THE REGULATORY FRAMEWORK FOR MICROFINANCE INSTITUTIONS

THE REGULATORY FRAMEWORK FOR MICROFINANCE INSTITUTIONS PRESENTED BY RACHAEL S. MUSHOSHO RESERVE BANK OF ZIMBABWE

Presentation Outline • Introduction • Characteristics of microfinance • Role of microfinance Institutions • Rationale for Regulating MFIs • Issues and Approaches • The Regulatory Framework • Regulatory Structures • Supervisory Challenges • Prudential Versus Non-Prudential • Conclusion

Introduction • Microfinance refers to the provision of financial services to the low income, the poor and marginalized, including the self employed- financial intermediation. • To most, microfinance means providing very poor families with very small loans (micro-credit) to help them engage in productive activities or grow their tiny businesses. • Overtime microfinance has come to include broader financial services such as insurance, money transfers and savings

Characteristics of Microfinance Clients • Typically low income people with no access to formal financial services • Self-employed and household-based entrepreneurs • In rural areas includes farmers and small businesses into food processing, agriculture • In urban areas may include artisans, shopkeepers, vendors, manufacturing, etc.

Characteristics of Microfinance Clients cont… • Small businesses • Usually owned and operated by one person • Family members assist • Little capital invested • It is taken as a form of employment • Less than 10 employees • High number of women

Characteristics of Microfinance • It is not simply banking but also a developmental tool • Small loans typically for working capital • Informal appraisal of borrowers and investments • Collateral substitutes- group or relationships • Access to repeat loans depends on repayment performance

Role of Microfinance Institutions • Financial depth and diversity - contribute to economic growth and development • Promotes financial inclusion which in turn helps the poor build assets and better manage risks • Poverty reduction and improvement of living standards • Social intermediation – provision of microfinance often integrated with developmental activities such as training in practical skills, entrepreneurship, etc. • Achievement of the MDGs

Role of Microfinance Institutions Cont… • Microfinance plays a critical role in fostering economic growth and development by increasing productivity and employment opportunities.

Preconditions Preconditions for MFIs to play a useful role in economic development include: • Enabling environment • Improved infrastructure • Government policy • Stable macro-economic environment • Low inflation rate • Low lending interest rate • Stable exchange rate

Preconditions Cont… • Appropriate regulatory and supervisory framework • Long-term and sustainable source of funds • Removal of interest rate ceilings • Setting interest rate ceilings would discourage outreach to poorer customers. • MFIs should be allowed to charge rates of interest that enable them to cover costs. • Disclosure of charges • Promote competition

Rationale for Regulation • Various reasons for regulating microfinance institutions • In order to reach significant scale and to provide adequate service to clients, microfinance institutions need to go beyond government and/or donor support to attract private capital and to mobilize savings. • To allow for an orderly development of the sector- • Most microfinance institutions started as donor-funded institutions and have to seek alternative strategies to survive due to donor fatigue • Shift from donor-funded NGOs to more commercially oriented entities- regulations lays the foundation for such transformation

Rationale for Regulation Cont… • Ensure financial sector stability- though players in the microfinance sector have little systemic impact, failure can have negative impact on the credibility of the financial sector • To render legitimacy and confidence to the sector- attract long-term funding to the sector • Investors, donors, need to have confidence in the systems in which the recipient of the funds operates in. • Regulation sets minimum acceptable standards and gives confidence in MFIs as a safe destination of donor or investor funds

What is Regulation? • A regulatory framework includes the laws, regulations, guidelines, rules and codes that regulated entities are required to comply with and an institution or structure for enforcing compliance. • The regulatory structure is therefore an institutional form which carries out supervision of the regulated entities. • Supervision has broadly been defined as a process of enforcing the regulatory framework. It includes the interaction between the regulatory authority and the regulated institutions that enables the regulatory authority to: • Monitor the financial soundness of the regulated intermediaries • Proactively identify and respond to emerging trends and problems in the industry and at specific institutions. • Enforce compliance with regulations • Manage the exit of failed institutions from the financial system with the aim of preventing financial system instability and losses to small, unsophisticated depositors.

What is Regulation? Cont… • The regulation of financial institutions is generally explained as a response to the need for systems to maximize the mobilization and intermediation of funds, enhance efficiency in the allocation of capital, ensure appropriate risk management, and protect depositors. • Focus is financial sector stability and depositor protection

What is Regulation? Cont… • Standard banking regulation and supervision tend to impose ineffective and overly burdensome requirements on MFIs if the same is applied without modification. • In determining the regulatory and supervision structure to be applied to microfinance markets, policymakers need to take into account a whole range of issues.

