MDGs) as access to financial services for all people underpins the attainment of the MDGs (ADB & ADF, 2006). However there has also been the frustrating exit of recently established microfinance institutions doing away with the savings of low and middle income earning Cameroonians, and the witnessing of several loan officers and managers being arrested and a few others taken to court to face charges of fraud. During 2005 there was the closure of over 200 MFIs in the country (Curtis, 2008). These developments are part of the changes stemming from the evolution of MFIs.

MFIs in the world are evolving from clubs and non-governmental organisations to selfsufficient financial institutions. The existence of MFIs dates as far back as the 18th century with clubs mobilizing funds to lend to members at very low interest rates. In the 1970s, most of the institutions were not profit oriented and at this time, financial self-sufficiency was secondary to donated resources. Development agencies provided subsidized funds, and the common belief was that the supply of such resources would remain reliable. The institutions were intermediaries, largely functioning as income transfer agents for social purposes rather than serious financial intermediaries. Hence there was no formalization of the microfinance sector. 3

Formalization of the microfinance sector only began in the early 1990s as MFIs began offering more financial services, such as savings and insurance. Microfinance also demonstrated that it could improve the socioeconomic well-being of its clients and their families. The poor experienced positive changes in attitude as microfinance helped them believe that they could lift themselves out of poverty. A sustainable credit culture was therefore created. However with the economic crisis especially in most developing countries and resources running scarce for most of the institutions originally set-up as nonprofit organisations, concerns with microfinance self-sufficiency became paramount. Efforts were therefore initiated to transform these grant and subsidy dependent schemes into self-sufficient financial institutions (Lairap, 2004).

This led to the mainstreaming of microfinance and its institutions into the formal financial sector. According to the ADB & ADF (2006), microfinance is evolving to where the term itself is becoming obsolete and building inclusive financial systems for the poor is the term that is increasingly used as microfinance becomes part of the formal financial sector without losing its focus on serving the poor. Mainstreaming requires that MFIs and other intermediaries operate according to the same standards of accountability, transparency, performance, and profitability as commercial banks and other formal financial institutions do. This has necessitated the identification and management of risks thus emphasising the need for effective risk management techniques and tools. These developments in
microfinance have set in motion a process of change from an activity that was entirely subsidy dependent to one that can be a viable business (ADB & ADF, 2006). Management thus must

set objectives and put in place measures and procedures which will facilitate the attainment of the objectives and this implies effectively mitigating the risks which could seriously 4

affect the growth and development of the institution especially operational risks. This mainstreaming phase only began in the mid-1990s.

The growth of microfinance in Cameroon truly began to escalate in the early 1990s, but it has existed in the country for almost fifty years. The provision of microcredit in Cameroon began in the 1950s, when attempts were made in the country, as in other parts of the developing world, to promote small scale agriculture and enterprises undertaken by lowincome people to raise their productivity and income (Lairap, 2004). The first cooperative
was created in 1963 by a Dutch catholic Father Alfred Jansen in Njinikom, in the North-west region. This cooperative is the founding-father of CAMCCUL (Cameroon Cooperative Credit Union League) the biggest microfinance institution and longest standing microfinance network in the country (COBAC Annual Report, 2000, 2006).

The economic crisis of the 1980s and the resultant restructuring of the financial institutions were contributing factors to the development of the microfinance sector. During the economic downturn in the late 1970s certain banks in the country began to suffer financially from a

lack of available liquid funds. By the early 1980s, banks in Cameroon became increasingly unable to support themselves as it became more difficult to receive international credit and they were largely unable to obtain their own resources within the country. This spurred the
government to action in the late 1980s and there was a complete restructuring of financial institutions in the country causing many banks to close their doors while taking the savings

of many Cameroonian citizens with them. It was out of the banking crisis that microfinance was born in Cameroon, as many citizens were still in need of banking services that were no

longer readily available. And the number of MFIs has been on the increase since then as they are proving to be able to provide these services via their operations.

