Chapter 7 Rural and Microfinance Institutions: Regulatory and Supervisory Issues 7.1 Overview The providing of financial services to the poor areas,is the purpose of crofinance institutions(MFIs),and the assessment of the regu latory framework for MFls is part of broader assessment of adequacy of access.Access however,is multidimensional,and assessing its adequacy requires a review of (a)the range of financial services provided-and target groups served-by several tiers of formal semiformal,and informal financial institutions;(b)the demand for financial services from households,microenterprises,and small businesses at different levels of the income srata;and (c)the differ ations of financial service prov viders,the users of those services,and the range of services that prevail in different geographical segments o the market.The primary objectives or the assess ment of the adequacy of access are (a)to identify the gaps that exist(and that need to be corrected)in the range of products that are available for different layers of households,microenterprises,and small businesses in various geographic markets;and (b)to assess whether the regulatory framework for finan- cial transactions helps expand or restrict access to the needed financial services. 7.2 Rationale for Assessing the Regulatory Framework for Rural Finance and Microfinance Institutions The core objectives for the regulatory framework are the sam for mi nd instinionss for ter components nd m of the over ancam However,the key principles and standards for the design of a regulatory framework for 187
187 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 7.1 Overview The providing of financial services to the poor and the very-poor, particularly in rural areas, is the purpose of microfinance institutions (MFIs), and the assessment of the regulatory framework for MFIs is part of broader assessment of adequacy of access. Access, however, is multidimensional, and assessing its adequacy requires a review of (a) the range of financial services provided—and target groups served—by several tiers of formal, semiformal, and informal financial institutions; (b) the demand for financial services from households, microenterprises, and small businesses at different levels of the income strata; and (c) the different combinations of financial service providers, the users of those services, and the range of services that prevail in different geographical segments of the market. The primary objectives of the assessment of the adequacy of access are (a) to identify the gaps that exist (and that need to be corrected) in the range of products that are available for different layers of households, microenterprises, and small businesses in various geographic markets; and (b) to assess whether the regulatory framework for financial transactions helps expand or restrict access to the needed financial services. 7.2 Rationale for Assessing the Regulatory Framework for Rural Finance and Microfinance Institutions The core objectives for the regulatory framework are the same for microfinance activities and institutions as for other components and segments of the overall financial system. However, the key principles and standards for the design of a regulatory framework for Chapter 7 Rural and Microfinance Institutions: Regulatory and Supervisory Issues
Financial Sector Assessment:A Handbook institutions providing financial services to the rural finance and microfinance sector are likely to be different from those for formal banking and finance institutions,because the design must consider the operational,market,and client characteristics of the rural finance and microfinance sector.This section focuses on the regulatory framework issues that have an important influence on access to financial services for low-income rural households. The term financial services extends bevond the traditional credit products and savings deposits facilities provided to varying degrees by different types of rural finance andmicro ce institutions.See se ion 7.3 and table 7.1 in tha organizatio and remittance services,and insurance and contractual savings products.It is important to focus on access to payments and savings products by different segments of the popula tion and the supply of those products by different institutions.Payment and savings prod. ucts are often the most important financial services for low-income households.Improved access to savings product can help households achieve higher returns on their savings and smoother cash flows,and can reduce vulnerability to external shocks. The decree and quality of access to manctal services available to low in mall bu quality of the lega framework.This fram ork should be guided by the folowing core principles of o evel playing field am ong partici of financial services beyond creditand vinfciies:(b)tolthe institutional rans ant ion of a rang formation of nontraditional and non-regulated MFIs(such as multipurpose and microcredit NGOs)into specialized,regulated,or licensed rural finance and microfinance intermediar ies;(c)to promote and reward transparency in financial accounting and transaction report- ing:and (d)to foster the exchange and sharing of credit histories of borrowing clients Available data and information show that deeper,more-efficient financial markets can contribute to accelerated agricultural growth and better food security.Scaling-up a wider of fi ces thro ediaries bec a holds me rural hous ed rang smooth enhance labe productivity,which is the mos factor controlled by the poor.Also,agriculture has strong forward and backward mult plier effects for the overall economy.Economic growth in agriculture is a key precondition for overall economic growth and poverty reduction,given that most of the world's poor still live in rural areas (Robinson 2001;Zeller 2003) There are examples of agricultural development banks,MFIs,and credit unions devel. oping strong rural portfolios,while commercial banks do not generally seem to fit this market niche as readily.Some MFIs have tried to transform fron ancial institution with notable reliable route to impro ptions,this a an general,commercial banks h nave not entered the rural and agricultural ces.In markets or a substantial scale in most developing countries,despite incentives designed to encourage downscaling and rural market penetration. In a few countries,agricultural development banks have succeeded in transforming themselves into more-sustainable institutions by offering demand-driven financial ser- 188
