Basics of Regulation

In this Section

This section is a short guide to the basic issues in the regulation and supervision of microfinance, providing insight into:

These issues encompass the major areas to consider in deciding when and how to regulate microfinance.

Take an in-depth look at how to approach the regulation and supervision of microfinance developed in consultation with regulators, legal counsels, practitioners and donors.

» Download the Microfinance Consensus Guidelines: Guiding Principles on Regulation and Supervision of Microfinance (264 KB, PDF)
» Download the Consensus Guidelines abstract (116 KB, PDF)

Regulation refers to the set of government rules (including laws, regulations, and their implementation) that apply to microfinance. It aims at overseeing the financial soundness of licensed intermediaries’ businesses in order to prevent financial system instability and losses to depositors.

Supervision is the process of ensuring compliance with those rules.

For definitions of other commonly used phrases, go to the Glossary.

Regulation is "prudential" when it is aimed specifically at protecting the financial system as a whole as well as protecting the safety of small deposits in individual institutions. When a deposit-taking institution becomes insolvent, it cannot repay its depositors. If it is a large institution, its failure can undermine confidence enough so that the banking system suffers a run on deposits. Therefore, prudential regulation involves the government in attempting to protect the financial soundness of the regulated institutions.

Prudential regulation is relatively difficult, intrusive, and expensive because it involves understanding and protecting the core health of an institution.

"Non-prudential" rules encompass regulations about the institution’s business operations, and as such do not have the ultimate aim of protecting the entire financial system. These rules tend to be easier to administer because government authorities do not have to take responsibility for the financial soundness of the organization. These issues include, among others, the formation and operation of microlending institutions; consumer protection; fraud and financial crimes prevention; credit information services; interest rate policies; limitations on foreign ownership, management, and sources of capital; tax and accounting issues; and a variety of cross-cutting issues surrounding transformations from one institutional type to another.

Based on experience in various countries, there is consensus that prudential regulation of microfinance may NOT be appropriate under the following circumstances:

Where safety of deposits is not at risk
Prudential regulation is needed only when there are depositors to protect, so it is not appropriate for credit-only MFIs that fund themselves from donors or commercial loans. Such MFIs may require relatively light non-prudential regulation.

For small community-based organizations
Some community-based deposit-taking organizations are so small or remote that effective prudential supervision would be too expensive.

While unsupervised deposit–taking institutions are risky, other options that clients use for savings may be even riskier, so shutting down such organizations may not improve depositor safety. Abundant studies show that poor people can and do save - using vehicles such as storing currency under the mattress, purchasing livestock or building materials, or making informal arrangements like rotating savings and credit clubs. All of these vehicles are often more risky than a formal account in a small, unsupervised intermediary.

Most regulators facing the question have decided to let these small intermediaries operate without prudential regulation and supervision, as long as their assets and number of clients remain below defined size limits.

In the absence of a critical mass of profitable MFIs
To take deposits safely, MFIs have to be profitable enough to cover their costs, including the financial and administrative costs of the deposits they collect. Otherwise, losses will eventually erode depositors’ money. It may make sense to wait until a critical mass of MFIs meets this qualification before setting up a licensing regime for microfinance.

In countries that have implemented microfinance regulation smoothly and effectively, the regulation has tended to follow rather than lead the development of the industry.

Many countries have approached the regulation of microfinance by creating new, specialized institutional types. In some settings, this can be the best option, especially when the existing financial framework does not have an existing financial license that would accommodate microfinance, or, as in many places in Eastern Europe and Central Asia, when microlending activities may be illegal under existing law. There is some danger that too exclusive a focus on a particular institutional form will cramp innovation and competition, and impede the integration of microfinance into the broader financial sector.

Incorporating the new institutional form within the existing financial sector framework will increase the likelihood that the regulatory changes are properly harmonized with the existing regulatory landscape. This can also reduce potential ambiguities between different pieces of legislation and may be easier from a technical point of view. However, local factors will determine the feasibility of this approach.

Finally, much can be learned from the experiences of other countries’ approaches to regulating microfinance. This overview of comparative approaches can help.

Regardless of whether a new institutional form is created or whether microfinance activity is conducted across the financial system, regulators will need to put special regulations into place that accommodate the uniqueness of microfinance activity.