However, the operations of a microfinance institution just like any other organisation continuously expose it to a wide range of risks. This includes liquidity risk, credit risk, interest rate risk, transaction risk, fraud risk, market risk, legal and compliance risk and governance risks. Furthermore, the changing nature of the environment in which microfinance institutions operate exposes them to new risks thus making it necessary for them to adopt more sophisticated risk management tools (Microfinance Network, 2000).

In addition, the financial services sector is one of the fastest changing areas in the business community. The combination of industry deregulation and the exploitation of new and emerging technologies have resulted in financial institutions having the ability to deliver a vast array of products and services with an increasing number of delivery channels (Aub & Russell, 2001). The probability of fraud occurring in MFIs has increased with the recent changes in their business environment, resulting in more flexible products and services for customers. According to Aub & Russell (2001), the benefits and flexibility now being provided to customers have, unfortunately, also been exploited by those seeking to gain an advantage through dishonest behaviour. Hence new opportunities for fraud are emerging almost daily.

Moreover, the result of a survey conducted by AuditNet in December 2009 reveals that fraud is still a recognized problem experienced by most organizations. Most MFIs experience financial loss as a result of fraud at some point in their development. Exposure 6

to fraud risk is a normal part of operations for any financial institution, as is exposure to credit, liquidity, interest rate, and transaction risks. The art of risk management is to determine the degree to which these risks should be controlled especially as proactive risk management is essential to the long-term sustainability of MFIs (Microfinance Network, 2000). A companys system of internal control has been attributed a key role in the management of risks that are significant to the fulfillment of its business objectives. In this light there has been an increased interest in internal controls and the fight against fraud over the past two decades.

This heightened interest in internal controls is in part, a result of significant losses incurred by several banking organisations (Basel, 1998). In the mid 1990s, after several surprise bank failures, US regulators shifted the focus of reviews to place greater emphasis on an institutions internal risk management capabilities in each area of operations, since those are better predictors of the banks ability to withstand internal or external uncertainties (Microfinance Network, 2000). Fraud and mismanagement were at the centre of the over 200 bank failures that occurred in the US. The Basle Committee analyzed the problems related to the losses incurred by banks and concluded that they probably could have been avoided had the banks maintained effective internal control systems. In addition, a review of traditional banks asserted that the implementation of effective internal control systems played an important role in reducing bank failures throughout the 1990s (Campion, 2000).

Thus MFIs must develop their own internal capacities to manage and monitor risk exposures (Campion, 2000). Experience has demonstrated that microfinance institutions cannot rely on external evaluations by donors, regulators or external auditors to identify 7

fraud or other internal problems; these evaluations are infrequent and often too shallow. More so, internal controls can only support risk minimisation if the MFIs risk management strategies are effectively integrated into its policies and procedures (Campion, 2000). As part of the risk management feedback loop they play a significant role in identifying, evaluating, and monitoring risks facing institutions. Also the internal control system comprises internal auditing which is a very important tool for ex-post evaluations.

In addition, internal auditors are expected to have sufficient knowledge to evaluate the risk of fraud and the manner by which it is managed by the organization as stated in the Institute of Internal Auditors (IIA) International Professional Practices Framework (IPPF) Standard 1210.A2. Nevertheless, small Microfinance institutions rarely find it profitable to employ qualified internal auditors as full time staff. Rather, they outsource their internal audit services from the firms of their external auditors. In most cases, the external auditors send a junior staff to carry out the internal audit at the microfinance institutions on a regular basis and his work is later supervised by one of the firms senior auditors. But with fraud on the rise, MFIs must set up their own in built systems of control to safeguard the shareholders investment and the companys assets.

Effective internal control systems are said to reduce the occurrence of fraud; by closing the gaps otherwise referred to as the opportunity for employees to commit fraud thereby discouraging them from committing fraud and doing away with company assets. Sound internal controls equally provide a working environment in which good employees are not tempted to do something they would not ordinarily do. In this light the performance of highly successful MFIS has been attributed to their internal early warning systems and 8

management responses that prevent small problems from exploding into larger ones (Microfinance Network, 2000).