188 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 institutions providing financial services to the rural finance and microfinance sector are likely to be different from those for formal banking and finance institutions, because the design must consider the operational, market, and client characteristics of the rural finance and microfinance sector. This section focuses on the regulatory framework issues that have an important influence on access to financial services for low-income rural households. The term financial services extends beyond the traditional credit products and savings deposits facilities provided to varying degrees by different types of rural finance and microfinance institutions. See section 7.3 and table 7.1 in that section for a listing and discussion of various types of MFIs, including those linked to nongovernmental organizations (NGOs) and various non-bank institutions). The term includes payments, money transfer and remittance services, and insurance and contractual savings products. It is important to focus on access to payments and savings products by different segments of the population and the supply of those products by different institutions. Payment and savings products are often the most important financial services for low-income households. Improved access to savings product can help households achieve higher returns on their savings and smoother cash flows, and can reduce vulnerability to external shocks. The degree and quality of access to financial services available to low-income rural households and their small businesses is influenced by the quality of the legal and regulatory framework. This framework should be guided by the following core principles of good microfinance: (a) to provide a level playing field among participants in the provision of a range of financial services beyond credit and savings facilities; (b) to allow the institutional transformation of nontraditional and non-regulated MFIs (such as multipurpose and microcredit NGOs) into specialized, regulated, or licensed rural finance and microfinance intermediaries; (c) to promote and reward transparency in financial accounting and transaction reporting; and (d) to foster the exchange and sharing of credit histories of borrowing clients. Available data and information show that deeper, more-efficient financial markets can contribute to accelerated agricultural growth and better food security. Scaling-up access in rural markets to a wider array of financial services through a varied range of financial intermediaries becomes critical to help low-income rural households smooth consumption and enhance labor productivity, which is the most important production factor controlled by the poor. Also, agriculture has strong forward and backward multiplier effects for the overall economy. Economic growth in agriculture is a key precondition for overall economic growth and poverty reduction, given that most of the world’s poor still live in rural areas (Robinson 2001; Zeller 2003) There are examples of agricultural development banks, MFIs, and credit unions developing strong rural portfolios, while commercial banks do not generally seem to fit this market niche as readily. Some MFIs have tried to transform from nongovernmental status to a regulated, supervised financial institution; however, with notable exceptions, this has not proven to be a reliable route to improved rural outreach of financial services. In general, commercial banks have not entered the rural and agricultural credit markets on a substantial scale in most developing countries, despite incentives designed to encourage downscaling and rural market penetration. In a few countries, agricultural development banks have succeeded in transforming themselves into more-sustainable institutions by offering demand-driven financial ser-
Chapter 7:Rural and Microfinance Istittions:Regulatory and Supervisory Issues ces,buildine lendn cotracts,and using full-cost recovery interest rates.The experiences of Thailand's Bank for Agriculture and Agricultur kya t Ind a's(BRI) units in its microbanking system(Yaron and Charitoner ko 1999;Zeller 2003),and the revival and restructuring for privatization of Mongolia's Agricultural Bank(Boomgard,Boyer,and Dyer 2003)and of Tanzania's National Microfinance Bank demonstrate that state-owned banks can be transformed into dynamic,profitable,and successful rural-oriented financial intermediaries with busi- ness-oriented management reforms.Of course,such transformation of state owned banks can be achieved only with firm political commitment,ownership of reforms,management autonomy,and incentives(Zeller 2003). Group-based models have built impressive p ortfolios in rural markets gs and loan Emp 50I importance of large-scale operations,internal systems,attractive products,and portfolio quality has contributed to improvements in performance.In addition,the village banking methodology2 pioneered by FINCA International has shown,in many cases,that rura community-based and self-managed financial entities can become self-sustaining.This model was later adapted with changes by CARE,Catholic Relief Services,World Vision, and even a few commercial banks. Several MFIs have shown that they can profitably serve large numbers of relatively small busine s.Although the client base is typi ally in peri-uban marke ts or in arm sine activities in ru arkets,tho se exp riences have renewed interest in the feasibility of reorienting rural nance nance institutions.There is a growing list of MFIs that have moved beyond their initial urban client base to tailor their products to rural clients,including the Equity Building Society in Kenya,CrediAmigo,a bank-affiliated MFI in Brazil and the Development Bank of Brazil (BNDES),MiBanco in Peru,Financiera Calpia in El Salvador,and Basix India ltd.a micro-credit institution serving the rural poor in India.The experiences of these MFIs point toward the possibilities of adaptation and replication by other MFls pe ral markets The rur e and mi is small relative to the ial on the verall stability of the financia arge numbe feveloping coutries,the total loans outstanding in the rafinanceandm sector was about 1 percent of broad money supply (M2),with this sector reaching fewer than l percent of the population as clients.A handful of countries stand out from the rest with higher levels of microfinance outreach and penetration,especially in Indonesia(6.5 percent):Thailand(6.2 percent);Vietnam and Sri Lanka(4.5 percent);Bangladesh and Cambodia (3.0 percent):Malawi (2.5 percent):and Bolivia,El Salvador,Honduras,India and Nicaragua (at 1.0 7.3 Institutional Providers of Rural Finance and Microfinance Services The distinction betweer microfinance and small and medium enterprise(SME)finance and the recognition of the different types of financial institutions catering to those 189
