Does Good Governance Guarantee Good Business?

> Posted by Andrea Horak, Program Coordinator, CFI 

The Investing in Inclusive Finance program at the Center for Financial Inclusion at Accion explores the practices of investors in inclusive finance. Across areas including risk, governance, stakeholder alignment, and fund management, this blog series highlights what’s being done to help the industry better utilize private capital to develop financial institutions that incorporate social aims.

A business can be profitable without strong governance, but can this be sustained? The past has taught us that weak governance practices are often critically detrimental for an institution (see Weathering the Storm and Failures in Microfinance: Lessons Learned). Have businesses and institutions accepted that good governance is positively correlated with profitability? If they haven’t, they should.

The Microfinance Information Exchange (MIX) ran a pilot project in 2011 testing a new set of governance indicators among a sample of 162 MFIs across 57 countries. From the initial findings, the MIX reported that the indicators showed a positive correlation among factors such as the presence of risk management functions, internal auditing, and board committees, suggesting that good governance practices do not exist in isolation.

In “Performance and Corporate Governance in Microfinance Institutions,” Roy Mersland and Reidar Oystein Strom examine the relationship between corporate governance in MFIs and firm performance on social and financial dimensions. In their study, the effects of various board characteristics, ownership types, and the external conditions of competition and regulation on an institution’s client outreach and financial performance are considered. As they analyze each of these relationships, the authors establish that the presence of internal auditors and local directors positively influence the financial performance of MFIs. The MIX data also found a strong correlation between MFIs with executive, risk, and audit committees, and the existence of risk management functions. Of course, as MFIs vary greatly in size, structure, and maturity, it’s also important to recognize that when it comes to governance, one size does not fit all.

The paper also yields interesting findings on shareholder firms (SHF), which you might expect to have better performing boards than other ownership types, as SHFs most often are regulated and have an internal auditor. However, this was not the case. One potential factor for this was that the SHFs predominantly had international directors instead of local ones with advantages due to factors like understanding of the local context and accessibility. Interestingly, SHFs also had fewer female CEOs, a factor which the study found correlated with stronger firm performance than male CEOs.

Regardless of the varying governance mechanisms and structures, the evidence is overwhelmingly clear: good governance leads to institutional strength. In a deep analysis of 10 cases of MFI failures in Failures in Microfinance: Lessons Learned, the authors found “The clearest and strongest conclusion derived from this study is that an institution’s governance structure proved to be the primary differentiating factor between those entities that overcame a crisis and those that did not.”

In the long wake of the financial crisis, governance is finally getting the attention it deserves. In the 2012 Microfinance Banana Skins publication, a report which measures the perceptions of risk in the microfinance industry, corporate governance moved from fourth place to second place in the brackets of the most pressing industry risk. In the 2009 report, corporate governance was not even present in the top five. Institutions are recognizing the importance of governance and its direct correlation to sustainability. Strong governance ultimately fosters healthy and profitable business and is a necessity for any MFI that wishes to remain successful.

Have you read?

Peer Pressure for Good: Applying Peer Learning to Governance Leadership

A Core Reference Tool Updated: CMEF’s Governance Guidelines

Banana Skins 2012: Improving MFI Governance