First, some definition of the term "microfinance" is needed to distinguish it from commercial or consumer finance. Such definitions are usually based on lending activity, and may include items such as:

Loan size limits
An upper limit on loan size is often specified. A more nuanced approach might be to specify that a microfinance loan portfolio must contain no loan above X, and Y percent of the loans must be below Z.
Microentrepreneurs as borrowers
When defining microcredit this way, the law or regulation should not require that loan proceeds be necessarily used for microenterprise purposes, because MFIs cannot effectively control the use of loan proceeds.
Credit decisions
Credit decisions are based primarily on the borrower’s character and (business or household) cashflow, rather than collateral. Note that this does not preclude the use of collateral in all cases.

Second, some regulations may need to be changed for microfinance portfolios

Capital adequacy ratios
A number of factors support mandating tighter capital adequacy requirements for specialized MFIs than the requirements applied to commercial banks. For example, well-managed MFIs maintain excellent repayment performance, with delinquency typically lower than in commercial banks. However, MFI portfolios tend to be more volatile than commercial bank portfolios, and can deteriorate rapidly because they are usually unsecured. The borrower’s main incentive to repay a microloan is the expectation of access to future loans. Thus, outbreaks of delinquency in an MFI can be contagious. The incentive of borrowers to continue paying declines because it is less likely that the MFI will be able to reward them with future loans. In addition, an MFI’s costs are usually much higher than a commercial bank’s costs per unit lent, so that a given level of delinquency will decapitalize an MFI much more quickly than it would decapitalize a typical bank.
Minimal capital requirements
There may be a need to ration the number of licenses that need supervision. There is a direct trade-off between the number of new institutions licensed and the likely effectiveness of the supervision they will receive. The most common tool for drawing this balance is minimum capital. Supervisors who will have to take responsibility for the financial soundness of new institutions tend to favor higher capital requirements, because they know there are limits on the number of institutions they can supervise effectively.
Limits on unsecured lending
Character-based microfinance is often impractical when there are limits on secured spending as a percentage of the bank’s equity capital or total assets.
Provisioning a high percentage of unsecured lending
Most microfinance providers find provisioning a high percentage of unsecured lending impractical.
Full registration of collateral costs
Many MFIs only partially register collateral with tiny loans, a technique that is both effective and affordable compared with the high costs of full registration.
Requirements for branches
Security standards, working hours, daily clearing of accounts, or limitations on location are some requirements for branches that can interfere unnecessarily with innovations that reduce costs and bring more convenient service to clients.
Standard loan documentation requirements
Good microlending often relies heavily on group guarantees making standard loan documentation requirements too expensive and time-consuming.
Interest rate caps
Since administrative costs are inevitably much higher for microfinance than for conventional bank loans, MFIs must be able to compensate with loan charges that are considerably higher than normal bank rates in order to continue to provide such small loans. Interest rate caps will almost always hurt the poor by contracting the financial services available.

Decades of experience around the world with many forms of alternative financial institutions—including various forms of financial cooperatives, mutual societies, rural banks, village banks, and now MFIs—demonstrate that there is a strong and nearly universal temptation to underestimate the challenge of supervising such institutions in a way that will keep them reasonably safe and stable. It is relatively easy to craft regulations, but harder and less attractive to implement concrete practical planning for effective supervision. The result is that supervision sometimes gets little attention in the process of regulatory reform, often on the assumption that whatever supervisory challenges are created by the new regulation can be addressed later, by providing extra money and technical assistance to the supervisory agency for a while. This assumption can be wrong in many cases.

The crucial importance of early and realistic attention to supervision issues stems from the fiduciary responsibility the government assumes when it grants financial licenses. Citizens should be able to assume, and usually do assume, that the issuance of a prudential license to a financial intermediary means that the government will effectively supervise the intermediary to protect their deposits. Thus, licenses are promises. Before deciding to issue them, a government needs to be clear about the nature of the promises and about its ability to fulfill them.

While prudential regulation and supervision is inevitable for microfinance, there are choices to be made and balances to be drawn in deciding when, and how, this development takes place. Those balances are likely to be drawn in the right place only if supervisory capability, costs, and consequences are examined earlier and more carefully than is sometimes the case in present regulatory discussions.

The first choice, however, relates to who will assume the supervisory role. For the prudential regulation of deposit-taking MFIs, the argument is often to leave supervision in the hands of the regulator who maintains control over all deposit-taking financial institutions (although sometimes credit unions are regulated and supervised by separate entities such as a Department of Cooperatives). Often, however, because the regulation and supervision of MFIs does not pose any systemic risk to the financial system, a choice is made to delegate supervision to a hybrid regulator or to a system of self-regulation.

about us | contact us | contribute | tell a friend