189 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 vices, building credible lending contracts, and using full-cost recovery interest rates. The experiences of Thailand’s Bank for Agriculture and Agricultural Cooperatives (BAAC, Bank Rakyat Indonesia’s (BRI) village units in its microbanking system (Yaron and Charitonenko 1999; Zeller 2003), and the revival and restructuring for privatization of Mongolia’s Agricultural Bank (Boomgard, Boyer, and Dyer 2003) and of Tanzania’s National Microfinance Bank demonstrate that state-owned banks can be transformed into dynamic, profitable, and successful rural-oriented financial intermediaries with business-oriented management reforms. Of course, such transformation of state owned banks can be achieved only with firm political commitment, ownership of reforms, management autonomy, and incentives (Zeller 2003). Group-based models have built impressive portfolios in rural markets; savings and loan cooperatives and credit unions have grown rapidly in diverse settings.1 Emphasis on the importance of large-scale operations, internal systems, attractive products, and portfolio quality has contributed to improvements in performance. In addition, the village banking methodology2 pioneered by FINCA International has shown, in many cases, that rural community-based and self-managed financial entities can become self-sustaining. This model was later adapted with changes by CARE, Catholic Relief Services, World Vision, and even a few commercial banks. Several MFIs have shown that they can profitably serve large numbers of relatively poor households, microenterprises, and small businesses. Although the client base is typically in peri-urban markets or in off-farm business activities in rural markets, those experiences have renewed interest in the feasibility of reorienting rural finance and microfinance institutions. There is a growing list of MFIs that have moved beyond their initial urban client base to tailor their products to rural clients, including the Equity Building Society in Kenya, CrediAmigo, a bank-affiliated MFI in Brazil and the Development Bank of Brazil (BNDES), MiBanco in Peru, Financiera Calpia in El Salvador, and Basix India Ltd, a micro–credit institution serving the rural poor in India. The experiences of these MFIs point toward the possibilities of adaptation and replication by other MFIs operating in predominantly rural markets. The rural finance and microfinance sector is small relative to the commercial financial sector, with limited effect on the overall stability of the financial system. In a large number of developing countries, the total loans outstanding in the rural finance and microfinance sector was about 1 percent of broad money supply (M2), with this sector reaching fewer than 1 percent of the population as clients. A handful of countries stand out from the rest with higher levels of microfinance outreach and penetration, especially in Indonesia (6.5 percent); Thailand (6.2 percent); Vietnam and Sri Lanka (4.5 percent); Bangladesh and Cambodia (3.0 percent); Malawi (2.5 percent); and Bolivia, El Salvador, Honduras, India, and Nicaragua (at 1.0 percent or slightly more) (Honohan 2004).3 7.3 Institutional Providers of Rural Finance and Microfinance Services The distinction between microfinance and small and medium enterprise (SME) finance and the recognition of the different types of financial institutions catering to those
Financial Sector Assessment:A Handbook segments are sment of the adequacy of access and the effect of regulation.While different categories of borrowers often face similar constrant.lend. ers commonly distinguish between microfinance,which refers to credit provided to poor households and to informal (i.e.,unregistered)microenterprises,and SME finance,which refers to credit given to enterprises registered as large microenterprises,small businesses and medium-size nt mportant differences between the two categorie of bo rower Microfinance is most often provided by non-bank institutions such as NGO MFIs s tha are often based on the group-lending approach (although numerous microfinance loans may consist of loans to individuals rather than to groups),as well as various membership based financial cooperatives and mutual-assistance associations.SME finance is provided mainly by banks,building societies,and non-bank financial institutions(NBFIs)and doe no a group-lendir ng approach.An mportant differen is almost never formally secured,alth secunty enot legally bindi the form of collateral interest over household goods and tools is commonly used,whil SME finance usually allows a firm's assets or personal guarantees to legally secure small business loans.those differences create a natural senaration between the institutions that specialize mainly in microfinance and the institutions that provide small business loans, although some stitutions do ovide both kinds of finan oviders of f cial services to low-income rural households,micro terprises,and small businesses fall into several categories according to the scope of regula tion,type of ownership,and type of services offered.The institutions can be differentiated on(a)whether they are required to obtain a license to carry out financial intermediation activities,to be registered with some central agency (but not required to obtain a license) that will provide nondeposit credit-only services,or to be registered as a legal entity;(b) what typ mat,includin owners spects,they have;and (c)what types of financial services are permitted and provided.The principa categories are .government programs or agencies for rural finance,microfinance,or SME finance .non-bank.nonprofit NGO MFls membership-based cooperative financial institutions(CFIs) ngs banks(PSBs)or institutions ance institution specialized ban ing institutions (usually licensed for limited I operations,activities or services to differentiate them from full-service commercial banks)such as rural banks,microfinance banks,and non-bank finance companies ●.commercial banks key differences in the organization and operation of those different institutions are highlighted in table 7.1.The institutions differ in terms of what products and services they are allowed by law and regulation to offer;whether they are subject to rigorou prudential regulation,internal governance structure,and accountability;and how funds for administrative and business operations are sourced.The differences arise from the applicability of legal and regulatory requirements,and those differences have important 190
190 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 segments are important to the assessment of the adequacy of access and the effect of regulation. While different categories of borrowers often face similar constraints, lenders commonly distinguish between microfinance, which refers to credit provided to poor households and to informal (i.e., unregistered) microenterprises, and SME finance, which refers to credit given to enterprises registered as large microenterprises, small businesses, and medium-size enterprises. There are several important differences between the two categories of borrowers. Microfinance is most often provided by non-bank institutions such as NGO MFIs that are often based on the group-lending approach (although numerous microfinance loans may consist of loans to individuals rather than to groups), as well as various membershipbased financial cooperatives and mutual-assistance associations. SME finance is provided mainly by banks, building societies, and non-bank financial institutions (NBFIs) and does not use a group-lending approach. Another important difference is security: Microfinance is almost never formally secured, although informal security (i.e., not legally