Chapter 4. Regulation of non-bank microfinance institutions

4.1 Background

The regulatory environment for microfinance institutions (MFIs) is very important if the microfinance sector is to achieve significant outreach on a sustainable basis. On the one hand, if MFIs are to flourish they should be able to operate relatively freely without unnecessary restrictions, and charge interest rates and fees that are sufficient to cover their costs. On the other hand, it is appropriate to have some kind of framework to encourage MFIs to meet certain minimum performance and reporting standards and to improve their performance over time. Berenbach and Churchill (1997, p.1) discuss the task at hand in the following terms:

As unregulated financial entities, the better microfinance institutions have had considerable freedom to adapt operating methods to serve their target markets effectively. This has led to the development of a small but growing number of robust, specialised financial institutions, innovative delivery methods, and an extension of the financial services market. When regulation is warranted, it requires coherent prudential guidelines that will allow the growth of the microfinance sector while protecting the interests of small savers and supporting the integrity of the financial sector as a whole.

This chapter considers the regulation of non-bank MFIs. Section 4.2 considers the broad regulatory framework, while regulations concerning interest rates are discussed in section 4.3. The subsequent three sections discuss alternative ways to ensure high standards within the microfinance sector, starting with an analysis of the scope for prudential regulation and supervision in section 4.4. This is followed by a discussion of the performance and reporting standards of second tier microfinance institutions in section 4.5, while section 4.6 covers matters to do with self-regulation. Section 4.7 discusses the difficult issue of savings mobilisation and deposit taking by MFIs, while section 4.8 summarises the chapter and provides recommendations.

Specific regulatory provisions for microfinance

In general, there is no separate regulatory framework for MFIs, and they are subject to the same regulatory framework as other NGOs or cooperatives. The one exception to this is the Grameen Bank in Bangladesh. The Grameen Bank is regulated under its own ordinance, the Grameen Bank Ordinance 1983. The ordinance specifically provides that laws relating to banking shall not apply to the Grameen Bank. According to the ordinance, the function of the bank will be to provide credit, with or without collateral security, to landless persons for all kinds of economic activities including housing. The ordinance further specifies a range of activities that the bank may undertake, including accepting money on deposit. The bank is not permitted to transact any kind of business other than those authorised. For instance, it is not permitted to engage in foreign exchange transactions. This legislation was specifically enacted to cover the Grameen Bank, and is tailored to its particular needs and circumstances.

It should be noted, however, that the ordinance applies only to the Grameen Bank. It does not cover other MFIs operating in Bangladesh. These are governed by the general provisions relating to NGOs in that country.

In most countries, MFIs are permitted to provide loans to poor clients so long as they are registered under one or other of the provisions applying to NGOs in general.

In India, Bangladesh and Pakistan, the provisions for NGOs to obtain registration are very similar, reflecting their common colonial heritage. In all of these countries, two options for registration are as a society under the Societies Registration Act of 1860, or as a trust under the Trusts Act of 1882, both dating from the colonial era. These Acts have been amended in each of the three countries, and in India they are administered by the state governments. Hence, requirements differ slightly between the different countries and in the case of India, between different states. Nevertheless, to be registered under these Acts, NGOs must generally have a memorandum of association and rules and regulations, or some similar document, covering such matters as the name of the organisation, objectives, membership, management committee and organisational structure. NGOs are also generally required to provide an annual report and financial statements to the regulatory agency. In most cases, these requirements for registration are relatively straightforward to fulfil. There are also some other options for registration, with broadly similar requirements. For instance, in Bangladesh some MFIs are registered as non-profit companies or charitable trusts, while in Pakistan some are registered as non-profit companies or voluntary social welfare agencies.

The framework for registration is also quite similar in Nepal and Sri Lanka. In Nepal, most MFIs are registered as societies under the Societies Registration Act of 1978, and are subject to similar requirements to NGOs registered as societies in the other South Asian countries. In Sri Lanka, there are three avenues for NGOs to obtain registration. Some large NGOs have been incorporated under their own Acts of Parliament. This is probably the most complicated method. The other options are to be registered as a non-profit company or as a society. Even though these various provisions for registration are not particularly onerous, there is no requirement for NGOs to be registered at all. It is quite possible for an NGO in Sri Lanka to operate a microfinance program without being registered under any Act of Parliament and without being accountable to any regulatory agency, although unregistered NGOs may have difficulty in attracting external funds.

In the Philippines, MFIs are classed along with other NGOs as ‘non-stock, non-profit’ organisations, and are registered with the Securities and Exchange Commission. While the system is different, the requirements for registration are quite similar to those applying in the countries discussed above. They must have a board of directors, and must file articles of incorporation and by-laws. They are also required to provide audited annual financial statements to the commission. In Indonesia, NGOs register as foundations, a legal entity which is simple to establish and extremely elastic in regard to the uses to which it can be put. NGOs intending to engage in lending do not require permission or specific registration in regard to credit activities.

In Malaysia and Thailand, it is more difficult for an MFI to meet the legal requirements to establish a microfinance program. In Malaysia there are three main options for NGOs in terms of registration: as a trust, as a non-profit company, or as a society. The requirements for registration are generally quite straightforward. However, registration under these provisions does not permit an NGO to engage in microfinance. Under Malaysian law, only specified institutions such as banks, cooperative societies and licensed moneylenders are permitted to lend money in consideration of a larger sum being repaid. If NGOs are to operate as MFIs and make loans, they need to obtain a specific exemption from the provisions of the Moneylenders Act of 1951. Such exemption must be obtained on a one-off basis from the Minister of Housing and Local Government, and is generally granted for a period of three to four years. There are no clear criteria for obtaining an exemption, and some commentators stated that it may be difficult for smaller NGOs without connections to obtain an exemption.

In Thailand, NGOs are generally registered as associations or foundations. Associations and foundations are not permitted to undertake business activities, and it is not clear if these organisations are strictly entitled to provide microfinance services. A number of multi-purpose NGOs which operate microfinance programs are registered under these provisions, and the authorities have tended not to intervene. However, these organisational forms would not appear to be appropriate for specialist MFIs which provide financial services only. One such specialist MFI found that the simplest way to obtain a legal identity was to register as a company under the Civil and Commercial Code. However, to register as a company, it is necessary to meet a minimum capital requirement of B500,000 ($19,760), and this may be prohibitive for a small NGO wishing to engage in microfinance.

Cooperative societies

All countries included in the study have long-established cooperative movements, including credit cooperatives. The legislation governing the establishment of cooperatives is quite similar in most countries. In general, a minimum of around ten members is necessary to establish a cooperative. Cooperatives are required to be non-discriminatory in membership and must have a democratic structure, with all members having equal voting rights. They are also generally required to have by-laws according to a standard format, covering matters such as name and objects, membership rules, power and functions of the general body, frequency of meetings, and the size and composition of the board of directors.

In most countries in South Asia and also in Indonesia, credit cooperatives have been largely unsuccessful in extending financial services to poor households. Generally, the cooperative movement includes people of all income levels within a particular village or community, and does not target the poor. Moreover, management of the cooperative movement has been inadequate in most countries.

In some countries such as India and Pakistan, a large proportion of cooperatives is reported to be non-functional, due to financial mismanagement and inability to recover dues. Even where they are functional, management is often dominated by rural elites, with funds allocated on the basis of patronage rather than needs. Frequently they rely heavily on government funds and are largely owned and controlled by governments. In India and Pakistan, for instance, state and provincial cooperative departments have the right to be represented on the board of directors, and can exert considerable influence on the management of cooperatives. For instance, permission may be needed to hold elections, invest funds, change their area of operations, use funds from their reserves, and similar matters. In Indonesia also, the officially sponsored cooperatives have been described as smothered by government bureaucracy. These controls make it very difficult for cooperatives to function efficiently or effectively. Nevertheless, in India in particular there is a small number of highly successful cooperative banks and societies which are devoted specifically to providing financial services to the poor, such as SEWA Bank and Working Women’s Forum.

