The regulation of microfinance:


Regulatory frameworks

IDLO TW-372E
Microfinance: Building Inclusive Financial Sectors & Supportive Legal and
Regulatory Frameworks (as a Tool to Achieve Poverty Reduction) in
East Africa

Simone di Castri
IDLO Microfinance Project Research Coordinator

November 2008
 “When we take savings in India, it is actually in violation of the law. I have a structure with
eight entities in order to sidestep enough of the law that it stays below the radar.”
Vikram Akula - McKinsey Consultant and Founder and Chair of SKS India
HQWHGEQHWE

“Think of the financial sector as a three-legged stool; if the law is the seat of a three-legged
stool, regulations are the legs. One leg is safety and soundness. One is profitability and
innovation, and one is consumer protection. All these virtual legs are equally strong and
supportive and each is essential to maintaining balance. It is through effective and
balanced regulations and rules that the system has retained its integrity, its edge and its
ability to deliver capital where it is needed. Regulations should allow this more risky activity
to be profitable.”
Diana Taylor - New York State Banking Superintendent

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 “Financial regulation around the world was designed to prevent fraud and to insure
stability of the financial system, how did it evolve into an instrument that prevents
innovation in financial services and broad access to credit? Unfortunately, it is no
accident. Many intermediaries benefit from restrictions to competition and may see
universal access as a threat. For this reason, the struggle to reform regulation in favor of
microfinance is not an easy one.”
Luigi Zingales - Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago

“Governments, including central banks, must balance the responsibilities they have been
given related to their banking and financial systems. We have the responsibility to
prevent major financial market disruptions through development and enforcement of
prudent regulatory standards and, if necessary, in rare circumstances, through direct
interventions in market events. But we also have the responsibility to ensure that the
regulatory framework permits private sector institutions to take prudent and
appropriate risks, even though such risks will sometimes result in unanticipated bank
losses or even bank failures.”
Alan Greenspan - former Chairman of the Federal Reserve of the United States

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Terminological confusion
•  Different countries use same terms differently
•  Different countries use different terms to mean the same thing
•  Non-lawyers use terms differently from lawyers and regulators

•  MFI and microfinance

are not regulatory terms, except in a small number of countries where they
have been added recently and
could mean many different things, depending on the country

What is your definition of microfinance?

Microfinance is the provision of a broad range of financial services such
as deposits, loans, payment services, money transfers and insurance
products to the poor and low-income households and their
microenterprises.
By definition, microfinance is not subsidized credit, not a dole-out, not salary or
consumption loans, and a cure-all for poverty.
Bangko Sentral ng Pilipinas (BSP)
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Basic concepts
Frameworks:
•  Institutional
• and Policy

•  Legal
• and Regulatory

Not only financial/banking regulation, but a multitude of laws and

regulations affects financial inclusion, the provision of microfinance
services and the access!

Regulation: Set of rules adopted by a legislative body (laws) or an

executive body (regulations)
Supervision: External oversight aimed at determining and
enforcing compliance with regulation.
Do not regulate what cannot be supervised!
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Institutional framework
•  National Poverty Alleviation Strategy
•  Economic and Monetary policy
•  Financial Sector Strategy
•  SME policy
•  Unemployment strategy,
•  Youth & women

•  Priority sector lending

•  Governance of the microfinance sector

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Institutional framework 2/2
Governance of the microfinance sector
•  National Strategy of which Micro-Finance is a part
•  Government Policy
-  Inflation/deflation policy
-  Wholescale debt relief initiatives (generally in agricultural loans; ie India)
-  Requirements regarding investments of state pensions and funds (ie Peru)
-  Community Development Finance type intiatives (public/private financing partnerships
USA, UK, Australia with tax incentives and public funding)
-  Nationalization risk (Bolivia, Ecuador, Russia)
•  Authority in charge of MFI licensing
•  Authority in charge of MFI supervision
•  Public administration in charge of MFI support
•  Public guarantee fund
•  APEX institution
•  Role of MFIs national/regional network

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Why to regulate?

•  to reduce the level of risk bank creditors are exposed to (i.e. depositors)?
•  to protect clients, and investigate complaints (i.e. representation of interest rates)?
•  to reduce systemic risk resulting from adverse trading conditions for banks causing
multiple or major bank failures?
•  to avoid misuse of MFIs and banks for criminal purposes (i.e. laundering the proceeds of
crime)?
•  to prosecute cases of market misconduct?
•  to protect banking confidentiality?
•  to direct credit to favored sectors or borrowers?
•  to license providers of financial services?
•  to maintain confidence in the financial system?
•  to attract investments?
•  in general, to reduce the moral hazard of the actors?
•  to increase financial inclusion (i.e. reducing adverse selection)?
•  to promote the development of the sector?