binding) in the form of collateral interest over household goods and tools is commonly used, while SME finance usually allows a firm’s assets or personal guarantees to legally secure small business loans. Those differences create a natural separation between the institutions that specialize mainly in microfinance and the institutions that provide small business loans, although some institutions do provide both kinds of finance services. Institutional providers of financial services to low-income rural households, microenterprises, and small businesses fall into several categories according to the scope of regulation, type of ownership, and type of services offered. The institutions can be differentiated on (a) whether they are required to obtain a license to carry out financial intermediation activities, to be registered with some central agency (but not required to obtain a license) that will provide nondeposit credit-only services, or to be registered as a legal entity; (b) what type of organizational format, including ownership and governance aspects, they have; and (c) what types of financial services are permitted and provided. The principal categories are • government programs or agencies for rural finance, microfinance, or SME finance • non-bank, nonprofit NGO MFIs • membership-based cooperative financial institutions (CFIs) • postal savings banks (PSBs) or institutions • development finance institutions • specialized banking institutions (usually licensed for limited operations, activities, or services to differentiate them from full-service commercial banks) such as rural banks, microfinance banks, and non-bank finance companies • commercial banks Key differences in the organization and operation of those different institutions are highlighted in table 7.1. The institutions differ in terms of what products and services they are allowed by law and regulation to offer; whether they are subject to rigorous prudential regulation, internal governance structure, and accountability; and how funds for administrative and business operations are sourced. The differences arise from the applicability of legal and regulatory requirements, and those differences have important
Chapter 7:Rural and Microfinance Instittions:Regulatory and Supervisory Issues Table 7.1.Institutional Providers of Financial Services Financial services Institutional provider 0r9a6mnal Ownership Regbatontatne P8eoied Trust fund or agency Government g8ncegrogran ns o NoNe8nMeproil n y Membrship-sd Savings and Members rmatenSACco Government and tin Specialized banking institutions Rural banks Microfinance banks taan Commercial banks com bybanngrnenmeo andimdands full banking implications for the outreach and sustainability of the institutions.For indicators of struc- ture,outreach.and performance of MFls.see box 7.1. Not all institutional providers of financial services listed in table 7.1 may exist in a n a number portant ons,including the stage of develo be provide by several types. ance and 7.3.1 Governm nt Rural Finance,Microfinance,or SME Finance Programs The direct provision of rural finance,microfinance,and SME finance loans and credit facilities by government agencies or programs should be noted and examined in the assessment of adequacy of access.Those government programs usually have an unfair
191 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 implications for the outreach and sustainability of the institutions. For indicators of structure, outreach, and performance of MFIs, see box 7.1. Not all institutional providers of financial services listed in table 7.1 may exist in a given country for a number of important reasons, including the stage of development of the rural finance and microfinance sector. In a number of countries, rural finance and microfinance services may be provided by several types of institutions. 7.3.1 Government Rural Finance, Microfinance, or SME Finance Programs or Agencies The direct provision of rural finance, microfinance, and SME finance loans and credit facilities by government agencies or programs should be noted and examined in the assessment of adequacy of access. Those government programs usually have an unfair Table 7.1. Institutional Providers of Financial Services Institutional provider Organizational format Ownership Regulatory status and how regulated Financial services permitted to be offered Government rural or micro or SME finance programs or agencies Trust fund or agency Government Not regulated by banking authority Wholesale or onlending funds to participating institutions Non-bank/nonprofit/ NGO MFIs Nonprofit foundation, trust, or association Private sector entities or organizations Not regulated by banking authority Microfinance loans only; no voluntary deposits Membership-based cooperative financial institutions (CFIs) Savings and credit cooperative organization (SACCO) or credit union Members Not regulated by banking authority, but may be regulated by department in cooperative Savings and time deposits and loans to members only Postal savings banks (PSBs) State-chartered institution Government Not regulated by banking authority Savings and time (fixed) deposits only and money transfers Development finance institutions State-chartered institution Government May or may not be regulated by banking authority Wholesale certificates of deposit, loans, and credits Specialized banking institutions Rural banks Limited liability company Private sector investors or shareholders Licensed or supervised by banking authority Savings and time deposits, loans, and money transfers Microfinance banks Limited liability company Private sector investors or shareholders Licensed or supervised by banking authority Savings deposits, microfinance loans, and money transfers Non-bank finance companies Limited liability company Private sector investors or shareholders Licensed but not necessarily supervised by banking authority Wholesale certificates of deposit, loans, and credits Commercial banks Limited liability company Private sector investors or shareholders, or state-owned institution Licensed or supervised by banking authority Demand and savings and time deposits, loans, credits, money transfers, and foreign exchange; full banking services
Financial Sector Assessment:A Handbook Box 7.1 Benchmarks for Outreach and Financial Performance and Soundness of Rural Finance and Microfinance Institutions and product (GNP)per capita and (b)national poverty income level an of equty to deb ratio of ge total loans outstanding to d ne (marke liabili ndness () rks can be vices as a percentage of administrative and fron loans,invest .Breadth and depth of ou L number of de it accounts(because tative and operating expe nt rat n 30 day number of active borrowers,and asa as a perc competitive advantage over and tend to crowd out the private sector-based providers of similar financial services to households,microenterprises,and small businesses.In a number of countries,state-owned development finance institutions or specialized banks are the institutional vehicles used.The key issues to address in the assessment.aside from whether the institutional vehicles are reaching their target sector or client base and have,in fact,contributed to the development and expansion of the target sector,are (a)efficiency of loan collection,(b)incidence of loan defaults and adequacy of loan-loss ver operating lo 7.3.2 Non-bank,Non-profit NGO MFls ose NGOs that have credit ecalecdc redit-only MFls.Tho 192