In India, the state of Andhra Pradesh has recently passed the Mutually Aided Cooperative Societies Act of 1995, designed to remove cooperatives from many of the administrative controls of the state and make them more self-reliant and autonomous. It is understood that the states have given in-principle agreement to the government of India to pass a similar law at the national level, which would apply throughout India. This would provide the opportunity to streamline the regulatory requirements facing cooperatives and remove unnecessary requirements.

In contrast to the other countries in South Asia, the credit cooperative movement in Sri Lanka has been highly successful and does not rely on the government for funding. Nevertheless, the regulatory framework is quite similar to that applying in other countries in South Asia, and the Federation of Thrift and Credit Cooperative Societies commented that it found the regulatory framework restrictive in a number of ways. The law gives considerable discretion to the Minister and to the Registrar of Cooperative Societies, and requires their approval for numerous activities undertaken by the societies. For instance, various staffing decisions, relatively small capital purchases, and even large loans to borrowers require approval from the registrar. These requirements are cumbersome and inefficient.

In the Southeast Asian countries other than Indonesia, the regulatory environment for cooperatives appears to be less intrusive. In Thailand and to a lesser extent the Philippines, the cooperative movement is an important player in the microfinance sector. Credit cooperatives in these countries did not report that the regulatory environment was an impediment to their efficient operation.

In all countries there is a wide variety of small, informal savings and loans groups, such as rotating savings and credit associations (ROSCAs) which operate informally and are not registered. In at least three countries, these or similar groups have been institutionalised to some extent by involving them in formal microfinance programs. In India self-help groups (SHGs) are an integral part of the National Bank for Agriculture and Rural Development (NABARD) program for linking banks and SHGs. Nevertheless, they are generally not registered. Under Indian law, SHGs are only required to be registered (as a society, trust or cooperative) if they have more than 20 members. For this reason, many SHGs restrict their membership to 20 persons or less. It is also understood that some larger SHGs operate informally and are not registered.

Indonesia has hundreds and thousands of groups engaged in savings and credit. Some of these are indigenous, based on traditional custom, while others are the result of action by government agencies, community groups and NGOs to form groups in connection with various government-initiated microfinance schemes. These include Bank Indonesia’s microcredit project and program linking banks with self-help groups (PHBK), the income-generating project for marginal farmers and landless (P4K) of the Ministry of Agriculture, and the newer mass programs (Inpres Desa Tertinggal (IDT) and Prosperous Family program). There is no provision for registration of SHGs, nor are they regulated except in the context of the particular government program from which they arise.

Similarly in Thailand, some of the community organisations involved in the microfinance programs of the Government Savings Bank (GSB) and Urban Community Development Office (UCDO) are registered as cooperatives. However, most are unregistered and operate informally. For instance, figures from UCDO show that of the 385 members with savings activities, only 66 are legally registered as cooperatives while the other 319 are not registered and operate informally.

In some countries, MFIs face additional regulatory controls that are not of a prudential nature. For instance, in Bangladesh all NGOs which receive foreign donations are required to be registered with the NGO Affairs Bureau. They are required to seek approval each time before they can receive a foreign donation, including providing detailed budgets of how the funds are to be used. The NGO Affairs Bureau considers these applications and also circulates them to relevant ministries. Through this process, the NGO Affairs Bureau and other ministries have wide powers to regulate the activities of MFIs. Most MFIs felt that the bureau operates in a relatively flexible manner, and seeks to solve problems through discussion and negotiation rather than through arbitrary rulings. Nevertheless, it was felt that there is not always a level playing field between MFIs. For instance, some MFIs have been required to liaise with other MFIs and NGO bodies as to the coverage of their operations, or have been asked not to provide services in some areas, thereby limiting competition between MFIs.

In India, all NGOs receiving grants from foreign sources are subject to registration and reporting requirements with the Ministry of Home Affairs. In general, this procedure is not onerous. However, if not all of the grant is spent, approval from the Ministry of Finance is necessary to return the unspent portion to the donor, and this can take some time. In the case of loans from foreign sources there are further complications. Approval from the Ministry of Finance is needed before any loan can be received from foreign sources, and such approval can be difficult to obtain. Moreover, it is necessary to obtain approval from the Reserve Bank every time a repayment is made. This requires a detailed utilisation report, and NGOs commented that this report is quite onerous to complete. While the requirement for approval can be waived by the Reserve Bank, it is still necessary to complete the utilisation report. These restrictions reflect a desire on the part of the authorities to conserve foreign exchange, but are cumbersome and can place a significant administrative burden on MFIs.

In some countries, most notably Bangladesh and the Philippines, there has been some discussion as to whether there should be a separate registration process for MFIs. This may offer some advantages, in terms of establishing a regulatory framework that specifically caters for the needs of MFIs and ensuring that all MFIs in the country face the same requirements. Nevertheless, it would appear that in most cases the present processes for registration work reasonably well. In most countries, it is relatively easy for MFIs to obtain registration under the general provisions applying to NGOs and cooperatives. The only exceptions to this appear to be Malaysia and Thailand. In these countries, governments should establish simple registration procedures for NGOs wishing to engage in microfinance.

In all countries, it is quite easy for NGOs to obtain registration. The broad requirements, such as having a memorandum of association or some similar document and preparing an annual report and financial statements, are quite simple and should pose no problem to any well-managed MFI. However, even though these requirements are not particularly onerous, in many countries they are not enforced rigorously. In some countries, this relatively lax regime may have enabled some unscrupulous operators to set up and take advantage of clients. In Bangladesh, for instance, it was reported that there have been a number of examples of fraud by MFIs. Some MFIs have set up and obtained compulsory savings from members by promising to give them loans. However, the loans have not been forthcoming and their principals have absconded with members’ savings. Similarly in Sri Lanka, it would appear that the unstructured regime has led to some problems, with some NGOs reportedly engaging in activities of a controversial nature.

While these cases have not been all that widespread, a number of poor clients have lost their money. Moreover, such fraud has the potential to undermine the confidence of borrowers in the vast majority of MFIs that are operating legitimately. To prevent such abuses, it would be appropriate to tighten up the regulatory framework. NGOs engaged in microfinance should be required to be registered, and regulatory agencies should undertake simple monitoring of their activities to reduce the scope for fraud. This may involve character checks on directors, and more rigorous enforcement of the requirements for the provision of annual reports and audited financial statements.

On the other hand, in some cases MFIs are subject to unnecessary and burdensome rules and regulations, and the rules are not transparent. This is most apparent in the case of cooperative societies, especially in South Asia. Governments should review the regulatory requirements facing cooperatives, with a view to making them more independent of government, limiting the discretionary power available to regulatory agencies, and removing unnecessary requirements.

Similar problems exist in the case of NGOs, albeit to a lesser degree in most cases. In Sri Lanka, Indonesia and Pakistan, for instance, the environment for NGOs has at times been highly politicised, with NGOs subject to considerable uncertainty. As noted above, the discretion granted to the NGO Affairs Bureau and other ministries in Bangladesh through the foreign donations approval process also leads to some uncertainty. In all cases, unnecessary restrictions should be removed, and the discretionary powers vested in regulatory agencies should be limited as much as possible. All regulatory requirements should be set out as clearly and transparently as possible, and any MFI that meets them should be free to operate without restriction.

Only two countries impose general ceilings on the interest rates that MFIs can charge borrowers. In Nepal, NGOs are subject to an interest rate ceiling of 15 per cent. In addition, they are permitted to impose a 3 per cent service charge, yielding a maximum effective rate of interest of 18 per cent. This restriction applies only to NGOs, with banks and cooperatives free to determine their own interest rates. In Thailand, there is a general ceiling of 15 per cent on interest rates. This ceiling applies to all bodies and transactions unless they are specifically excluded. Thrift and credit cooperatives are excluded from the ceiling, but are subject to a separate interest rate ceiling of 19 per cent. Other MFIs, such as agricultural cooperatives, informal organisations, private and NGO microfinance programs and private transactions, are subject to the 15 per cent ceiling. It is understood that registered cooperatives generally stay within the relevant ceilings, but that unregistered community organisations generally charge higher interest rates.

