the implications of the evolving microfinance agenda for regulatory and supervisory policy

Development Policy Review, 2002, 20 (3): 293-304

Overseas Development Institute, 2002.

Published by Blackwell Publishers, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.

The Implications of the Evolving MicrofinanceAgenda for Regulatory and Supervisory Policy

Colin Kirkpatrick and Samuel Munzele Maimbo∗∗∗∗

The growth in microfinance institutions (MFIs) has been accompanied by awidening of the range of financial services provided to the poor, to includevoluntary savings facilities. This entails prudential risk to clients and posesthe policy question of the most appropriate form of regulatory frameworkfor MFIs. This article examines the implications for regulatory policyof the recent trend towards MFI provision of microfinancial servicesencompassing savings, credit and insurance, by evaluating what we know ofthe existing regulatory approaches, the main concerns with theseapproaches, and the merits of recent regulatory proposals for MFIs.

Five years after the notable paper by Berenbach and Churchill (1997) on microfinanceregulation and supervision, the appropriate level of government-supplied regulation inthe industry remains unclear. Although subsequent studies have successfully identifiedthe basic options available to regulators, namely, no regulation, self-regulation, existingbanking regulation, and special regulations, the literature has yet to establish a clear setof core principles which national regulators can translate into specific performancebenchmarks, guidelines, rules and regulations.

This article contributes to the literature by advocating a regulatory and supervisoryframework that reflects the evolving microfinance agenda. The article starts with areview of the current state of knowledge on the delivery of financial services to the poorand traces the recent trend towards the provision of microfinancial servicesencompassing savings, credit and insurance. It then considers the implications forregulatory policy by evaluating what is known of the existing regulatory approaches, themain concerns with these approaches and the merits of recent regulatory proposalsdesigned to match the pace of innovation, diversity and development in themicrofinance industry. It concludes with suggestions of areas to which future researchmight be usefully directed.

The evolving microfinance agenda

While there is a long-standing consensus that access to financial markets is importantfor poor people, an on-going debate exists on the most appropriate type of institutionand method for delivering financial services to the poor. Matin et al. (2002) classifysuch institutions into three groups: formal, semi-formal and informal. Formalinstitutions are those that are subject to the banking laws of the country; they provide

∗Respectively, Director and Professor of Development Economics, Institute for Development Policy andManagement, University of Manchester, UK, and Banking and Financial Restructuring Department, WorldBank, Washington, DC.

294 Colin Kirkpatrick and Samuel Munzele Maimbo

conventional retail facilities and engage in a wide range of financial intermediationactivities. Semi-formal institutions are largely non-governmental organisations or bankswith a special charter, such as the Grameen Bank in Bangladesh. The informal groupincludes residual providers of finance, such as money-lenders, traders, rotating savingsassociations and non-bank pawn-brokers. This article focuses on the first two groupsbecause of the attention their regulation has received in the recent literature.

Subsidised agricultural-credit era

During the era of subsidised agricultural credit (1950s to 1970s), formal institutions,especially those in the public sector, were the main providers of financial services to thepoor, who were seen as small and marginal farmers, usually men, whose poverty couldbe overcome by credit induced increases in productivity (Matin et al., 2002). In the1970s, governments and donor agencies took the lead in supplying credit with relaxedrequirements for collateral and subsidised interest rates, usually directed at theagricultural sector (Rutherford, 2000: 13-14). Private formal institutions avoided thissegment of the financial market because of the high risks associated with lending to thepoor, namely, little or no collateral, high transaction costs because of the small loansinvolved and, in areas of low population density, the difficult and expensiveaccessibility (World Bank, 2001: 74). These problems, together with other institutionalweaknesses, such as interest-rate restrictions, patronage, arbitrariness and corruptpractices, resulted in formal institutions failing to deliver beneficial financial serviceseffectively to the poor. Instead, the high default rates amongst farmers, widespreadpoliticisation of the lending process, low interest revenues, high cost structures andoverall poor institutional design prevented them from becoming financially viable andmost were abandoned after years of public financial support (Matin et al., 2002; WorldBank, 2001: 75).

