Table of Contents
What are the key principles of microfinance regulation and supervision?
When is microfinance regulation and supervision needed?
In the last 10 years, financial authorities in transitional and developing economies have placed greater emphasis on ensuring that the largest number of the poor people in the world have access to formal banking and financial services. The majority of the world’s poor currently lack any adequate access to the financial services (CGAP, 2012, p. 1). The question that many policy makers grapple with is how or even whether the microfinance institutions should be regulated or supervised. The term microfinance refers, in a narrow definition, to the provision of microcredit for the small informal businesses and people through the use of methods developed in the 1980’s by the non-governmental organizations (NGOs) that are socially oriented (Christen, Lyman and Rosenberg, 2003, p. 6).
However, microfinance is not narrow as shown by the above definition. The clients of the microfinance institutions (MFIs) entails not only the micro businesses and entrepreneurs but also the whole body of clients who are poor. Such poor clients can use MFI financial services to acquire items for their homes, undertake home improvements, manage their various emergencies, fund the various social obligations and also smoothen the consumption (Christen et al., 2003, p. 6). The general definition of MFI is that it refers to a formal organization that plays the primary role of offering microfinance. The research will explore two main research questions. First, the research will focus on the key principles of microfinance regulation and supervision. Secondly, the research will also explore reasons why microfinance regulation and supervision needed.
The next section focuses on the key principles of microfinance regulation and supervision. The various principles that are discussed include permitted activities, capital adequacy, governance, foreign exchange risks, loan documentation and reporting amongst others.
What are the key principles of microfinance regulation and supervision?
Some of the prudential principles developed for the conventional commercial banks do not have a perfect fit with the microfinance requirements (CGAP, 2012, p. 22). There is thus a need for the development of key principle for the regulation and supervision of the microfinance institutions. The key principles of MFI regulation and supervision include permitted activities, capital adequacy, governance, foreign exchange and liquidity risk, loan documentation, restrictions regarding co-signers, branching requirements, reporting, reserves against the deposits, and insider lending (CGAP, 2012, pp. 23-31). The key principles above are a product of several revisions undertaken in 2006 and again in 2012 to reflect the significant changes in the regulation of global banking and the global financial crisis of 2012.
The key principles that will be discussed below entail and highlight the proportionality principle. In 2010, BCBS developed 25 principles for the MFI activities especially the deposit institution reflecting on the licensing requirements, the existing differences between the commercial banks and the MFIs, reserves and provisioning, as well as the assessment of the operational risks, internal control of procedures for undertaking audits. The research will however focus on capital adequacy, governance, foreign exchange and liquidity risks as well as loan documentation.
The key principles include:
i. Capital adequacy
Years of debate regarding whether specialized MFIs need tighter requirements on capital adequacy as compared to the requirements for the commercial banks that are highly diversified. There are a number of reasons that have been proposed for the need to impose the high capital adequacy ratios. First, the micro loans portfolios can deteriorate more quickly as compared to the portfolio of retail conventional banks (CGAP, 2012, p. 24). The above trait of the microloans is due to the fact that the microloans are in many cases secured using insufficient assets or are all together unsecured. Further, the major incentives for the borrowers is the expectation of loans in the future thus when a client sees that the other borrowers are not making their repayments, they will also stop making their repayments. By stopping the repayments, the credit-only MFI can face delinquency outbreaks that prevent the MFI from rewarding the clients who are faithfully making their repayments from accessing further loans. An outbreak of loan repayment delinquency can be contagious for the MFIs.
The MFIs also have high costs of administration due to the relative sizes thus they have to charge higher rates of interest to be able to stay afloat. Since the costs of operating the MFIs per unit lent is higher than that of commercial banks, the delinquency of the loans can lead to massive decapitalization of the MFIs. Such a decapitalization due to loan delinquency would be faster than the decapitalization of the commercial banks (CGAP, 2012, p. 25). There are also diversification issues as the MFIs operate in constructed geographic areas and offer just a few products – usually one or two products. The low diversification can lead to significant covariant risks thus calling for the need for regulation and supervision. Recent research has indicated that lending only MFIs have a number of long-term risks especially due to the fact that many markets are reaching market saturation following rapid expansion by the various competitors. However, the principle should only apply for the organizations that offer uncollateralized microcredit. The above is due to the problems such as collection issues and over-indebtedness of the clients in the matured markets.
Empirical research by Berger (2010, p. 2) indicated that MFIs should have a minimum capital buffer of 12 percent, but a higher capital adequacy is prudent owing to the more volatile and riskier environment in which the MFIs operate. The empirical research did not find any linkages between minimum capital and the poor access to the services of the MFIs.
The key point is that deposit-only microfinance institutions should have boards that are comprised of members who have banking and finance experience as well as those who have a deep understanding of the customers. Further, the boards should be independent of the MFI’s management (CGAP, 2012, p. 28). The above view is based on Basel Core Principles that focus on the development of sound and stable corporate governance that aid in ensuring effective management of risks and enhancing the public confidence in the financial systems of a country (International Monetary Fund [IMF], 2008, p. 8). The management of the MFIs should be under the oversight of the board – which is independent of the management. The deposit taking MFIs should have a board made up of people who understand the customers especially how the clients use the various financial services. The principle of good corporate governance is important for the MFIs double-bottom line that is adherence to the organizations missions. The mission of many MFIs is to increase access to the poor and women as well as ensure the sustainability of the operations.