In both of these countries, the ceilings are generally too low for MFIs to cover their costs. In Thailand this is implicitly recognised by regulatory agencies, in that they do not enforce the ceilings, even in the case of MFIs that receive funding under government microfinance programs.

In other countries, there is no general ceiling applying to MFIs. However, this does not always mean that MFIs are free to determine their own interest rates. For instance, in India, MFIs are subject to interest rate ceilings if they borrow from second tier institutions such as Rashtriya Mahila Kosh (RMK) or the Small Industries Development Bank of India (SIDBI), or if they participate in the National Bank for Agriculture and Rural Development (NABARD) program for linking banks and self-help groups. As noted in chapter 3, these ceilings make it extremely difficult if not impossible for them to achieve self-sufficiency. Moreover, while there are no legal restrictions on the interest rates cooperatives can charge, in some cases state governments control the interest rates that cooperatives can charge through their ownership of shares in them. This may make it difficult for cooperatives to cover their costs and operate on a commercial basis.

In Pakistan, there are no regulations concerning the mark-ups that NGOs involved in microfinance can charge borrowers. However, mark-ups charged by cooperatives are regulated, with a ceiling of 14 per cent on loans from the primary societies to final borrowers. There is also considerable social and political pressure on financial institutions in general, including MFIs, to keep mark-ups low, and it would appear that this ‘moral suasion’ has a significant effect on MFIs.

In Bangladesh, MFIs generally have much more freedom to charge market interest rates at a level sufficient to cover their costs. However, some MFIs reported that the NGO Affairs Bureau and other ministries have sought to influence their interest rates when approving foreign donations. It is understood that some MFIs have agreed to reduce their interest rates. Recently, the NGO Affairs Bureau has held informal discussions with some of the larger MFIs about the possibility of an overall interest rate ceiling to apply to all MFIs, but no decision has been taken.

More generally, other aspects of the policy environment can affect the ability of MFIs to charge full-cost interest rates. For instance, in the Philippines the proliferation of government-sponsored credit schemes introduces substantial subsidy elements into microfinance and leads to market distortions, making it harder for NGO programs to cover their costs. This is also true in other countries, including Indonesia, Sri Lanka and Malaysia. In Indonesia, for instance, while MFIs are free to set their own interest rates, mass programs providing credit to the poor on a grant basis (the Inpres Desa Tertinggal (IDT) program), or at heavily subsidised rates (the Prosperous Family program) have introduced distortions into the microfinance market.

All of these measures impede the development of microfinance on a sustainable basis. Countries that impose interest rate ceilings should either remove them or set them at levels that are consistent with the sustainability of efficient, well-managed MFIs. Other countries should examine policies designed to support microfinance, to ensure that such policies do not reduce the interest rate margins available to MFIs and make it difficult for them to operate sustainably. It would also be desirable if all governments could positively encourage MFIs to charge interest rates sufficient to cover all of their long-term costs, including operating and financing costs and the cost of their capital, after adjusting for inflation and subsidies.

In most areas covered by this study, the policy and regulatory environment differs substantially from country to country. However, in one area there is almost complete uniformity. Microfinance institutions (MFIs) which do not accept deposits from the general public are not subject to prudential regulation or supervision by a government agency in any country included in the study. MFIs are not subject to any minimum capital requirements beyond the nominal requirements that may be necessary to register as a society or similar body. Nor are there any prudential regulations covering matters such as capital adequacy, liquidity, reserves or loan loss provisioning in any country.

There are also no compulsory reporting requirements designed specifically with the needs of MFIs in mind. As noted above, in most countries MFIs are required to be registered as societies or some similar organisational form, and are required to produce annual financial statements. In some cases, these financial statements are required to be audited. Some regulatory agencies also require additional data about certain aspects of the operations of MFIs, such as the NGO Affairs Bureau in Bangladesh which requires detailed acquittals of foreign donations. However, these financial reports are not designed to be used for prudential supervision, and are not suitable for this purpose. Most importantly, the data are collected on an annual basis only, and therefore cannot be used for regular and timely supervision. Moreover, much of the information that a supervisory agency would generally require from financial institutions, such as detailed portfolio information, is not collected. Regulatory agencies do not collect the type of information that is needed to monitor the sustainability or risk of the operations of MFIs, and do not in fact attempt any such monitoring.

Is this absence of a framework for prudential regulation and supervision a weakness that countries should seek to rectify? The general consensus among academics and practitioners in the international microfinance community is that it is not. It is generally agreed that where MFIs do not accept deposits from the public, it is unnecessary and may even be counter-productive to subject them to formal prudential regulation and supervision by a government agency. For instance, CGAP (1996, p.1) argues that:

In most countries 85 per cent of MFIs are not financial intermediaries — i.e. they are lenders only, and do not take deposits from the public. There is probably no strong reason for public prudential oversight of such MFIs, since protection of depositors is usually viewed as the principal rationale for such oversight.

Berenbach and Churchill (1997, p.27) make the case even more strongly. They argue that:

Regulators are primarily responsible for two things: (1) to preserve the integrity of the financial system and (2) to protect small depositors. Almost all the experts who advised this research felt strongly that as long as MFIs do not mobilise savings from the general public, they should not be regulated.

In most countries, there would also be significant practical difficulties in subjecting MFIs to prudential regulation and supervision. One issue would be to find a suitable regulatory agency to regulate them. Most central banks in the region do not have a unit responsible for microfinance, and do not have a sound knowledge and understanding of the requirements of MFIs. A number of commentators from more than one country have argued that in the absence of significant changes in the methods of regulation and supervision, placing MFIs under the supervision of the central bank would be likely to stifle them. It is also not obvious that there are any other government agencies that would be better placed to regulate and supervise MFIs.

Moreover, in most countries the cost of subjecting MFIs to full prudential regulation and supervision would be prohibitive. In Bangladesh, for instance, there are around 1,000 NGOs involved in microfinance. And while MFIs in other countries do not have nearly the same outreach as in Bangladesh, the number of MFIs is not necessarily less. In India there are perhaps as many NGOs engaged in microfinance as in Bangladesh, plus some 90,000 primary agricultural credit societies and thousands of self-help groups. In the Philippines, there are some 500 MFIs reaching a combined total of only 30,000 borrowers. In Thailand there are more than 1,500 community organisations engaged in microfinance. Clearly, it would not be possible to subject all of these bodies to prudential regulation and supervision. In summary, full prudential regulation and supervision by a regulatory agency of MFIs which do not accept deposits from the public would appear neither desirable nor practicable.

While full prudential regulation and supervision may not be an option, it is nevertheless important to establish some mechanisms for ensuring that MFIs maintain high standards in their operations. It is clear that at present most MFIs are not operating on a sound basis. For instance, in an analysis of MFIs in Bangladesh, the World Bank (1996) noted that the accounting, management information systems and external audit policies and standards followed by the large MFIs are good and comprehensive. However, for the most part, the standards adopted by the small and medium MFIs need to be substantially upgraded. Inadequate standards are likely to threaten the long-term viability of such MFIs, potentially leading to reduced confidence in the sector as a whole. For this reason, most commentators in our Bangladesh country study considered that some standards for MFIs are necessary.

This is even more true in other countries, with many MFIs appearing to have inadequate and unsound practices and procedures. In the case of the Philippines, for instance, Llanto et al. (1996) found that a number of major MFIs have inadequate financial reporting and monitoring, making it difficult to determine past due loans and the extent of arrears. They also found that the absence of adequate and sound performance standards and a standardised accounting and reporting system makes it difficult to evaluate the relative performance of MFIs. They concluded (p.21) that:

In sum, internal financial policies and practices need a lot of improvement, particularly in the installation of sound financial reporting and monitoring systems, portfolio management, assessment and management of risks, product packaging and pricing, management of loan arrears and strategic business planning. Related to these will be the need to upgrade and institutionalise performance standards, particularly in loan repayment, appreciation of loan default and ageing of delinquent accounts, and the installation of appropriate accounting and internal audit systems.

