Impact of Corporate Governance on Performance of MFIs: A Case from Pakistan Raheel Gohar (Corresponding Author) Assistant Professor Dar Al Uloom University (DAU) College of Business, Riyadh, Kingdom of Saudi Arabia. 2 Impact of Corporate Governance on Performance of MFIs: A Case from Pakistan Abstract The determinants of economic/financial, social performance and productivity of twenty five MFIs are estimated for the period 2005 to 2009 in case of Pakistan. The results indicate that the governance variables influence the performance (economic and social) and productivity of the MFIs in Pakistan. Larger boards inversely effect economic performance but has a positive effect on outreach and productivity. Female directors do not play role in improving economic performance but effect positively outreach. Duality of chair with CEO is a negative contributor to performance, outreach and productivity. The firm size, experience, regulated MFIs, non-profit activities in lending have positive effect on performance outreach and productivity. Keywords: Corporate governance, Financial performance, Microfinance Institutions, Pakistan, , Social performance. JEL CLASSIFICATION: G21, G32 3 1. INTRODUCTION Provision of loans, savings and other basic financial services like insurance, to the poor and deprived segment of economy is referred as Microfinance (MF). Microfinance facilitates poor and near poor households by providing them permanent access to not just credit but also savings, insurance, and fund transfers against no collateral. (Christe, Roseberg, and Jayadev; 2004). Major reason of poverty in developing economies is lack of credit availability to poor. Two major reasons for non availability of loans to poor are: Inability of poor clients to provide acceptable collateral and banks find it more costly to screen the poor customers i.e. problem of adverse selection and to monitor the repayment by poor i.e. problem of moral Hazard. Survey conducted by United Nations (UN) has found that almost one fifth of world population is living in extreme poverty and their earning per day is less than dollar. Microfinance is considered to be important instrument to combat with extreme poverty. UN put lots of emphasis on microfinance for achievement of Millennium development goals which aims at halving the extreme poverty. Concept of solidarity group lending is playing boosting role in development of MF sector. It facilitates both the micro entrepreneurs as well as credit providing institute. Peer pressure and mutual support of the entire group members encourage each individual of group to put in best efforts for loan repayment as inability of repayment will forfeit the chance for further loan. Pay back rates of group loans is approximately 98% which is higher than individual loan repayment rate. In evolution of MF sector two factors have brought tremendous progress. First, poor people have very good repayment rates especially women and secondly, it is found that poor people are ready and able to pay subsidized interest rate for survival and better performance of Microfinance Institutions (MFI’s). Further more studies have shown that most of the loans 4 are given to women by MFI’s that not only reinvest their earnings but also spend on their families. It helps to improve their standard of living as well as community get benefit due to job creation and knowledge sharing. MF sector of Pakistan has well developed legal, regulatory and strategic framework. MFIs have been working since late 1980’s but mentionable efforts of MFIs have started after period of 2000. This sector plays an important role in alleviating poverty, improving living standards of individuals and providence of health and education to deprived segment of society. Lots of researches have been conducted to evaluate the performance of MFIs in Pakistan which came up with guiding results. But up till now there is lack of studies which cover Corporate Governance (CG) impact on MFI performance. Literature has recognized good CG as key element for success of MFI. Importance of CG mechanism is alike for both developing and developed sophisticated economies. Now long- term capital growth is not possible for countries that lag behind in adoption of CG practices. Concept of corporate governance was introduced globally in late 1990s. In Pakistan code of corporate governance was applied to business firms in year 2002. For designing CG framework of different type of business, it requires to cover different areas. MF entities are of various types depending on variations among their institutional structures. Some NGOs are incorporated and Securities and Exchange Commission of Pakistan (SECP) regulates them, some work as societies registered under societies act and some are governed by Ministry of Industries and work as Trust. So they do not have a single transparent and formal governance structure and processes to follow. The aim of this research is to study the relationship between performance and different dimensions of CG for regulated MFIs of Pakistan. So the results of this research can be used 5 to make a clear, well defined and formal CG structure to MFIs which ensure success of MFIs in terms of both outreach and sustainability. First time for Pakistan, this study is evaluating relationship of economic and social performance of MFIs with corporate governance. This study helps to understand the current scenario of MF sector regarding to economic and social performance, outreach and productivity and also suggests that how MFIs in Pakistan can be improved if good governance practices are introduced. This study also investigates that firm specific characteristics such as type of lending, firm size, lending status (profit or non-profit) and years of experience also contribute to performance and productivity. This research is organized as follows. After introduction the overview of MFIs in Pakistan is provided in section 2. The brief literature review of studies is given in section 3. The empirical methodology and data is discussed in chapter 4. Chapter 5 presents the empirical results and last section chapter 6 concludes the study. 