Microenterprise era

Semi-formal financial institutions became prominent between 1980 and 1996 when thepoor were seen as mostly female micro entrepreneurs with no assets to pledge (Matin etal., 2002). New lending approaches, collectively referred to as microfinance, began toemerge, primarily among registered non-governmental organisations or banks withspecial charters, such as the Grameen Bank in Bangladesh, BancoSol in Bolivia and thevillage banks of Bank Rakyat Indonesia (World Bank, 2001: 75). These institutions,now commonly referred to as microfinance institutions (MFIs), concentrated on lendingsmall amounts of money to individuals and groups, using basic loan appraisaltechniques and a variety of special techniques to motivate repayment. They recognisedthat, despite the lack of collateral, the poor were capable of repaying loans if providedwith the appropriate incentives, such as access to additional loans at a pre-determineddate. The timeliness of loans and consistency in the availability of credit were moreimportant to borrowers than the interest rate they paid (McGuire et al., 1998; Berenbachand Churchill, 1997).

Since the late 1990s, MFIs have moved from the margins of the financial systemtowards the mainstream. By September 1995, the aggregate loan portfolio of 206 MFIssurveyed by the World Bank was an estimated US$7 billion (1994: US$5 billion), held

The Implications of the Evolving Microfinance Agenda 295

by approximately 14 million individuals and groups. During the 1990s, the World Bankfinanced 185 projects involving micro and rural finance. Direct finance from theInternational Finance Corporation for microfinance projects grew between 1997 and1999, averaging 60 projects a year. The success of MFI initiatives has also resulted inthe creation of the World Bank-sponsored Consultative Group to Assist the Poor(CGAP) and more recently, the Small Business Development Initiative, the primarycombined objective being to link microfinance with micro and small enterprises forpoverty alleviation purposes (Wolfensohn, 2000:6).

Microfinancial services era

Towards the end of the 1990s, however, a small but increasing volume of literatureemerged which was critical of MFI practices, in particular their failure to meet the needsof the poorest of the poor. The critics argued that the MFI industry had not even‘scratched the surface of poverty’ (Hulme, 2000: 26). In Kenya, for example, less than700,000 out of an estimated 9 to 10 million poor people have access to microfinance. InZambia, which has a similar size of population, the number of people with access toMFI services is estimated at a mere 100,000. In a country where 70% of the populationis said to be living in poverty, with 54% of them classified as being part of the ‘corepoor’ (living on less than US$1 per day), current MFI usage is disappointingly low(Maimbo, 2000: 11). Critics contend that current MFI models, that rely on pre-determined group sizes and graduating loan amounts at pre-agreed access andrepayment dates, obstruct the development of the full range of services and productsthat poor people want, namely, flexible savings and deposit facilities, loans foreducation and health, micro insurance and lines of credit (Hulme, 2000: 28; Wright,2000).

Wright, in particular, is highly critical of the claims made by MFIs. His workdevotes great effort to deconstructing what he refers to as the ‘extraordinary, and almostshameless rhetoric surrounding microfinance’. He is highly critical of key aspects oftraditional MFI programmes, such as group lending and the graduation of MFI clientsfrom small loans to increasingly larger amounts in predetermined stages, arguing thatsuch standardised schemes inhibit MFIs from reaching the poorest of the poor.Although he is sympathetic towards MFI efforts to achieve self-sustainability throughstandardised, inflexible, low-cost and credit-driven systems, he claims that it is possiblefor MFIs to be sustainable while offering quality and flexible services. The failure toprovide flexible services, he maintains, is what accounts for high drop-out rates and theexclusion of the poorest among the poor. High drop-out rates, which are costly for boththe MFI and the client, reflect dissatisfaction with the quality of services, he argues,rather than a failure on the part of the client to conform to the membership requirementsof a particular MFI.

Wright (2000) and others contend that, as MFIs seek their own self-sustainability,they are focusing on existing small- and medium-scale businesses and are increasinglyexcluding the key constituents they ought to be reaching, namely, severelyundercapitalised businesses, new and start-up businesses, businesses with slow and/orirregular turnover, fragmented societies, and risk-averse poor people who are scepticalof debt. They argue that the traditional ‘Grameen-style’ MFIs need to move away fromthe ‘microenterprise era’ and enter the ‘microfinancial services era’, where emphasis is


put not simply on providing credit on inflexible terms but rather on providing savings aswell as insurance facilities. Microfinance practitioners must embrace the need to supplythe poor with a variety of financial services and not fear the perceived ‘complexity’ ofproviding a mix of financial services for the poorest.