These findings are consistent with the survey of MFIs conducted by Sustainable Banking with the Poor (1996). Only a few of the questions in the survey relied on accurate accounting. The authors commented (p.4) that:

While these basic figures should be relatively standard throughout the world, it was disappointing to see numerous institutions (mainly NGOs) that reported implausible figures. . . If some managers of microfinance institutions are unable to answer questions about their own costs and arrears without the help of outside experts, how can they be expected to run sustainable financial institutions? Clearly, a greater emphasis on financial monitoring and reporting using standardised accounting is needed.

The challenge is therefore to find cost-effective ways of improving the standards, in terms of both performance and reporting, of the large numbers of MFIs that are not currently operating on a sound basis. While it may not be possible to reach all MFIs, it is desirable to establish mechanisms to ensure that at least the major MFIs are able to reach and maintain high standards. Some possible approaches are discussed in sections 4.5 and 4.6 below.

In many countries, one very promising avenue for ensuring that microfinance institutions (MFIs) operate on a sound basis is through the lending policies of second tier microfinance institutions. Such institutions are not regulatory agencies, and cannot impose any legal obligation on MFIs to meet their standards. However, they can require MFIs that borrow from them to meet certain performance and reporting standards. In countries where there is one dominant second tier institution and this institution is a significant source of funds for MFIs, there is a powerful incentive for MFIs to meet these standards.

Bangladesh

The second tier institution that is making most progress in establishing performance and reporting standards is Palli Karma Sahayak Foundation (PKSF) in Bangladesh. It encourages MFIs to recover at least their recurring administrative and funding costs from interest income. It imposes a minimum lending rate of 16 per cent to ensure that MFIs do not lend below commercial bank rates, and to promote cost recovery from operations. It also encourages MFIs with outside sources of income to set aside a portion of interest income as reserves. Finally, it requires all MFIs to have a savings program for members, and generally requires that these savings be kept in a bank. Only those MFIs with a good track record and high standards of financial accounting are allowed to use savings in credit programs. PKSF also imposes a number of requirements in terms of the type of loan program that MFIs must offer to be eligible for funding.

In terms of reporting, PKSF requires monthly reports from all MFIs borrowing from it, covering information on the number of loans, disbursements, loans outstanding, recovery of principal and interest, and repayment rates. It monitors repayment rates (measured as repayments collected as a percentage of repayments due), and seeks to ensure that repayment rates remain above 98 per cent. MFIs borrowing from PKSF commented that PKSF is active in following up on these reports. It visits all borrowing MFIs at least four times a year for on-site inspections, and MFIs reported that these inspections are very rigorous. It audits each borrower MFI once a year, and in addition PKSF’s external auditor audits one third of these MFIs each year.

While PKSF is rigorous in supervising the MFIs that it funds, some of the performance standards that it uses to measure their performance are quite general. The World Bank poverty alleviation microfinance project provides for refinement of these standards, and it is envisaged that MFIs will only be eligible for support if they meet these criteria. In particular, PKSF is to receive technical assistance to establish standards in a number of important areas, namely:

(1) Standards for loan classification and provisioning. Draft standards were released in early 1997. Broadly, the draft standards provide for a provision of 50 per cent of the outstanding balance for doubtful loans (all loans past expiry which have not been paid off), and 100 per cent of the outstanding balance for bad loans (all loans one year or more past expiry which have not been paid off).

(2) Standards for savings facilities. Draft standards were expected to be released in 1997.

(3) Uniform accounting policies in respect of reporting repayment rates, arrears, rescheduling, portfolio quality, etc. and audit standards.

(4) Standards for measuring MFIs’ progress in terms of sustainability.

(5) In the case of multi-purpose NGOs, guidelines for measuring and separating the costs of delivering financial and non-financial services.

PKSF is clearly a leader in developing performance and reporting standards for MFIs, and in developing techniques for monitoring and supervision. It is likely that many of the standards currently being developed will be useful in other countries as well.

In the Philippines, the People’s Credit and Finance Corporation (PCFC) also imposes certain conditions on MFIs before they can obtain loans from it. Most importantly, they must have a three-year track record in lending, their working capital must be at least Ps250,000 ($9,500), lending operations must be segregated from other activities with appropriate full-time staff, past due loans must be not more than 20 per cent, they must not have any loans in arrears to PCFC or other agencies, and ‘established systems of proven effectiveness’ must be in place.

Interestingly, PCFC has set different minimum performance standards for MFIs depending on their stage of operations, with different standards for start-up, intermediate and advanced institutions. It feels the need to recognise that institutions progress as their capacities improve, and to provide for this progression in the standards. In this way, PCFC sees its role as an explicitly dynamic one, of not only enforcing standards but of facilitating the progression of institutions over time:

(1) In terms of outreach, the guideline is for 500 borrowers for start-up institutions, 1,500 for intermediate institutions and 5,000 for advanced institutions.

(2) PCFC has set minimum performance standards for viability (cost recovery) of 50 per cent for start-up institutions, 75 per cent for intermediate institutions and 100 per cent for advanced institutions.

(3) The minimum collection rate also varies depending on the stage of development of the institution, ranging from 90 per cent for start-up institutions, to 95 per cent for intermediate institutions to above 98 per cent for advanced ones.

PCFC has also set guidelines relating to such qualitative issues as governance, information systems and staffing, to benchmark the standards thought necessary at each stage of an institution’s development.

If the performance of the microfinance sector is to improve over time, it is important to ensure that the standards that are developed are actually enforced. In Sri Lanka, the National Development Trust Fund (NDTF) has laid down quite detailed operational procedures for partner organisations which borrow from it. According to the guidelines, an organisation must have legal status and must have at least two years experience in lending to the poor, with a recovery rate of at least 90 per cent over the last year. In addition, it must meet a number of other criteria relating to financial viability, savings mobilisation, and management and accounting. In the past, however, these conditions were not enforced. Many partner organisations with little or no previous experience in microfinance were given loans. An external audit of partner organisations completed in August 1996 found that a significant number had not maintained proper accounting records and did not follow generally accepted accounting principles.

Since 1995 the requirements in terms of experience and repayment rates have been enforced more rigorously. NDTF has also introduced a number of more specific prudential requirements. In particular, partner organisations are required to:

(1) Maintain a group contingency fund, established by deducting 5 per cent of the principal of all loans, and subject to certain conditions.

(2) Establish a loan loss reserve as a provision against defaults. A minimum of 20 per cent of interest earned on sub-loans must be retained in the reserve, which must be invested in an interest-earning bank account.

(3) Maintain a minimum of 35 per cent of members’ savings in reserve at all times.

In terms of financial reporting, NDTF requires partner organisations to have their accounts audited by a qualified auditor. Partner organisations are also required to provide a quarterly report to NDTF, but this is very brief and does not provide the information needed for prudential monitoring of their activities.

In India, there are at least three official second tier institutions which on-lend to specialist MFIs. However, none of them imposes rigorous performance and reporting standards. The second tier institution with the largest lending program is Rashtriya Mahila Kosh (RMK). For a partner organisation to borrow from RMK, it should have at least three years experience in thrift and credit administration, a 90 per cent recovery performance during the last three years (in practice, RMK generally accepts a recovery rate in the range of 80 to 90 per cent), satisfactory funds management and financial performance, and a good track record of work in the socioeconomic field. These requirements are all quite general in nature. There are also a number of requirements relating to loans by the partner organisations to individual borrowers. Further, partner organisations are supposed to maintain 10 per cent of the loan provided by RMK as reserves, but this is not strictly enforced.

