Group I:

POLICY AND REGULATORY ENVIRONMENT

FOR MICROFINANCE INSTITUTION 

Members:

Mr. Saleem Ullah (Pakistan)

Mr. Kah Leong Wang (Singapore)

Mr. Kachesa Chookole Bbenkele (South Africa)

Mr. Sidup Belaman (Brunei Darussalam)

Mr. Saman Ghasemi (Iran)

Mr. Achmad Rofi’ie (Indonesia)

1. Introduction

A conducive policy and regulatory environment is widely accepted as an important prerequisite for the development of a viable, sound and stable microfinance sector. One may question that microfinance in most parts of the world has grown in the absence of specific financial  sector policy. Bangladesh, the world’s leader in microfinance has yet to have a formal framework for microfinance, but its policies and regulations could be instrumental in promoting financial services to the poor. The conducive policy environment, however, is required both for formal and informal microfinance programs. The NGOs and donors etc don’t initiate/expand their programs in areas/countries having restrictive policy environment. The exceptional growth of microfinance in the last two decades is also attributable to the overall supportive policies adopted by the various governments.

The objective of formulating the guidelines on microfinance policy and regulatory issues is to disseminate the best practices in the developing countries and provide them a basic layout/structure of microfinance policies and regulations normally required for the development of a sound, stable and vibrant microfinance sector. The guidelines however are suggestive in nature and the governments and policy makers are encouraged to review the guidelines and consider for introduction in their countries after necessary customization.

2. Policy and Regulatory Environment

The policy and regulatory environment for MFIs very much depends on the governments’ intention and commitment to promote the sector. The major features of a conducive policy & regulatory environment will be discussed in the following segments. However, the governments and policy makers should review this guideline in the light of their own environment and  introduce the necessary changes, if any, to ensure the development of a sound and vibrant microfinance sector best suited to their economy.

The following points are required in the development of a microfinance:

1. Conducive economic policies for microfinance

2. Governments’ commitment to promote the sector

3. Financial market and system approach for the development of microfinance

4. Partnership and collaboration with stakeholders

5. Creation of apex institutions and capacity building support

6. Conducive legal and regulatory framework

7. Responsive regulatory and supervisory framework

8. Capacity building of central bank/regulatory body in microfinance

3. Conducive Economic Policies for Microfinance

Low inflation, substantial investment in education, health and physical infrastructure  and an effective and transparent governance system are some of the economic policy issues which directly affect the provision and effectiveness of microfinance services. High inflation erodes the already weak purchasing power of microfinance clients, forcing them to default in their loan payments which cause further dip into the poverty cycle. The governments, by maintaing low inflation rates and creating empolyment, business and investment opportunities can enable the poor to gradually increase their purchasing power and asset base so as to get out from vicious poverty cycle.

Investment in social sector, education, health and physical infrastructure creates business, investment and capacity building opportunities for the poor, which enables them to productively use the microfinance services. Empirical evidence shows that the areas/countries where micofinance services were provided along with investment in physical and social infrastructure, have experienced visible improvement in poverty conditions and living standards of the poor. For government agencies, it is advisable to make investments in social and physical infrastructures and develop the framework for delivery of services to the masses instead of directly delivering microfinance and other services to the poor.

The non-existence of an effective and transparent governance system has been one of the major reasons for the poor state of social and physical infrastructure in most of the developing countries. A transparent and effective governance system with well defined authorities and responsibilities, built in control systems, effective monitoring mechanism and the board accountability is a pre-requisite for success of any sector of the economy including microfinance. In a number of developing countries, huge resources made available by donor agencies and governments for poverty alleviation were largely wasted without making any impact on the poor, primarily due to weak governance and monitoring systems. The governments, besides allocating resoureces for poverty alleviation, will have to demonstrate political will and commitment to develop and enforce a transparent governance systems in order to make a visible impact on the poverty levels which has been exhibiting a rising trend in most of the developing countries.