Issues and Approaches • Need to be clear about the rationale of regulation and supervising the sector • The general structure must be translated into specific prudential norms, supervision and reporting systems, and rules governing entry and operations of MFIs. • The implementation of these norms and systems. • Norms and systems should be designed in ways that make them easy to administer; • Supervisory body should have the necessary resources and capacities to ensure proper implementation of the norms and systems

Issues and Approaches Cont… Issues that need to be taken into account when designing regulation for the microfinance sector: • its attempt to deepen financial markets - to serve micro-enterprises and poor households; • its high unit costs of lending; • its approach of physically taking banking services to clients who have few other options to receive financial services; • the relatively undiversified and sometimes volatile nature of MFI credit portfolios; • Any regime of regulation that is adopted must cope with the special problems of regulating and supervising MFIs. • These include: - the absence of owners’ capital to draw on to meet capital calls - for most MFIs; - the fact that MFI lending modalities make audits and corrective steps difficult; - the potentially high costs of MFI supervision.

Issues and Approaches Cont… • Different cost structures and Funds sources; • The difference in institutional orientation, with some MFIs clearly profit-oriented while others are committed to providing services to the poorer segments of the population on a non-profit basis; • The fact that most MFIs began as unregulated credit NGOs, with a focus on social goals rather than financial accountability and sustainability;

Issues and Approaches Cont… • The fact that MFIs deal in savings and credit transactions with relatively low value in relation to the financial system as a whole - and as a result are unlikely to have problems that cause broad systemic instability; • The market risk posed within the microfinance sector itself when MFIs (especially large ones) are not properly managed and monitored.

Regulatory Framework • The regulation and supervision of microfinance institutions by an independent regulatory agency is relatively new in many countries. • The introduction of regulatory framework for MFIs in many countries was mainly aimed at addressing a number of concerns in the MFI industry. • A number of MFIs are operating in an unregulated market. This is because regulatory agencies focus their regulatory resources on deposit-taking MFIs

Regulatory Framework Cont… • It should be noted that a sound regulatory structure for MFIs is critical in ensuring that MFIs perform their functions efficiently. • A regulatory framework can either stimulate or retard the growth and development of MFI. • Excessive regulations can stifle MFIs’ growth • Appropriate regulations promote market development.

Regulatory Framework Cont… • Given that most MFIs have or are evolving from NGO forms to commercial forms, there exists a wide array of regulatory structures for MFIs. • There is no ideal regulatory structure that fits all countries as regulatory structures are dependant on: • MFI industry development, • Legislative environment, • Resources, • Capacity. • The regulatory structures may be one or a combination of the following forms: • Primary registrar • Network of MFIs • Self-regulatory body • Apex institution • Delegated authority • Central bank

Regulatory structures Primary Registrars • In a number of countries MFIs are registered as legal entities under various pieces of legislation. In the case of Zimbabwe, MFIs may be registered as legal entities under the following pieces of legislation: • The Money Lenders and Rates of Interest Act; • Banking Act [Chapter 24:20] through the Minister of Finance invoking section 3 of this Act. • Cooperatives Societies Act [Chapter 24:05]Registrar of Societies • Private Voluntary Organizations Act [Chapter 7:05] • Regulation and supervision by the Primary Registrars’ is non-prudential.

Regulatory Structures Cont… • Network of MFIs • Various national and international networks exist that offer support to MFIs. • These networks may comprise formal and informal MFIs. • Networks play a regulatory role in the sense that they develop performance standards and best practices which member organisations are encouraged to strive to achieve. • Failure to abide by the norms of the network often leads to loss of benefits that such networks offer which include capacity building opportunities (training and systems implementations) and financial services (e.g. grants and guarantees)

Regulatory Structures Cont… • Self-Regulatory Body • This is a body that is formed, owned and controlled by member MFIs to be supervised. It can be an association of MFIs (Zimbabwe Association of Microfinance Institutions) • Self-regulatory bodies play a useful role in regulating market conduct by formulating codes of conduct and other norms for members. • The self-regulatory body has the primary responsibility for monitoring and enforcing agreed norms. • Evidence suggests that this regulatory structure is not suitable for prudential supervision as participating institutions often do not have enough incentive to induce them to hold a rigorous line when problems arise. For instance, they would find it difficult to sanction closure of an ailing member.