Reporting standards are also not sufficient to enable proper prudential monitoring. Partner organisations are required to submit monthly and quarterly reports to RMK, but these deal with the utilisation of the loan from RMK and do not cover data necessary for monitoring their overall financial performance. They are also required to submit annual financial statements audited by a registered chartered accountant. The performance and reporting standards imposed by two other significant second tier institutions, the Small Industries Development Bank of India (SIDBI) and the National Bank for Agriculture and Rural Development (NABARD) are even less specific that those imposed by RMK and do not provide a basis for monitoring the financial performance of the NGO.

Where community organisations in Thailand obtain funds from the Government Savings Bank (GSB) or Urban Community Development Office (UCDO), they are subject to various requirements. To become a member of the GSB program, a community organisation is required to have operated a savings program for at least six months and to provide a financial statement and details of the group’s operating performance during that period. Moreover, every month, organisations are requested to provide a trial balance and some basic portfolio data to the bank. The requirements for members of the UCDO program are broadly similar, with some slight differences. For instance, in addition to operating a savings program for six months, UCDO encourages organisations to operate a loans program from their own funds for three months before they obtain a loan.

Both programs also impose limits on the amount that they will lend to a community organisation. GSB tailors the amount of the loan to the particular circumstances of the group, but with a maximum of five times the group’s own funds. Under the UCDO program the maximum loan amount is set at ten times the value of the group’s own savings, reflecting the fact that loans are also given for housing. However, it is preferred that groups build up gradually to this amount. These limits are of a quasi-prudential nature in that, to some extent, they restrict the degree to which organisations can leverage members’ savings to obtain external resources. However, the limits apply only to loans from GSB and UCDO, and do not prevent organisations from obtaining loans from other sources.

UCDO intends to strengthen its guidelines progressively in the future. For instance, it has been giving some thought to developing standards for loan loss provisioning. It should also be noted that UCDO places a great deal of emphasis on developing its standards through a process of consultation with community organisations.

In developing standards for MFIs it is also important to look at work being done on performance standards by international networks and agencies. A number of organisations, including the SEEP Network, ACCION International and the International Financial Advisory Group, have sought to define key performance standards for MFIs.

In 1992, ACCION International designed an instrument for assessing MFIs which took the CAMEL analysis as its conceptual framework. While it uses the same five areas of financial and managerial performance as the conventional CAMEL instrument, the indicators are designed specifically with the microfinance sector in mind.

The ACCION CAMEL is discussed in detail in Saltzman, Rock and Salinger (1998). It was designed to be independent of any methodological biases, and can be applied to any type of institution servicing the microenterprise sector. Its objective is to lead MFIs towards accessing financial markets, so only those aspects that ‘the market’ deems relevant and important are included in the CAMEL rating. Hence, the rating does not consider issues such as poverty targeting or social impact. It is also designed to relate specifically to Latin American MFIs operating in urban environments, who make up the majority of ACCION affiliates. The five areas examined are as follows:

(1) Capital adequacy. This covers the capital position of the MFI, including its capacity to support growth in the loan portfolio, and its ability to raise additional equity in the case of losses.

(2) Asset quality. This area covers the overall quality of the loan portfolio, including the level of portfolio at risk and write-offs, and the appropriateness of the portfolio classification system, collection procedures and write-off policies. The quality of other assets is also examined.

(3) Management. The focus here is on human resource policy, general management, management information systems, internal control and auditing, and strategic planning and budgeting.

(4) Earnings. This area examines the key components of revenues and expenses, including operational efficiency, interest rate policy, and return on equity and assets.

(5) Liquidity. Finally, this component looks at the institution’s ability to project funding needs in general, and credit demand in particular.

The instrument analyses and rates 21 key indicators relating to these five areas. There are eight quantitative indicators contributing 48 per cent of the final rating, and 13 qualitative indicators contributing 52 per cent of the final rating. MFIs are given overall alphabetical ratings based on their scores on these indicators:

(1) An ‘A’ classification indicates an MFI with strong financial performance in all of the key areas analysed.

(2) A ‘B’ rating generally indicates that the MFI is undergoing a difficult period which is adversely affecting its normally strong financial condition.

(3) An MFI receiving a ‘C’ classification is experiencing fundamental problems administering its credit program, with basic weaknesses in various key indicators.

(4) A ‘D’ rating implies that the MFI should not be operating a credit program.

(5) A classification of ‘NC’ (not rated) is given where it is impossible to assess the MFI due to a lack of basic operational information or because the MFI has not embraced the most minimal characteristics of an acceptable credit program.

Out of 11 MFIs evaluated to date, one received an ‘A’ rating in its most recent evaluation, while the other ten all received ‘B’ ratings in their most recent evaluations.

While the CAMEL review is comprehensive, it is also intensive. A first-time review requires a team of three to four people for ten working days to gather, adjust and analyse the financial and management information necessary to conduct the analysis. Even where a review has previously been completed, the team consists of three people working eight days on site. Clearly, it would be very difficult for second tier institutions to devote this much time to each of their partner MFIs on a regular basis. Nevertheless, the instrument provides a number of very useful insights into developing performance and reporting standards.

Most recently, the Consultative Group to Assist the Poorest (CGAP) has become a focal point for developing industry standards in microfinance. CGAP is currently developing a number of tools which are designed, among other things, to foster the development of industry standards in reporting and performance measures, and to bring greater transparency to the industry. These build on existing systems used by leading MFIs and networks, and are tailored to meet the needs of MFI managers.

The first of these is the format for appraisal of MFIs, which has already been released. The format is divided into four main sections:

(1) Institutional factors. This section examines issues such as governance, leadership, human resource management, organisational structure, management information systems, and internal audit and control.

(2) Services, clientele and market of the MFI. This section looks at the type and quality of services provided, breadth and depth of outreach, targeting of poor clients, and similar issues.

(3) Strategic objectives. This section considers issues related to the MFI’s mission statement and objectives, business plan and financial projections. The objective is to assess the extent to which these factors will facilitate increased outreach on a financially sustainable basis.

(4) Financial performance. This section presents the MFI’s financial statements in standard format adjusted for inflation and subsidies. It then goes on to calculate a number of ratios designed to assess profitability, efficiency and portfolio quality, and looks at other issues concerning financial management and performance.

The format does not actually establish specific performance standards that MFIs should meet in each of these areas. Nevertheless, many of the items could be turned quite easily into specific, measurable criteria that could be used by second tier institutions in monitoring and supervising MFIs that borrow from them. The minimum standards required could differ between countries depending on the size and quality of MFIs in the particular country, and by institution depending on the stage of development of the particular institution.

CGAP is currently finalising a number of other tools for practitioners: in particular, guidelines for business planning and financial modelling for MFIs; a handbook to assist with the external audit of MFIs; and a handbook for management information systems for MFIs. These tools should also be very useful to second tier institutions in developing appropriate standards for MFIs and appropriate methodologies for supervising them.

Comment

This section has surveyed the work being done by second tier microfinance institutions in a number of countries, in developing performance and reporting standards for the MFIs that they fund. While these experiences are diverse, it is possible to offer a number of general comments.

First, in those countries which have active second tier microfinance institutions, these institutions can play a very important role in developing standards for the microfinance sector. This role fits in well with their other activities. Quite apart from issues to do with overall sectoral standards, such institutions need to develop methodologies for assessing MFIs in order to protect their own loan portfolios. Hence, much of the work associated with developing performance and reporting standards needs to be done in any case. Moreover, such institutions have an effective mechanism for enforcing any standards that they develop, as any MFIs which borrow from them, or intend to borrow from them in the future, will need to meet the required standards. Over time, there is considerable potential for such standards to become accepted as sectoral norms, at least by the more significant MFIs, even if they themselves do not borrow from the second tier institution. It may also be possible for credit rating agencies to develop standards for MFIs and to rate MFIs according to these standards, to make it easier for donor agencies and commercial investors to assess the performance of MFIs and to encourage MFIs to improve their performance.