The poor have the right to exercise financial management over their affairs, whichinvolves access to a comprehensive range of financial products that facilitate credit,savings and insurance services. Rutherford (2000: 13-24) lists five qualities of goodfinancial services that the poor deserve, namely, easy facilities and a disciplined regimefor making deposits, easy procedures for taking out lump sums, a wide range of valuesof deposits, a wide range of time-scales for savings-to-lump-sum swaps, and a full rangeof swap strategies. In short, they must offer a wider choice of delivery systems andinstitutional structures within which they provide financial services for the poorest ofthe poor.

Implications for regulatory and supervisory policy

The evolving microfinance agenda has significant implications for regulatory andsupervisory policy with respect to licensing requirements, monitoring for unsafe andunsound practices and the orderly existence of financially distressed MFIs. During thegovernment-led subsidised agricultural credit era, the majority of institutions werecreated through parliamentary legislation that was independent of financial sectorlegislation. Their entry into the financial sector was determined by political decisionsand, once in operation, they were subject to little or no supervision. During themicroenterprise era of 1980-96, the institutions providing the poor with financialservices were primarily registered as non-governmental organisations and again notsubject to financial regulation or supervision by the central bank or other competentorganisation. Moreover, with the financial crises of the 1980s and early 1990s, thelimited regulatory resources available to most developing economies were directedtowards reforms in the banking and financial sectors. However, with the emergence ofthe microfinancial services era when the provision of deposit-taking facilities was seenas key to achieving self-sustainability, microfinance began to attract regulatory concern.Towards the end of the 1990s, a plethora of microfinance regulation literature followed(Berenbach and Churchill, 1997; Rock and Otero, 1997; McGuire et al., 1998; Greuninget al., 1999).

Entry regulations and supervision practices

Effective entry regulations and supervision practices are key components of thedevelopment of a sound regulatory and supervisory framework for an industry.Effective regulations insulate an industry against individuals and institutions that are arisk to its stability and the well-being of individual clients. Regulators are currentlyunder pressure to elaborate licensing legislation for MFIs. While banking laws andregulations prescribe clear entry criteria with regard to minimum capital requirements,the financial condition of the owners, management qualifications, and the developmentof a reasonable business plan, comparable microfinance legislation, where present, israrely as detailed. Christen and Rosenberg (2000: 1-2) note different reasons for thekeen interest in MFI licensing, including the following:


• Looking to fund themselves, NGOs involved in microcredit operations oftenwant to be licensed (and thus regulated) in order to access deposits from thepublic or credit lines from donors or governments.

• Some NGOs, governments and donors want financial licences to be morewidely (and easily) available in order to expand savings services for the poor.

• Where unlicensed MFIs are already taking deposits, the central bank’smotivation in pushing to license them may be to protect depositors.

• Governments may look to regulations as a means of clamping down ontroublesome foreign-funded NGOs or other groups that they would like tocontrol more tightly.

Berenbach et al. (1998: 10) recommended that regulators ‘establish reasonablestandards of entry, not necessarily barriers to entry, and to foster professionalism in thisemerging segment of the financial services industry’. However, given that, in mostcountries, there already exist greater numbers of MFIs than regulators can effectivelysubject to prudential regulation and supervision, there is agreement that they should notattempt to regulate all MFIs. Instead, they should structure their licensing framework ina way that provides thresholds of financial activities, which would trigger a requirementto satisfy external or mandatory regulatory requirements (Greuning et al., 1998: 11). ‘Alaw that can not be implemented is a waste of time and resources’ (Hannig andKatimbo-Mugwanya, 2000: 7).

Although the literature abounds with different proposals for the most suitabletypes/forms of thresholds/benchmarks that researchers can use (asset size, number ofmembers, ownership and control by members, and the existence of a common bondamong members (Christen and Rosenberg, 2000: 11)), there is a dearth of literature thatactually recommends what those benchmarks should be, both for entry purposes and forsubsequent on-going supervision. Questions for regulators at this stage include: ‘howmany regulated MFIs do the banking authorities want to encourage? Given the limitedhuman, technical and financial resources of the bank superintendencies, which and howmany MFIs can be supervised effectively?’ (Berenbach et al., 1998: 9).