192 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 competitive advantage over and tend to crowd out the private sector-based providers of similar financial services to households, microenterprises, and small businesses. In a number of countries, state-owned development finance institutions or specialized banks are the institutional vehicles used. The key issues to address in the assessment, aside from whether the institutional vehicles are reaching their target sector or client base and have, in fact, contributed to the development and expansion of the target sector, are (a) efficiency of loan collection, (b) incidence of loan defaults and adequacy of loan-loss provisions, (c) claims on budgetary or fiscal resources for loan guarantees and additional capital to cover operating losses, and (d) level of solvency or insolvency. 7.3.2 Non-bank, Non-profit NGO MFIs Non-bank, non-profit NGO MFIs include (a) mixed-purpose NGOs that have credit provisions in their socially oriented activities and (b) specialized credit-only MFIs. Those MFIs are generally private sector-owned institutions and are typically organized as nonBox 7.1 Benchmarks for Outreach and Financial Performance and Soundness of Rural Finance and Microfinance Institutions Standards and indicators for the breadth and depth of outreach, the operating and financial performance, and the financial soundness of rural finance and microfinance institutions have been developed by an international network of donors and practitioners. Those standards and indicators have been adopted by prudential supervisory agencies and regulatory authorities in a number of countries. Among the more prominent examples are the standards and indicators developed and detailed in the monitoring systems developed by ACCION International (ACCION “CAMEL”), World Council of Credit Unions (WOCCU “PEARLS”) and Microfinance Information eXchange (MIX). For purposes of comparison with and reference to best practices, the benchmarking standards published periodically by WOCCU, MIX (MicroBanking Bulletin), MicroRate, and Microfinance Centre for Central and Eastern Europe (CEE) and the Newly Independent States (NIS) are easily accessible. Those benchmarks can be useful in carrying out the assessment of adequacy of access for rural finance and microfinance institutions, and are summarized here. • Breadth and depth of outreach − number of deposit accounts (because some institutions such as postal savings banks [PSBs] provide only deposit services) − number of active borrowers, and as a percentage of total population and of population at or below poverty line − average loan balance or amount per borrower, and as a percentage of (a) gross national product (GNP) per capita and (b) national poverty income level • Financial structure − ratio of institutional capital to average total assets − ratio of equity to debt − ratio of average total loans outstanding to average total assets − commercial funding (market-price liabilities) as a percentage of gross loan portfolio • Overall financial performance and soundness − adjusted Return on Assets (ROA) − adjusted Return on Equity (ROE) − operational self-sufficiency (revenue from loans, investments, and other financial services as a percentage of administrative and operating expenses) − financial self-sufficiency (revenue from loans, investments, and other financial services as a percentage of financial or interest expenses, loan-loss provisions, and administrative and operating expenses) − on-time loan repayment rate − portfolio at risk overdue greater than 30 days as a percentage of gross loan portfolio − loan–loss reserve as a percentage of portfolio at risk overdue greater than 30 days
Chapter 7:Rural and Microfinance Instittions:Regulatory and Supervisory Issues 心n nies Act.Some MFIs are stand others may be affiliated with or sponsored by intema tional NGOs such as FINCA,CARE,Catholic Relief Services,World Vision,ACCION International,and Women's World Banking.The geographical reach of their operations vary depending on their organizational and legal status and on the type of NGO sponsor with some MFIs operating only at the district or county level others on a province-wide or region-wide basis,and a few on a nationwide scale. 7.3.3 Membership-Based CFls associations (e.g.,producers,services,marketing and rura savings and credit functions;and (b)singl membership-based,financial cooperative organi ns (e.g credit unions and savings and credit cooperative organizations [SACCOs]).CFls,which have been in existence in many countries much longer than non-bank,nonprofit NGO MFls,are clearly distin. guishable from the NGO MFIs in that their financial transactions (deposit taking and credit giving)are generally limited to registered members under a closed-or open-com- mon bond typically defined by geography (residence),occupation,or place of employ ts and pri vileg in CFls a and m ment is exercised b owners.In gene I CFIs wil umber MFin many countreand their sombned outrechill tend to b member larger as well 7.3.4 Postal Savings Banks A PSB has the ability to reach a very large number of depositors for savings and time deposits in generally small amounts,and to provide payments and transfer or remittance services,particularly in the rural areas in a number of countries,including Azerbaijan Kenya,Pakistan,and Tanzania.However,PSBs are limited to deposit-taking and payment es and do nd credit PSBs e intended primari ovide a safe and se mall savings of poo r and I eholds,especially in rural area even though the management and boards of PSBs may be tempted to expand into rura finance and microfinance lending services to improve earnings.In practice,the priority should be on improving efficiency,cost-effectiveness,and governance before broadening the asset portfolio beyond safe assets such as bank deposits and government issues. 7.3.5 Development Finance Institutions In many countries,Development Finance Institutions (DFIs)have been established and pital ine cted prim the gaps in the of fin a services t at are not normally provided by the banking institutions.The DFIs also play a crucial role in the development of SMEs,the housing sector,and in some countries micro