Second, standards should be based on results achieved rather than the model used. There is a diverse range of institutions involved in microfinance, including financial intermediaries, social intermediaries and mixed financial/social intermediaries. Standards for social intermediation should also be developed.

Third, standards should have a proactive role in facilitating improvement in the performance of the microfinance sector over time. While all second tier institutions need to ensure that the quality of their loan portfolio is maintained, countries with relatively undeveloped microfinance sectors, such as Pakistan, may not be able to impose standards as rigorous as those imposed in countries such as Bangladesh. However, standards should be raised over time so that MFIs are gradually forced to improve their performance. It may also be appropriate to impose differential standards depending on the stage of development of the particular MFI, and to provide for progression from one stage to the next. Second tier institutions also have an important developmental role in assisting MFIs to improve their performance so that they can meet the standards.

Fourth, enforcing standards is just as important as establishing them. This involves developing cost-effective methods for off-site and on-site supervision that are suitable to the operating procedures of MFIs. The approaches used by PKSF in Bangladesh, and the work being done by CGAP on external audit, may be particularly instructive here.

Fifth, in countries such as India and Thailand with more than one second tier institution, it is important that they establish common, or at least consistent, standards. Sixth, standards should be developed through a process of wide consultation with MFIs, to ensure that they meet the needs of MFIs and are accepted throughout the sector.

4.6 Self-regulation

Another approach to establishing performance and reporting standards for microfinance institutions (MFIs) is through self-regulation. Self-regulation may take a wide variety of forms, ranging from a voluntary code of conduct to which MFIs agree to adhere, to a rigorous licensing system administered by an apex body and backed by the force of law. In between, there is a wide variety of possibilities with varying degrees of monitoring and compulsion.

The feasibility of various forms of self-regulation depends on a range of factors, including the extent to which there is an apex body that can represent MFIs as a whole, the quantum of resources available for monitoring and supervision, and the availability of incentives and/or sanctions to enforce compliance. Self-regulation can be an alternative to, or can supplement, prudential regulation and supervision by a government agency or the performance and reporting standards of a second tier institution.

The country that is making the greatest progress in developing standards for self-regulation is the Philippines. A major new initiative, the Developing Standards for Microfinance Project (DSMP) was set up in 1996 with funding from USAID. A coalition known as the Philippine Coalition for Microfinance Standards has been formed under the project to develop and promote standards for MFIs. The coalition has 55 member institutions, including leading MFIs, the central bank, the People’s Credit and Finance Corporation (PCFC), government and donor agencies, and others.

The coalition has begun to build the database for benchmarking and standard setting, and has commenced documenting best practice among MFIs in the Philippines. The objective is to arrive at benchmarks or standards for good practice for a national microfinance summit in 1998. In establishing the benchmarks, the following indicators are to be observed:

(1) Organisational and operational factors (organisation structure, culture and capacity, management information systems, operational efficiency, etc.)

(2) Outreach and services (scale and depth of outreach, range and quality of services, etc.)

(3) Financial sustainability (self-sufficiency, portfolio quality, etc.).

Developing performance standards in these areas is the first step in the process. Further steps include assisting MFIs to adopt the standards, and moving beyond that to ensure widespread implementation of them by MFIs. The DSMP is also working towards the development of a ‘capacity measurement system’ to identify the strengths and weaknesses of individual MFIs. This implies a rating system for MFIs based on the indicators which have been developed. A rating system would be useful to domestic financial institutions which need information to assess the bankability of MFIs, and to government and donor agencies in identifying areas for intervention and support.

As noted above, a key issue in any system of self-regulation is compliance. While there are currently two major networks of MFIs in the Philippines, both have limited membership. The Association of Philippine Partners in Enterprise Development (APPEND) has nine member institutions, while PHILNET, a group of Grameen replicators, has seven members. It is not clear how the new coalition will seek to ensure that individual MFIs comply with the standards. One option may be to create a new apex body covering all major MFIs. Another option may be to back the standards with some form of incentives or sanctions, such as through the legal system or through the policies of a second tier institution. The coalition itself suggests that ‘. . . this may involve establishing a system of accrediting NGOs which have adopted the standards, a system of reporting and validation, and a system of rewards or penalties for compliance or non-compliance’ (Microfinance Coalition for Standards 1997).

No other country included in the study has progressed as far as the Philippines in establishing standards for self-regulation. The apex body for MFIs in Bangladesh is the Credit and Development Forum (CDF), which was established in 1992. CDF currently has 662 members. It includes most major MFIs, but not the Grameen Bank, which is not an NGO. CDF is making significant progress in a number of important areas. Nevertheless, there is a lack of consensus on policy and other issues among the major MFIs operating in Bangladesh, and this limits the ability of CDF to fulfil all of the functions of an apex body for the microfinance sector. While it could play a very useful role in developing a voluntary code of conduct or similar mechanism for self-regulation, it would not appear at this stage to have the resources or the authority to enforce a more rigorous model of self-regulation based on compulsion.

In other countries, apex bodies for MFIs are only just starting to be established. In India, a proposed apex body, the All India Association of Micro Enterprises Development (AIAMED) Network was registered in February 1997. It is conducting a series of seven regional coordination consultations in different regions, and some 400 MFIs have expressed an interest in attending these consultations, including the most prominent MFIs.

In Sri Lanka, there is a very effective apex body for the credit cooperative movement, in the form of the Federation of Thrift and Credit Cooperative Societies (FTCCS). Below the federation are 33 district unions, which in turn are responsible for some 8,340 primary societies. The federation coordinates guidelines and procedures for the operation of primary societies. For instance, it has introduced standard loan documentation and other forms for all primary societies. In turn, the district unions supervise the day-to-day activities of the primary societies. The primary societies are required to provide monthly financial statements, covering portfolio data, income and expenses, and balance sheet data, to the district union. Officers from the district union monitor this information and conduct visits to the primary societies. Hence, there is a well-developed structure for coordination and self-regulation, with the federation and district unions providing a range of services to the primary societies.

However, there is no apex body for MFIs as a whole. An informal forum for NGOs was established in early 1995 under the auspices of UNDP, and meets once every two months. There are around 55 members, with about 35 attending meetings regularly, but only around ten to twelve of the participants are local NGOs.

In Indonesia, an organisation of NGOs associated with the Bank Indonesia linkage program exists, but is currently inactive. There are also plans to establish an apex body for NGOs engaged in microfinance in Pakistan. A planning committee has been established consisting of major NGOs involved in microfinance, and the committee intends to organise a workshop, with funding from the Asia Foundation, to look at relevant issues. In the other countries included in the study, namely Malaysia, Nepal and Thailand, there do not appear to be any concrete moves to establish apex bodies for MFIs.

Self-regulation is a very attractive way of establishing appropriate standards for MFIs. Establishing standards through self-regulation can avoid the tendency for regulatory agencies to impose burdensome regulations that do not take account of the specific needs of MFIs. Self-regulation also ensures ownership of the standards by the MFIs themselves, and there is likely to be much greater acceptance of standards established through self-regulation than of standards imposed from above.

While there are many forms of self-regulation, more rigorous models require some mechanism for achieving compliance, through regular monitoring and a system of incentives or sanctions. This is likely to require a very effective and representative apex body for the MFI sector. Bangladesh and the Philippines have better developed networks of MFIs than the other countries in this study. Nevertheless, it is doubtful even in these cases that the apex bodies have the necessary resources or authority to monitor individual MFIs regularly and ensure that they meet the agreed standards. Hence, systems of self-regulation may need to be reinforced with some legal or quasi-legal system of incentives or compulsion. It is instructive that the Philippine Coalition for Microfinance Standards appears to be thinking along these lines.