Regulatory Structures Cont… • Apex Institution • In some countries there is an apex institution or national fund that does wholesale lending to local MFIs. • As an investor, such an apex is by its nature a kind of regulatory structure. • The Apex evaluates and monitors the soundness of the MFIs it lends to. For MFIs that fail to meet its standards, the sanction is denial of loans. In this regard, MFIs strive to comply with the terms and conditions of the borrowing which would include: • Financial soundness (adequate capital); • Achieving and maintaining acceptable profitability; • Ability to meet obligations as they fall due (liquidity); • Having a competent Board of Directors; and • Having annual audited financial statements

Regulatory Structures Cont… • Delegated Supervision • Delegated supervision is an arrangement where a government financial supervisory agency delegates direct supervision of financial institutions to an outside body, while monitoring and controlling that body’s work. • Delegated supervision can be conducted by an apex regulatory structure, an association of MFIs or audit firms. • Delegated supervision has its own issues which need to be clearly understood before a decision is taken to implement it. Some of these issues include: • Who will pay the costs of delegated supervision? • If the delegated supervisor is unreliable and its delegated authority must be withdrawn, is there a realistic fallback option? • When a supervised institution fails, which body will have the authority and ability to clean up the situation by intervention, liquidation, or merger?

Regulatory Structures Cont… • Financial Supervisory Agency • The central bank in a number of countries is the financial supervisory agency that is responsible for regulating banks and other financial institutions including MFIs • Financial supervisory agencies focus their resources on deposit-taking MFIs and apply non-prudential supervision on credit only MFIs. • There is limited financial and human resources to effectively supervise all MFIs. • Other central banks have raised the minimum start-up capital for MFIs as a way of rationing prudential supervision.

Tiered Approach to Regulation

Supervisory Challenges • There are regulatory challenges that arise when supervisory authorities attempt to apply a regulatory structure to an evolving sector such as the MFI sector. Some of the common challenges in the MFI sector include the following: • Corporate Governance; • Shareholding limited • Board of Directors

Supervisory Challenges Cont… • Regulatory Arbitrage • Limited delivery channels in rural areas • Cost • Pricing of products • Limited sources of funds • Supervisory

Regulation of MFIs • The continuum of institutions providing microfinance cannot develop fully without a regulatory environment conducive to their growth • Without such an environment, fragmentation and segmentation will continue to inhibit the institutional transformation of microfinance institutions • A transparent, inclusive framework for regulation will preserve the market specialties of different types of microfinance institutions - and will promote their ultimate integration into the formal financial system • Require standard registration documents and procedures

Regulation of MFIs • In order to reach its full potential, the microfinance industry must eventually be able to enter the arena of licensed, prudentially supervised financial intermediation, and regulations must eventually be crafted that allow this development

Prudential or Non-Prudential Supervision • Prudential regulation should not be imposed on “lending-only” microfinance institutions (MFIs) that merely lend out their own capital, or whose only borrowing is from foreign commercial or non-commercial sources or from prudentially regulated local commercial banks. • Depending on practical costs and benefits, prudential in some cases may not be necessary for regulation MFIs that take cash collateral (compulsory savings) as part of a loan contract, but do not take other savings (especially if the MFI is not lending out these funds). • Financial cooperatives—at least large ones—should be prudentially supervised

Prudential or Non-Prudential Supervision Cont… • Designers of new regulation for microfinance need to pay much more attention than usual to issues of likely effectiveness and cost of supervision. • In issuing financial intermediation licenses, the government invites public reliance and implicitly promises effective measures to mitigate depositor risk. • Before issuing licenses, a government needs to be clear about the nature of such promises and its practical ability to honor them.

Prudential Supervision Versus Non-prudential Prudential • Aimed at protecting the financial system • Protect safety of small depositors • More complex, difficult and expensive • Minimum capital requirements, lending limits, corporate governance issues, and standard loan documentation Non-prudential • Focus on conduct of business • Applied to non-deposit taking MFIs • Disclosure of effective interest rates

Conclusion • Microfinance institutions are increasingly becoming formalised and this has implications for the suitability of existing regulatory structures for microfinance regulation. • Therefore, a well-developed and properly regulated MFI sector is an important component of a broad, balanced, efficient financial system that spreads risks and adds to systemic stability. • Regulatory authorities should consider extending deposit insurance to MFIs as well as engendering public confidence in this growing sector that is providing financial services to low-income citizens

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THE REGULATORY FRAMEWORK FOR MICROFINANCE INSTITUTIONS