193 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 profit foundations, trusts, or associations. In a number of cases, the MFIs are organized as formally incorporated entities under a country’s Companies Act. Some MFIs are stand-alone local entities, while others may be affiliated with or sponsored by international NGOs such as FINCA, CARE, Catholic Relief Services, World Vision, ACCION International, and Women’s World Banking. The geographical reach of their operations vary depending on their organizational and legal status and on the type of NGO sponsor, with some MFIs operating only at the district or county level others on a province-wide or region-wide basis, and a few on a nationwide scale. 7.3.3 Membership-Based CFIs CFIs are (a) multipurpose cooperative associations (e.g., producers, services, marketing, and rural cooperatives) that include savings and credit functions; and (b) single-purpose, membership-based, financial cooperative organizations (e.g., credit unions and savings and credit cooperative organizations [SACCOs]). CFIs, which have been in existence in many countries much longer than non-bank, nonprofit NGO MFIs, are clearly distinguishable from the NGO MFIs in that their financial transactions (deposit taking and credit giving) are generally limited to registered members under a closed- or open-common bond, typically defined by geography (residence), occupation, or place of employment. The rights and privileges of ownership in CFIs are based on the one person–one vote principle, and management is exercised by members–owners. In general, CFIs will outnumber NGO MFIs in many countries, and their combined outreach will tend to be larger as well. 7.3.4 Postal Savings Banks A PSB has the ability to reach a very large number of depositors for savings and time deposits in generally small amounts, and to provide payments and transfer or remittance services, particularly in the rural areas in a number of countries, including Azerbaijan, Kenya, Pakistan, and Tanzania. However, PSBs are limited to deposit-taking and payment services and do not extend credit. PSBs are intended primarily to provide a safe and secure facility for the small savings of poor and low-income households, especially in rural areas, even though the management and boards of PSBs may be tempted to expand into rural finance and microfinance lending services to improve earnings. In practice, the priority should be on improving efficiency, cost-effectiveness, and governance before broadening the asset portfolio beyond safe assets such as bank deposits and government issues. 7.3.5 Development Finance Institutions In many countries, Development Finance Institutions (DFIs) have been established and funded by the Government to develop and promote certain strategic sectors of the economy (e.g., highly capital intensive investments, the agricultural sector) and to achieve social goals. DFIs are expected primarily to fill in the gaps in the supply of financial services that are not normally provided by the banking institutions. The DFIs also play a crucial role in the development of SMEs, the housing sector, and in some countries micro-
Financial Sector Assessment:A Handbook credit.The key issue to monitor is the extent towhich DFIs are accorded special benefits in the form of funding at lower rates,implicit government guarantees to the institutions's debts,favourable tax treatment etc. 7.3.6 Specialized Banking Institutions The regulatory framework for banking and finance in a number of countries also cov- ers lower-tier licensed banks that have the legal capability for deposit-taking activities (generally limited to savings and fixed deposits)and for providing loans,but the capabil- ity excludes tus and in ment service sand foreign nge rading faciliti ,banking activities may be limited ion).Th the geographica t area tha is serviced (county or distri ct,province,or re limited-servic tions,(e.g.,rural banks and microfinance banks)are subject to prudential supervision by a country's central supervisory authority,and they are required to comply with reporting requirements and with applicable prudential standards.Non-bank finance companies involved in rural finance microfinance and Sme finance-which do not take rerail public deposits but are permitted to fund their operations and loan portfolios through cial bor wholesale,large value tional dep are red to regis and to obtain a license.However,th iynveibyacontrscenalsupenioyauthori se companies may not be pru 7.3.7 Commercial Banks Commercial banks may have direct participation in low-income markets as a result of their complying with directed or credit quota policies of goverment for targeted sectors. Sometimes.hanks have indirect involvement in rural and microfinance as depositories of the operating funds of mels and cels or they have involyement through commercially priced wholesale loans and credit facilities to MFIs and CFIs as bank clients.An important area to focus on is the existence of vertical and horizontal busine ss relationships betweer nercial banks,on the one hand,and MFIs and on the of this point stemsfrom the synergistic relationships that the smaller CFls can form with the larger commercial institutions from the formal sector,whereby the comb nation can reach a larger number of clients with resources than may be obtained from the latter large institution at commercial-not subsidized-rates and terms. 7.4 Conceptual Framework for the Regulation of Rural Finance and Microfinance Institutions lated of all types (a)topro vide se on a sustainable basis under uniforr and (b)to ntial regulat oencourage the regular ry autho ns and staff capacity that are ta lored to th institutions'operational and risk profiles.This objective requires defining different tiers of financial institutions with different degrees of regulatory requirements.The requirements could vary from (a)simply registering as legal entities,to (b)preparing and publishing 194
194 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 credit. The key issue to monitor is the extent to which DFIs are accorded special benefits in the form of funding at lower rates, implicit government guarantees to the institutions’s debts, favourable tax treatment etc. 7.3.6 Specialized Banking Institutions The regulatory framework for banking and finance in a number of countries also covers lower-tier licensed banks that have the legal capability for deposit-taking activities (generally limited to savings and fixed deposits) and for providing loans, but the capability excludes trust and investment services and foreign exchange or trading facilities. In some countries, banking activities may be limited to the geographical market area that is serviced (county or district, province, or region). The limited-service banking institutions, (e.g., rural banks and microfinance banks) are subject to prudential supervision by a country’s central supervisory authority, and they are required to comply with reporting requirements and with applicable prudential standards. Non-bank finance companies involved in rural finance, microfinance, and SME finance—which do not take retail public deposits but are permitted to fund their operations and loan portfolios through commercial borrowings and wholesale, large-value, institutional deposits—are generally required to register and to obtain a license. However, those companies may not be prudentially supervised by a country’s central supervisory authority. 