Similarly, Campion (2000) concludes that as MFIs grow and more operate as regulated financial intermediaries, internal control becomes essential to long-term institutional viability. More over, according to the ADB & ADF (2006), financial intermediation designed to serve low-income groups must be addressed from a financial sector perspective and rely on best practice standards in order to succeed. Also, an effective system of internal control allows the MFI to assume additional risks in a calculated manner while minimising financial surprises and protecting itself from significant financial loss; thus making internal control an integral component of risk management.

1.2 Problem Statement The African microfinance sector is a dynamic and growing marketplace. In general, since 2005 there has been a spurt of overall growth in microfinance activity in sub-Saharan Africa. The regions aggregate loan portfolio increased by 69 percent from 2006 to 2007 and savings increase by 60 percent in the same period of time (Africa Microfinance Action Forum [AMAF], 2009). In 2007, sub-Saharan Africa experienced economic growth of 6.7 percent and continued to accelerate progress in human development, improve the huge lack of infrastructure, and strengthen governance. Microfinance has been able to capitalize on these positive developments, experiencing strong growth in recent years.

Consequently, there has been astounding progress in the delivery of financial services to low-income markets in Africa over the past ten years, in particular during the past five years. A recent study by Womens World Banking (WWB) and the African Microfinance Action Forum (AMAF) found that more people in low-income market segments in countries across Africa are now able to access an increasing range of financial products. This tremendous growth in MFIs across Africa has been attributed to the fact that they use savings mobilization as a main funding source (International association of Microfinance investors, 2010).

Similarly, in Cameroon the number of institutions has been growing and the over 460 functional microfinance institutions have accumulated by way of deposits, a sum

amounting to over FCFA 258 billion from close to one million customers. And ever since the first micro-financing institution was set up in the country in 1963 in the Northwest

10

province the micro-financing sector has been moving steadily upwards offering the country more than FCFA 22 billion as capital, employment to over 15,000 people and loans that amount to more than FCFA 138.5 billion; thus offering worthwhile support to poor people who would not be eligible for traditional banking facilities (Cameroon today, 2011).

However, with over a decade in existence, even fewer microfinance institutions operating in Cameroon have reached the level of self-sufficiency. The majority of microfinance institutions in Cameroon are not-for-profit organizations registered as financial cooperatives and credit unions. As such, their main source of loanable capital comes from the savings of their members (Lairap, 2004). Mismanagement of the savings of members and customers is becoming rampant. Thus many are not able to survive resulting in a
decrease in the number of microfinance institutions over the last few years. The number of

MFIs decreased from 652 in 2000, to 481 in 2008 (COBAC Annual Report, 2000, 2008).

In addition, the development of the microfinance sector is hampered by a loose regulatory and supervisory framework for MFIs. There is clear absence of governance in the management of most MFIs. In fact, almost all the microfinance institutions have at least one strong shareholder who tends to influence the smooth functioning of the institution especially when it comes to giving out loans. Likewise the President of ANEMCAM highlighted among others poor governance, loan delinquency and incompetent staff as the major hurdles faced by MFIs in Cameroon (Cameroon today, 2011). Majority of the MFIs in Cameroon, similar to most in Africa, struggle with sound leadership which is believed to be the primary condition for success as successful MFIs on the continent have a strong

11

board of directors. Therefore their internal controlling environment is seemingly lagging behind.

Furthermore, the controlling environment is weakened by an absence of a policy guideline regarding the protection of savings of clients among the COBAC regulations (Ndiaye, 2005).With a majority of the MFIs relying on savings mobilised from their members and customers, as funding for capital for their operations, the protection of the savings and its efficient utilisation become paramount. Moreover transparency and accountability are increasingly being required from all financial institutions including MFIs. Currently, as investors are more and more demanding regarding financial accountability and transparency, internal control has acquired the utmost importance.

On the other hand, fraud has continued to be an issue of concern owing to its nature and the large losses reported from several cases. According to the KPMG fraud survey released in 2003, 75% of the respondents reported losses due to fraud as against 62% in 1998 (Singleton et al., 2006). Furthermore of the frauds reported, 36% incurred $1 million or more in costs, up from 21% in 1998.The Association of Certified Fraud Examiners (ACFE) reported an estimated $660 billion in losses due to fraud in 2004. Disturbing as the figures may be, the occurrence of fraud has rather been on the increased in recent years (Singleton, Singleton, Bologna, & Lindquist, 2006). Also, employee fraud was the most common category of fraud with 60%. This is evidence that fraud is a major problem for corporate organisations and institutions. Thus, prompting the search for techniques and risk management frameworks which effectively mitigate fraud.

