Regulatory Framework for Financial Inclusion

1. Regulatory Framework for Financial Inclusion Governor, Bank of Uganda

2. Agenda • This Presentation addresses a specific question. Can the framework for financial regulation contribute to the goal of promoting financial inclusion? • In addressing this question we first seek to clarify what are the objectives of financial regulation and the practical constraints which it faces.

3. Introduction • The majority of the population in Uganda, as is the case in many other developing economies, lack access to financial services from formal sector financial institutions (FIs). • Despite the financial deepening and strong growth of financial intermediation that has taken place in Uganda over the last decade, the majority of the population do not have current or savings accounts and can only access credit from informal money lenders and relatives. • Financial exclusion affects the poor and those living in the rural areas the hardest.

4. Introduction (2) • Based on the results of a 2007 survey, it is estimated that only 18 percent of the Ugandan population has access to formal sector FIs (banks, credit institutions and microfinance deposit taking institutions) and a further 3 percent of the population has access to semi formal FIs such as SACCOs. • This leaves 79 percent of the population which can access financial services only from informal FIs such as village savings and loan associations or who have no access at all. Access to formal sector • FIs is much worse in the rural areas than in the urban areas. Whereas 32 percent of the urban population has access to formal sector FIs, only 14 percent of the rural population has similar access. • The survey was conducted by the Steadman Group for a DFID Financial Sector Deepening Project.

5. Introduction (3) • Financial exclusion in countries such as Uganda is the consequence of several factors which undermine the commercial viability of FIs operating in the rural areas and serving a clientele comprising predominantly poor people. • The main factors contributing to financial exclusion are the very high transactions costs of serving poor customers, who make small transactions, especially in the more sparsely populated rural areas where it is difficult for formal FIs to operate at an efficient scale. • In addition, loan markets are severely constrained because most of the population lacks access to assets which can be used for collateral.

6. Financial Regulation • Financial regulation is designed to change or constrain the activities of the regulated institutions; i.e. to make regulated FIs behave in ways they would not willingly choose to do if they were not subject to regulation. • The rationale for financial regulation is that there are externalities involved in the operation of financial markets, so that in unregulated markets private costs are not aligned with social costs. • For example small depositors do not have adequate incentives to monitor the activities of their bank and to constrain its risk taking; hence a public regulator which imposes prudential regulations on the bank for the benefit of depositors can improve welfare.

7. Financial Regulation (2) • The economic regulation of FIs is intended to induce them to engage in activities which serve economic or developmental objectives: typical examples are the setting up of bank branches in rural areas and directed lending to designated priority sectors of the economy, such as agriculture. • This type of regulation was implemented extensively by governments and central banks in developing countries, including Uganda, in the 1970s and 1980s. • In theory regulations of this sort could be used to directly tackle financial exclusion by, for example, issuing regulations to FIs directing them to provide services to sections of the population regarded as underserved.

8. Financial Regulation (3) • In the 1970s and 1980s regulations to direct banks to expand their operations in rural areas were motivated in part by the desire to promote financial inclusion, even if the term itself was not used at that time • However, economic regulation of the financial sector has usually proved to be ineffective at best and often counterproductive. • Banks do not willingly engage in activities which are not profitable and thus seek ways to circumvent the spirit if not the letter of regulations.

9. Financial Regulation (4) • It is often not difficult to do so. For example, controls on interest rates can be circumvented by the imposition of various fees on borrowers, or requirements on the borrower to hold unremunerated deposits. • Directed credit to agriculture is often monopolised by larger, politically influential, farmers who are not in any way “financially excluded” and sometimes this credit is diverted into non agricultural activities.

10. Financial Regulation (5) • Moreover, economic regulations can jeopardise the viability of banks, as was the case with the agricultural lending schemes operated by government owned and cooperative banks in Uganda in the 1970s and 1980s. • For these reasons economic regulation of the financial sector has largely been discontinued in developing countries, including Uganda. • The lessons learned from past experiences of economic regulation remain valid today and hence the Bank of Uganda does not recommend using this type of regulation as a tool for promoting financial inclusion.

11. Financial Regulation (6) • The second objective of financial regulation is prudential: it entails the protection of deposits and the overall stability of the financial system. • For the last two decades prudential objectives have provided the primary motivation for financial regulatory frameworks in most countries around the world, including Uganda. • This is why the regulatory framework in Uganda only covers deposit taking FIs: commercial banks, deposit taking non bank financial institutions and deposit taking microfinance institutions.

12. Financial Regulation (7) • Regulators also impose consumer protection regulations on licensed FIs, alongside prudential regulations; for example by requiring banks to disclose information on the fees they charge to account holders, but this is not the main focus of financial regulation. • Prudential regulation could, in principle, help or hinder financial inclusion. It could promote financial inclusion by enhancing public confidence in the safety of the deposits of FIs. • Unless they can command a high degree of public confidence, banks and other deposit taking FIs cannot hope to mobilize funds from the general public.