7.3.7 Commercial Banks Commercial banks may have direct participation in low-income markets as a result of their complying with directed or credit quota policies of government for targeted sectors. Sometimes, banks have indirect involvement in rural and microfinance as depositories of the operating funds of MFIs and CFIs, or they have involvement through commercially priced wholesale loans and credit facilities to MFIs and CFIs as bank clients. An important area to focus on is the existence of vertical and horizontal business relationships between commercial banks, on the one hand, and MFIs and CFIs, on the other. The importance of this point stems from the synergistic relationships that the smaller MFIs and CFIs can form with the larger commercial institutions from the formal sector, whereby the combination can reach a larger number of clients with resources than may be obtained from the latter large institution at commercial—not subsidized—rates and terms. 7.4 Conceptual Framework for the Regulation of Rural Finance and Microfinance Institutions The aim of a supportive regulatory framework is to build strong regulated and unregulated institutions of all types (a) to provide services on a sustainable basis under uniform, common, shared performance standards and (b) to encourage the regulatory authority to develop appropriate prudential regulations and staff capacity that are tailored to the institutions’ operational and risk profiles. This objective requires defining different tiers of financial institutions with different degrees of regulatory requirements. The requirements could vary from (a) simply registering as legal entities, to (b) preparing and publishing
Chapter 7:Rural and Microfinance Instittions:Regulatory and Supervisory Issues orudential tules conductin iness operati g subject to eevisionorbothby a cen tral supervisory authority.Lower-tiers institutions serving the lower end of the market can enable non-bank microlenders to seek greater formalization without actual licensing. As the rural finance and microfinance sector grows,adding a licensing tier that per mits MFls to legally mobilize savings and other commercial sources of funds can encourage capacity building and innovation that are aimed at self-sufficiency and greater outreach. Another approach that has been used is to open a special window for micro-lending as a enables commercial banks,as well as alternative specialized institutions,to cost and regulator structures.Licensing of rural and c anks can also facilitate the emergence However,the prema ew type tion of spec of MEls that tiers with easy entry m tutions,may affect the development of the commercial financial system,and may risk 7 overwhelming inadequate supervisory resources. Thus,the licensing of MFls should be designed to balance promotional and pruden tial obiectives.The main potential threats pertaining to deposit-taking mels are that (a) deposit-taking MFIs could collapse,thus adversely affecting the commercial system,and that (b)prudential regulation of deposit-taking mels could prove to be an administrative burden that distracts supervisors from adequately prorecting the safety and soundness of the main fina ial s .The Consult roup to Assistthe p idelines (Christen, yman, 00) 】view,arguing that leposit taking on a sm scale may essentially go unsupe -especially where the deposits consist of only force I-savings components of the ending product,so that most depositors are net borrowers from the MFI at most times This approach would leave the supervisory apparatus unencumbered from having to deal in-depth with a profusion of tiny MFls. A consensus on the framework for the regulation of rural finance and microfinance institutions has evolved on the basis of country experiences in recent years.This frame work (summarized in table 7.2)identifies differe t cate ories and tiers of institutional cifies the the nee ed for progr ely ronger types of regulation ands supervi sion. The legal and regulatory framework for banking and finance in many countries ma not include lower tiers for rural finance and microfinance banks.Some countries may be in the process of establishing the legal and regulatory framework specifically to create new tiers for rural finance or microfinance banks,which usually have a limited geographical coverage specified by law.Regulation of microfinance activities and institutions may take three main forms:(a)simple registration as a legal entity;(b)non-prudential regula tions that provide standards of business operations and oversight,such as operating and financial r clal reports to be submitted,to protect the interests of clients or members;and Global oce ill tes that the benefits ce may be limited when commercial bankin dards s are applied to MFI Non-ioof inance nance companies and other types of registered institutions providing rura finance and microfinance services are not subject to statutory prudential regulation and 195
195 Chapter 7: Rural and Microfinance Institutions: Regulatory and Supervisory Issues 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 periodic reports on operations and financial results, to (c) observing non-prudential rules of conduct in business operations, to (d) securing a proper license and being subject to prudential regulation by a regulatory authority, prudential supervision, or both by a central supervisory authority. Lower-tiers institutions serving the lower end of the market can enable non-bank microlenders to seek greater formalization without actual licensing. As the rural finance and microfinance sector grows, adding a licensing tier that permits MFIs to legally mobilize savings and other commercial sources of funds can encourage capacity building and innovation that are aimed at self-sufficiency and greater outreach. Another approach that has been used is to open a special window for micro-lending as a product that enables commercial banks, as well as alternative specialized institutions, to benefit from different cost and regulatory structures. Licensing of rural and community banks can also facilitate the emergence of new types of MFIs that serve specific markets. However, the premature creation of special tiers with easy entry may result in weak institutions, may affect the development of the commercial financial system, and may risk overwhelming inadequate supervisory resources.4 Thus, the licensing of MFIs should be designed to balance promotional and prudential objectives. The main potential threats pertaining to deposit-taking MFIs are that (a) deposit-taking MFIs could collapse, thus adversely affecting the commercial system, and that (b) prudential regulation of deposit-taking MFIs could prove to be an administrative burden that distracts supervisors from adequately protecting the safety and soundness of the main financial system. The Consultative Group to Assist the Poorest (CGAP) Microfinance Consensus Guidelines (Christen, Lyman, and Rosenberg 2003) takes a balanced view, arguing that deposit taking on a small scale may essentially go