4. Government’s Commitment to Promote the Sector

Governments’ and policy makers’ belief in the utility and importance of microfinance and their sustained commitment demonstrated through sector friendly policies is critical for growth of the sector. It sets the tone and pace of development and gives direction to the stakeholders to plan and initiate different types of services to support the poor. The best way to demonstrate a government’s committment to promote the sector is to formulate and issue their national microfinance policies explicitly, by defining its plans and strategies for the sector. While some countries have already developed and issued their national policies for microfinance, others, though developed, have yet to institute the policies. The policy makers are encouraged to develop the policies in consultation with the stakeholders and formally issue the same to demonstrate their firm commitment to promote the sector as well as to give direction to the stakeholders. The National Policy for Microfinance may inter alia cover the followings:

• Governments’ vision about microfinance; their plans, approach and policy to develop the sector;

• Its plans and policy to increase access of the poor and micro enterprises to microfinance services;

• Governments’ and Public Sector Institutions’ role in Development of the Sector and delivery of services;

• Nature and types of institutions engaged or to be engaged in microfinance;

• Basic features and underlying theme of Legal & Regulatory Framework for providers of microfinance;

• Role of private Sector MFIs in provision of financial services to the poor/micro enterprises;

• Institutional support mechanism for MFIs;

• Need for establishment of apex institutions, MFIs association etc.

5. Financial Market and System Approach for the Development of Microfinance

Traditional approach and financial markets/systems approach are the two most commonly used approaches for provision of micro and rural finance services. The traditional approach  assumes that the poor cannot save and pay market rates of interest on their loans. Based on this assumption, governments and donor agencies have to channel heavily subsidized funds to a selected target group. The results, however, in almost all the countries, which adopted the approach, had not been encouraging as there was limited outreach to the target sectors, gross abuse of subsidized credits, acute repayment problems, collapse of institutions and most importantly, the non-development of financial market conducive to support the sector.

The finacial market and system approach considers micro and rural finance as an important part of over all financial system, dispels the myth that the poor cannot save and pay market rate interest on loans and encourages the provision of demand driven financial services to the poor through self sustainable institutions. The financial markets approach assumes that the poors are able to generate economic surpluses, which enable them to repay the real costs of loans and also to save. The unprecedented success of BRI of Indonesia, Bancosol of Bolivia and ASA & BRAC of Bangladesh supports the assumptions of the financial markets approach. This approach requires the governments and policy makers to develop conducive policy and regulatory environment and implement the necessary support and financial infrastructure for MFIs in order for them to deliver the various financial services to the poor and micro enterprises.

6. Partnership and Collaboration with Stakeholders

Partnership and collaboration with practitioners and stakeholders should be the hallmark of the policy formulation process. These countries, including Indonesia, Philippines, Pakistan and Bolivia, amongst others, which have institutionalized the consultation mechanism have been able to produce remarkable results both in policy formulation and increase its outreach of services to the poor. It is highly recommended that the governments/central banks should consider forming Microfinance Consultative Groups/forums in their respective countries by having the representation of major stakeholders viz. the practitioners (from both formal and informal sectors), Central Bank, relevant government ministries and donor agencies to deliberate upon the microfinance policy issues and to make recommendations to the governments/central banks on such policy issues. The partnership and collaboration with stakeholders would help to develop trust between the policy makers and practitioners, thus enabling the central bank to develop sector-friendly policies and regulations and to provide an effective platform to ensure sustained growth in the sector.

7. Creation of Apex Institution and Capacity Building Support

Limited capital base and unstable sources of fund has been one of the major impediments to growth of the microfinance sector. Most NGOs do not normally have the capacity and collaterals to raise commercial funds from the money/capital markets but have to rely largely on grants and credit lines from donor agencies to expand their programs. The countries who created apex instituions like PKSF of Bangladesh have been able to provide stable sources of on lending funds and capacity building grants to the MFIs. The apex institutions are particularly useful for countries where microfinance is at evolutionary or initial stage of development that requires handholding by government and policy makers at least for the medium term in order to attain maturity.