2. OVERVIEW OF MICROFINANCE IN PAKISTAN This section presents the origin and development of MF sector in Pakistan. Over view of MF sector and different types of MFIs operating in Pakistan are also discussed and challenges faced by various operational levels of MF sector are also presented in this part. 2.1. Origin and development GNI per capita of Pakistan is $2780 by year 2010.With this figure Pakistan is ranked as low income country. Almost 22.3% of total population is living below poverty line and 20.5% is living on the 100-125 % of poverty line. Pakistan is facing problem of poverty since its independence. Microfinance is considered as one of the important tool for eradicating the poverty as well as it increases women empowerment. In Pakistan, microfinance is first 6 introduced by development of Agha Khan Rural Support Program (AKRSP) and Orangi Pilot Project (OPP) in early 1990s. These MFI’s were setup with the purpose of providing credit to poor and alleviate poverty. In 1990’s Government of Pakistan (GoP) and Central Bank realized that MF is key component of financial sector. At that time large number of institutions was developed with the objective of offering micro credit on group lending basis. With passage of time increase in number of new entrants, products, practices and growing clientele showed expansion of Pakistan MF sector. In year 2000 MF sector experienced rapid growth with establishment of Khushhali Bank (KB), first specialized microfinance bank and Pakistan Poverty Alleviation Fund (PPAF) an apex funding body. Moreover, in year 2001 formulation of Microfinance Ordinance, invites commercial players to take part in MF activities and bring some expansion in the sector. State bank of Pakistan (SBP) also takes different initiatives for the florishment of MF sector. In year 2007, SBP and MF stake holders together have designed a strategy named “Expanding Out reach of Microfinance” (EMO). Main objective of this was to achieve target of three million borrowers by year 2010 and for year 2015 target of 10 million borrowers was set out. 2.2. Overview of Pakistan Microfinance Sector: Due to its well-developed legal, regulatory and strategic frame work, the MF sector of Pakistan is globally recognized. In terms of both outreach and asset base MF industry of Pakistan is still very small. Currently MF sector is serving 2.07 million borrowers representing that only 7% of potential market is served. Penetration level is lowest in Pakistan. 56% of target market is totally excluded and 32% are served through informal ways. Microfinance institutions are operating in country through 1379 branches and serving almost 2.07 million borrowers with gross loan portfolio of PKR 26.4 billions. MF sector is mainly operated by few major institutions which jointly serves 85% of the market. These are fastest growing players of MF sector. Most of MFI’s are operative in provinces of Punjab and 7 Sindh. Most of specialized MFIs are operative in Punjab due to its infrastructure and higher population density. 60% of active borrowers are from Punjab and 23% of them are from Sindh. These provinces attract maximum business of MFIs due to their dense population. By year 2009, 56% of credit clients are women. Among the other peer groups, MFI peer group is serving maximum women and its 90% of clients are women. Asset base of MF sector reached to PKR 35 billion. Seven major MFIs hold 85% of total industry’s assets. Industry improved its profitability in year 2009. Globally, industry was less profitable but some RSPs and MFIs have positive ROA. One of the prominent reasons for low profitability is high personnel ration for Pakistan. Group lending methodology is adapted by most of MFIs for providing loans which are primarily used for agriculture, livestock and trade businesses. Typical size of loan is from $100 to $500. Individual loans are also offered by some MFI’s as most of them wants to avoid the risk associated with non social collateral in case of individual loan. 3. LITERATURE SURVEY A large body of literature exists on the economic and financial performance of MFIs and their outreach for other developing countries; however, very few studies have been done for Pakistan. As regards the impact of corporate governance on MFIs performance limited research has been done so far and in case of Pakistan this research is non-existent. This section provides the brief review of empirical literature in this area. Keasey, Steve and Write (1997) concluded that framework of effective governance comprises of key mechanisms like ownership, board and structure of boards, CEO, Director, remuneration, auditing and markets for corporate control. Ownership checks whether firm is owned by any institute or manger. Board structure will look for how large board is and of which members it is composed of. 8 Hartarska (2005) in her study of Central Europe and newly independent states found that different CG mechanisms