unsupervised—especially where the deposits consist of only forced-savings components of the lending product, so that most depositors are net borrowers from the MFI at most times. This approach would leave the supervisory apparatus unencumbered from having to deal in-depth with a profusion of tiny MFIs. A consensus on the framework for the regulation of rural finance and microfinance institutions has evolved on the basis of country experiences in recent years. This framework (summarized in table 7.2) identifies different categories and tiers of institutional providers of microfinance, and it specifies the thresholds of financial intermediation activities that trigger the need for progressively stronger types of regulation and supervision. The legal and regulatory framework for banking and finance in many countries may not include lower tiers for rural finance and microfinance banks. Some countries may be in the process of establishing the legal and regulatory framework specifically to create new tiers for rural finance or microfinance banks, which usually have a limited geographical coverage specified by law. Regulation of microfinance activities and institutions may take three main forms: (a) simple registration as a legal entity; (b) non-prudential regulations that provide standards of business operations and oversight, such as operating and financial reports to be submitted, to protect the interests of clients or members; and (c) full prudential supervision. Global experience illustrates that the benefits from regulating microfinance may be limited when commercial banking standards are applied to MFIs without adequate consideration of microfinance methodologies. Non-bank finance companies and other types of registered institutions providing rural finance and microfinance services are not subject to statutory prudential regulation and
Financial Sector Assessment:A Handbook Table 7.2.Tiered Structures and Regulatory Triggers by Type of MFl Activities None None required None required None if total loans do not and cum ation A registrar of c com g8geoenend Category CSpeciaicnd wholesae and am8gaMoacpeatiresoy te on into loans and quirements work for the classi ally proposed by van Greuning,Galla rdo,and Rand habi fie sou undin gory B have a long but i ire man atory s re loa eintafopeheow8nrnigosancen8teaapeg0heopeehic98atOreeof2sa8gmetorthehancasiem ao supervision by a central supervisory authority,because they do not mobilize retail deposits from the public and intermediate those deposits into loans and investments.Nevertheless, such institutions should observe and adhere to a set of rules and standards with respect to the conduct of their business operations toprovide prorection for their borrowing custom er orhr-partypovefhmthuh fund providers and institutional investors are presumed to be well informed and to be capable of any required due diligence.An overview of desirable standards for conduct of business is provided in box 7.2. 7.5 Assessment of the Regulatory Framework Issues for Rural Finance and Microfinance Institutions The ass nt of the regulatory framework for the rural finance and microfinance secto covers both the institutional aspects and the benchmarks used to evaluate the sector's per formance and soundness.The considerations include(a)assessing the need for prudential supervision versus non-prudential regulation and for the technical capacity for supervi- 196
196 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 supervision by a central supervisory authority, because they do not mobilize retail deposits from the public and intermediate those deposits into loans and investments. Nevertheless, such institutions should observe and adhere to a set of rules and standards with respect to the conduct of their business operations to provide protection for their borrowing customers and for third-party providers of wholesale commercial funds, even though commercial fund providers and institutional investors are presumed to be well informed and to be capable of any required due diligence.5 An overview of desirable standards for conduct of business is provided in box 7.2. 7.5 Assessment of the Regulatory Framework Issues for Rural Finance and Microfinance Institutions The assessment of the regulatory framework for the rural finance and microfinance sector covers both the institutional aspects and the benchmarks used to evaluate the sector’s performance and soundness. The considerations include (a) assessing the need for prudential supervision versus non-prudential regulation and for the technical capacity for superviTable 7.2. Tiered Structures and Regulatory Triggers by Type of MFI Type of microfinance institution (MFI) Activities that trigger regulation Forms of external regulation Recommended regulatory authority Informal savings and credit groups funded by members fees and savings None None required None required Category A: Nongovernmental organizations (NGOs) funded by donor funds Category A1: Funding only from grants None, if total loans do not exceed donated funds, grants, and accumulated surplus Registration as a nonprofit society, association, or trust A registrar of societies or selfregulating body, if any Category A2: Funding from donor grants and from commercial borrowings or securities issues Generating liabilities through borrowings to fund microloan portfolio and operations Registration as a legal corporate entity; authorization by a banking authority or securities commission A registrar of companies, banking authority, or securities agency Category B: Financial cooperatives and credit unions funded members’ money and savings Accepting deposits from and making loans to members Registration as a financial cooperative A registrar of cooperatives or banking authority Category C: Special-licensed banks and MFIs funded by the public’s money (deposits, investor capital, and commercial borrowings) Accepting wholesale and retail public deposits for intermediation into loans and investments Registration as a corporate legal entity; licensing as a finance company or bank (with full prudential requirements) A registrar of cooperatives or banking authority Note: This regulatory framework for the classification of MFIs was originally proposed by van Greuning, Gallardo, and Randhawa (1999) and modified by Randhawa (2003). Except for informal groups, MFIs are classified into four categories that are based on the structure of their liabilities (i.e., sources of funding). Cooperatives in category B have a long but inefficient history of regulation. If their deposit taking is small in scale and limited to their members, they should be given low regulatory priority. Category C should not include MFIs that require mandatory savings to secure loans as long as most customers are net borrowers most of the time. Formal banks with a microfinance department are not included in this regulatory framework because they are subject to prudential supervision, even if it is usually not adapted to the specific features of this segment of the financial system