The financial market approach emphasizes building of institutional capacity of MFIs to deliver the services on longer term basis. It requires governments and policy makers to create support mechanisms for MFIs to build their capacities through trainings, consultancy support for information systems and product development and grants for network expansion. Although the support system for MFIs is imperative, however, it should only finance the institutional building cost of MFIs rather than subsidising the operational cost in order that the system can be made effective.

8. Conducive Legal and Regulatory Framework

Microfinance in most parts of the world have  been developed without any specific legal and regulatory framework. The NGOs and other microfinance programs not covered under any proper legal, regulatory and supervisory framework have been and are still the major providers of microfinance to the poor. With such results, one could hardly see any reason in developing the legal & regulatory framework for MFIs. However, with increased recognition of microfinance as an important poverty alleviation tool, there is a consensus amongst the governments and practitioners that the outreach of services should be increased manifold to reach out to the maximum number of the poor in medium and long term. The NGO-MFIs however, given their capacity and resource constraints, could not be solely relied upon to increase the outreach; other institutions such as specialized microfinance banks, commercial banks etc with capacity to raise public savings to finance their operattions will have to be established/permitted.  Furthermore, the NGOs,  though established with a social cause of serving the poor, were utilizing handsome grants from government and donor agencies. There is thus a need to ensure transparency in their governance by way of adequate disclosure about their operations so as to check the financial health of these institutions. Some countries, including Pakistan, Bolivia, Cambodia, Uganda, etc, have developed separate legal and regulatory frameworks for microfinance banks whereas others, such as the Philippines, has made changes in their existing regulatory framework to allow establishment of second tier banks to extend microfinance services to the poor in both the urban and rural areas. The legal and regulatory framework in all these countries is applicable only to MFIs involved in deposit mobilization from the general public to finance their operations whereas NGOs have been encouraged to form their own associations/networks to promote transparency, good governance and dissemination of information about their operations. The countries that have adopted the tiered approach of regulation and supervision of microfinance institutions suggest self regulation for NGO-MFIs through associations/networks and formal and conducive regulatory framework for MFIs mobilizing public savings to finance their operations. The developing countries are therefore encouraged to explore the following tiered approach of regulation and supervision of MFIs as it not only caters to a diversity of microfinance institutions, but also helps to promote transparency, discipline and maturity in such institutions.

Self Regulation

The NGO-MFIs are encouraged/required to form their associations/networks to function both as a representative body/focal point for MFIs to promote microfinance and to hold dialogue forum with policy makers and government agencies for capacity building of MFIs, dissemination of information  and ensuring discipline amongst its members. The network/associations normally undertake the following functions:

• Capacity building of member NGOs through training, workshop, seminar, consultancy support for development of information system, etc;

• Devise forms of financial statement for members to ensure standardisation, comparability, transparency and adequacy of disclosure;

• Collect operating information from the members on the prescribed formats for collation, consolidation and dissemination to members and stakeholders;

• Develop standards and code of conduct for members particularly on governance system;

• Identify the issues and challenges of the sector and raise the same at the appropriate forums with policy makers and government agencies;

• Develop linkages and partnership with policy makers and international networks to develop and strengthen the sector; and 

• Develop Credit Bureaus for members to facilitate their credit appraisal process

Formal Regulatory Framework                

There is a wide spread consensus amongst policy makers and practitioners that the institutions interested in deposit mobilization from the public to finance their operations by providing a range of financial services to the poor including credit, savings, payment transfers etc should come under a formal regulatory framework.  The developing countries are encouraged to develop their own legal framework or make appropriate changes to their existing frameworks so as to allow the establishment of more financial institutions to provide financial services to the poor. The ideal legal framework normally addresses following areas:

• the nature and type of institutions covered under the framework;

• the functions and powers of the institutions;

• minimum capital and conditions required for establishing the institutions;

• the regulatory agency and its powers;

• the audit and disclosure requirements

• winding up procedures

It should be highlighted that the framework should neither create entry barriers (such as high capital requirements) nor allow the mushrooming of weak and under capitalized microfinance institutions. It should ideally provide adequate incentive to the private sector to invest in this pro-poor sector as well as to ensure adequcy of cushion to the depositors in the form of strong capital base. Experiences from different countries show that unusually low capital requirement have resulted into an enormous growth of weak and under capitalised micro and rural banks making it difficult for central banks/supervisory agencies to ensure effective supervisory oversight and thus giving rise to systemic risk to the financial system in such countries. Whereas in countries with high capital requirements, the growth of formal microfinance banks has been low and less than satisfactory.