12

Consequently, the techniques and frameworks will not only significantly reduce the incidence of fraud but also facilitate its detection. According to the COSO Landmark study on Fraud in Financial Reporting, the average fraud period extended over a period of 23.7 months. Thereby laying emphasis on the need for internal systems of control which will facilitate the prevention and hence detection of fraud for timely corrective action. In addition the ACFE in its Report to the Nation (RTTN) in 2004 reported that financial frauds lasted an average of 25 months before being detected (Singleton et al., 2006). Thus there is need for effective techniques, which will make it easier for fraud to be detected, reducing the losses resulting from the perpetration of fraud.

On the contrary, traditionally financial institutions have left the identification of fraud and operational errors to external auditors who may identify unexplained losses in the process of reconciling the accounts (Campion, 2000). This is a misleading conception owing to the fact that the detection of fraud is not the prime objective of external auditors and it constitutes what has been described as the expectation gap (the variance between what the clients of external auditors expect of them and what their job actually entails). Also most external auditors conduct a surface review of operations and therefore do not help to identify fraud (Microfinance Network, 2000). In addition, Trebesh (2003) acknowledged that external auditors rely heavily on sampling and sampling may not detect fraud. This is owing to the fact that only evidence gathered from such samples determines the necessity for additional tests. More so their visits are short term and as such do not provide room for timely corrective and preventive action. More over the chances of an external auditor detecting fraud in the course of the audit are slim due to the clandestine nature of fraud and

13

the procedures of financial audits; which when combined it is not likely that financial auditors will detect fraud during their audits (Singleton et al., 2006).

Also, Singleton et al. (2006) emphasized that the procedures of financial audits only make it feasible for them to detect financial frauds which are typically perpetrated by executive management and average millions of dollars in losses. This is owing to the fact that by their nature they are material and result in material misstatements on the financial statements. Similarly, according to the International Standard on Auditing (ISA) 240, fraud may involve sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor. Such attempts at concealment may be even more difficult to detect when accompanied by collusion. Collusion may cause the auditor to believe that audit evidence is persuasive when it is, in fact, false. In this light therefore, the use of internal risk management systems have gained wide recognition. And frauds involving collusion and management override of control can best be prevented by the existence of a strong control environment (Singleton et al., 2006).

Since its creation the microfinance sector in Cameroon has undergone several changes, as it seeks to reach the 'poorest' of the poor to get them into employment and out of poverty and

powerlessness. Legally, before 1998, the regulation of microfinance institutions in Cameroon

was flexible. There was no distinction between rural cooperatives involved in poverty alleviation and commercial microfinance institutions involved in profit- making activities. The flexibility in the law generated a free-entry in the micro lending and in the micro saving activities in Cameroon. Institutionally, the lay-off of qualified banking employees, the lack of

14

confidence of customers in the traditional banking institutions and the free-entry of Savings and Credit Cooperatives in banking activities led to a great increase and creation of microfinance institutions. The laws of 1998 and 2001 in relation to differences between profit-making microfinance institutions and non-profit making microfinance institutions did not stop that increase in creation of Savings and Credit Cooperatives in Cameroon. But the CEMAC/UMAC/COBAC regulation on microfinance institutions set on April 2002 and implemented from 2007 restructured the sector of microfinance institutions in Cameroon and henceforth faced out illegal, unqualified and unprofessional microfinance institutions. Thus, the number of microfinance institutions in Cameroon sphere started instead reducing (Lairap 2004).

The changes in the microfinance sector in Cameroon over the years have had significant influence on the management of MFIs. Currently, MFIs have to be managed like profit oriented organisations and as such must have more formalised structures put in place for the running of their operations. Nevertheless the cost of these structures must not outweigh the benefits from their existence. MFIs conduct effective risk management by carefully analyzing their risk exposures and selecting cost-effective ways to mitigate them. By linking effective risk management to internal control, MFIs can assume more risk when doing so offers potential for increased profits. To maximize efficiency, management should identify internal controls that are cost-effective, that is, provide the maximum risk reduction for the least cost (Campion, 2000).