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How to regulate?
Prudential regulation (and supervision)
function: to protect solvency of regulated institutions
  the stability of financial sector
for
  the safety of deposits

Non-prudential regulation
function: other than preventing insolvency

• Some rules have both functions

• Soft regulation
• Self-regulation

Should these norms differ from those applied to commercial banks

that offer more typical financial products?

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The costs of regulation
•  Costs of compliance, of supervision, of enforcement

•  Direct
•  Indirect

What to regulate?
•  Institutions v. Activities

•  Deposit-taking institutions
•  Credit providers

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Regulatory Framework – MFIs 1
Capitalization requirements and risk management
•  Minimum capital
•  Initial reserve requirements
•  Liquidity requirements
•  Minimum capital adequacy/gearing ratios
•  Risk-weighting of assets
•  Loan loss provisioning
•  Loan loss provisioning fiscal treatment
•  Concentration of risk
•  Unsecured lending limits
•  Restrictions on use of funds

Should MFIs and commercial banks be treated equally?

Financial Requirements in Cambodia MFIs Commercial banks
Minimum paid-up capital KHR 250 million KHR 50 billion
Liquidity ratio 100% 50%
Solvency ratio 20% 15%
Capital guarantee 5% 10%
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Reserve Requirement 5% 8%
Regulatory Framework – MFIs 2
Ownership and governance

•  Standards for ownership officers

•  Restriction on foreign ownership
•  Other restrictions on ownership
•  Standards for managers
•  Possibility to create stock-options or other incentive tools for
management by the shareholders
•  Restrictions on managers
•  Other governance standards and restriction
•  Prohibited sources of funds

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Regulatory Framework – MFIs 3
Accounting, auditing and reporting, and operational concerns

•  Accounting norms
•  Estimated cost of auditing requirements
•  Estimated cost of reporting requirements

•  Loan contract registration

•  Collateral registration
•  Loan recovering enforcement legal tools
•  Connected/insider business
•  Involuntary and voluntary liquidation procedures
•  Corrective action powers

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Regulatory Framework – MFIs 4
Fiscal concerns

•  Tax breaks
•  Taxes on Income
•  Taxes on Transactions
•  Taxes on Payroll
•  Double taxation treaty
•  Others

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Regulatory Framework – MFIs 5
Financial intermediation activity

•  Lending
•  Mobilizing deposits
•  Mobilizing savings
•  Borrowing in foreign currency
•  Type of investments MFIs are allowed to make
•  Type of transactions MFIs are allowed to enter into
•  Insurance services
•  Remittances transfers
•  Restrictions on geographical opérations
•  Interest rate caps

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Credit-only Microfinance Institutions
•  Registration with authorities
•  Tax benefits
•  Annual financial statements/audits (perhaps only relevant if
MFI is borrowing from commercial banks)
•  Limited reporting of activities/business for statistical purposes
•  KYC (Know your customer)
•  Anti-money laundering/combat financing of terrorists (AML
/CFT)
•  Consumer protection
•  Interest rate regulation/usury
•  Consider possible abuses:
-  across variety of products (not just credit);
-  over life cycle of product (marketing, delivery, collection)
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Interest rates
CGAP 2004: IRs caps in 40 developing countries
•  20 interest rates control
•  13 usury limits
•  7 de facto controls

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Interest rates 2/2

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Regulatory framework for foreign financing
Some issues donors and investors may consider before they invest in your country

•  Equality of treatment of foreign investors with local investors in case

of crisis
•  Relevant procedure of conflict resolution in case of commercial
disagreements with the public, private local and private foreign
partners.
•  Possibility to cash dividend from equity investments
•  Tax treatment of foreign investment
•  Foreign ownership restrictions and governance matters
•  Availability of hedging instruments and cost of hedging
•  Sequestering foreign direct investments for long periods of time
(Argentina, Brazil and Venzuela)
•  (in)Ability to repatriate profits
and more (AMT/CFT, US/EU regulation, etc.)
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References
•  CGAP, Guiding principles on regulation and supervision of microfinance
•  UN, Building Inclusive Financial Sectors for Development, also known as the
"Blue Book”
•  GTZ, USAID, ADB

Database:
•  Microfinance Gateway
•  IDLO
•  CGAP/CAPAF 
•  Worldbank DoingBusiness.org for property rights and contract enforcement and
steps to register/license a business, taxation
•  Transparency Intl. Corruption index
•  IFAD Womenʼs rights to own/inherit/control property

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