Recent moves to establish apex bodies for MFIs in a number of countries should be encouraged, while appropriate arrangements should be put in place in other countries. Apex bodies have the potential to undertake a range of important activities, including information exchange, training, research, and policy dialogue with governments and donor agencies. Over time, they may also become focal points for the establishment of standards for self-regulation. MFIs should be encouraged to join these apex bodies and become active in their affairs, to ensure that they are well resourced and fully representative of the microfinance sector.

So far, this chapter has not discussed the question of savings mobilisation and deposit taking by microfinance institutions (MFIs). In almost all cases, it is clear that MFIs cannot accept deposits from the general public unless they establish regulated banks.

There are several cases in the countries included in the study where MFIs are permitted to accept deposits from the public. First, in Bangladesh the Grameen Bank Ordinance provides scope for the Grameen Bank to accept deposits from the general public as well as from its members (while the Grameen Bank is classified as a specialised development bank, it is not really a regulated bank in that it is not subject to prudential regulation and supervision by the central bank). To date, however, the Grameen Bank has not actually raised deposits from the general public.

Second, in Sri Lanka and Bangladesh the law specifically permits cooperative societies to receive deposits from persons who are not members. In Sri Lanka, many thrift and credit cooperative societies (TCCSs) are now actively seeking deposits from non-members by offering competitive interest rates, and deposits by non-members account for around 15 per cent of total deposits. Given the lack of prudential requirements, it is perhaps surprising that societies should be permitted to receive deposits from non-members. Indeed, the federation itself commented that the lack of prudential requirements reduces the credibility of societies as deposit-taking institutions, making it difficult for them to attract deposits on a large scale.

Third, in Nepal the central bank has permitted two large NGOs, namely Nirdhan and the Center for Self-Help Development (CSD), to accept savings deposits from non-members pursuant to the ‘limited banking’ arrangements instituted in 1994. Under these arrangements, the two NGOs are permitted to accept savings deposits, but are not allowed to engage in other banking activities such as foreign exchange and bills transactions. These NGOs are subject to a number of prudential requirements, including a liquidity requirement of 10 per cent and loan loss provisioning requirements similar to those applying to banks.

Finally, in Indonesia there is a range of small non-bank financial institutions, many of them supervised by provincial governments, which are empowered to accept deposits. These provide microfinance services.

In general, MFIs should not be permitted to accept deposits from the public unless appropriate regulations concerning capital adequacy, reserves, liquidity and reporting are in place. Accepting deposits from the public places a very heavy responsibility on any institution. As Berenbach and Churchill (1997, pp.58–59) argue:

. . . very few NGOs have the right management, financial discipline, information systems and profitability to be safe deposit takers. In addition, no institution should be allowed to take savings if its ownership and governance structure is not appropriate for that function. If an institution is capitalised with donor money and retained earnings, and therefore does not have owners in the traditional sense, then it is hard to justify the authorisation of deposit-taking services.¹

In all countries, it is clear that cooperatives are permitted to mobilise savings from their members for on-lending. However, in most cases the position of NGOs engaged in microfinance is somewhat ambiguous. Generally, regulatory authorities tend not to intervene so long as they mobilise savings from members only. In such cases, however, NGOs do not have a clear legal basis for accepting deposits, and there is always the possibility of sanctions.

This is best illustrated by the case of Sri Lanka. According to the law, NGOs in Sri Lanka are not allowed to provide any savings facilities. This applies to all deposits, whether from members or non-members, and includes compulsory savings that may be a pre-condition for obtaining a microfinance loan. Any such savings must be invested in a bank account, and cannot be used for re-lending by the NGO. In practice, the prohibition on mobilising savings has generally not been applied strictly. Indeed, major government programs such as the National Development Trust Fund (NDTF) and the Small Farmers and Landless Credit (SFLC) project have required NGOs borrowing from them to establish savings programs, and have encouraged them to use these savings in their credit programs. On the other hand, in 1992 the largest NGO, Sarvodaya, was prosecuted for mobilising savings and required to return all savings to members. It now mobilises savings only through independent primary societies, and these are not remitted to Sarvodaya itself. Clearly, the current situation leads to a great deal of uncertainty.

In the Philippines too, the legal situation with regard to mobilising savings from members is unclear. Under the Banking Act, NGOs are not permitted to accept savings and deposits in any form. Many NGOs are reported to have informal deposit-taking relationships with members, using devices such as accepting funds for ‘capital build-up’. Llanto et al. (1996) comment that this is skating on thin ice because of potential legal sanctions against this illegal activity. The legal situation is also somewhat ambiguous in a number of other countries, including Bangladesh, India, Indonesia and Malaysia. In Indonesia, inability to access capital resources through savings mobilisation is a factor in the movement by some NGOs to create rural banks (BPRs).

One country that has clarified this situation is Nepal, where the central bank has issued two types of ‘limited banking’ authorisations. In the first category two large NGOs have been authorised to accept savings deposits from both members and non-members, as discussed above. There is also a second category, whereby NGOs are permitted to mobilise savings from members. To date, 380 NGOs have been authorised under this category.

The question of savings mobilisation by MFIs is a difficult one for regulators. On the one hand, savings facilities provide a valuable service to clients, and can be important in reducing poverty. Requiring borrowers to demonstrate an ability to save before they obtain a loan is also a useful screening device and helps to instil borrower discipline. Just about all successful microfinance programs operate on the principle of ‘savings first, credit later’. On the other hand, mobilising savings places a very strong responsibility on an institution to ensure that the savings of poor clients are not at risk. Hence there is an inter-relationship between the standards applying to MFIs and the types of savings facilities offered.

In many cases, MFIs require loan-linked deposits or compulsory savings as a pre-condition to receiving a loan. CGAP (1996) argues that such savings should probably be thought of as part of the cost of the loan, rather than as true financial intermediation requiring public intervention to protect depositors. At any point in time, the vast majority of clients with compulsory savings deposits will also have loans, and will be net borrowers. As such, their savings are not at risk if the institution encounters financial difficulties. Such compulsory savings requirements are an integral part of many if not most microfinance programs. The law should be clarified to make it clear that MFIs are permitted to impose compulsory savings requirements. It would also seem appropriate to permit MFIs to use compulsory savings in their lending programs.

Some MFIs also offer voluntary savings facilities to their clients. Voluntary savings are a very important service, especially in areas where clients do not have access to any other formal savings facilities. In general, it would be appropriate to permit MFIs to accept voluntary savings from their members. Nevertheless, as noted above, accepting voluntary savings imposes a heavy responsibility on MFIs in terms of financial management. For these reasons, it would generally not seem appropriate to permit MFIs to use voluntary savings in their lending programs unless effective protections are in place. One option is to require MFIs to establish an earmarked account for voluntary savings with a regulated financial institution, with the MFI maintaining shadow accounts for each individual client. It should be noted that in Bangladesh, the Palli Karma Sahayak Foundation (PKSF) generally requires MFIs that borrow from it to keep members’ savings in a bank account, and only those MFIs with a good track record and high standards of financial accounting are permitted to use savings in credit programs.

As noted above, in all countries member-owned institutions following the cooperative structure are permitted to mobilise savings from members. Chaves and Gonzalez-Vega (1994, p.73) note that:

Regulators have tended to allow member-owned organisations to govern themselves to a greater degree than investor-owned banks, on the presumption that members will look after their own best interests. Although this is true to some degree, there are sufficient problems — as testified by the history of the credit union movement — to warrant outside regulation and supervision.

This suggests that it is also important to have a sound legal framework regulating the activities of the cooperative movement, and an effective apex body which is able to supervise the activities of individual credit cooperatives. As noted above, in most countries these conditions are not met.

In the case of community groups, CGAP argues that public supervision is both unnecessary and impractical for ‘community groups which accept voluntary savings from a few dozen members, who know each other and who control the group’s lending decisions’. In a sense it is debatable that supervision is unnecessary, in that such community organisations can and do experience financial difficulties. On the other hand, in most cases it is clearly not practical to monitor their activities or to restrict the uses to which they put members’ savings.