An empirical study by Hartarska (2005) undertook a research that offers evidence regarding the impacts of governance mechanism, independence and board diversity on the costs coverage (sustainability), and outreach (ability to offer the financial services to the poor people) of microfinance institutions. The research by Hartarska (2005, p. 1628) applied unique data retrieved from surveys conducted in Newly Independent States (NIS) and in Eastern and Central Europe. The results indicate the governance plays an important role in the sustainability and outreach differing ways. The research found that the use of external mechanisms of governance have a very limited role on the outreach as such measures only leads to improvements in the audit. Further, when the research controlled for such factors as those specific to MFIs, institutional factors as well as the economic factors, the use of governance as a key principle for regulation and supervision of MFIs does not have any impacts on the sustainability.
However, supervision and regulation also has elements such as internal governance mechanisms. The research found that the MFIs that have effective mechanisms for internal governance can lead to an increase in the sustainability. The diversity of the MFI’s boards play an important role in increasing both the sustainability and outreach. Further, the research found that the use of governance as a means of achieving sustainability and outreach can lead to massive difficulties for the various stakeholders whose interests are to be achieved. For instance, the result of the study indicates that by having the donors represented in the board, there would be a significant improvement in the depth of the outreach (Hartarska, 2004, p. 2).
However, the broadening depth makes the outreach breadth and sustainability to worsen. This is an indication that governance should not be a key principle of regulation and supervision for MFI as it neither broadens the access to the services by the poor nor increase the sustainability of the MFIs. The results indicate that various mechanisms for external governance are not effective as supervision through prudential guidelines issued by the central banks do not have any effect on the outreach or sustainability. The findings of the research are consistent with other empirical studies such as that by Barth, Caprio, and Levine (2004, p. 205) that indicated that direct regulation does not improve the efficiency of banks.
iii. Foreign exchange and liquidity risk
CGAP (2012, p. 28) indicated that specialized microfinance institutions require higher liquidity requirements. Further, the MFIs need to first develop, manage and assess their various currency risks before the organizations can transact or even borrow in foreign currencies. Empirical research by Gietzen (2017, p. 120) was focused on the examination of the MFIs exposure to liquidity, and foreign exchange risks. The research found that the MFIs have lower liquidity risks and lower foreign exchange risks even though the common assumption is that they face higher risks. The research concluded that “despite the exposure of single institutions to noteworthy FX [foreign exchange] risks”, the quality of the regulation does not affect the exposure to such risks (Gietzen, 2017, p. 129). Due to the findings of the empirical research, the principle should focus on the knowledge and competence in managing the various risks rather than using a blanket position that MFIs have higher liquidity and FX risks.
iv. Loan documentation
Given that the nature of the microloan borrowers and the size of the various microloans, the documentation should be lighter as compared to the documentation required for the conventional banks. Such requirements as tax obligations compliance, formal registration and the formal financial statements of the micro borrowers should not be considered in the case of MFIs (CGAP, 2012, p. 30). The empirical research that exists only focus on the management of micro-credit loan performance and there is a general lack of research on the documentation (Moti et al., 2012, p. 99).
When is microfinance regulation and supervision needed?
When considering when MFI regulations and supervision are needed, there is the need to consider the state of the industry and timing. The next section considers the timing and state of industry influence on whether a new regulatory window is needed.
Timing and state of industry
By considering the timing and the state of the given industry, a clear picture of the new regulatory window for the deposit taking microfinance institutions can be determined. Many countries are in the process or have already created new window for the regulation of deposit taking MFIs. For the countries that are considering new regulatory window, the considerations should be how and whether the existing regulations in the financial sector hinder the MFIs from providing financial services to the poor or hinder the MFIs from raising deposits to allow for the expansion of their services. In the event that the policy makers determine that the regulation that exists does not hinder the MFIs, then a new regulatory window is not needed as a means of improving access (CGAP, 2012, p. 19). When it is determined that access to the services by the poor or the ability of the MFIs to raise funds is not hampered by the existing regulations, then new regulatory window will not be needed. However, even when it is determined that the existing regulations in the country can lead to the inhibition of the development of the deposit taking MFIs that serve the poor, regulations may still not be needed as alternatives can be explored. Such alternatives include provision of exemption or amendments to the current regulation rather than focusing on the development of new window. The development of a new regulatory window is a complex process that can lead to significant challenges in the provision of access or even the expansion of the financial services.
The new regulatory window can also be used to attract new capital and investment in the sector. The policy makers need to consider the takers for instance start-up operations that may be interested. Such takers can include those who offer technical expertise as well as those with foreign investments that can be pumped into the economy. The actors can also be local start-ups that are interested. However, when the consideration is for the local actors, factors such as the demonstrated profitability, experience in collecting and making micro loans, the level of entrepreneurship of the private sector also need to be considered. The consideration of the factors above are critical as many countries have shown. Several countries that have developed sound regulatory windows for the MFIs have achieved little success and response. The state of the industry is thus important as countries that have developed new windows in a micro lending industry that is strong have achieved greater success (CGAP, 2012, p. 20). It can thus be stated that by relying solely on a new supervisory window, the country cannot be able to achieve a significant emergence of new providers.
Cull, Dermirguc-Kunt, and Morduch (2009b, p. 3) undertook an empirical study that determined that when considering a new regulatory window, deliberate choices must be made with regards to the impacts of the new regulation on the extent of competition, rigor of the regulation itself and the commercialization level. The paper thus describes the significant trade-offs that regulators, donors, and MFI practitioners navigate on a daily basis. The empirical research found that regular and rigorous supervision is important for deposit taking microfinance institutions. However, the research also states that the regulation can be costly thus hampering access of the MFI services to the poor as the microfinance institutions will switch towards serving the well-off customers as a means of maintaining profitability levels.