Monitoring for unsafe and unsound practices

There are four levels of agreement in the literature on monitoring for unsafe andunsound microfinance practices. First, there is a clear demarcation betweenrecommended regulatory practices for credit-only MFIs and deposit-taking MFIs, with aconsensus that credit-only institutions should in general not be supervised on an on-going basis because of the limited level of risk, if any, that they pose to individualclients and the industry as a whole. Supervising credit-only MFIs merely acts as a‘signal’ to prospective investors and donors that the institution is financially sound anddoes not justify government regulation (Christen and Rosenberg, 2000: 10; Staschen,1999: 7; Hannig and Omar, 2000: 4). However, deposit-taking MFIs, especially thosethat use public money to finance their lending business – fully-fledged financialinstitutions – should attract government-supplied supervision. The literature weighsheavily in favour of only regulating MFIs that accept deposits from the public and have


the potential to achieve significant scale (Berenbach et al., 1998: 10; Hannig andKatimbo-Mugwanya, 2000: 7).

Secondly, there is agreement that the specific risk profile of MFIs necessitatesadjustments to supervisory tools and techniques as compared with traditional financialinstitutions. Differences in credit risk, interest-rate risk, liquidity risk, management risk,new industry risk, ownership and governance risk suggest that MFIs need speciallydesigned regulatory and supervisory frameworks (Chaves and Gonzalez-Vega, 1994:69-74; Berenbach et al., 1998: 4-7; Staschen, 1999: 12). Because of the size and numberof microloans, traditional tools for inspection and audit are not effective or efficient inevaluating their portfolio risk. Checking individual client files for compliance with loanapproval procedures, reviewing the amount and registration of collateral or mailingthird party confirmation letters are not feasible when dealing with tiny unsecured loansto informal borrowers (Christen and Rosenberg, 2000: 9)

Thirdly, there are four conventional approaches to on-going regulation andsupervision – no regulation, self-regulation, the application of existing regulations andthe development of specific MFI regulations (Greuning et al, 1998: 11; Berenbach et al.,1998: 10-14; Staschen, 1999: 18-19; Christen and Rosenberg, 2000: 20-23).

• Advocates of the ‘no regulation’ approach argue that the cost of designing,developing and implementing regulations exceeds the benefit of leaving theindustry without a regulatory regime. Others feel that the operations of mostMFIs are too small to pose a threat to the overall stability of the financialsystem. Those opposed to this approach point to the risk profile of MFIs andargue that they need some form of regulation – self-regulation, existingregulation or special regulation – if the industry is to develop.

• ‘Self-regulation’ is thought to be useful while the industry is still in its infancyand regulators have no experience in dealing with MFIs. However, as theindustry enters the ‘microfinancial services era’ self-regulation is unlikely tosucceed because of the diversity in size, scale of operations, objectives andresources of the various institutions providing microfinance.

• Although extending ‘existing banking regulations’ to the MFI industry is apopular approach, especially for deposit-taking MFIs, it can be very costly.Compliance with bank regulations may require significant changes in theorganisational structure of an MFI, and the additional reporting requirementsmay lead to an increase in operational costs.

• Microfinance practitioners are championing the development of ‘specialregulations’ because they allow MFIs to maintain their distinct characteristics,providing a reduced range of financial services, without becoming a bank, inexchange for a lower capital requirement. Unfortunately, this approach has thepotential to create an imbalance in the treatment of other deposit-takinginstitutions in the financial system. It is also argued that developing a specialregulatory framework is premature and running too far ahead of the organicdevelopment of the local microfinance industry.

Fourthly, the literature suggests that the performance benchmarks for regulatedMFIs, such as capital adequacy ratios and loan classification and provisioningrequirements, should be higher for MFIs than for comparable banks (Conroy and


McGuire, 2000a: 43). The reasons for this include the fact that most of the capital inMFIs comes from investors with primarily non-commercial interests; MFI activities aregenerally restricted to certain geographical areas and/or client groups, hence their highlyconcentrated portfolios; MFIs operate with relatively high costs and high interest rateson loans; and bank regulators have little experience in regulating MFIs.