The functions and activities to be prescribed for MFIs in the framework should also allow for flexibility to offer a wider range of services to the poor and facilitate MFIs in achieving break even level and generate profit at the earliest. However, such flexibility should not result in a loss of focus of the MFIs from their core market and objective of serving the poor. The policy makers should carefully evaluate their local conditions and ensure active consultation with stakeholders before finalizing the framework.

As the primary objective of the regulatory framework is to ensure soundness and stability of the microfinance institutions and safety and the interest of the small depositors are safeguarded, framework should be simple, yet flexible so as to promote efficiency and innovation in the delivery of services to the poor. The major features of the regulatory framework for MFIs are recommended as follows:

• Microfinance banks are to be treated as an integral part of the financial system; failure of MFB(s) is not only deterimental for growth of microfinance sector but also have adverse repercussions on the over all financial system of the country;

• MFIs are required to develop sound risk management systems for all areas of activities;

• MFIs are to ensure good corporate governance and a high standard transparency in all areas of operations;

• MFIs are to remain focused on their core market viz. the poor and the micro enterprises;

• Reporting requirements are to be simple, limited and effective so as to enable the MFIs to comply with the requirement at reasonable cost and the supervisory agency to ensure effective regulatory and supervisory oversight of MFIs;

• Forms of financial statements are to be standardized to allow for comparability, transparency and adequacy of disclosures;

• Know Your Customers/Clients (KYC) regulations are fully developed. 

9. Responsive Regulatory and Supervisory Framework

The regulatory framework will remain ineffective without an equally responsive supervisory framework. The supervisory function primarily ensures compliance with the regulations and monitors the risks inherent in/assumed by  MFIs. Though the experience of microfinance supervision is limited, it is advisable to use risk based supervision with focus on assessing the quality of risk management systems in place and identifying and measuring the risks to which the MFI is exposed to. The supervisory bodies may use following approaches/tools to monitor and assess the level of risks assumed by MFIs and their operating and financial health:

• Off-site surveillance and

• Periodic on-site examination

Off-site Surveillance

Off-site surveillance is undertaken based on periodic information- monthly, quarterly or annual reports received from MFIs. Through off-site surveillance the supervisor continuously monitor the risks taken by individual MFIs and trends thereof, the operating performance and financial health of the MFI viz a viz its peer members and assess overall performance and condition of the microfinance sector. It is also used to identify grey areas of MFIs enabling the supervisors to effectively target the scarce on-site supervisory resources on such areas.

On-Site Examination         

On-site examination of MFIs is an important supervisory tool to assess the quality of control structure and environment in place in the MFI, the reliability and capacity of accounting and information system, which produce operating and financial information for consumption of different stakeholders including the supervisor, the accuracy of information submitted to it on periodic basis, the quality of credit, investments and other assets porfolio and most importantly the risk management systems put in place by the MFI and level of risks assumed by MFI and coverage thereof. The supervisor should develop compehensive manuals/guidelines for reviewing different areas of operations/risks particularly the credit risk as it is entirely different than that of commercial banks.

10. Capacity Building of Central Bank/Regulatory Body in Microfinance

The capacity of policy makers and regulatory/supervisory agencies to formulate policies, which allow flexibility and innovation while ensuring soundness and stability of microfinance sector is an important condition for development of a self sustainable and vibrant microfinance sector. The position however, in most of the countries is not satisfactory and central banks and policy makers have very limited microfinance related capacities. With wide consensus on commercialization of microfinance and delivery of services through formal and informal institutions it is critical for central banks/regulatory agencies to develop their capacities in microfinance to be able to uphold prudential regulation standards and discipline while allowing flexibility and keeping an open mind to the uniqueness of microfinance.