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