Internal audit, loan losses, and financial performance in microfinance institutions- a global evidence

Abstract

Purpose Microfinance institutions (MFIs) are recognised as a niche market where microloans and other financial services are provided to the poor, especially in developing economies. This study examines the relationship between the presence of the Internal Audit (IA) function, loan losses, and financial performance in MFIs. Design/methodology/approach Employed fixed-effects regression models to estimate the required coefficients based on an unbalanced sample panel dataset of 1,226 MFI-year observations from 1,029 MFIs across 63 countries. Findings The research found that the presence of IA in MFIs is associated with a reduction in loan losses in MFIs, showing the potential of the IA function for improving governance and risk management in MFIs. Similarly, the presence of IA is related to improved financial performance of MFIs through its significant positive effect on institutional operational self-sufficiency. However, the findings suggest that the negative relationship between loan losses and financial performance is not significantly higher in MFIs without IA, than in those with IA, indicating that although IA reduces the risk of loan loss occurrence and improves profitability in MFIs, it cannot solitarily eliminate the adverse impact of loan losses on MFI financial performance. Originality/value Although arguments have been made for IA in MFIs, this is the first study to empirically examine the impact of IA on risky MFI loans measured by loan loss rate and impairment losses on loans. This study responds to stakeholders’ calls for MFIs to set up better internal governance mechanisms and risk controls aimed at enhancing their viability. The study further shows that IA may not be the universal solution for reducing the impact of credit risk and loan loss problems on MFI financial performance, especially if other risk management and internal governance controls are poorly implemented.