affect performance of MFI differently. For example, External mechanisms of control i.e. auditing, regulation and rating of MFI, management remuneration and board independence and diversity all have different impact on the outreach and sustainability of MFI. Supervision by regulatory authority and Independent agency rating has no impact on both sustainability and outreach. Auditing does not affect sustainability but have positive impact on outreach. Characteristics of board have major effect on both sustainability and outreach with MFI having local board have better sustainability, having larger boards have poor performance and MFIs with boards comprising of higher proportion of insiders showed worse financial results. Sustainability as well as depth and breadth of outreach are improved when there is woman on board. Breadth of outreach is improved due to presence of local businessmen on board but it does not affect sustainability. Presence of financers and members with diverse skills enhances sustainability. Presence of donor representatives on board promotes depth of outreach but have negative impact on breadth of outreach and sustainability. Clients on board decrease the depth of outreach but improve sustainability. There is no relation between MFI performance and performance based compensation of manger. Less outreach is observed for such MFIs who have under paid mangers. Experience of manger has weak positive impact on depth of outreach and no impact on sustainability. Akash (2008) studied some governance and ownership aspects of MFI’s of Bangladesh. He found that top most MFIs of Bangladesh having entirely different ownership structure. Results showed that performance of MFI has nothing to do much with its ownership structure. Mersland and Storm (2009) in their study of Central Europe and newly independent states found that the presence of international directors and internal board auditors have no impact 9 on financial performance of MFI. CEO / Chairman Duality undermine financial performance and increases cost. Female CEO tends to decrease cost and improves financial performance. Financial performance has no relation with the ownership type. Regulation shows the relation with performance as it gives customers a feeling that they are treated fairly. Female CEO has lesser branches. Monitoring practices are less in MFIs having larger boards. Outreach is greater in case of group lending. Providence of individual loans decreases number of credit clients but improves average loan. Number of clients increased with CEO/ Chairman duality. MFI sector start emphasizing on individual lending instead of group loans which shows that sustainability is given more importance by sector than outreach. MFI regulated by Government has lower risk exposure and more experienced MFI faces more risk. According to Keasey et al., (1997) effective governance framework should cover ownership, board and board structure, CEO remuneration, director, auditing Information and nature of corporate control. Fama and Jensen (1983) put large emphasis on the nature of MFI board and its impact on performance of MFI. Lipton and Lorch (1992) found that large boards are less effective than smaller boards. Internal board members show independence and have positive impact on performance (Oxelheim and Randoy, 2002). Board diversity is another important CG mechanism. Carter, Simkins and Simpson, (2003) found that boards having higher proportions of women and ethnic minorities perform far better. Presence of MFI clients on the board of MFI affects the performance. Ashbaugh and Warfirelid (2003) pointed out auditing as most important aspect of CG. They found positive relation between audited financial statement and MFI performance. Scott and Hopkins (1999) have shown that if NGO mangers pay and for profit managers pay are same and NGO has edge in technology over for- profit firm, then NGO will outperform the industry. 10 Adoption of best CG standards by MFIs helps them to achieve their social as well as their commercial objectives and aims. Microfinance industry can increase its depositors, borrowers, counter parties and investors by adherence to best CG mechanism. Furthermore shareholders of MFI which has clear CG practices are protected against risks and are sure about multiplicity of their wealth. Regulatory authorities can also get benefit from CG practices as it helps in reducing frauds and mismanagement. Different set of rules and different mechanisms are used by researchers for explanation of best CG practices. Whatever theses dimensions are, but all of them strive to achieve fairness, responsibility, respect for rights, corporate integrity, loyalty, compliance with regulations, and transparency. 4. DATA AND METHODOLOGY This section discusses the methodology used to estimate the performance and productivity relationship with good governance in case of Pakistani MFIs. The data and sources of data are also presented. 4.1: Data Currently large number of MFIs is operating in Pakistan. However only 31 out of them are regulated by September 2010, and other are non-regulated. Focus of this study is regulated MFIs only. 27 MFIs out of 31 are member of Pakistan Microfinance Network (PMN) and constitutes almost 95% of MFI business in Pakistan (State Bank of Pakistan, Department of Microfinance, Jan 2011). Our data set comprises of 25 MFIs (list is provided in Appendix “A”) for period of five years from 2005 to 2009. Those MFIs are included in data set whose data is available for at least two consecutive years.