13. Financial Regulation (8) • Public confidence in the safety of deposits can be further enhanced through a public deposit protection scheme, but this entails a further responsibility on the regulator to protect taxpayers’ funds. • Prudential regulation could also impede financial inclusion if the regulatory burden on banks and other FIs deters them from offering financial services to customers which they regard as marginal. • Hence regulators may face conflicting objectives; do they impose less stringent prudential regulations which might allow banks to extend the scope of their services to the financially excluded even if this risks undermining the prudential soundness of the banks? This is not simply an academic issue.

14. Financial Regulation (9) • The global financial crisis, the most severe in more than half a decade, was triggered by the losses incurred on sub-prime mortgages in the United States. • The enormous growth in the subprime mortgage market which had occurred prior to the financial crisis was spurred by the efforts of policymakers in the United States to make it easier for FIs to extend mortgage credit to borrowers who had hitherto been excluded from access to credit: the so called “sub-prime borrowers”.

15. Financial Regulation (10) • Given the enormous financial damage done by bank failures, financial regulators can be justified in erring on the side of caution in deciding where to draw the line between potentially conflicting objectives of regulation. • However there may be regulations which can be relaxed without adding significantly to the prudential risks faced by the financial sector but which could allow innovative approaches to providing financial services to the financially excluded to be implemented.

16. Financial Regulation (11) • For example, Uganda intends to liberalise its regulations on money transfer services to allow mobile phone companies to offer these services in collaboration with banks. • This could provide large benefits to people in rural areas who lack access to the payments services of the banking system. • Prudential regulation is most effective when applied to formal sector FIs which must prepare regular financial statements and audited financial accounts and must work with the regulator in order to carry out their normal operations; for example commercial banks use the settlement systems operated by central banks.

17. Financial Regulation (12) • Prudential regulation requires intrusive supervision to be enforced, which is very expensive in terms of financial and scarce human resources. • Hence there is a practical limit to the number of FIs which can be regulated effectively. How is this relevant to the problem of financial exclusion? • In principle, regulators could try to extend the coverage of prudential regulations to the currently unlicensed semi formal and informal FIs, with the objective of trying to protect the funds which they have mobilized from their members or the general public. • Unfortunately, the practical challenges of extending prudential regulation to small scale semi formal or informal FIs are immense.

18. Financial Regulation (13) • It is difficult to formulate meaningful prudential regulations for many of these FIs, given their informal characteristics. • Because there are so many semi formal and informal FIs, it is not remotely possible to supervise them effectively. • In such circumstances regulations are no more than a charade. • Furthermore, ineffective regulation is worse than no regulation. • Because the public justifiably expects the regulator to deliver some degree of protection for their savings: the regulator cannot escape some degree of fiduciary responsibility for the FIs which it regulates.

19. Financial Regulation (14) • If the regulator promises, but cannot deliver, effective regulation, the public will be lulled into a false sense of security, making it more likely that their money will be lost through mismanagement or abuse by those with whom it is entrusted. • For the reasons outlined above, the Bank of Uganda does not believe that extending the regulatory framework to all or most of the currently unregulated semi formal and informal FIs will contribute to promoting financial inclusion. • Instead we believe that the most feasible approach is to gradually encourage the few, larger, semi formal FIs, such as the larger SACCOs, to graduate to tier 3 status: i.e. to become licensed and regulated as deposit taking MFIs.

20. Financial Regulation (15) • There are incentives for them to graduate to tier 3 status. Regulation by the BOU should enhance public confidence, helping them to mobilize more deposits and to establish commercial relations with other licensed FIs which can facilitate their operations. • It will provide a stimulus to the professionalization of their operations. Furthermore, by graduating to tier 3 status, their deposits will be eligible for protection under the Deposit Protection Fund.

21. Conclusion • Promoting financial inclusion is an important goal of financial sector policy. Because many factors contribute to financial exclusion, a range of policies are needed to tackle it. • Financial regulation can play at most a somewhat limited role for two reasons. • First, economic regulations, designed to force banks to provide specific services to designated priority sectors of the population, have proved to be ineffective and often counterproductive, not just in Uganda but in countries all over the world. • Secondly, prudential regulation, which is designed to protect the safety of deposits and the stability of the financial system, is only really effective when applied to large scale formal FIs.

22. Conclusion (2) • It cannot be effectively extended to the vast multitude of small scale semi formal and informal FIs which could potentially reach the financially excluded sections of the population. • As a consequence, we should resist the notion that financial regulation can offer a panacea for financial exclusion. • Because financial regulation is not an effective tool for promoting financial inclusion does not mean that public policy has no role to play in furthering this objective.

23. Conclusion (3) • On the contrary there are many policy measures which could potentially contribute to financial inclusion; for example the establishment of the credit reference bureau, strengthening land titling so that assets can more readily be used as collateral, and setting up a crop insurance scheme. • It is in this direction that public policy should focus if we are bring financial services to a wider section of the population.