However, most MFIs have not been able to come to terms with the benefits of effective internal controls due to their inability to analyse the impact of effective internal controls

15

and how much they could actually save financially. In this light management of most MFIs simply ignore the need to put in place simple yet efficient internal control systems to safeguard assets, ensure reliable financial reporting and compliance with laws and regulations especially as the regulating of these institutions has not been comprehensibly developed.

On the other hand, the ability of management to override controls raises doubts as to the impact internal controls have on the incidence of fraud principally because they have been charged with the responsibility of establishing the internal controls in the first place. More so a system of internal control cannot, however, provide protection with certainty against a company failing to meet its business objectives or all material errors, losses, fraud, or breaches of laws or regulations. It becomes imperative therefore to examine the impact of internal controls on the incidence of fraud in MFIs. This research is therefore structured to provide answers to the following question: What effect do internal controls have on the incidence of fraud in MFIs? In this light our specific research questions are: To what extent do control environment and control activities influence the incidence of fraud in MFIs? What are employees perceptions of the nature of fraud in MFIs?

16

1.3 Research Objectives This main objective of this research is to examine the effect of internal controls on the incidence of fraud in MFIs. Our specific research objectives include: Examine the extent to which control environment and control activities significantly influence the incidence of fraud in MFIs. Identify employees perceptions of the nature of fraud in MFIs. Make appropriate recommendations.

1.4 Hypothesis This study sets out to test the following hypothesis: Ho: Integrity and ethics, Human resource policies, Board oversight, Performance reviews and Reconciliation of accounts, have no statistically significant influence on the incidence of fraud in MFIs.

1.5 Delimitation of Study This study aims at examining both the internal control measures and the function via internal audits. The data for this study will be collected from a sample of Category I and II microfinance institutions in the Buea Municipality. This is owing to the fact that they are institutions that are in a full growth and expansion phase, becoming financially selfsufficient, and increasing their outreach to thousands of people who previously had no access to quality financial services. As such have the capacities to implement effective internal control systems and run internal audit departments. In addition they are

17

continuously being threatened by the occurrence of fraud. Moreover, they have the potential to develop into commercial banks to which effective internal control is primordial.

Also the study is limited to fraud committed by employees who are not part of the executive management; fraud committed against the company or institution. This is because the fraud perpetrated by this group of persons is likely where internal controls are weak (Olaoye, 2009). Hence though it will consider collusion with third parties; it will not evaluate the adequacy of the internal control to mitigate fraud committed by customers and third parties such as suppliers against the company, although this type of fraud also results in significant losses.

In addition the study focuses on asset misappropriation owing to the fact that this type of fraud is more likely to be detected by internal controls and has received little attention from prior researchers who have focused on financial misstatements (fraudulent financial statements). Moreover, those frauds categorized as asset misappropriation are typically perpetrated by employees against the organisation and for the benefit of the employee are more likely to be detected by efficient internal controls; whereas fraudulent financial statements are more likely to be detected by external auditors because they result in material misstatements on the financial statements (Singleton et al., 2006).

Finally, though external auditors equally play a role in the prevention and detection of fraud, the researcher does not aim to evaluate the role external auditors play in the prevention and detection of fraud in MFIs.

18

1.6 Significance Of Study This study will contribute to the existing literature on risk management in microfinance institutions specifically on fraud risk management. The study examines asset misappropriation- a fraud scheme which has received little attention from prior researchers. It will provide an insight on the controls implemented by microfinance institutions to prevent and detect asset misappropriation schemes and how effective these controls are. Moreover the difficulties faced by microfinance institutions as far as the controlling of asset misappropriation is concerned will be brought to light. Furthermore, recommendations will be made on how microfinance institutions could improve upon the effectiveness of their internal control systems in the light of controlling asset misappropriation. In addition, suggestions for further areas of research as far as the management of risk in microfinance institutions is concerned will be made.

19