Establish simple, appropriate registration procedures for MFIs

In most countries, microfinance institutions (MFIs) are able to obtain registration under the general provisions applying to non-governmental organisations (NGOs) and cooperatives. The broad requirements, such as having a memorandum of association or some similar document and preparing an annual report and financial statements, are quite simple and should pose no problem to any well-managed MFI. The only exceptions to this appear to be Malaysia and Thailand, where the usual registration procedures for NGOs may not permit an institution to engage in microfinance. In these countries, governments should establish simple registration procedures suitable for MFIs.

Require registration for MFIs and ensure simple monitoring

Even though the requirements for registration are generally not onerous, in many countries they are not enforced rigorously. In some countries, this relatively lax regime may have enabled some unscrupulous operators to set up and take advantage of clients. NGOs engaged in microfinance should be required to be registered, and regulatory agencies should undertake simple monitoring of their activities to reduce the scope for fraud.

Remove unnecessary regulation of NGOs and cooperatives

On the other hand, in some cases MFIs are subject to unnecessary and burdensome rules and regulations, and the rules are not transparent. This is most apparent in the case of cooperative societies, especially in South Asia. Governments should review the regulatory requirements facing cooperatives, with a view to making them more independent of government, limiting the discretionary power available to regulatory agencies, and removing unnecessary requirements. Similar problems exist for NGOs in some countries, albeit to a lesser degree. In all cases, unnecessary restrictions should be removed, and the discretionary powers vested in regulatory agencies should be limited as much as possible.

Only two countries, Nepal and Thailand, impose general ceilings on the interest rates that MFIs can charge borrowers. In both of these countries, the ceilings are generally too low for MFIs to cover their costs. In fact, in Thailand this is implicitly recognised by regulatory agencies, in that they do not enforce the ceilings.

In other countries, there is no general ceiling applying to MFIs. However, this does not always mean that MFIs are free to determine their own interest rates. In a number of countries, there are ceilings on interest rates under government microfinance programs or as a result of various other actions by government.

Remove interest rate ceilings and other restrictive practices

All of these measures impede the development of microfinance on a sustainable basis. Countries that impose interest rate ceilings should either remove them or set them at levels that are consistent with the sustainability of efficient, well-managed MFIs. Other countries should examine policies designed to support microfinance, to ensure that such policies do not reduce the interest rate margins available to MFIs and make it difficult for them to operate sustainably.

Prudential regulation and supervision

In most areas covered by this study, the policy and regulatory environment differs substantially from country to country. However, in one area there is almost complete uniformity. MFIs which do not accept deposits from the general public are not subject to prudential regulation or supervision by a government agency in any country included in the study. There are also no compulsory reporting requirements designed specifically with the needs of MFIs in mind.

Do not introduce prudential regulation for MFIs

This lack of prudential regulation is appropriate. It is generally agreed that where MFIs do not accept deposits from the public, it is unnecessary to subject them to formal prudential regulation and supervision by a government agency. In most countries, there would also be significant practical difficulties in subjecting MFIs to prudential regulation and supervision.

Find ways to improve MFI performance and reporting standards

Nevertheless, it is clear that at present most MFIs do not have adequate standards. The challenge is to find cost-effective ways of improving the standards, in terms of both performance and reporting, of the large numbers of MFIs that are not currently operating on a sound basis.

Performance and reporting standards of second tier institutions

In those countries with second tier microfinance institutions, these institutions can play a very important role in developing standards for the microfinance sector. This role fits in well with their other activities. Moreover, such institutions have an effective mechanism for enforcing any standards that they develop, as any MFIs which borrow from them, or intend to borrow from them in the future, will need to meet the required standards. There is a broad range of experience to draw from in establishing appropriate standards, including the work currently being undertaken by Palli Karma Sahayak Foundation (PKSF) in Bangladesh and other second tier institutions in the region, and work being conducted under the auspices of ACCION International and CGAP.

Establish and enforce appropriate standards for MFIs to improve their performance over time

Standards should be based on results achieved, rather than the model used. They should have a proactive role in facilitating improvement in the performance of the microfinance sector over time. Countries with relatively undeveloped microfinance sectors may not be able to impose standards as rigorous as those imposed in countries such as Bangladesh. However, standards should be raised over time so that MFIs are gradually forced to improve their performance. It may also be appropriate to impose differential standards depending on the stage of development of the particular MFI, and to provide for progression from one stage to the next.

Enforcing standards is just as important as establishing them. This involves developing cost-effective methods for off-site and on-site supervision that are suitable to the operating procedures of MFIs. Standards should be developed through a process of wide consultation with MFIs, to ensure that they meet the needs of MFIs and are accepted throughout the sector.

Self-regulation

Another approach to establishing performance and reporting standards for MFIs is through self-regulation. Self-regulation may take a wide variety of forms, ranging from a voluntary code of conduct to which MFIs agree to adhere, to a rigorous licensing system administered by an apex body and backed by the force of law. The feasibility of various forms of self-regulation depends on a range of factors, including the extent to which there is a apex body that can represent MFIs as a whole, the quantum of resources available for monitoring and supervision, and the availability of incentives and/or sanctions to enforce compliance.

Reinforce self-regulation by MFIs through incentives

The Philippine Coalition for Microfinance Standards is the most important initiative for self-regulation in the region. Bangladesh and the Philippines have better developed networks of MFIs than the other countries in the study, but even here it is doubtful that the apex bodies have the necessary resources or authority to monitor individual MFIs regularly and ensure that they meet the agreed standards. Hence, systems of self-regulation may need to be reinforced with some legal or quasi-legal system of incentives or compulsion.

Encourage establishment of apex MFI bodies

Recent moves to establish apex bodies for MFIs in a number of countries should be encouraged, while appropriate arrangements should be put in place in other countries. MFIs should be encouraged to join these apex bodies and become active in their affairs, to ensure that they are well resourced and fully representative of the microfinance sector.

Savings mobilisation and deposit taking

In general, MFIs are not permitted to accept deposits from the general public unless they establish regulated banks, although there are several exceptions to this in the countries included in the study. Prohibiting non-bank MFIs from accepting deposits from the public is generally appropriate, as accepting deposits from the public places a very heavy responsibility on any institution.

In terms of mobilising savings from members, the position of NGOs engaged in microfinance is somewhat ambiguous in most countries. Generally, regulatory authorities tend not to intervene so long as they mobilise savings from members only. In such cases, however, NGOs do not have a clear legal basis for accepting deposits, and there is always the possibility of sanctions. One country that has clarified this situation is Nepal. The central bank has established ‘limited banking’ arrangements for authorising NGOs to accept deposits, and 380 NGOs have been authorised to mobilise savings from members under these arrangements.

While the question of savings mobilisation by MFIs is a difficult one for regulators, savings facilities provide a valuable service to clients, and can be important in reducing poverty. Moreover, requiring borrowers to demonstrate an ability to save before they obtain a loan is also a useful screening device and helps to instil borrower discipline.

Clarify right of MFIs to require loan-linked deposits or compulsory savings

In many cases, MFIs require loan-linked deposits or compulsory savings deposits as a condition to receiving a loan. Such compulsory savings requirements are an integral part of many if not most microfinance programs, and impose few prudential risks. The law should be clarified to make it clear that MFIs are permitted to impose compulsory savings requirements. It would also seem appropriate to permit MFIs to use compulsory savings in their lending programs.

Allow MFIs to mobilise voluntary savings with safeguards

Some MFIs also offer voluntary savings facilities to their clients. It would generally not seem appropriate to permit MFIs to use voluntary savings in their lending programs unless effective protections are in place. One option is to permit MFIs to mobilise voluntary savings from members if they establish an earmarked account for voluntary savings with a regulated financial institution.

In all countries, cooperatives are permitted to mobilise savings from their members for on-lending. To protect these savings, it is important to have a sound legal framework regulating the activities of the cooperative movement, and an effective apex body which is able to supervise the activities of individual credit cooperatives. In most countries these conditions are currently not met.