Beyond these four levels of consensus, there is a glaring absence of detailedproposals for specific regulations and supervision tools. For example, while recentstudies recommend higher capital ratios for MFIs than for banks because of the higherlevels of risk perceived by researchers and regulators, few studies propose specificratios. Even fewer discuss the need to maintain adequate loan provisions, let alonesuggest appropriate benchmarks. When researchers have suggested specific ratios, theratios are invariably country-specific and the methodology used to derive them has notbeen explained. For example, Meagher and Wilkinson (2000: 36) proposed capitaladequacy ratios ranging from 33% to 10% and loan provisioning ratios of 25% for loans90 days overdue, 75% for 180 days, and 100% for 12 months.

The difficulties in prescribing specific performance ratios derive from the widevariations in MFI activities and individual country characteristics. It is unlikely, norperhaps is it desirable, that detailed international benchmarks such as the Basel 8%capital adequacy standards will be achieved for MFIs. In fact, Schmidt (2000: 19)argues that the ‘adoption of a “one size fits all” approach will necessarily have adverseeffects’. However, this diversity should not preclude further academic research effortsseeking a set of coherent principles which will aid the design, development andenactment of microfinance legislation and regulations currently absent in developingcountries.

The search for comprehensive performance benchmarks has been furthercomplicated by the recent momentous drive towards MFIs that provide a wide range offinancial intermediation services. MFIs that believe in serving the poor (and particularlythe risk- and credit-averse poorest) and in generating indigenous capital funds, aremoving ahead with the development of voluntary, open access, savings facilities.Because these mimic formal sector banking services, they attract regulatoryintervention. However, because the savings are small, the cost of direct central banksupervision outweighs the expected benefits.

In the light of the evolving microfinance agenda, and the difficulties facingregulators noted above, microfinance practitioners and academics have proposed newforms of regulation. Wright (2000: 103) argues that if MFIs are to reach the poorest ofthe poor, the regulatory environment will need to adopt a more flexible approach to MFIactivities and growth: ‘effective but not restrictive regulatory systems and (ideally)depositor protection schemes should be in place to underpin the introduction of large-scale savings mobilisation schemes’. Four proposals which are moving in this directionare: the credit union rating agency, savings guarantee, market-driven deposit insurance,and a voluntary register (Wright, 2000: 95-100; Cracknell, 2000: 46-7) (see Box 1).

The premises for the Credit Union Rating Agency regulatory model are that, withgreater disclosure, the public will better decide where to invest their funds. Byadvertising both the compliance and non-compliance of registered MFIs, the regulatoryauthorities will encourage the public to ‘regulate out’ bad performers.


Box 1: New regulatory modelsGuatemala Credit Union Rating Agency: The Guatemala Credit Union movement is workingwith the World Council of Credit Unions (WOCCU) and the Consultative Group to Assist thePoorest to develop a private organisation to act as a rating or certification agency. This agency willtrain, qualify and monitor the auditors to review participating credit unions (which will pay for theservice) to ensure that they comply with standards based on the existing PEARLS (WOCCUequivalent to the CAMEL system). In addition, the agency will maintain a watch list of CreditUnions showing signs of problems, and will expect the management of these Credit Unions toprepare and negotiate remedial actions. Credit Unions which pass certification will be permitted todisplay the agency’s logo of certification (which will be heavily marketed as part of the system).Credit Unions which fail to maintain the standards will have their certification and right to displaythe logo withdrawn.

Savings Guarantee Foundation: In the light of the Bangladesh Bank’s reluctance to getinvolved in supervising MFIs, Henry Jackelen has suggested an innovative approach. He proposesa Savings Guarantee Foundation with the central purpose of certifying organisations and providingfinancial backing to guarantee client deposits. To obtain this guarantee, organisations would haveto pass through an intrusive review of their operations and would have to be continuallymonitored. Certified organisations would be required to pay an insurance premium for this service.Two basic types of guarantees would be provided: (i) certifying that NGOs place the amountsraised from clients in identifiable banks and do not use them for on-lending, or (ii) for NGOsdeemed to have appropriate capacity, certifying that the financial condition, lending policies,procedures and management of the institution are of a quality acceptable to use members’ savingsin on-lending activities.

Deposit insurance: This proposes a system that requires: (i) that all deposits must be insured;(ii) that any suitably insured institution be allowed to offer deposit services; (iii) that the insurermust be a bank doing business in the country concerned; (iv) that the insurer have extensivereinsurance; (v) that some of the reinsurance be off-shore and in hard currency, and (vi) the role ofthe state is to define the minimum acceptable insurance contract, to ensure that the partiesconcerned have the capacity to undertake the obligations, and to ascertain that the parties haveappropriate legal standing for enforcement against them. This market-driven scheme is expected toresult in a variety of contracts, market-based premiums reflecting insurers’ views of risk, and adispersion of risk. And private insurance would concentrate more on leading indicators (policies,standards and systems) and less on lagging indicators.

Voluntary register: Stuart Rutherford has proposed an ingenious scheme for helping thepoor better assess the risks that they face as they choose to entrust their precious savings to MFIs.The scheme centres around a voluntary register, backed by law that works as follows: (i) Aninstitution (in Bangladesh the Credit and Development Forum, the MFI’s trade association, isproposed) would open a register of MFIs wishing to mobilise deposits. However, the institutionwould have absolutely no say in whether or not any particular MFI is allowed to register, andabsolutely no say whatsoever in what the MFI chooses to include in its registration document. (ii)The registration document will give details about the MFI, its name, its address, the names of itsowners and backers, its area of operations, and its resources, financial products and so on. (iii) Itwill also have to state on what basis aggrieved parties could make a case against it in theeventuality that it failed to honour deposits that it had accepted. For example, it might give thename and address of some immovable property that it would be willing to be confiscated. (iv) TheMFI would then be obliged to hand out a copy of its registration document, in easy local language,to every one of its clients. It would also be obliged to distribute copies of the document to anymember of the public who wanted one. There would also be copies displayed at the localgovernment offices. (v) In this way, clients would be able to compare one MFI with another, andto estimate the balance of risk and benefit represented by ‘their’ MFI. Unregistered MFIs would, itis hoped, lose business. As Rutherford notes, to be effective and useful, the voluntary register mustbe accurate, up-to date, simple, clear and accessible.

Source: Wright (2000: 95-100).


Apart from merely providing more information to the public, the SavingsGuarantee Foundation seeks to certify either that a MFI deposits monies received fromclients in identifiable accounts in banks and that the funds are not being on-lent to otherclients, or that it has sufficient expertise and capacity to engage in on-lending activities.

Under the third option, government regulators play a secondary role by allowingbanks to act as insurers to MFIs. Under this arrangement, a MFI would have its depositsinsured by a designated bank which would then obtain reinsurance from either hardcurrency or another organisation willing to provide reinsurance facilities. The state’sregulatory role would be reduced to monitoring the suitability and acceptability of thecontract between the bank and the MFI.

The fourth option requires MFIs to voluntarily register their details with a centralagency of the state. In addition to basic information regarding its name, address, thenames of its owners and backers, its area of operations and resources, the MFI wouldregister any other information it regarded as relevant to its operations, the idea beingthat each client would receive a copy of the information to enable them to compare thatMFI with others.

Although these options are innovative, they suffer from information asymmetry,adverse selection and moral hazard problems that require further research before theycan be accepted widely. First, they place a significant amount of faith in the capacity ofthe MFI’s clients to distinguish between good and bad performers. Yet the typical‘poorest of the poor’ clients may not be in a position to understand or interpret theinformation disclosed. Unless the rating system under the first option is simple andclear, clients may find it difficult to decide which aspects are more important to them.The voluntary register complicates the issues further by denying clients standard criteriaupon which to base their decision.

Secondly, even if clients were able to distinguish between ‘good’ and ‘bad’performers, it is unclear that they would be in a position to easily disengage from oneMFI and move on to another. Some MFIs monopolise certain areas, leaving clients withfew or no alternatives. In addition, because of the Grameen-style lending whichprovides successively larger amounts of money to borrowers, clients will be reluctant toleave a ‘bad’ MFI if it means that they will have to start again at the bottom of thefinancial graduation ladder with a new MFI. The cost of moving may outweigh the riskof staying with their present MFI.

Thirdly, the types of certification and deposit insurance arrangements under thesecond and third options may encourage MFI managers to engage in riskier activities.Furthermore, deposit insurance for MFIs faces challenging actuarial problems. Becauseof the relatively small number of MFIs, their unsecured portfolios and the absence ofexperience of loss, it is difficult to arrive at an appropriate sized fund and appropriateinsurance premiums (Christen and Rosenbeg, 2000: 40). The regulatory guaranteesoffered by the two options may suggest to clients that their funds are safe when in factthe MFI managers are abusing them. Rather than introducing a deposit insurancescheme, the risk-based approach to supervision discussed by Hannig and Omar (2000:6-8) may be more appropriate. Here the focus is on sharing responsibility among all keyplayers, and on licensing, internal controls, information disclosure and the adequate useof assessment tools.

Fourthly, the new proposals seek to minimise or eliminate state involvement in theregulation of MFIs by encouraging a risk-based approach. This is understandable, since


in most developing countries the poor state of the formal sector leaves little institutionalcapacity to support the MFI sector, MFIs are radically different from banks and requireadditional resources to develop independent supervisory frameworks, and the size of themicrofinance sector makes it impossible to supervise all MFIs. A fundamental difficultyin deciding which model is suitable lies in the relationship between risk and the size andnumbers of MFIs. Cracknell (2000: 46) notes that smaller MFIs exhibit greater risksrelated to liquidity, management innovation, ownership and governance. However,adopting a purely risk-based approach means that smaller MFIs should be allocated alarger proportion of regulatory time and resources and the costs of regulating smallerMFIs are proportionately higher than those for large MFIs. It is also unlikely that thebenefits of such regulation will outweigh the costs.

Exit regulations and supervision practices

Unlike the banking literature, the literature on microfinance has yet to document thecauses of MFI failure, methods for managing the orderly exit of institutions which failto operate in a safe and sound manner, and procedures for meeting an institution’sobligations to its depositors and other creditors in the same way as the banking literaturehas done. Because the failure of a MFI does not present systemic risks for otherinstitutions, it does not attract immediate widespread public concern. In addition, mostMFIs are usually net lenders and thus their clients are not typically at risk in the event ofa failure. Nevertheless, large MFIs have failed in the past and more will fail in future.Christen and Rosenberg (2000: 26) warn that the failure of one or two might reduce adepositor’s willingness to entrust his/her savings with other MFIs. Since MFIs aregrowing in scale and deposit bases, the risk they present to the industry in the event offailure will increase.

Christen and Rosenberg (2000: 9-10) also warn of the bluntness of traditional bankregulatory responses to financial distress. First, they observe that a capital call is lesseffective with MFIs than it is with banks. When regulators ask bank owners to injectadditional capital, they are likely to comply, in order to avoid losing the capital theyhave already committed. In a MFI, the principal owner is usually a NGO, whose boardmembers will not face personal loss at the closure of the MFI. It is therefore unlikelythat they will commit personal resources to the ailing institution’s recovery.

Secondly, when a bank is financially distressed, regulators can instruct it to stoplending until its problems are resolved, without jeopardising its on-going efforts at debtcollection. With a MFI, such an instruction will drastically reduce the collectibility of itsoutstanding loan portfolio. The main reason why clients repay their loans is theirexpectation of further loans. Without the possibility of additional loans, there is noincentive to pay back outstanding amounts.

Thirdly, because MFIs grant loans with little or no collateral, the loans have littlevalue once they are separated from a MFI with going concern status. When a bank isfailing, regulators can separate its good assets from its bad assets and pass them on toanother institution that is more viable. With MFIs, however, once the future of theinstitution is uncertain, clients stop repaying their loans and their collection can costmore than the value of the outstanding loans.


Conclusion

The literature on regulating MFIs suggests that bank regulators and microfinancepractitioners have yet to reach a consensus on the most appropriate regulatoryframework for MFIs. Beyond the four basic options of no regulation, self-regulation,existing regulations and special regulations, new regulatory models are being proposedin the literature, for example, a credit union rating agency, a savings guaranteefoundation, market-driven deposit insurance, and a voluntary register. Undoubtedly,other models will continue to emerge because of the diverse range of microfinanceinstitutions and activities. Furthermore, the on-going debate about the proper objectivesfor MFIs will necessitate a constant evaluation of the objectives, forms and types ofgovernment-supplied regulatory intervention.

In the interim, therefore, it is important that research is directed at establishing aconsolidated set of core principles for effective microfinance activities that nationalregulators can translate into specific performance benchmarks, guidelines, rules andregulations. These principles must give direction on entry requirements, tools foreffective monitoring of unsafe and unsound microfinance activities, and exitregulations, policies and procedures.

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